By Nigel Dudley
As the global financial turmoil spreads to the Gulf, there is a growing realization among policy-makers that the region's position could be bolstered by monetary union
The heads of state of the six Gulf Cooperation Council countries – Bahrain, Kuwait, Oman, Qatar, Saudi Arabia and the UAE – will meet in November to talk once more about whether to push ahead with the idea of creating a single currency for the region.
Talk of a single regional currency has been around for at least two decades, but for most of the time it has never got beyond the starting post: it’s been just talk. But following a September meeting of finance ministers and central bank governors in Jeddah, the issue is back on the agenda – and prominently.
“We have an agreement on the accord to set up the monetary union and the monetary council as well as the basic structure,” says Yousef Hussein Kamal, Qatar’s finance minister, who chaired the Jeddah meeting.
If this is the case, and a framework for monetary union has been agreed, then the question goes, where to next? Talk of a timetable for setting up a single currency by 2010 is clearly ambitious – and possibly all the more so in that the first equivalent of an opt-out is in place. Oman decided in December 2006, after the GCC summit in Riyadh, which also discussed the issue, that it would not join.
The location of the central bank is also a thorny issue as are the political implications of monetary union.
The arguments for a single currency have been gaining ground. In part it’s a matter of independence. The recent turmoil on Wall Street and in global financial markets has begun to take its toll on the region, and the retraction of liquidity has already had a severe impact on the Gulf.
Although the region’s institutions have limited exposure to US banks and subprime assets, the loss of confidence across global markets leaves Gulf financial institutions exposed to the headwinds. Against this backdrop, there is a growing realization among Gulf policy-makers that the region’s position could be bolstered by monetary union – which could also eventually lead to a reserve currency, with the backing of oil assets. In heading down this route, the Gulf could help limit its vulnerability to the policy decisions made in Washington.
“We are beginning to see that if we don’t agree on these issues relating to monetary union, future storms may be more difficult to deal with,” said Kamal after the meeting between GCC finance ministers and central bank governors in Jeddah in September.
The economic case too is stronger than for some years. There are compelling economic reasons for a single currency as the commercial efficiencies and economies of scale should produce benefits for producers, traders and consumers.
The creation of a single currency would mean the elimination of intra-regional transaction costs and of the remaining – though limited – bilateral exchange rate risks. This should encourage trade and enable companies to set up a regional operation more easily.
Equally important would be more cross-border direct and equity investment from both Gulf and international investors. In particular, multinationals would see the opportunities in the regional manufacturing and services sectors because an enlarged single market would provide economies of scale and production efficiency. Moreover, customers would benefit from increased transparency in pricing, greater competitiveness and the reduced costs that would result in simplification of procedures.
Saudi finance minister Ibrahim Al-Assaf for one is not prepared to abandon the goal of GCC economic and monetary union just yet. “The benefits include, but are not limited to, harmonizing economic policies, reducing transaction costs, and levelling the playing field for domestic, regional and foreign investments. These benefits remain as relevant today as they have been before,” he told Emerging Markets. The political question
But the critical question now for the Gulf’s political leadership is, are they ready to seize the opportunity – although they implemented a customs union successfully in 2003, the GCC has not had a good track record for cooperation in its 30-year history.
That said, the economic data for convergence looks better than for a number of years. Ironically, the rise in inflation in Saudi Arabia – to more than 10% – has brought it in line with other Gulf currencies, and therefore all states now meet the condition that inflation must be less than or equal to 200bp above the weighted average of the GCC bloc.
The five aspirant members of the single currency in mid-September also meet the other criteria. These state that short-term interest rates should not exceed 150bp above the GCC average; that the budget deficit should not be higher than 3% of GDP; that total government debt should not exceed 60% of GDP, and each state should have foreign exchange reserves to cover at least four months’ imports.
One key advance at the Jeddah meeting was the agreement on forming a joint monetary authority, which will include a monetary council comprising the central bank governors, which will form the nucleus of the new central bank.
The council will be responsible for strengthening coordination between national central banks, determining the legal and regulatory framework for the new central bank, preparing for the issue of the new currency and overseeing the performance of national economies to ensure they continue to meet the convergence criteria.
According to Daniel Kaye, senior economist at the National Bank of Kuwait, one of the most significant elements of the document accompanying the Jeddah meetings is the statement that government bodies will be prohibited from issuing any instructions that would influence the central bank’s performance and functions. This, says Kaye, “establishes the principle of independence that will benefit the credibility of future monetary policy”.
