Gulf monetary union: Dollar peg versus a basket of currencies

JEDDAH, 16 December 2002 — The GCC has lately assigned the preparation of the common Gulf currency to the European Central Bank (ECB) in what is considered a serious attempt to speed up the process of the currency union. The Gulf is looking forward to benefiting from the ECB’s considerable experience, during the previous years, in preparing for issuing the common European currency, the “euro”. Without a doubt, the experience of the ECB tremendously exceeds that of the Gulf, due to the fact that it has been through the actual experience. In the last two years, and after surpassing numerous political and economic obstacles, the ECB has succeeded in issuing the euro, which has vastly contributed to the development of international financial markets. The Gulf countries, in turn, have to interact with the new economic facts and the market forces recently established by the euro.

On the long term, establishing a Gulf monetary and economic union would be worthwhile and ideally suited to the member countries’ needs at this age of regional alignments and globalization. Issuing a unified currency as expected by the year 2010, however, has to be supported and accompanied by a strong political vision. The economic structures of the GCC countries are remarkably similar, still predominantly dependent on oil as the main contributor to GDP. In addition, most Gulf currencies are pegged mainly to the dollar — Oman directly pegs its riyal to the dollar, while Saudi Arabia, Qatar and the UAE peg their currencies to Special Drawing Rights (SDRs) — but they also maintain a fixed exchange price for their currencies against the dollar, Kuwait pegs its dinar to a basket of currencies, and this linkage to a common currency should in turn facilitate the convergence into a monetary union in the future.

However, to the extent that dollar is coming under pressure by the euro while Gulf countries remain sensitive to oil prices, here arises the question of the dollar peg sustainability. In the short and medium terms, it is perhaps suitable to peg the Gulf currencies’ exchange rates to the dollar, as the Gulf’s foreign currency reserves are still at a high level, which enables them to offer a full coverage for their monetary supply (M1). The foreign currency reserves of GCC countries have grown over the last two years due to higher oil prices. In the long term, however, the continuous pegging of Gulf currencies solely to the dollar would perhaps put them under pressure from various factors, most important of which are:

1) Fluctuations due to lower oil prices, as in 1998 when the average price for an oil barrel reached $12.7, which reduced the GCC’s oil revenues and thereby exposed some of their national currencies to speculations.

2) Political tensions in the Gulf and the Middle East region and its negative impacts on the economy, as happened after Sept. 11.

3) Lagging process of diversifying the economic structure of these countries, as the contribution of private industrial sector is merely 7 percent of GDP.

The recent structural weakness of the dollar if it continues is likely to put an additional pressure on the common Gulf currency if it were to be denominated solely by the dollar. Therefore, pegging the common Gulf currency to a currency basket based on trade volumes with the major partners would provide GCC countries with another alternative to the US dollar pegs, to meet the economic and demographic challenges in the long term. Even if the dollar was the predominant currency in the basket, this would still increase the flexibility of the common currency’s exchange rate. It would also be more in accordance with the structure of global trade in these countries, and would better equip them to face the structural economic changes. Finally, the currency basket would help the GCC countries avoid the negative impacts of both fixing or floating their currency, especially after the Asian crisis proved the failure of a fixed exchange rate in an open economy and complete capital freedom.

The oil revenues in the GCC countries are still priced by the dollar, and therefore most of the foreign currency reserves in their central banks are denominated in dollar, which is not expected to change over the short term. Having the GCC countries’ currencies pegged to the dollar has been economically beneficent in many ways, as it has helped to keep inflation rates at low levels (averaging 0.8 percent in 1999 — 1.7 percent in 2002), which in turn has maintained a stable environment for investment and high living standards. It has also strengthened the GCC countries’ trading power and its monetary credibility over the last few years.

