A butterfly in the desert

Recently a one-day decline in the Chinese stock market led to a succession of reactions, which continue to reverberate around the world's financial markets.

It's an example of the so-called 'butterfly effect', the theoretical notion that a minor event in one location can lead to major consequences elsewhere.

The Gulf region's foreign exchange markets are seeing their own version of the same phenomenon.

Yet, here the butterfly of regional currency fluctuations is caught in the net of official intervention. Once it is freed, however, the implications for those markets will be wide-ranging.

Much has been made about the recent increase in Gulf Cooperation Council (GCC) currency volatility, akin to the flapping of this butterfly's wings. While it is a sign of the times, it is nevertheless important to put these fluctuations into context, demonstrating how limited they really are.

The two charts below highlight two themes.

First, chart 1 shows that volatility in regional currencies has indeed picked up since the beginning of this year, though at different times for different currencies (mid-January for the Kuwaiti dinar, mid-February for the Saudi riyal and early March for the dirham).

Second, compare this 'volatility' with those experienced in freely-floating currencies - the Japanese yen and the euro in chart 2 for instance - and it suddenly puts things into perspective.

Range trading

While the yen and the euro have traded within a band of approximately +/-2 per cent since the beginning of the year, regional currencies have traded in a range of only +/-0.04 per cent over the same period.

Thus, the impact on people's purchasing power or on the region's competitiveness (key for the non-hydrocarbon sector) has been dominated by changes in the value of international currencies versus the US dollar rather than any regional currency shift.

However, this does not mean we should shrug off these minor statistical moves as insignificant. Indeed, it is indicative of changing sentiment with regards to the region's currency pegs to the US dollar.

While the exact form of the currency pegs is different from country to country, let's take the UAE as an example.

During the local time zone, the UAE central bank promises to sell US dollars in exchange for dirhams from the currency market at 3.6730. It also promises to buy US dollars at 3.6720.

Against this backdrop, it is hardly surprising that currency volatility is kept low during local trading hours. But even outside the local time zone, banks have the knowledge that they will be able to get these exchange rates from the central bank on the next trading day, and therefore deviations outside this range are generally minimal.

What has changed is where the dirham is trading within the 3.6720-3.6730 band. Historically, the US dollar almost always traded at 3.6730 to the dirham, indicating that there was generally a net demand for US dollars from the banking sector - presumably due to individuals or companies investing overseas, or multi-national firms remitting profits back to their headquarters.

More recently, there appears to be a net surplus of US dollars in the market, pushing the exchange rate towards the bottom of the range. A major reason for this is increased speculation for currency revaluations in the region.

We have been arguing (for over a year now) that the region should pursue more flexible currencies so that it can set interest rates according to local needs rather than relying on the US Federal Reserve to effectively determine local interest rates.

Against the backdrop of negative real interest rates and strong growth, UAE Central Bank Governor Sultan Bin Nasser Al Suwaidi indicated in January that GCC central bankers would re-examine currency pegs in the region at the forthcoming meeting in Riyadh in early April.

Since then, Kuwait has suggested it may change its currency arrangements, while the other four members indicated that no change would be made this year.

Explicit

However, last week saw, to our knowledge, the first explicit admission from a Saudi Arabian official - the central bank governor - that the single currency (due in 2010, but likely to be delayed) may not be pegged to the US dollar.

While this may appear insignificant given the timeline involved, it will lead to more questions being raised about whether retaining currency pegs ahead of the single currency is as important as it once appeared to be - when, for instance, Al Suwaidi suggested that the single currency would initially be pegged to the US dollar.

Unsurprisingly, all the above has increased the focus on regional currency players by those looking to profit from any currency revaluations that take place, and thus the supply of US dollars to the local banking sector, hence pushing US dollar-regional exchange rates slightly lower within that tight band.

Of course, whether central banks actually change policy this year is something totally different.

Standard Chartered Global Research believes Kuwait stands out as most likely to change policy, by allowing another minor appreciation like that it conducted in May 2006.

It would probably be in the second quarter, when we expect the dollar to weaken again, and might be in the order of one per cent.

Elsewhere, we are less convinced. The UAE would appear, according to official comments, to be next in line to move, although we doubt it will happen this year.

Therefore, the trend for greater currency flexibility appears clear, with only the timing and form it takes being in question. This particular butterfly is likely to have the opportunity to spread its wings eventually.

The writer is Regional Head of Research, Middle East and South Asia, Standard Chartered Bank.