Typically, the topics in the business section of a newspaper in the Gulf Cooperation Council (GCC) region almost always focus on issues such as the budget, deficits, subsidies, investment, etc. Meanwhile, a publication in the US will dedicate more time towards speculating on the Fed’s imminent actions. Global financial markets gyrate to every move made by the Fed and hence are constantly trying to guess what its next one is likely to be. The GCC spends most of its time on fiscal issues since it has effectively outsourced its monetary policy responsibilities to the US Federal Reserve and therefore they are compelled to mirror the Fed’s policies regardless of its domestic economic underpinning. Fortunately, for most part of the arrangement, this worked reasonably well with business and economic cycles of the US and GCC being roughly synchronised. Additionally, strong oil prices throughout much of this period enabled GCC governments to build reasonable reserves, which also thwarted any occasional challenges which would pressurise the pegged currencies.
However, the recent drastic fall in oil prices and oil revenues (on which the budgets are heavily dependent) and the near unanimous consensus of the new low oil price reality going forward has changed that scenario. Given the high and growing break-even oil price (the oil price required to balance the budgets), GCC governments will now either have to draw down on their reserves at a faster rate or resort to borrowings to fill the gap. Being modelled as welfare economies, the restructuring process to rationalise subsidies and stop providing pseudo-employment in the public sector can be painfully slow. Hence, GCC governments will focus on reducing their role as the main investor in their respective markets and dedicate resources towards diversification strategies. The private sector will be encouraged to play a larger role in this diversification effort, especially in sectors such as health care, education and transportation where the government is currently forced to commit significant funds and capital. Also, research and innovation will rightfully be granted a higher priority as it can quicken the transition from public to private sector-based economies. As the shift happens, maintaining a positive business environment will take precedence over government expenditure. Improvements in ease of doing business ranking will have to be achieved in swift time as the economy faces liquidity shortfalls, increase in cost of capital and higher risk premium.
In such a scenario, where government spending and employment will reduce and private sector led diversification process takes centre stage, an outsourced monetary policy model may be counterproductive and costly. The ability to set short-term interest rates in order to manage domestic cost of capital and inflation will become important in order to orchestrate the transition. Monetary policy independence would be a necessary requirement for this to be possible. Otherwise, a pegged currency dictated by US monetary policy, where the interest rate curve may be sloping upward going forward, can create serious frictions in the GCC’s low economic growth environment.
GCC monetary policy independence is also warranted in an environment where the Fed is running out of ammunition. According to The Economist, in the three most recent US recessions the Fed slashed rates by 675 bps, 550 bps and 512 bps respectively. However, what is interesting to note is the time taken for rates to return to normal levels. The Fed took 2.5 years and three years to return to normality in the first two recessions respectively. However in the most recent recession of 2008, it is eight years and counting. Should another recession occurs, the Fed will not have the necessary tools at its disposal. It is generally opined that long-term problems which are enveloping in the global system like low economic growth, deflationary concerns and lack of business confidence cannot be solved using the Fed’s short-term monetary tools. For a variety of factors, sooner or later, the Fed will lose its role as the financial market’s sole saviour. Such factors include the fact that its short-term interest rates have already hit rock bottom, an inability to move back to normal rates for a long stretch of time and the long-term nature of many problems that the Fed do not have resources to provide solutions with.
It is therefore time for the GCC to have an independent monetary policy framework like its fiscal policy framework. Such monetary independence will provide the GCC with the ability to set short-term rates and help guide the capital allocation process more cost effectively. It will also enable better control of inflation and will reduce friction in a challenging low growth economic environment.
— M.R. Raghu, member and a founder of CFA Society Kuwait