Meanwhile, it is expected that other currencies, especially the euro, will occupy an important place in the foreign currency reserves of the GCC countries, in their attempt to diversify their financial assets, which would be a long term strategic decision. Europe, the United States and Asia were the most important trading partners of the GCC countries in the last few years. The United States’ trading volume with the Gulf has diminished lately, however, while those of Europe and Asia have increased. It is thus expected that the GCC countries’ need to pay for their imports in euros will increase, as the volume of these imports increases and the confidence in the euro grows over time. Therefore, it might be relevant to the GCC countries to increase their euro reserves, which they gain from their exports to Europe, so as to avoid the risks of foreign exchange price fluctuations. In addition, the euro has become a global currency, and is now considered the second supporting currency to the international financial system after the dollar, hence it is expected to play an important role in the GCC countries’ economies. The East Asian currencies (with the exception of the Japanese yen) could also be included in the currency basket to which the common Gulf currency would be pegged, since these countries have floated their currencies since 1997, and their trading volume with the GCC countries has increased.

Some might argue that establishing a Gulf monetary union is perhaps a purely political decision as some tend to believe, however in addition to the political advantages, there are a number of economic benefits that could be reaped from that union if it was established on sound foundations and a concerted and effectives effort from the member countries. The most important of these economic benefits are:

1) An increase in the capital flow among GCC countries. A citizen from one Gulf state could get a loan from a commercial bank in another Gulf country if the liquidity is not available in his mother country, especially since this will be preceded by unifying of interest rates within the Gulf Union.

2) Encouraging the mergers between commercial Gulf banks. The total sum of the biggest 25 Gulf banks’ assets is $258.7 billion, which is still less than the value of one foreign bank like Citigroup who’s assets are valued at $1 trillion. By merging, Gulf banks could become more efficient and profitable, thereby strengthening their ability to compete with international banks coming to the region as most GCC countries join the WTO and to finance investment ventures and companies, which will in turn support the common currency in the foreign exchange market.

3) Unifying monetary policies of member states would boost confidence in the exchange rate price of the common currency and lessen the risk of currency speculation, so that if the foreign currency reserves of one member country decrease due to a budget deficit, then the reserves of the other members would lessen the pressure.

4) The GCC countries will attempt to unite their monetary policies and control their budget deficits so that it will not exceed a certain percentage of their GDP. The percentage of the accumulative public debt to GDP is now more than 100 percent in Saudi Arabia, 40 percent in Oman and 20 percent in Kuwait. The GCC countries are currently suffering from the burden of the public debts on their economies and the decreasing ability of public sectors to service these debts and finance future infrastructure requirements. These countries should, therefore, follow more stable and sensible monetary policies that aim to increase the ratio of domestic investments to their current expenditures in order to maintain the stability of the common currency.

5) Encourage privatization and diversification of the economic structure to increase economic growth in member countries, thereby diminishing the risk of speculation on the common currency. Privatization, however, would require support and financing from commercial banks. And if the member countries continue to depend on local banks to finance their budget deficits, this would hinder the development process and constrain the commercial banks’ ability to finance investment projects of the private sector, (what is economically known as the crowding-out effect).

6) Facilitating trade exchange between member countries, and lessening the costs which individuals and companies bear due to the difference between buying and selling prices of foreign currency exchange. This would encourage trade between the member countries, and promote economic growth.

7) Uniting the currency would stabilize the monetary and economic environment, making the region more attractive to foreign investment. This is something that GCC countries badly in need for, especially in the field of in infrastructure financing.

8) For a Gulf monetary union to be established, member countries must adopt common and effective legal and judicial regulations for their banking and credit policies. In addition, they must develop their capital and investment laws.

9) Increasing the diversity of foreign assets in investment portfolios of the GCC countries, thereby encouraging the growth of their reserves and avoiding fluctuations in their common currency. Kuwait and the UAE, for instance, are considered the best in managing their official foreign assets (Kuwait has what is known as Future Generation Fund, while the UAE has its own UAE Investment Fund). The monetary union could also further encourage cooperation and the exchange of expertise between member countries, in order to vary their investment portfolios and increase their revenues.

Finally, if the project of Gulf monetary union is established, it would seriously encourage further cooperation between the member countries in the fields of economic, political and corporate reform.