Calls to scrap the GCC’s fixed relationship with the dollar have to reckon with the alternatives.
May 1, 2006 | Gulf News | Andrew Shouler
https://gulfnews.com/business/sectors/features/to-peg-or-not-to-peg-that-is-the-question-1.235046
If you are invited to a presentation about corporate ethics hedging, it may take you a moment to grasp the concept. Since ‘ethical investment’ has become an established term, the phrase actually trips off the tongue. However, I’m glad to say it didn’t sound right when I heard it down the telephone. It suggested something implicitly like the route to an Enron-type result. Even if a company wanted to ‘hedge’ its ‘ethics’, would there be anyone proudly advertising such a service, let alone a well-known and reputable institution?
Better, of course, to hear clearly what you’re being told. Corporate FX hedging is the name of the game, and Standard Chartered Bank is talking that book. The much-awaited US dollar slide may be under way, and there is business to be had in offering protection against such foreign-exchange risk exposure.
That’s not the most interesting bit of the bank’s recent research report, however (in case you were wondering). It’s not even the second most interesting bit which, to me at least, was the forecast of the British pound falling even against a falling dollar over the course of the year. (The idea that the UAE dirham might still rise against sterling makes dollar-equivalent earnings less troubling to a British expat.)
And, on an infinitely bigger scale, that is the kind of issue which is the real story. It’s about not only risk, but real returns, to the Gulf countries as a whole.
Standard Chartered Bank recommends that the proposed GCC single currency should de-peg from the US dollar. It is not alone in that. The Dubai Chamber of Commerce and Industry implied as much in an economic bulletin a year ago, saying that floating would allow independent policy-making and avoid the same fate as the dollar.
The Gulf Research Center in Dubai has been discussing the issue on and off for some while.
Indeed, many have wondered aloud on this topic, while not all committing to a verdict. But the bank has repeated it, again, and argued a case.
Decision
If such a decision came, it would undoubtedly be a bold step, with significant implications. The currency itself may still be some way off, with occasional rumours that the 2010 deadline is in doubt. Yet, though timing is undoubtedly important (and especially so if the problem to be resolved is here and now), that’s actually not the key point.
Why, in fact, suggest such a radical step for a region whose currencies have mostly been pegged to the dollar for decades, which has not been especially troubled in doing so, and indeed now appears to be flourishing?
The bank’s reasoning, amid its carefully-defined research, boils down to two points, both easily accessible.
First, it is not in the best interests of the Gulf countries for their currencies to go down with the (apparently) sinking ship which is the dollar. While exports are mostly dollar-denominated, imports are substantially in other currencies, which would therefore become more expensive. That’s clear enough, leaving aside for the moment the incendiary topic of whether oil should continue to be priced in dollars.
Second, running domestic monetary policy in line with US policy (i.e., setting interest rates in parallel to the US Federal Reserve) always runs a risk, namely that the policy stance is inappropriate (too lax or too tight) for local conditions. The trade-off between the confidence generated by the fixed relationship on the one hand and policy inflexibility on the other is the core conundrum, and an increasingly live issue now, when interest rates seem considerably too low for the Gulf’s rampant economies.
They explain it further. The decline of the dollar against the euro through 2000-2004 increased the GCC’s import bill. The subsequent decline against Asian currencies too, projected to continue, represents a further “threat to the bottom line”. That currency mismatch applies also to budgets, where revenues are also mostly dollar-denominated, but spending frequently is not.
At the moment, whereas the dollar peg brings useful certainty vis-à-vis the dollar, with the hydrocarbon sector still so dominant it means that the impact of oil-price fluctuation is imparted fully to the real economy. Some form of currency float would allow the exchange rate (and interest rates) to take some of the strain.
Theme
Moreover, “Forex diversification is likely to become an increasingly important theme going forward” at the global level, so that having 90 per cent + of reserves in the dollar “is not necessarily appropriate any more”. A couple of diplomatic euphemisms there. In layman’s terms, if Asian central banks, Russia and others are going to flee the dollar, it may be better to be with them rather than trying to hold the fort.
