GCC Insights: Adopting a broad-based foreign exchange regime

GCC Insights: Adopting a broad-based foreign exchange regime

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On the sidelines of the IMF-World Bank conference held in Dubai last month, calls were made for the cessation of pegging the GCC currencies solely to the dollar. Currently, the currencies of all Gulf countries are linked to the dollar. For years, Kuwait was the only GCC state using a basket of currencies, including the dollar, but has ended such a practice not long ago.

The six-nation grouping has disclosed plans for a unified currency by 2010 or possibly as early as 2007. As per the arrangement, the new currency would most likely be linked to the US dollar.

No decision has been made regarding the possible name of the proposed currency, which by one report would be likely known as "Gulf riyal" because the majority namely Saudi Arabia, Qatar and Oman use riyal. Kuwait and Bahrain use dinar and only the UAE uses dirham.

One proposal calls for adopting a joint dollar/euro to avoid being vulnerable to developments in the US economy. Currently the American economy suffers budget deficit, which in turn requires selling bonds to international investors for financing the shortfall.

Pressure on China

For example, China which its currency linked to the dollar has been coming under American pressure to buy US government instruments. The argument goes that the euro has become established in the international markets, hence warrants serving as a reference currency.

Another suggestion prescribes linking the GCC currencies to a basket that includes the dollar and euro.

To be sure, there are sound arguments for linking the currencies to the US dollar. The use of the American currency reflects the fact that key GCC exports such as oil and petrochemicals are priced in dollar. Also, some non-oil trade and investments are dollar-denominated. More importantly, the peg provides confidence to investors on the grounds that the GCC economies are relatively small.

For instance, Saudi Arabia, which commands the largest economy in the region, boasts a gross domestic product of $175 billion, representing less than 2 per cent compared to the US GDP. Yet the statistics are notoriously lower for the smaller economies of Bahrain and Qatar.

However, the practice of pegging the currencies to the US dollar is not without cost. The link requires interest rates in the GCC states follow those prevailing in the US, albeit with a slight positive differential to entice deposits. True at the moment Interest rates are historically low level, but that could change in the future.

Essentially the link denies the central banks in the GCC the opportunity to influence interest rates, a key monetary policy instrument. Instead, the governments are forced to rely on fiscal policy to influence economic conditions. This in turn is limited to spending in the light of narrow tax revenue base.

The GCC economies do not apply tax on corporate or personal income. Oil revenues, which are priced in the US dollar, constitute the majority of treasury income in the GCC, ranging between 60 per cent in the case of Bahrain to 80 per cent in Kuwait. Also, the dollar link limits the prospects for non-oil growth and the eventual diversification of the economies.

All told, the link exposes the GCC currencies to the adverse consequences associated with the vulnerability of dollar in the international markets. Maybe in the long run, the economies need to consider adopting a floating exchange regime.

The writer is assistant professor, College of Business Administration, University of Bahrain.

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