The document also talks of the new bank’s need to pursue price stability subject to the optimal allocation of economic resources. Kaye interprets this as meaning that the bank would not be like the Bank of England or the European Central Bank and adopt explicit inflation targeting. “The new monetary authority sounds a lot more like the policy set-up in the US where the Federal Reserve has dual targets of price stability and economic growth,” he says.
Despite the progress that has been made, the toughest questions still have to be addressed: there has been no decision about what the currency will be called, where a new central bank will be based and who the governor will be. This will be a delicate political balancing act as there has to be a balance between respecting the rights of the smaller states and recognizing that Saudi Arabia is the most powerful state, accounting for half the GCC’s economy.
The Saudi Arabian Monetary Agency (SAMA) has over the past 30 years established a reputation as a robust controller of monetary policy. It has dealt brutally with speculators who have tried to manipulate the Saudi riyal market; it would not accept any structure that might lead to a weaker approach.
Decisions will also have to be taken on the new bank’s objectives, how it will implement monetary policy and the full extent of its independence. But perhaps the most sensitive decision of all will be the initial valuation of the currency.
In an interview with Emerging Markets last year, SAMA governor Hamad Al-Sayari underscored emphatically the depth of the region’s commitment to the dollar. “There is no change in [Saudi Arabia’s] exchange rate policy. You can discuss this further, but this is going to be my answer.”
Asked about the rate and severity of the dollar’s decline, which has intensified pressure on Gulf central banks in recent months, the governor said: “I am concerned about the stability of the financial system. What is most important is an orderly development which does not cause a disruption to the global economy.” He went on, “Maintaining a well-functioning global economy is in our interests as well as all other countries.”
Peter Panayiotou, acting chief executive at Gulf Finance House, puts the issue differently. “The reason that they [Gulf central bankers] refused to de-peg [their currencies from the dollar] was that they knew the dollar was oversold, and in their conversations with the Fed they must have been advised that dollar weakness was just temporary since it suited the interests of the US in the short term,” he notes.
When Emerging Markets asked Saudi finance minister Al-Assaf directly about the fate of the riyal peg, however, he sought to curb that perception with an unwavering stance. “The riyal’s exchange regime has served, and continues to serve, the economy so well, and there is no need for any change at this time. We have repeatedly expressed our views of no intention to change the parity. This view remains strongly valid.”
At present all of the currencies except Kuwait are fixed to the dollar with interest rates effectively moving in line with dollar rates – the exception is Kuwait, which recently reverted to its traditional valuation against a basket of currencies that was dominated by the dollar.“This policy provided Kuwait with more flexibility to reduce external inflation pressures associated with exchange rate developments,” Kuwait’s central bank governor Salim Abd al-Aziz al-Sabah tells Emerging Markets.
Yet with so much of the region’s earnings coming in dollars, because oil is priced in the currency, there is a case for retaining the current peg. But if the political decision were taken to price oil in the new currency, there would clearly be implications for any currency valuation.
According to Howard Handy, chief economist for Samba Financial Group, the decision about the initial exchange rate level is critical. Agreeing on a realistic starting point is an essential condition for its viability. “A currency union need not involve a fixed peg to the dollar, nor any other currency, and the project therefore also presents an opportunity to introduce a more flexible regime,” says Handy.
He says this would allow the central bank some control over interest rates – at present GCC central banks have little alternative but to follow dollar rates, even when domestic monetary conditions suggest a different interest rate policy.
“This would enable the central bank to manage domestic demand more effectively,” says Handy. “The end result would likely be more stable and predictable price growth, laying the foundations for sustainable, investment-led growth over the long term.”
Any such move would have massive implications for the region’s relationship with the US – and the final decision is likely to be as much political as economic.
But, if the five GCC governments are serious about the single currency, they are approaching a time when all these difficult issues have to be faced. Assuming the current momentum is sustained, a new central monetary authority could be in place as early as the end of 2009.
The time taken to establish the euro would suggest that it will require a significant number of years to set up the GCC’s single currency. But Kaye says that the process could be implemented a lot more quickly than the euro. The combined Gulf economy at $1 trillion is much smaller; cultural and historical links are much closer; and there is no need to negotiate complex opt-outs such as were required for the eurozone. He adds that institution building should be a lot easier as the GCC countries share a common language.
Ultimately the final decision to set up a single currency in Europe depended on political will. So too for the GCC – and it could be that the credit crunch and international banking crisis will concentrate minds in a way that nothing else has done since the project was tentatively re-activated in 2001.