Issue 845 - 16 January 2009

After the GCC’s Muscat summit, currency plan credibility hangs on acts, not words

Five country ratification is the first hurdle. Policy and structural detail will have to follow soon if markets are to take the GCC’s monetary union plan seriously.

This promises to be a crucial test year for the commitment of Gulf Co-operation Council members to their long discussed monetary union project. At December’s Muscat summit, GCC heads of state formally endorsed next steps for the scheme. Now they must clear the way for implementation, by ensuring that it is ratified at the national level. While few believe it is now practicable to introduce the planned new single currency at the beginning of 2010, there is a growing market expectation that GCC states need to rapidly finalise and publish the practical details, if they want the plan to be taken seriously.

The late December annual’s summit agreed on a final draft of the monetary union accord, and approved plans to set up a monetary council that should be the precursor to a new Gulf central bank. But this cannot be set up until the Muscat agreement has been ratified by each of the five participating states – Bahrain, Kuwait, Qatar, Saudi Arabia and the United Arab Emirates. Ironically, the summit host Oman is not joining in at this stage.

Leaders first decided on monetary union back in 2001, promising to complete the necessary legislative steps by 2005, in time for notes and coins to be issued in 2010. Governments later agreed a set of economic and financial convergence criteria, largely modelled on the European Union’s Maastricht framework. But little progress was made in finalising the actual plan for a currency, because of leaders’ reluctance to face up to the unavoidable sacrifices in national sovereignty that would be required for the project to become workable. They were slow to admit that a common central bank would be required and they have still not agreed on where it should be located, despite earlier assertions that it would be based in Abu Dhabi.

Several big hurdles were eventually overcome. In 2006, central banks governors agreed on the need for a common monetary council. At talks last September in Jeddah with International Monetary Find managing director Dominique Strauss-Kahn, GCC states accepted the need for decisive progress in integrating financial markets and building a common institutional structure. These decisions, reconfirmed at talks in October and endorsed by at the Muscat summit, signalled a new seriousness in their commitment to monetary union: they have now accepted the scale of the measures needed, while starting to think in practical terms about a timetable that is achievable.

Kuwaiti Finance Minister Mustafa Al-Shimali said at the summit that agreement had been reached on achieving monetary union by December, whereas the launch of an actual new currency was a “next stage” that could follow a separate timetable.

Fixed rates achievable

The achievement of the first basic stage of monetary union – fixed exchange rates between the participating national currencies – should be achievable by end-2009. All GCC countries are dollar-pegged except Kuwait, which abandoned that anchor in 2007, in favour of a basket valuation in which the dollar counts for 70%; the rest is shared among the euro and other currencies. Kuwait saw the basket as a better defence than a weak dollar against the inflation that was then surging ahead in the Gulf, but circumstances have since changed. Inflationary pressures have softened across the region, while growth has slowed sharply, thanks to the global downturn and subsequent plunge in oil prices; a lax US-style monetary policy is no longer inappropriate. This creates conditions in which, once again, GCC states can unite around a common stance.

Kuwait would have to abandon its basket. But with inflation easing anyway, it could now afford to do this, to secure the greater goal of first stage monetary union. And in any case, IMF research suggests that, in the dollar-weighted form adopted by Kuwait, the basket has been of only limited use in containing price pressures.

Given the strength of Saudi Arabia’s political commitment to the dollar peg, it seems most likely that initially the monetary union will start out by retaining the fixed link to the dollar. But in the longer term, governments will come under strong market pressure to move to full monetary independence, based either on a basket of currencies or on their own independent monetary policy, run by the new central bank.

The case for dropping the dollar peg

“The arguments in favour of a unified currency that is not based on a dollar peg are still pretty strong,” HSBC’s chief economist for Gulf markets Simon Williams told GSN. “We still see an argument for a flexible currency regime that could reflect oil price movements and also allow Gulf countries greater control over their interest rates.” Since early 2008, as inflation and growth have slowed, GCC needs have come back into synch with those of the United States as it maintains low interest rates. But that situation would not endure, Williams believed: “Now, following the [US Federal Reserve] Fed is not causing difficulties. But when we return to normal times, I expect that the monetary policy needs of the Gulf and the Fed will diverge again.” Moreover, it’s not just about monetary issues – fiscal policy also matters, Williams noted.

