from Follow the Money

Meanwhile, over in the (Arabian) Gulf …

May 21, 2007

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Kuwait decided to shift (back) to a basket peg, and in the process it allowed the Kuwait dinar to appreciate (though not by much) against the dollar.   Its central bank presumably bought a substantial quantity of dollars today to keep the Kuwaiti dinar from appreciating by more.  

Kuwait’s move isn’t a total surprise.  It always has been the GCC country least committed to the dollar peg.  Its investment fund already holds a relatively diverse portfolio.  It presumably thought all the GCC countries should have adopted a Kuwaiti-style basket peg rather than a Saudi-style dollar peg in the run-up to the GCC’s planned (but increasingly uncertain) monetary union.

Moreover, Kuwait’s initial move was rather modest.    Shifting to a euro/ dollar basket after the dollar has already depreciated substantially against the euro doesn’t accomplish much.     It protects the dinar from following the dollar down even further. But, if it is a true basket, it also means the Kuwait dinar wouldn’t appreciate along with the dollar if the dollar rebounds against the euro.   That isn't enough. 

Most of the oil-exporters need to appreciate against a euro/dollar basket - not just against the dollar.   After all, oil has appreciated substantially in real terms, and that usually implies over time a real appreciation in the currencies of the oil exporters.  If that appreciation doesn’t come from a nominal appreciation, it has to come from higher levels of inflation. 

It consequently shouldn’t be a surprise that inflation has picked up substantially in the Gulf – and in a lot of other oil exporters – as these countries started to use more of the oil surplus domestically, whether to finance more spending or more property investment.   

I don’t think Kuwait’s move goes far enough.   Kuwait would benefit from an exchange rate regime that allowed its currency to appreciate against a basket, not just a basket peg.   For more – a lot more – see my paper for the Peterson institute/ Bruegel institute/ KIIEP conference.    Or read something by Serhan Cevik

Still, not following the dollar down is a start.

And if Kuwait’s move prompts some of the other GCC states to reconsider their dollar pegs, all the better.   Real adjustment from high inflation -- with very negative real interest rates -- strikes me as rather risky. 

Up until know the Gulf states have insisted that any discussion of alternatives to dollar was off the table until after their 2010 monetary union.  But it is now pretty clear that the monetary union won’t happen in 2010, and it may not make sense to insist on following the dollar down between now and the time when the GCC is really ready to form a monetary union.   As Steve Brice of Standard Chartered notes, that time may not come for some time:

One of the criteria of monetary union was a common monetary policy. Now of course we don't have that … We didn't think the single currency was likely, at least by the 2010 deadline, and we are getting less convinced that it is going to happen at all.

It never really made sense, in my view, for oil-exporting countries with large external surpluses to tie their currencies so tightly to the currency of an oil-importing country with a large external deficit.

One of the ironies of Kuwait’s move is that it is, at least among the Gulf countries, perhaps the one that has had the smaller problems with inflation.   Its pre-2003 basket peg helped, as has its more conservative fiscal stance.    Kuwaiti inflation is no longer low (5.15% in q1) and is clearly rising, but it remains well below inflation in Qatar and the UAE.   It is a bit higher than reported Saudi inflation (3%).   But I don’t believe the reported Saudi numbers.   

There are also some intriguing parallels with China, the other part of the world economy with a really large external surplus and something close to a dollar peg.  

Both China and the GCC generally pegged to the dollar throughout the period of dollar weakness, and both are perhaps moving toward basket pegs.    Kuwait isn’t the Gulf, and China doesn’t really seem to have a basket peg – so the “perhaps” is important.   For different reasons – oil in the Gulf, a mix of capital inflows and a current account surplus that has risen even in the face of the oil shock for China – both have experienced rapid money growth, as an influx of foreign exchange hasn’t been fully sterilized.    Both have experienced a surge in domestic asset prices.   In China, housing surged before the stock market.  In the Gulf stocks surged before housing.   

Both now have very low – if not negative – real interest rates. 

And looking ahead both still have large external surpluses despite their domestic booms, and both are looking to invest that money aggressively.   Both soon will have placed money either in or with private equity funds.  China here is catching up with the Gulf …  more on that later.