“We believe the dollar is overvalued, and therefore could be subject to a significant correction,” says Standard Chartered. While that forecast appears cannily hedged itself, the warning is clear. The recommendation is that the planned GCC currency “should be marked against a trade-weighted basket instead”.
At one level, the logic is compelling. The idea that the Gulf region selling oil lucratively at $70 and in huge surplus should be tied to the dollar, with America in chronic deficit and buying expensively at the same price, does have a ring of absurdity about it. But is it as simple as that?
Stepping back, a barrage of advice has come over the years from the IMF (the same IMF which last week called for dollar devaluation). The outcome, however, has been inconclusive. While agreeing that a more flexible exchange rate policy may become desirable as the GCC economies become more diversified and integrated with world markets, it has generally found that a trade-weighted basket peg would be no better than a dollar peg in procuring stability, and the flexibility versus credibility debate becomes no clearer, though a euro/dollar combination may offer a reasonable alternative.
At the Gulf Research Center, economist Emilie Rutledge seems more convinced. As the “GCC’s economies are maturing and diversifying rapidly” the current inability to set their own monetary policy “is far from optimal”. Additionally, “as a longer-term investment the euro looks more promising than the dollar”.
She raises the further matter of the creation of a single GCC currency (the ‘Gulf dinar’) itself creating downward pressure on the dollar, as the oil-producing countries will invest more at home instead of (as previously) in dollar assets. The dinar may itself attain reserve status, especially if oil were priced in the same terms, though there would be “political disquiet” from the US in that event which is another understatement.
It should all give further pause for thought.
Wouldn’t the GCC states be prejudicing the value of their own existing reserves if they (effectively) acted against the dollar, whether by diversifying their assets, depegging, or pricing oil differently? In an environment of very high oil prices, could it actually be done without serious revaluation, which would jeopardise emerging non-oil activities and, ironically, call for (entirely inappropriate) lower interest rates? Not pegging risks the GCC tent being blown about by a potentially storm-force wind.
Standard Chartered Bank’s analysis suggests that flexibility will be manageable. The authorities could still offset current account inflows by capital outflows (though less into dollars), and would simply have to judge whether the exchange rate or interest rate were their priority.
So there it is. I’m not entirely convinced, but perfectly well accept that the GCC may have outgrown the peg. Meanwhile, it’s worth remembering that no exchange-rate regime on its own delivers a definitive economic framework. Fiscal control and structural matters remain beasts which have to be tamed for a successful, overall strategy.
Also, we are still talking about 2010. By my calculation, that’s getting on for four years away.
The dollar might still be ‘weak’ and the euro ‘strong’. We cannot know. But, won’t the markets have moved on a bit by then?
On the practical side, the European Central Bank is offering the GCC states advice, and their technocrats are probably among the least objectionable of the EU’s infrastructure. Whether the euro will appear in the policy mix is then an intriguing issue. Europe does not have much call for an even higher dollar exchange rate, but it does like gestures denoting prestige.
There’s another idea I could mention. If the GCC is on the lookout for another possible fix, like a ready-made US dollar & euro basket, it could consider a fairly heavyweight international currency which already fits that description. Despite the fact that it has been threatened with expiry, including by ministers and (almost hysterically) by so-called experts in its own country, it’s been around a very long time and it still works. It is far less volatile historically than either the dollar or the euro (see chart), because its balance of payments is relatively evenly exposed to both. You may even have heard of it. It’s called sterling: the British pound. Snag is: Standard Chartered do say it will fall faster than the dollar. Maybe. Anyway, it’s just a thought.
QUOTE
Hany Genena, Senior Economist, EFG-Hermes
Of course, de-pegging would imply appreciation of all GCC currencies. In 2005, the combined current account surplus of the six GCC states is estimated at approximately $160 billion, with net foreign assets in the banking system (excluding reserves accumulated in stabilisation funds) at approximately $260 to $300 billion.
