For more than three decades, GCC economies have benefited from having their currencies anchored to the US dollar. In that time, the US dollar peg has served the region well, providing monetary stability for investors, traders and businesses alike. But structural changes in the economies of the region, including the re-alignment of trade and investment ties towards Asia, make it reasonable to consider reform proposals.
GCC central bank governors attending the 72nd meeting of the GCC Committee of Governors of Monetary Institutions and Central Banks in Muscat in March 2019 were clear about the challenges faced in the “new oil era” sparked by the oil price downturn in 2015.
That year, the region registered its largest fiscal deficit, as governments imposed the first spending cuts in 20 years, giving a new impetus to efforts to prepare for the post-oil era.
While GCC states were able to defend the US dollar peg through their robust level of foreign reserves, volatile oil prices and shifting trade patterns raise questions about the costs versus the benefits for the region of maintaining the US dollar anchor, and whether this regime continues to be well-suited to the needs of economies implementing an economic diversification agenda.
Time for change
Being tied to US monetary policy has deprived policymakers of an essential tool to take countercyclical measures – ie, dampen inflation and prevent excess investment and trade surpluses when oil prices are high, and the opposite when oil is low – and may harm non-oil sector competitiveness in the long term.
In monetary policy, the choice of currency anchor should reflect trading relationships as well as the currency composition of public debt.
Since GCC debt levels are generally low, it is the structure of trade relationships that counts.
In its 2008 study ‘Why do countries peg the way they peg? The determinants of anchor currency choice’, the IMF stated that it is “optimal for a country to adopt the anchor currency that minimises the sum of bilateral exchange rate volatilities, weighted by the importance of each trade partner”.
Rise of Asia
The re-alignment of GCC trade patterns, particularly towards Asia, needs to be considered when weighing the benefits and costs of the current regime.
More than two-thirds of Saudi and UAE imports were sourced from Europe and Asia in 2016. Asia supplied 39 per cent of Saudi imports, a 10 per cent increase since 2000, and accounted for 40 per cent of the UAE’s imports. North America meanwhile accounted for 15 per cent of Saudi imports and 12 per cent of the UAE’s.
Similarly, more than half of exports for both economies were directed to Europe and Asia, while North America barely registers as an export market, at 3 and 4 per cent respectively.
As for energy exports, 68 per cent of Saudi Arabia’s oil exports went to East and South Asia, and the Asia Pacific region, while for the UAE 99 per cent went to those regions. By comparison, the Americas accounted for 16 per cent of Saudi oil exports and only 0.8 per cent of the UAE’s.
While this Asian dominance of GCC energy exports may seem surprising, Asian countries have much fewer regional oil supplies to draw from.
This is in contrast to Europe, which sources a large part of its energy needs from Russia, Norway and North Africa, while the US imports close to 45 perc ent of its oil from neighbouring Canada, in addition to producing for its own needs.
While it can be argued that oil exports are denominated in US dollar and the dollar remains essential in any GCC exchange rate regime, trade flow analysis suggests that the yuan and the euro should not be ignored. One of the consequences of not including them becomes clear when one considers inflation.
When exchange rates are prevented from adjusting in the face of unexpected capital inflows or outflows, adjustment can only take place through prices.
In the case of the GCC, a sudden spike in the price of oil and resulting capital inflows can lead to significant increases in inflation, while a drop can lead to deficits and capital outflows.
High inflation or deflation are never good for an economy and are why nearly all major commodity exporters – Canada, New Zealand and Norway – allow some fluctuations in their exchange rates, and practice inflation-targeting using interest rates. Norway for example, implements a crawling band against the US dollar to manage oil price fluctuations.
In the run-up to 2008, as oil prices peaked, GCC states struggled to contain inflation, which reached 12.3 per cent in the UAE and 9.9 per cent in Saudi Arabia. The chart below shows how closely inflation in the region follows oil prices.
Inflation is only one outcome of being pegged to the dollar in the boom phase of capital inflows. Increased government and private spending, financial and real estate bubbles, and higher levels of imports, which also feed inflation, are other consequences. Having some exchange rate flexibility during the boom phase can help absorb inflation, while raising interest rates can discourage excess spending and asset bubbles.
The problem with the peg is that GCC states are unable to utilise interest rates to manage the domestic economic cycle. A particularly fatal combination was in the years leading to 2008 when low US interest rates coincided with high oil prices, leaving policymakers with their hands tied. Similarly, following the 2015 oil downturn, GCC states would have benefited from continued low interest rates to boost economic activity, yet US interest rates were on an upwards trend until late 2018.
In May 2007, Kuwait reintroduced a basket peg of the dollar, the euro and possibly the yuan (the official composition of the basket is undisclosed) and regained control over its interest rate. Tying its currency to that of its main trade partners in Europe and Asia has allowed for better management of inflation, as the exchange rate adapts to movements in the three major currencies.
The following chart shows the smooth progression of monthly inflation in Kuwait from 2015 to 2019 against a composite index of oil prices and the yuan-dollar exchange rate compared to more sporadic movements in Saudi Arabia and the UAE, where prices react more directly to movements in oil and the yuan.
|Kuwait, Saudi Arabia and UAE monthly inflation against index of oil and yuan-dollar exchange rate, 2015-2019Composite index of oil price and yuan-dollar exchange rate (left axis) and consumer price index (right axis)|
To understand this in practice, when the yuan strengthens against the dollar, imports from China become more expensive in AED and SR-terms, as the UAE and Saudi are pegged to the dollar, resulting in imported inflation. These are described as “pass-through” effects in economics.
Economist Nasser Saidi, a member of the IMF’s Middle East Regional Advisory Group, argued in 2018 that the dollar anchor was “no longer appropriate for maintaining macroeconomic stability” and suggested the adoption of a basket peg composed of the dollar, the euro and yuan, adjusted over time to reflect changes in trade, GDP and financial ties.
Anchoring to these three major currencies provides an equal level of credibility as being pegged to the dollar, while enabling the economies to better navigate the imported inflation problem. Crucially, a basket regime would also enable GCC central banks to exert better control over interest rates and the domestic economic cycle.
Another approach, developed by Harvard economist Jeffrey Frankel, would be to include the weighted average price of oil in the basket peg, alongside the three currencies, what he calls a ‘commodity-plus currency basket’.
While this approach is interesting, allowing domestic currencies to quickly adapt to oil price movements, it is untested and may prove too unstable for GCC currencies.
Abandoning such a long-standing element of monetary policy should not be done in haste. Reforming the exchange rate regime in favour of a three-currency peg, for example, would require GCC states to implement important policy reforms. This includes establishing a stronger inflation forecasting capacity, as well as enhancing tools to intervene in money markets.
None of these reforms are beyond the capabilities of the GCC states and given the realignments that are taking place in the global economy, would also serve to boost the non-oil sectors they are seeking to develop.
About the author
Samer Srouji is a director at Tanmia Capital consultancy and is pursuing his PhD in economics at the Universite Cote d'Azur in France
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