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14:22 2006/07/22
GCC currency peg to dollar poses risk to monetary union
By Santhosh V Perumal
DOHA: GCC countries??™ currency peg with the greenback have long been taken for granted, thus increasing the risks for not hedging against a potential removal of the USD-GCC peg, according to a study.
Besides, the biggest threat for the GCC ??“ whose critical issue is who calls the shot in monetary policies once the common currency evolves by 2010 ??“ will be currency reform delays, said the ???Middle East Focus??™ of Standard Chartered Bank.
Such delays could curtail the political freedom to pursue independent monetary policies in the GCC, which has extreme growth amid rising inflation, Standard Chartered Bank regional head of research (Middle East, Pakistan and South Asia) Steve Brice said in the study.
???The GCC currency pegs have been taken for granted in the region for many years with most policymakers stressing their benefits rather than the weaknesses,??? he said.
This confidence in the pegs has led many corporate treasurers and finance directors to focus largely on the USD-Europe and USD-Asia currency risks and the outlook for the US interest rates, he said.
???Therefore, in most cases, these activities have not hedged any USD-GCC risk, either in terms of the direct exchange rate implications or more importantly the risk that local interest rates could deviate significantly from those in the US,??? Brice said.
The typical interest rate hedge, he said, therefore has been to protect the local currency floating interest rate exposure through USD interest rate swap (IRS).
The key assumption underpinning such behaviour is that the USD peg will remain for a foreseeable future but ???it is being increasingly called into question,??? he said.
While Saudi Arabia continues to stress that its riyal??™s peg to the USD will remain at 3.75, in the past one month officials from the UAE and Kuwait central banks have indicated that an alternative model may be more appropriate once the GCC single currency comes into being.
Noting that the USD pegs are not expected to be removed ahead of the single currency, Brice said: ???There are increasing risks from not hedging against a potential removal of the USD-GCC pegs and the associated divergence in local and USD interest rates.???
???If the single currency was to be introduced today and the USD pegs were to be removed, the pressure would be for a stronger currency and higher interest rates, a costly scenario for those hedging via the USD IRS,??? Brice said.
The primary reason for such a scenario is due to the fact that growth in the region is ???extremely strong??? and inflation is picking up in many countries, he said.
In this environment, he said there are two appropriate policies - either to raise interest rates or allowing the currency to appreciate.
If interest rates are hiked, it can reduce the incentive to spend for slowing the economy and reducing pressure on capacity constraints and thus inflation, he said.
Instead, if currency is allowed to appreciate, it could reduce imported inflation pressures.
???Meanwhile, the natural pressure on the currency, with oil prices so high and the 2006 current account surplus for the region expected to be 31% of GDP, is for it to appreciate in any case,??? he added.
Observing that by 2010 the situation become less clear in terms of outlook, Brice said the monetary policy needs at that point will depend on the region??™s stage of the economic cycle.
Finding that a lot needs to be decided since the region is gearing up to forming a single currency, he said ???the key political issue is likely to be who will be responsible for monetary policy decisions.???
???Will it be based on the one country-one vote system of European Central Bank or will it be GDP-weighted such that Saudi Arabia gets nearly 50% of the voting rights and therefore dominates the central bank??™s policy decisions,??? he said.
Naturally, Brice said, the latter is unlikely to be acceptable to smaller nations and such leads to a real risk that the single currency project is delayed or even shelved together and ???some have even suggested that a single currency area without Saudi Arabia is possible.???
If the single currency project is abandoned, then some of the more proactive discussants (including Kuwait, the UAE and possibly Qatar) of exchange rate policy will pursue currency reform anyway, he said.
???The biggest risk to the currency reform outlook would be continued short delays to the project, which would reduce the political freedom for countries to move independently,??? Brice said.
Citing that Kuwait revaluation of its currency by 1% has ???upset??? the region, he said if a country were to change the floating exchange rate system, it would ???cause lot of political problems and could even derail the single currency project.???
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