GCC dollar standard poses a challenge

The UAE Central Bank has had limited monetary policy tools due to the dirham's peg to the US dollar, and due to the fact that it has never really had monetisation power.

Monetisation describes the process through which the central bank replaces government bonds with high-powered money, thus injecting new money into the system.

When the central bank buys and sells outstanding government bonds, these are referred to as open market purchases and sales, which affect the monetary base and the money supply. There is no active government bond market in the UAE, and the Central Bank does none of the above - it does not buy or sell government bonds and does not monetise debt.

I argue that most of the growth in issued currency and money supply is driven by dollar inflows, whether petrodollar inflows (via government spending), or other foreign dollar inflows like foreign portfolio investment, foreign direct investment, tourism, foreign debt, and so on.

If we take into account the dollar-dirham peg and the resulting auto-pilot mode of interest rates, this implies that dollar inflows are critical for money growth, but interest rates are not actually managed in response to those flows; they are based on the policy actions of the Federal Reserve that could be and have been counter-cyclical from a UAE point of view.

Preconditioned policy

Given the regional plans for a monetary union, and given that the exchange rate policies of different states have been preconditioned by the Union, i.e., the pegs stay until monetary union, it is important to broaden the discussion, and look at the GCC monetary architecture.

Thus, in order to clarify the issues and expand the analysis to the regional level, I explore the balance sheets of the six GCC central banks, i.e., Saudi Arabia, Qatar, Oman, Bahrain, Kuwait and the UAE. The analysis reveals interesting facts.

Naturally, the GCC central banks are not all the same, and as the analysis here will reveal, their balance sheets reflect very different organisations. For example, the UAE Central Bank, according to its own publications, is the only GCC central bank that does not hold gold as an asset. All the other five have gold holdings, and some like Qatar increased their gold holdings by 2,654 per cent between December 2006 and December 2007. Another difference is the Kuwaiti dinar peg to a basket of currencies rather than just the dollar.

While such differences are interesting, the focus here is on the fundamental similarity of the GCC central banks and their mode of operation.

The key feature that characterises the GCC central banks is what I call their "Dollar Standard". This is most clearly revealed in the balance sheet of the Saudi Central Bank due to the reporting format it uses. The Saudi Arabian Monetary Agency (SAMA) is the only central bank in the region that publishes a balance sheet in which there is a distinct separation between its banking department and its issue department. This follows the Bank of England model.

The balance sheet reveals that the Saudi central bank issues currency in direct proportion to the amount of gold and foreign currency it holds. Naturally, the central bank has additional foreign reserves which it invests in foreign securities. In other words, the amounts of local currency issued are only a portion of the bank's foreign reserves. The vast majority of the foreign currency item consists of the dollar, and gold is a smaller proportion of the holding: a de facto dollar standard. The dollar peg is part and parcel of this equation.

The other five central banks follow the same principle, although they do not report separate balance sheets for their issue departments, and all assets and liabilities are put together. However, as the annual reports and statistical bulletins of these banks reveal, foreign currency inflows are a fundamental driver of money growth.

Given that SAMA's accounting practice follows the Bank of England model, it is interesting to look at the 2007 balance sheet of the Bank of England Issuance department.

What is interesting and revealing here has nothing to do with the numbers, but the components of the asset side of the two balance sheets. In the Saudi and GCC scenario, issuance is dependent on foreign currency holdings, in the Bank of England case, issuance is based on holdings of local government securities and other assets and reverse repo agreements. The other assets of the Bank of England include the deposits of the issuance department with the Bank of England's banking department.

If you were to look at the balance sheet of the Federal Reserve, although no distinction is made between issuance department and banking department, US government securities are the most significant item on the asset side.

In the GCC central banks' balance sheet, one cannot find any significant amounts of government bond holdings. In fact, there is no such item on the asset side of their balance sheets.

Insignificant holdings

Looking at the ownership of local currency denominated investments and/or securities (potentially government securities) by GCC central banks, we find supporting evidence. Out of the six GCC central banks, only two have any amounts of local securities denominated in local currency. Those two banks are SAMA and the Kuwaiti Central Bank.

These holdings, however, are extremely small and insignificant relative to the banks' foreign holdings. In the case of Saudi Arabia, investment in foreign securities abroad is valued at 709 billion Saudi riyals, while its investments in local securities stand at 8.7 billion Saudi riyals (as on June 30, 2007). In the case of Kuwait, deposits and investments in foreign currency are at 2.6 billion Kuwaiti dinar in March 2006, while local Kuwaiti dinar denominated bonds and public debt instruments stand at a minuscule 6 million dinar.

In March 2007, the Kuwaiti Central Bank reports 5.6 billion dinars of foreign currency investments, and no investment in local Kuwaiti dinar denominated instruments. In other words, even when not pegged to the dollar, the issuance of the Kuwaiti dinar follows the same principle, and Kuwait can still be considered within the dollar standard.

Even in the case of Saudi Arabia, as demonstrated by the earlier analysis, local currency bonds are not the assets based upon which currency is issued, like in the case of the Bank of England, or the Federal Reserve for that matter.

Looking at the asset side of other central banks in the GCC, we observe the same, a very different composition, which corroborates the earlier discussion.

Now, a look at the asset side of the balance sheets of central banks of the UAE, Qatar, and Bahrain.

Qatar has an item titled "claims on government". While potentially relevant, this item has had a value of zero for the last five years. Oman has an item titled "due from government". However, the amount mentioned in the 2007 balance sheet is 300,000 Omani rials. Indeed, too insignificant to be relevant.

All in all, not only GCC central banks do not have any significant holdings of government bonds, i.e., no monetisation and no open market operations, but also, domestic currency issuance is backed 1:1 by foreign currency holdings and or gold.

The GCC central banks operate in an environment where: the exchange rate is pegged, the interest rate follows US interest rates, the issuance of currency is determined by foreign currency holdings (dollars), there is no monetisation of government debt, and there is no substantial investment in local currency denominated securities. This is the dollar standard in action.

Naturally, oil revenues and wealthy governments have played an important role in slowing the development of government bond markets in the region.

Why borrow when there is enough oil revenue to pay for expenditure? It is important to clarify that the arguments made here do not aim to create governments in debt, the point is to build an architecture that supports independent and domestic money creation and management. Whether that is achieved through government bonds or other innovative mechanism is another issue.

Undue dependence

Why is value and wealth creation in the GCC so dependent on the US dollar? It is quite clear why oil has to be priced in dollars, but not clear why domestic wealth creation has to be subordinated to a currency the GCC states do not print. Taken individually, or collectively, money creation is unduly dependent on foreign currency holdings and flows.

While this dollar standard might inspire confidence to those who trust the dollar more than GCC local currencies, the current state of affairs is ultimately a state of dollarisation which inhibits domestic wealth creation independently of the dollar. This is most relevant especially in times of crisis, and when the US economy is going through a recession.

Indeed, if economic diversification is so high up on the agenda of local governments, why is monetary diversification and self reliance not?

Money printing and management are human phenomena. They are key elements of the economic game of a nation. The value of money is fundamentally derived by the trust invested in it, by the competence and goodwill of the printers, by the monetary policy that manages it, and the level of economic activity and assets it represents. Self-reliance and domestic money creation need not necessarily follow the US or UK examples.

- The writer is associate at Judge Business School, University of Cambridge