The US dollar has a huge influence on Gulf currencies. All GCC currencies, except the Kuwaiti dinar, are pegged to the dollar, and their values are fixed. Kuwait has pegged the dinar to a currency basket, but it can’t evade the effect of the US dollar, which has an overbearing weightage (more than 80 per cent) on the currency basket.
The fourth and final part of the series on GCC economies explores how deficits spawned by low oil prices and COVID-19 shocks affected the Gulf currencies.
Read part 1 here: Why GCC economic recovery will be slow until 2023
Read part 2 here: How Gulf countries are recovering from the economic slump
Read part 3 here: How sovereign wealth funds help GCC countries weather economic shocks
How account deficits impact currencies
GCC countries have maintained their currency pegs based on their strong fiscal and current account positions. They usually have fiscal and current surpluses with solid oil revenues and exceptionally high levels of forex assets held by sovereign wealth funds and public institutions.
Despite constrained spending and marginally recent improvement in oil prices, an absence of new revenue-raising measures (with the exception of VAT in Oman) means that GCC governments’ fiscal deficits will narrow only slightly in 2021. Moody’s forecasts the median fiscal deficit to remain wide at 6 per cent of GDP in 2021, driving a further deterioration in fiscal strength, which will be most acute in Bahrain, Oman and Saudi Arabia.
The economic crisis, driven by low oil prices, supply cuts and COVID-19 fallout, has led to a significant deterioration in GCC’s fiscal balances and external accounts last year. The current account balance has turned into a deficit of 3.4 per cent of GDP in 2020, relative to a surplus of 3.2 per cent of GDP in 2019.
■ More than 65 countries peg their currencies to the dollar or use the dollar as their legal tender.
■ The US dollar is the world’s reserve currency, a status bestowed by the 1944 Bretton Woods Agreement.
■ For more than three decades, GCC countries anchored their currencies to the US dollar. Saudi Arabia pegged its riyal in June 1986, and UAE’s dirham joined in January 1978. Kuwait in 2003 became the last Gulf state to peg its currency to the dollar.
■ The US dollar peg has served the Gulf well, providing monetary stability for investors, traders and businesses besides keeping the inflation rates moderate.
■ Kuwait switched its dinar exchange rate mechanism to a basket of currencies in 2007 to rein in the domestic inflation.
Fiscal balances [difference between a government’s revenues and its expenditure] of GCC countries will improve this year as oil prices recover to an average of $45 per barrel (bbl) and coronavirus-related expenditures are phased out, according to Fitch Ratings.
“In 2021, we expect gross foreign debt issuance of around $50 billion in the GCC for new financing and rollover of maturities, including by Kuwait, assuming the government will receive new legal authorisation to borrow,” said Jan Friederich, senior director at Fitch.
A debt issue [bonds, debentures, etc] helps raise funds with the promise of repayment in the future. In the GCC, the increase in debt issuance is expected to be accompanied by about $60 billion in withdrawals from wealth funds and more than $40 billion in local issuance, mainly in Saudi Arabia.
Despite the rising fiscal deficits and deterioration in current accounts [a nation’s transactions with the rest of the world], Fitch expects the GCC’s exchange-rate pegs to remain unchanged this year or in the medium term.
“In the lower-rated sovereigns, maintenance of the pegs beyond the near term will require challenging fiscal adjustment, which is underway in varying degrees. In most cases, staving off pressure on pegs will entail significant depletion of foreign assets and/or build-up of debt,” said Friederich.
The currency pegs of the UAE, Saudi Arabia, Qatar and Kuwait are supported by ample external reserves, and they prefer fiscal consolidation as a means of fiscal and external rebalancing. For Bahrain and Oman, GCC support is a key source of strength to the peg as they face rising debt burdens, increasing fiscal and current account deficits, with limited recourse to sovereign wealth funds.
How GCC currencies are pegged to the US dollar
How currency pegs are linked to deficits
Budget deficits and current account deficits could have a debilitating effect on a country’s financial strength leading to adjustments and volatility in currency values.
The key to supporting a pegged currency depends on the country’s ability to manage both fiscal deficit and a current account deficit when the domestic economy is facing a contraction. It requires large fiscal support when export earnings are shrinking due to lower prices of exports (oil for GCC) or a sharp decline in demand for key exports.
■ The major components of a current account are goods, services, income, and current transfers.
■ The current account balance should theoretically be zero, indicating whether a country is in a surplus or deficit.
■ A current account balance surplus means the country is providing resources to other economies. A deficit reflects a government and an economy that is investing more than it is saving and is using resources from other economies to meet its demands.
■ The current account balance reflects the state of the economy but necessarily indicate its strength or weakness.
How current account deficits impact currencies
The current account of the balance of payments of a country comprises the balance of trade in goods and services plus net investment incomes from overseas assets and net transfers.
A deficit is usually the result of an increasing net trade deficit where the value of imports exceeds the value of exports. The rising net trade deficit might have also been caused by a drop in the value of exports (oil prices in GCC).
In simple terms, when current accounts are in deficit, there will be a net outflow of money from a country. Households and businesses pay for imports in their currency, but this is eventually converted into the exporting nation’s currency.
Hence, a rising current account deficit leads to an increased supply of a nation’s currency in the foreign exchange markets. Therefore, in the currency market, there will be an outward shift in supply. This might lead to the external value of the currency falling.
In a free-floating system, this is called depreciation. In a fixed peg regime, a large and persistent deficit in the current account will pressure the peg if the markets believe that the country doesn’t have sufficient resources to defend its currency against speculative pressures.
How fiscal deficit and debt affect currencies
Fiscal deficits are negative balances that arise whenever a government spends more money than it brings in during the fiscal year. Fiscal/budget deficits are financed through borrowings and or withdrawals from government reserves.
A rise in deficits across the GCC has resulted in higher external borrowing, a general rise in debt burden and a significant drawdown from their sovereign wealth fund reserves. While a higher debt burden will increase the cost of funds for sovereign borrowings and the ability to borrow in the international markets, increased drawdowns from external reserves could deplete these sources. It will send out the message to the markets that these sovereigns do not have adequate resources to defend their currencies.
Most GCC sovereigns have huge SWF reserves, and they historically support those with lower reserves in difficult times. The relatively low debt to GDP ratios (gross government debt in relation to GDP) makes the GCC currencies peg less susceptible to market speculation and volatility.
