Revaluation call getting louder

Last month, US Treasury Secretary Henry Paulson visited Saudi Arabia for his first official trip to the Gulf countries to stress US openness to GCC-based investment as well as highlight the dangers to economic growth from surging oil prices.

With much talk and speculation about the Saudi riyal's revaluation or depegging versus the greenback, the visit provided Paulson an update on the kingdom's fixed exchange rate.

The visit comes on the heels of the US Treasury's report to the Congress on International Economic and Exchange Rate Policies as well as calls by some financial firms to GCC countries to revalue their currencies.

Earlier in April, GCC officials agreed to strengthen their efforts to establish a currency union by 2010, diminishing speculation on a quick change in the dollar pegs. The latest Treasury report highlights rigidities in the GCC currencies, specifically Saudi Arabia's, and represents a modest change in focus, which some analysts believe represents a big signal for the GCC currencies. Paulson reiterated the official US stance that currency policy is a sovereign decision and pegs in five GCC countries have served these countries well.

Robust outlook

With global oil prices hovering at $125 per barrel, Saudi Arabia's short-term economic outlook looks robust. Domestic recycling of the country's oil windfall through government spending will remain high throughout this year, with rising government subsidies. Real GDP growth is projected to accelerate to 6.5 per cent in 2008 and then to slow marginally to 5.7 per cent in 2009, from 4.0 per cent in 2007.

Rising inflationary pressures have become a major concern in Saudi Arabia as well as many other countries in the region. According to the latest data, consumer price inflation in Saudi Arabia reached 9.3 per cent in March, up from 8.7 per cent year-on-year in the preceding month.

Dollar-pegs in five of the six GCC countries lead their respective central banks to match US interest rate moves. Last year in May, Kuwait de-pegged from the dollar to a basket of currencies; the dinar has since appreciated by some 7.70 per cent against the dollar. Saudi Arabia, Bahrain, Oman, Qatar and the UAE have so far turned down calls for an adjustment to their exchange rates. At a time when the US dollar is weakening, the peg has reduced purchasing power for goods denominated in other currencies.

Depegging dilemma

Saudi economic experts believe Gulf countries, especially Saudi Arabia, may revalue their currencies against the US dollar or peg them to a basket of currencies. The basket could include the dollar, euro, yen and pound sterling. "It's about time Gulf countries, especially Saudi Arabia, move to a dollar de-peg and head towards a basket of currencies," said Osama Filali, professor of Economics at King Abdul Aziz University.

There is now growing consensus among the media and general public that the solution to the inflation problem lies in breaking the link to the US dollar completely or realigning the exchange rate at a higher value. So far, Saudi authorities have resisted rising political pressure for such moves, arguing that the impact of the local currency revaluation on inflation is small.

Given the severity of inflation and the weakening of the dollar, calls for a revaluation are getting louder. Although adjusting the peg would not address the underlying causes of inflation (which are primarily domestic in nature), it would have significant adverse impacts, and is probably the most effective way of reducing inflation in the short term. Will there be a de-pegging or a revaluation? This question remains to be answered.

- The writer is executive vice-president (investment management), Morgan Stanley Saudi Arabia.