Economics to decide dollar peg shift

GULF WEEKLY

THE Gulf Co-operation Council (GCC) countries backing the dollar peg now would have to rethink their strategy if inflation got out of hand.

If the dollar drops further and Gulf currencies fall with it, the region will import more inflation from its trade partners in Europe, whose euro currency has surged to record highs against the dollar. Central banks cannot ignore popular sentiment and let rising inflation and falling exchange rates go unbridled for long.

Therefore, it will be finally economics and not political convenience that decides if the GCC will remain tied to dollar woes.

Except for Kuwait, which in May dropped the dollar peg in favour of a basket of currencies to ward off imported inflation, the remaining five GCC states have kept their currencies linked to the dollar.

They have agreed to keep the dollar peg until monetary union in 2010. By keeping the peg, the Gulf currencies have become undervalued against the dollar by about 20 to 25 per cent, according to estimates.

UAE’s official inflation rate for 2006 was 9.3 per cent, but international agencies place it above 10 per cent.

Analysts say the surge was caused by rent increases as housing supply fell short of population growth. In 2006, the annual inflation reached the highest level of 11.8 per cent in Qatar, followed by the UAE at 10.1 per cent, Oman 3.2 per cent, Kuwait and Bahrain three per cent each, and Saudi Arabia 2.2 per cent.

This year, inflation in Kuwait hit 5 per cent in the first quarter and in Saudi Arabia it increased to 3.1 per cent as food and housing costs climbed.

Serhan Cevik, an economist at Morgan Stanley, says the weaker dollar will worsen already high inflationary pressures in the Gulf countries.

Average inflation in oil-exporting economies in the Middle East has soared from 0.1 per cent between 1998 and 2002 to 6.5 per cent this year.

Imported inflation is becoming a bigger threat, as currencies pegged to the dollar keep weakening, says Cevik. Moreover, the abundance of petrodollar liquidity is going to continue with higher oil prices.

Inflation rates would not get corrected unless the authorities decide to revalue exchange rates, Cevik says.

The greenback fell almost 2 per cent against a basket of major currencies in the week after the Federal Reserve cut America’s short-term interest rates on September 18, hitting a new low for the post-1973 floating era.

The fall was particularly pronounced against the euro, where the dollar fell to a record $1.41 per euro on September 25.

Saudi Arabia’s decision not to follow the Fed’s lead and cut interest rates fuelled speculation that the oil kingdom was about to break its 21-year peg with the greenback. There was also the fear that a plunging dollar will fuel inflationary pressure in America and thus limit the Fed’s ability to cut interest rates further.

In Europe there are worries that a high-value euro will imperil the region’s growth.

With inflation rising fast in Saudi Arabia, the link to a falling dollar is causing a growing headache.

A revaluation against the dollar or, better, a link to a basket of currencies – similar to the one Kuwait now has – would make more sense.

But the Saudi government has denied that it plans anything of the sort. Its central bank governor repeated a commitment to the dollar peg on September 26.

More important, a change in Saudi Arabia’s currency regime—or that of other oil exporters—need not cause a dollar crash. Shifting to a currency peg does not mean a central bank would suddenly dump its dollar assets.

Bahrain too has reiterated that it would stick to the dollar peg. But if Saudi Arabia dumps dollar, then we might see Bahrain also following suit.

Considering the rate at which inflation is rising, the UAE looks the most likely candidate to revalue.

The European Union’s importance to the country has risen with imports increasing from 11.3 billion euros in 2002 to 26.4 billion euros in 2006.

The EU now accounts for close to 30 per cent of all imports to the UAE, while the USA accounts for only 11 per cent, according to EU trade statistics.

From 2002 to 2007, the exchange rate between the euro and the dirham has plunged by 28 per cent, making EU goods almost one-third more expensive.

Even for exports the dollar peg does not make sense. The US accounted for only 1.2 per cent of UAE exports in 2006 even as Japan bought 26.4 per cent of all UAE export goods in the same year.

Another major issue caused by the dollar slump is falling exchange rates, which is a major worry for the large expatriate population in the GCC countries.

While the nationals and expatriates alike feel the pinch of the rising cost of living, the expatriates face the risk of losing a significant share of earnings to inflation and currency volatility.

The Indian rupee has gained more than 14 per cent against the dirham from the beginning of the year. The exchange rate losses combined with domestic inflation have cut into more than one third of the earnings of Indian expatriates working in the UAE.

Most western expatriates have also suffered heavily from the dirham’s fall.

The GCC invests nearly 25 per cent of its oil revenues in dollar-denominated assets, according to a study by the Federal Reserve Bank of New York.

The euro would be the biggest beneficiary should the GCC shift reserves since the euro zone is one of the Arab region’s biggest trading partners.

Euro-zone exports to all oil producing nations, including those in the Gulf, had climbed $77 billion to hit $167 billion from 2002-2006.

Further adding to revaluation talk has been the dollar’s generalised weakness, which was exacerbated by the Fed’s recent rate cut. At $3.5 trillion, the currency reserves of the oil-producing nations are roughly three times the size of China’s, and their current account surplus of $500 billion is more than twice as high.

A diversion of even part of this financing base would further undermine the dollar, which has been hammered by the large and growing US current account deficit, analysts say.

Already, Qatar’s $50 billion sovereign wealth fund has cut its exposure to the dollar by more than half to around 40 per cent of its portfolio over the past two years.