Oil is priced in dollars and the fixed Gulf/dollar peg therefore means that the full impact of energy price volatility is directly translated into local currency and GCC government revenues. During the oil boom, revenues soared, boosting revenues and creating an inflationary tendency for public expenditure to surge. Now, after the oil price slump, Gulf governments’ capacity to spend in local currency terms has been slashed commensurately. Williams argued that an independent exchange rate would moderate such volatility: at times of high oil prices, the Gulf currency would rise against the dollar, reflecting market confidence in the region but limiting the degree of excess government local spending power. And at times of oil price slump, the decline of the Gulf currency against the dollar would help to soften the blow, in state revenue and spending power terms.

Stronger dollar creates ‘false sense of security’

Gulf governments should not think that the dollar’s resurgence, and the easing of inflationary pressure, has spared them the need to face up to difficult decisions about the long term, believes Standard Chartered group chief economist Gerard Lyons. “The recovery of the dollar has lulled some people into a false sense of security,” he warned. With the inflationary pressures of recent times, the GCC countries have paid the price for their slowness in moving towards a common monetary policy independent of the dollar. “The whole region had too loose a monetary policy for far too long,” Lyons told GSN. “The last 18 months should be telling them that they should have decided on a single currency or a switch to a basket of currencies much sooner – perhaps two years ago – as the boom was gathering momentum. The lesson is that you need to have a currency or monetary policy that’s suited to domestic or regional needs.”

As it happens, the likely impending new decline of the dollar will suit the Gulf economies at a time of economic slowdown, Lyons said. And the immediate priority should be economic recovery rather than a fundamental rethink of monetary policy. But he feels that the fundamental case for a change in policy remains strong – and has been amply demonstrated by the inflationary impact of dollar-pegging during 2007 and 2008.

From words to action

The agreement to create a monetary council and the Muscat summit’s reaffirmation of the single currency plan, have now created a sense of expectation. The project’s credibility will be badly damaged if governments of the five participating countries fail to ratify their draft agreement by their end-December 2009 target date. Furthermore, Lyons said that countries also needed to take steps towards the deepening and the integration of capital markets. One key contributory factor in this regard will be the harmonisation of financial regulations and structures – a point made by Strauss-Kahn in last September’s Jeddah talks.

But GCC countries’ commitment will also look questionable if they fail to agree or publish the essential principles and details behind the proposed single currency – such as whether the planned central bank’s mandate will be limited to monetary stability or whether it will also include other goals such as sustaining non-oil GDP growth. Institutional development could probably move in two phases. Headline issues such as the location of the central bank – the subject of nationalistic rivalry for this prestige role – or the identity of the first governor will be less important than the principles governing its structure and operation. Both dinar and Khaliji (Gulf) have been suggested as possible names for the currency.

The Muscat summit adopted a monetary union accord that sets the legal and organisational framework, and it also reached an agreement on how the monetary council should be governed – which itself could be a pointer to the central bank’s eventual governance structure. However, the detailed content of these key agreements is not widely known to the markets. For example, it is not yet known whether votes on the central bank board will reflect simply the number of countries – so that Bahrain or Qatar each carry the same clout as Saudi Arabia – or if they will also be weighted to reflect population or GDP.

Monetary council

The monetary council is designed to carry out many of the technical preparations required before the bank can be fully established and the actual currency launched. It is modelled on the European Monetary Institute, the forerunner of the European Central Bank. But by the time the institute was set up, most of the key decisions about the future shape and operation of the new eurozone institutions had been settled; the institute’s relative lack of profile and political clout therefore did not matter. If the GCC states plan to emulate this example, they do not have much time to clarify their planned new council’s role.

A key test of their recognition of these practicalities will come in the middle of this year, when GCC secretary-general Abdelrahman Al-Attiyah said governments will finally select the central bank’s location. Dubai International Financial Centre chief economist Nasser Saidi said some departments will be hosted by different countries.

Observers have noted that the currency project will work to enhance the standing of the GCC as a regional group. “You’re talking about a trillion dollar economy, with immense foreign assets under its control, managing a very large proportion of the global energy supply. I think it would be a formidable economic block,” said Williams. Lyons was similarly upbeat: “The important thing is to view the single currency as a positive development and not as a defensive gesture. The world economy needs to be more balanced – and this means that capital surplus regions need to rise to the challenge and play on the world stage.”

For Williams, that is a reason for the Gulf countries to be self-confident in their planned new monetary policy, and not feel the need to remain tied to the US currency and policy stance. “They could start off with a dollar peg, and then move on.” But, he said, “In my view, this would be an ideal opportunity to adopt a more flexible currency regime, even if this is one of the factors that pushes back the launch of a single central bank a little way.”