Calls are growing for Gulf countries to revalue their currencies in order to stem a surge in inflation, as regional policy-makers wake up to mounting public discontent over rising prices.
“Given the decision to stick with dollar pegs, Kuwait excepted, higher inflation is inevitable,” said Charles Seville, associate director at Fitch, the ratings agency.
“The region’s increased oil wealth warrants an increase in real exchange rates, which can come either through a revaluation of the nominal exchange rate or higher prices, or a combination of the two,” he said.
Fiscal expansion, high real estate and food prices, tight labour markets, along with booming consumer credit and imported monetary easing from the Federal Reserve since September, have fuelled price pressures.
Inflation has hit double digits in Oman, Qatar and the UAE and is approaching 10% in Saudi Arabia. The IMF forecasts Gulf states’ consumer price index will average 7.1% this year, up from 6.1% in 2007.
The reduction in purchasing power has led governments to hike salaries and subsidies to ward off the political risks of price instability.
But the rationale for using exchange rate policy to combat rising prices is growing: in May last year, Kuwait dropped its currency peg to the weak US dollar to increase its flexibility in the fight against inflation. Kuwait’s move threw plans for a common currency among Gulf Cooperation Council (GCC) countries by 2010 into disarray.
Then in February this year, the executive president of Oman’s central bank Hamood Sangour Al-Zadjali – who announced in December 2006 his country would not join the monetary union project – argued that a cheap currency was helping to attract foreign investment and boost exports. These benefits greatly outweighed the risks to inflation, he said.
Economists remain divided. John Sfakianakis, chief economist at Riyadh-based SABB (formerly the Saudi British Bank) said revaluation in the near term is unlikely because the economic rationale for maintaining the currency peg remains strong: namely, dollar oil revenues. “They [Gulf policy-makers] look at the long term. They cannot just shift because they have more inflation, or because the dollar has just weakened,” he said.
Sfakianakis argued that the political costs would be too high. “They have been telling everybody for the past year that they are not going to revalue; if they were to do so, they would lose credibility.”
The governor of the Saudi Arabian Monetary Agency (SAMA) Hamad Al-Sayari has so far resisted calls for a revaluation of the riyal. In an interview with Emerging Markets last year, he said: “There is no change in [Saudi Arabia’s] exchange rate policy. You can discuss this further, but this is going to be my answer.”
While some economists are now calling for a one-off coordinated revaluation of regional currencies to ensure price stability, some are calling for amendments to the currency peg system now.
“I had expected Gulf states to move away from a pure dollar link earlier, once China began to do so,” Michael Spence, head of the World Bank-sponsored Commission on Growth and Development, told Emerging Markets. “I think these countries should base their exchange rates on trade-weighted baskets, like Kuwait.”
But Sfakianakis said that a public exchange rate move away from the dollar peg would risk destabilizing the currency at a time when confidence in the US currency is already weak; it could also undermine the economic alliance between Washington and the region.