Gulf not ready for currency reform

Dubai: A sinking dollar, soaring inflation and US interest rate cuts may appear to make a convincing case for Gulf currency reform, but the oil producers are not quite ready to tinker with their dollar pegs.

Concerns over the future of their dollar assets, fears about what a move would mean for their alliance with Washington and questions over how effective any new currency regime would be in controlling inflation are causing central banks to tread softly.

With Gulf states preferring to act together on currency policy as they prepare for monetary union, investors betting on revaluations could have to wait a year or more before they are vindicated.

"I don't think that change is imminent," said Simon Williams, regional econ-omist in Dubai at HSBC. "Some states may be persuaded by arguments for change but I don't sense that they are on the brink of acting."

Speculation that Saudi Arabia and four neighbours would ditch fixed-exchange rates has been mounting since Kuwait severed its dollar peg last May to contain inflation.

Since then the case for currency reform has only grown stronger.

The dollar has extended a record-breaking slide on global markets, plunging more than 16 per cent against the euro and almost 13 per cent against a basket of major currencies since Kuwait's May 20 move, driving up the cost of many Gulf imports.

Inflation

Inflation has surged across the region, almost doubling in five months in Saudi Arabia to a 27-year high of 8.7 per cent in February. And Gulf central banks have been cutting interest rates to deter bets on currency appreciation as the Federal Reserve slashed borrowing costs by three percentage points since September to stave off recession.

With more Fed cuts and dollar weakness looming it is little wonder investors expect Gulf pegs to crumble in months. Forward contracts showed investors expecting the Qatar riyal and UAE dirham will rise 4.2 per cent and 3.3 per cent in a year.

"There have been several arguments made against a revaluation. However, we do not find them compelling and we dismiss them," Standard Chartered Bank said in a March note.

"We view rising inflation as the biggest risk to achieving sustainable growth. Monetary policy needs to tighten," said the bank, which expects Qatar and the UAE to revalue as early as April.

Compelling as the case for reform may be, it is not that simple.

For one thing, the dollar peg is only one strand in a web of diplomatic, economic, political and security interests that bind the Gulf oil producers to the United States.

The Gulf states share Washington's suspicion of Iran, including of Tehran's nuclear programme.

After Al Qaida leader Osama bin Laden, battling to overthrow the US-allied Saudi monarchy, criticised dollar pegs as "unjust and arbitrary" in a December video, economists said the Gulf's commitment to pegs could strengthen.

Even if there were no political overtones to currency reform, any attempt by the Gulf, with its $1.2 trillion in state funds and reserves, to shun the dollar, could deliver a kick in the teeth to a US currency battered by a flurry of bad news.

"They cannot act in a way that is negative to the dollar," said John Sfakian-akis, chief economist at Riyadh-based SABB Bank, an HSBC affiliate.

"The United States provides security to the region and that does not come at zero cost. Iran is a huge factor and they are all scared because all of them are exposed," Sfakianakis said.

Investments

Besides, the bulk of the Gulf state funds are probably invested in US assets. Anything that hurts the dollar would also hurt the Gulf.

Then there are concerns about whether any new currency regime would help contain inflation, driven in part by a surge in state spending of record oil and gas revenue.

Achieving consensus on any spending restraint in the UAE, a federation of seven highly autonomous emirates, will be difficult, said Malcolm D'Souza, head of treasury at the National Bank of Ras Al Khaimah.

"The central bank is watching the situation but it may not have the power to do anything," he said.

There is fear of change. Governments still see the pegs as a source of stability. Saudi Arabia fears currency fluctuation would deter investment when it is wooing foreign capital to create jobs, the vice central bank chief said last month.