With a positive outlook for crude oil prices over the medium term in addition to capital inflows, all GCC states will have significant appreciation pressures on their currencies. There is an important point to note here, though.
If the bulk of foreign currency inflows is channelled directly to central banks or stabilisation funds and re-invested abroad, then appreciation pressures could be mild.
De-pegging GCC currencies will not likely have a negative impact on the USD. Since GCC countries do not have enough investment opportunities domestically to absorb petrodollars, they will continue to find their ways into US Treasuries even after a revaluation.
In addition, unlike the case of China, currency revaluation in the GCC will not imply a decline in exports and a decline in accumulation of reserves, since crude oil exports are denominated in USD and are not sensitive to exchange rate movement. In fact, an appreciation of the GCC currencies could help resolve global imbalances by making US imports cheaper and reducing the deficit.
A shift in the demand for the USD by reallocating reserves, however, could indeed de-stabilise it. An outright exit from the USD by global central banks could indeed lead to its collapse. The cost of [the resulting] abrupt shock to interest rates in the US could be large. It could indeed lead to a global slowdown. I think that most GCC countries will opt towards a gradual shift in reserves.
Simon Williams, Senior Economist, Economist Intelligence Unit
De-pegging does make sense [for the GCCs], to run their own monetary policy. The inflationary situation at the moment throws that into very sharp relief. A lot of preparation would need to be done, including stopping pricing oil in dollars. Otherwise it risks compounding the volatility of the local currency value of oil revenues. The authorities would also have to guard very carefully against the kind of substantial appreciation pressures that there would undoubtedly be at the moment if the currency were floating.
Steve Brice, Regional Head of Research, Standard Chartered Bank
The key here is for the region to do what is best for the long-term sustainability of the region’s economic performance. We believe that authorities still have time to diversify reserves quietly before the new single currency comes into effect.
Forex reserves in fact are not the issue. The bigger issue is the investment agencies who are clearly large even in a global context. They would likely be discreet in their diversification efforts. However, the impact on the value of the dollar would be there for all to see.
[The interest-rate, exchange-rate trade-off] is a real challenge for the region, especially when taking into account the need to diversify the economies in order to create jobs for the hugely-expanding labour markets. In the short-term, this may create a conflict between managing the boom (higher interest rates) and help boost the diversification process (by ensuring a competitive currency). Clearly, the situation would need careful monitoring and managing.
On the issue of what currency to price oil in, we see no reason why an alternative currency/ies could not be used. If the GCC countries were to pursue a trade-weighted exchange rate target, then imagine the UAE, for instance, exporting to Europe. This would mean the importer would need to hedge its euro/dollar exposure and the UAE exporter would have to hedge its dollar/GCC exposure. Why not transact in either the GCC single currency or euro, which removes the need for one counterparty to hedge?
If [oil pricing] were in euro, the UAE would be able to naturally diversify its reserves away from a structurally weak dollar. Alternatively, it could price oil in dirham, and then make a rational investment decision as to what to do with that money.
Pierre Cailleteau, Senior VP, Sovereign Risk Unit, Moody’s
We do not make recommendations, but I am not entirely sure whether a change of policy would help fix the problem. I don’t really see an alternative regime that would be superior. If you have a flexible exchange rate, and it rises with capital inflows which create higher credit and inflation, then interest rates are raised, then the exchange rate rises again ? [It is a vicious circle.]
Practically, it may be better to endure the peg. It is the price paid for a less-than-perfect policy regime [like any]. Any country with high commodity dependence has this issue. In the case of Norway or Canada, the ratio is lower than here. The UAE [and GCC] are a special case, with a huge exchange-rate ‘overshoot’ and ‘undershoot’ possibility. In any case, it is unwise to shift from a fixed system to flexible without the rest of the policy framework and banking system being ready. Change could mean GDP would become even more volatile.