Passing the buck

The recent Muscat meeting of GCC leaders has breathed new life into the commitment to unify Gulf currencies by 2o1o. It remains unclear whether the new currency will actually be in circulation by then, and key questions like where the central bank will be located still have to be answered.

Among those is whether the new Gulf currency will be pegged to the US dollar. In recent years, this issue has aroused passions among academics, financiers and governments.

The International Monetary Fund (IMF) and European Central Bank have weighed in on the question as well. On one side, some argue that the GCC should continue the dollar peg.

On the other, opponents are ready to move to another regime. A peg to the euro gets some votes but a more likely and desirable outcome is a basket of currencies.

In 2001, anticipating unification, GCC leaders mandated a dollar peg to stabilise the relationship between the region's currencies. As a result, Gulf currencies are now formally tied to the dollar (Kuwait which in 2007 converted to a currency basket is the exception).

The dollar was the logical choice. Not only was the greenback the dominate world currency, but Gulf economies were already closely tied to it since oil prices have been denominated in dollars since the 1970s. Gulf currencies have had a de facto dollar peg for decades.

Another advantage was the dollar's historical stability. This was a key consideration because economists cite financial stability during economic shocks as the most desirable feature of an exchange rate. Economic shocks are an enduring feature of oil-dominated economies like those in the Gulf.

The IMF points out that a pegged currency is par for petroleum-based economies. Nations in the Central African Economic and Monetary Community (Cemac), Brunei and Ecuador all have fixed pegs.

Other oil producers like Russia, Algeria and Kazakhstan allow their currencies to float but only within a restricted range. The conclusion the IMF draws from this is that it's hard to juggle foreign currency exchange when an economy is being whipsawed by a dominant export commodity.

But few people contest the argument that the new GCC currency should remain pegged or at least managed float. The question is pegged to what?

The IMF concludes that in fact the dollar peg has helped insulate Gulf nations from both economic as well as geopolitical shocks.

The implication is that Gulf economic stability is attributable, at least in part, to the peg. It further notes that "these risks are likely to continue, placing a premium on a credible US dollar peg."

Both points are arguable.

The dollar peg is credible for two reasons, says the IMF. First, it has historically been stable and dependable which keeps inflationary expectations low and provides some certainty about exchange rates.

Moreover, economic data suggest that the United States and Gulf economies are to a large extent synchronised and over time have become more so. In fact, this 'cyclical synchronicity' - regarded by some experts as a measure of peg appropriateness - is one of the highest among nations.

Second, the IMF argues, why reinvent the wheel? Institutions that cater to dollar exchange are well developed and so the peg is "easy to administer."

Building institutions for another currency peg would be hobbled by weak regional capital and credit markets. Capital market strength spills over into trade as well because the dollar makes it easier to hedge commercial transactions.

This is important for emerging non-oil industries that are diversifying regional economies and helping insulate them from oil price shocks. Those emerging industries need investment capital and capital flow is nourished by exchange rate stability.

Exchange rates do not function in isolation, but are closely tied to economic factors like inflation, interest rates, reserves, fiscal balance, and public debt. With the dollar peg, Gulf nations had - in the words of the International Monetary Fund - "imported monetary discipline."

Finally, some believe that no more financial stability could be achieved with a euro or basket than with the existing dollar peg. The dollar has served the purpose well and would presumably continue doing the same in the future.

The dollar peg has disadvantages, even the IMF admits, and the recent financial crisis has thrown them into sharp relief.

By tying to the dollar, GCC countries have been following American monetary policy which, the IMF says, "may not be appropriate for local needs." While this downside may have been manageable in the past, the recent financial crisis has increased the pain to potentially intolerable levels.

Real danger lies in the extremeness of current American monetary policies. Washington bureaucrats are frantically trying to restart the stalled economy's engines by flooding capital markets with liquidity.

President-elect Barack Obama has already made it clear that he will redouble efforts to stimulate the American economy. The growing fear among some observers is that this liquidity tsunami will trigger massive inflation in the future.

Such policy overreactions are not uncommon in American politics. But the magnitude of the current crisis and its global reach may have blown the response out of proportion. Some believe that the real global economy has underlying strength despite current crunch-induced recessions in many countries.

The staggering economic problems faced by the United States - with or without a financial crisis - leave real doubts about the ability of the government to maintain a stable dollar in the future.

Doing so would force legislators and policy-makers to implement domestic economic policy decisions that would be highly unpopular with the US electorate.

Downward pressures on the dollar continue to be significant. A cheaper dollar would allow American goods and services to be more competitively priced in the global market. The voluminous US debt would be easier to digest if foreign creditors could be repaid with a devalued dollar.

Thus if the criterion for a foreign exchange regime is financial stability, then GCC leaders must be wondering about the wisdom of tying the new Gulf currency to the US dollar in the post-Bretton Woods era.

This and other factors have led some critics to argue that the new GCC currency should by tied to an alternative currency with the euro as the obvious choice.

But the cost of switching from one currency peg to another makes little sense since no real benefit would be obtained. The decision boils down to either continuing the dollar peg or moving to a managed float regime.

Managed float has significant advantages. One is that it would provide a two-way cushion. The impact of economic shocks at home would be softened by ties to another currency. The fluctuation of the peg currency would in turn be muted by the ability to float the exchange rate.

This is the path China has taken. In the past, the yuan was pegged to the dollar but now floats within a managed range. This testifies to the importance Beijing leaders still place on the American market and also its concerns about massive Chinese investments in American assets including US government securities.

However, the next step in the progression would be to implement a managed float against a basket of currencies rather than a single currency.

In fact, the Dubai International Financial Centre recently advocated a basket comprising 45 per cent US dollars, 30 per cent euros, 20 per cent Japanese yen and 5 per cent British pounds.

The IMF notes that research suggests that a basket would be unlikely to improve financial stability over a single currency. Still the basket approach is appealing for a variety of reasons, some political as well as purely economic.

Indeed, the GCC has always contemplated this scenario.

According to the Gulf Cooperation Council, "the Supreme Council provided for pegging currencies of GCC member states to the US dollar at the current stage, leaving it for the GCC Common Monetary Authority, after introducing the single currency, to choose the appropriate pegging to one or more currencies or floating it depending on the requirements and conditions of the next stage" of economic unification.

Does that mean the choice of a peg was a 'done deal' years ago? Doubtful. GCC leadership simply believed that the time was not ripe to make that decision.

The current financial crisis and the recent instability of the US dollar have, in retrospect, made this an exceedingly wise move.

Rod Monger writes on economic, business and political issues.