GCC: Change Is Needed

TO PEG OR NOT TO PEG: Five of the six GCC states peg their currency to the U.S. dollar. Kuwait pegs its dinar to a basket of currencies.

GCC central banks need to bolster research to reform decades old dollar pegs

BY Martin Dokoupil

Oil-rich Gulf Arab states’ central banks lack adequate research capabilities to pursue a currency reform that could help them better control their economies in both harsh periods of low crude prices as well as in times of economic boom, says a senior Gulf central banker.

“I am not asking anyone to dream to have a vision, but I am asking the GCC central banks to build strong research departments to help them formulate visions,” says Khalid Alkhater, a former member of the GCC Technical Committee for Monetary Union where he represented his country, Qatar.

Since the 1980s, most of the six Gulf Cooperation Council members (GCC) have linked their currencies to the U.S. dollar to tackle highly volatile economic fortunes by giving up their monetary policy independence in favor of stability imported from abroad.

No economic challenges such as high inflation coupled with unprecedented speculative attacks on the GCC pegs prior to the global financial crisis, nor the recent plunge in oil prices to 12-year lows, have swayed the long-repeated mantra of the region’s central bankers that the currency pegs served them well and there was no reason for change.

But while arguments for keeping the pegs have weakened over the past decade as economic paths of the United States and the GCC have diverged, the region’s central banks were left behind without adequate economic research to look at the alternatives, according to Alkhater.

“They are technically not ready because they lack the required research and human capital infrastructure and they lack them because of the peg. So it is like a vicious circle, and this can lead to the fear to float,” he adds.

“The peg may give false perception of relief of responsibility for inflation as it may be used as an excuse that central banks can’t fight inflation. Therefore, it is much easier and more convenient to cling to the peg rather than risking conducting an independent monetary policy and being responsible for its outcomes, including inflation,” he says.

Alkhater, who has long been advocating the exchange rate policy reform in the GCC, says that his remarks represent his personal research-based academic view as a monetary policy specialist.

The GCC economic cycle fell out of sync with the United States over the past 15 years. Maintaining the peg has become less efficient and more costly, and has put GCC policymakers under the pressure to mirror the U.S. Federal Reserve’s decisions even if economic trends at home called for the contrary.

According to Alkhater “the macro-policy framework under the peg has failed to deliver price stability during the boom period and income stability during high, and now during low oil price periods.”

“With monetary and exchange rate policies stripped off and a reactionary pro-cyclical spending policy, it rather tends to aggravate the cycle through unnecessarily deepening and prolonging recession in a low oil prices period and causing economic overheating and inflationary pressures during a high oil prices period,” he adds.

Qatar, which adopted a currency peg after gaining independence from Britain in 1971, had questioned merits of the peg eight years ago.

In 2008, the Emir’s adviser Ibrahim Al Ibrahim called for the peg to be abandoned as Qatar reeled under a record 15 percent inflation. But as capital flows dried up in the global crisis, the Qatar central bank was able to break free from tracking unprecedented U.S. interest rate cuts.

In 2013, Qatar Central Bank Governor Sheikh Abdullah bin Saud Al Thani said that the country may change its peg when the economy becomes less dependent on hydrocarbons and local financial markets deepen.

When the Fed hiked interest rates for the first time in nine years last December to reflect its belief in the strength of the U.S. economic recovery, four GCC countries—Saudi Arabia, the United Arab Emirates, Kuwait and Bahrain—copied the move, raising their policy rates by a quarter of a percentage point. Qatar and Oman stayed put.

Only Kuwait pegs its dinar to an undisclosed basket of currencies of its major trade partners rather than the dollar directly after ditching the peg in 2007. However, analysts believe that the basket is heavily dominated by the greenback.

With their currencies pegged, the Gulf countries have to watch the size of the interest rate gap with the U.S. rates as they could face potentially destabilizing capital inflows or outflows. With low oil prices dragging down economic activity in the region, future interest rate rises in the United States could further dent the GCC growth.

“Now, with the U.S. economy recovering the Fed is likely to continue to raise interest rates, but the GCC countries are slowing down due to lower oil prices which is expected to persist in the medium to long term. The potential implication would, again, be a policy conflict reinforcing the slowdown and contributing to further economic contraction as the GCC central banks will follow the Fed as they have always done historically,” Alkhater explains.

The International Monetary Fund expects this year’s growth in the GCC to range from as low as 1.2 percent in the region’s top economy Saudi Arabia, to 3.4 percent in liquefied natural gas powerhouse Qatar with the Saudi clip the worst performance since its 2.1 percent downturn in 2009.

A flexible exchange rate would allow the GCC countries to absorb shocks that are not possible to under the hard peg, Alkhater notes, adding that a strong negative correlation between oil prices and the dollar during the past decade negates the claim that pegging to the dollar would ensure a stable stream of income and price stability.

“A superior arrangement that would deliver a higher level of price and revenue stability would be to peg to oil prices within a currency basket such as to minimize volatility of oil revenues in terms of the local currency,” he says.

Alkhater adds that currency depreciation during the low oil price period means relatively higher oil revenues in the local currency, to stimulate growth, and consequently less pressure than necessary on other sources of revenues, including sovereign wealth funds and taxes; while currency appreciation during oil boom period would help to contain imported inflation, and better anchor expected inflation, all needed in the overheating period.

“The more we delay (the reform) the higher price we pay in terms of cost and benefit of not implementing the appropriate monetary policy for our domestic economic needs,” he says.


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