To revalue or not, the debate goes on

Currencies of the GCC states are increasingly under the spotlight. At issue is whether governments should continue to peg their currencies to the dollar - and if so, should they be re-valued?

GCC central banks are under increasing pressure at home and from international investors to let their currencies appreciate significantly against the dollar. Many would like to see GCC central banks introduce more flexible regimes as opposed to retaining such a close link to the US dollar.

Merrill Lynch estimates that the region's currencies need to appreciate by as much as 37 per cent against the dollar. Pegging GCC currencies against a basket of currencies would help to combat rising domestic inflation and to correct economic imbalances caused by an excess of savings.

"The fixed currency regimes in the GCC region have exacerbated the problems associated with a sustained rise in oil prices, strong economic growth, higher inflation and rapidly rising current account surpluses," says Emma Lawson, Foreign Exchange Strategist at Merrill Lynch.

Signs of change

The first signs of change have appeared. Kuwait decided in May to peg its currency to a basket of currencies and allowed its currency to appreciate against the dollar for a second time on July 11. Merrill Lynch expects a similar move by the UAE or Qatar before the end of this year.

The dollar peg combined with an accumulation of oil revenues has allowed GCC nations to build up an excess level of savings of $134 billion. This figure accounts for a large share of the $180 billion 2006 current account surplus for the region.

Allowing the GCC currencies to appreciate would also enable the region to reduce its excess surplus to a sustainable level, thus restoring some balance within the global currency system.

The strength of GCC economies means that a change in the foreign exchange regime is unlikely to generate any slowdown. Growth in the region is running well ahead of 10-year averages. The availability of and use of credit is rising rapidly, the demand for domestic goods is increasing and most importantly, infrastructure spending is very strong.

Investment spending numbers in the Middle East are massive. Projects valued at more than $1.4 trillion are either planned or are currently under way in the GCC, according to the Middle East Economic Digest.

Merrill Lynch believes moving from the dollar peg to a basket of currencies could help alleviate some of the inflationary pressure now being felt in the GCC. It also believes that Kuwait decided to move to a floating exchange rate regime in order to address inflation, which at 5.2 per cent is well above the 10-year average of 1.8 per cent.

Merrill Lynch expects that if the economic boom continues and real interest rates rise, the region would see significant inflows of capital from outside the region - from both portfolio investment and foreign direct investment.

- The writer is vice president, Financial Dynamics, Bahrain.