Thursday, 8th March 2018

Defences waver of currency pegs that served GCC states well

Currency pegs to the US dollar have been a central element of the Gulf Co-operation Council (GCC) states’ economic stability since the late 1970s, when Bahrain, Qatar and the UAE led the way. By 2003, the six GCC economies had all turned what started out as a de facto policy into an official one, although Kuwait subsequently diverged from the pack in 2007 by pegging to an unspecified basket of currencies (albeit dominated by the dollar).

The system has generally worked well, providing a level of exchange rate stability governments may otherwise have struggled to maintain and greater certainty over the value of revenues from their principle exports of oil and natural gas. But a currency peg does not guarantee exchange rate stability across the board. The currencies of Bahrain, Oman and Saudi Arabia have all been depreciating in the currency forward market – a sign that traders are pricing in a possible devaluation in the near future, or at least taking account of the higher likelihood of that happening in a climate of sustained fiscal pressure and regional political instability.

The real effective exchange rate of many GCC currencies – the weighted average of a currency against a basket of others – weakened by between 4% for the Bahraini dinar and 7% for the Saudi riyal last year, according to Oxford Economics senior economist Maya Senussi. There have been further losses this year and Senussi expects the trend to continue. That isn’t enough to warrant any changes to the fixed exchange rate regimes now in place, which remain a good option for the GCC states; but it does highlight the fact that policy-makers’ ability to support the pegs varies markedly.

The lower oil price environment since June 2014 has seen governments accumulate an estimated $353bn in fiscal deficits, $76bn in current account deficits, $270bn in foreign-exchange reserve losses and a reduction of $213bn in sovereign financial net worth. There has been a collective sigh of relief since mid-2017 when the oil price started to rise again, but the current price of around $64 a barrel is still far below previous highs and well under the fiscal breakeven price for four of the six GCC countries – the exceptions being Kuwait and Qatar.

In most cases, the assets held by governments are still more than adequate to support their currencies, but Bahrain looks weak according to almost any analysis and Oman is vulnerable. This is important because, as Brookings Doha Center and Qatar University joint fellow Luiz Pinto points out in a paper published in mid-February, “a currency event in one of the GCC states may have a contagion effect on others”.

One solution to offset these risks, Pinto suggests, is greater regional financial co-operation – although he acknowledges that is difficult (and perhaps impossible) to achieve in the current climate, in particular with regard to the dispute between Qatar and the GCC-3 of Bahrain, Saudi Arabia and the UAE. The Qatari economy has stabilised from the initial shock of trade and transport links being severed with its three opponents in June 2017, according to the International Monetary Fund, but its search for new trading partners has seen its links to half the GCC bloc markedly reduced.

Despite the diplomatic stand-off, Pinto says the GCC ought to consider setting up more formal liquidity support facilities to help its weakest members and prevent any financial crisis taking root. This should go beyond existing support mechanisms, which tend to be ad hoc, to encompass bilateral surveillance and monitoring mechanisms which could provide early warnings of a possible economic shock. Over the medium-term, a network of swap agreements could be arranged to help Bahrain, Oman and others if and when they experience balance of payments problems.

To get around the Qatar issue, rather than attempt to set up a GCC-wide arrangement that would likely fail, Pinto suggests countries start with other arrangements to strengthen policy dialogue, information-sharing, co-ordination and, ultimately, liquidity provision. One option could be to split the GCC into two groups, with a weak member in each supported by the two others stronger economies. Under this scenario, Qatar could only conceivably pair up with Kuwait to support Oman, while the other natural grouping would be Bahrain supported by Saudi Arabia and the UAE.

There are good reasons for doubting whether all parties would sign up to such a mechanism. It could entrench the Qatari economy’s separation from other parts of the bloc and reinforce the sense of a two-tier GCC. This could hasten the GCC’s demise, which is regularly forecast despite the bloc’s record of pragmatic resilience. In the meantime, there may be some positives from the process of weakening currencies. Oxford Economics says the UAE stands to gain the most, as its economy is less reliant on oil export revenues than GCC neighbours. It calculates that a 3% gain in UAE competitiveness will boost non-oil goods exports by 0.7% in 2018-19. However, Bahrain and Oman will see far lower gains and Kuwait would be likely to miss out entirely. Weakening currencies also make imports more expensive and will feed in to inflationary pressures already apparent from subsidy cuts, the introduction of new taxes and rising US interest rates.

Further regional support will be needed in some form for the weakest economies. The question is whether the richer GCC states can set up a formal arrangement or will continue with ad hoc measures.

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