Peg an anchor of stability for GCC

The new normal of low oil prices suggests challenging times ahead for fiscal balances in the Gulf Cooperation Council (GCC) region, and prompts the enduring debate on the sustainability of their long-standing pegged foreign exchange (FX) rate. To put things in perspective, the GCC is expected to post fiscal deficit of about 10.1 per cent and current account deficit of about 5 per cent in 2016 (Source: World Bank) as compared to the surpluses in the past.

Despite the low oil revenues and widening fiscal imbalances, the region’s central banks have successfully upheld the peg, aided by large accumulated FX reserves. However, these reserves in the GCC are being depleted in order to fund the budget deficit, which will eventually put some pressure on the central banks’ control over maintaining the peg. For instance, Saudi Arabia’s FX reserves, which stand at $562 billion as of August 2016, have reduced by about 15 per cent year-on-year and about 25 per cent over the last two years, primarily to fund budget deficit (Source: Bloomberg). This gives fuel to market speculation that the relatively weaker GCC countries would de-peg or devalue its currency to alleviate the pressure of fiscal imbalance and plummeting forex reserves.

Nevertheless, any imminent risk of de-pegging is mitigated by the GCC government’s expressed willingness and ability to maintain the fixed currency peg over the short to medium term. There are five strong arguments to advocate that the GCC countries will continue to maintain the peg.

Firstly, GCC countries have successfully maintained the fixed peg over several decades, in times of both high and low oil prices, which has served the region as an anchor for monetary policy stability. As a result, the economies have not developed an independent monetary policy framework for managing a free-floating currency. Additionally, any possible expectation of a peg adjustment could make the peg vulnerable to speculative attacks.

Secondly, a devaluation resulting from potential de-pegging can cause a sudden spike in inflation because of the higher cost of imports and FX pass-through effects. Given GCC countries imports about 90 per cent of food items, currency devaluation will have a substantial direct impact on the local population. The extent of FX impact can be drawn parallel to the recent de-pegging of the Azerbaijan Manat (AZN) in December 2015, which resulted in the AZN weakening by more than 30 per cent against the dollar within a few days.

Third, the GCC’s exports are relatively less diversified and mainly dominated by hydrocarbons, which are priced in US dollars. In this case, any currency devaluation would only have limited benefits to its export competitiveness. Consequently, the expected gains from currency devaluation to external and fiscal accounts would be short lived.

Fourth, the GCC countries (except Bahrain and Oman) have substantial FX reserves, Sovereign Wealth Funds and low debt levels, which enable them to fund their deficits over several years while maintaining the fixed currency peg; even during this prolonged period of low oil prices. For instance, Saudi‘s forex reserves stands at about 86 per cent of its GDP (2015) as of August 2016 and its Government Debt to GDP was only about 5.9 per cent in 2015.

Fifth, most of the GCC countries have initiated reforms to achieve fiscal sustainability, such as the introduction of Value Added Tax (VAT), subsidy cuts, opening up capital markets to foreign investors and other necessary steps to diversify the economy. This is expected to alleviate the pressure of currency de-pegging.

While maintaining the peg is the most advantageous choice for the GCC countries at present, the demerits of upholding the peg in an adverse environment can’t be ruled out. The case for de-pegging may gain prominence in an unlikely scenario of a higher than expected Fed rate hike. This would force the GCC policy rates to follow suit tracking the US monetary policy in order to maintain its peg; consequently impacting its growth in the process. In the present scenario, with a longer than expected dip in oil prices, the GCC countries must be prepared with a strategy that will allow a very gradual and well-administered de-pegging of their currencies. A smooth transitioning process should minimise the FX impact. While some countries such as Oman and Bahrain are more vulnerable given their relatively weaker fiscal profile, a cohesive deliberation and action plan by the GCC countries would be a positive way to address the pressure on its currency peg.

— Deepak Mutha, CFA, member of CFA Society Bahrain