With Kuwait’s decision to peg its currency to a currency basket instead of the dollar exclusively, questions about the future of GCC monetary policies have come to the fore once again — how can inflation be contained, how can oil savings be preserved for future generations and whether a unified GCC currency can become a reality.
The decision itself has come as a surprise after mixed signals by GCC monetary authorities over recent months. By and large, GCC announcements of currency diversification out of the dollar have appeared to be mere rhetoric in the past.
The one percent change in Kuwait’s currency peg in May 2006 was rather modest, and other GCC countries, like Saudi Arabia, Oman, and Bahrain, were quick to deny that they would follow suit in making changes to the status quo. In spring 2007, renewed dollar weakness spurred expectations of an imminent revaluation of GCC currencies by market participants, but the GCC authorities once again denied such intentions, and Kuwait and the UAE even lowered interest rates to quell speculation against the dollar.
On the other hand, and somehow contradictorily, UAE Central Bank Governor Sultan bin Nasser Al-Suwaidi had mulled in January 2007 the idea of a departure from the dollar peg before the planned establishment of a unified GCC currency in 2010; a step, which appears to be out of the question now after the UAE has denied any plans to follow Kuwait in abandoning the dollar peg.
The decision of Kuwait apparently has been taken alone, although it has severe ramifications for the planned GCC currency union.
From now on, the Kuwaiti dinar will move in slightly different way from the rest of the GCC currencies. Although the dollar will still retain a large weighting of 70-80 percent in the currency basket, whose exact composition hasn’t been announced yet, the difference will be big enough to become a stepping stone for harmonization of monetary policies by 2010. After the withdrawal of Oman and repeated words of caution by other GCC countries about “ambitious timeframes” and “technical challenges”, the picture does not look very rosy for the planned unified GCC currency.
The rationale to reconsider over dependence on the dollar is sound. The American twin deficit has spiraled out of control and in the long run, further dollar devaluations are likely. But it would be advantageous for the GCC to contemplate alternative schemes together, because only as an economic bloc could they muster the strength and be a force to reckon with on international markets. In particular, plans raised by the UAE central bank governor to build capacities to make the unified GCC currency a free floating one by 2015 would open new ways to maneuver in monetary policy and set interest rates independently of the Fed in Washington.
As high oil prices are potentially bad for business, which can lead to monetary easing in industrial countries to stimulate the economy and the other way around; business cycles and interest rate requirements of oil exporting countries can be quite different from industrial ones. Therefore, such independence in monetary policy could prove beneficial.
Instead, Kuwait has decided to go it alone half-heartedly. With the share of the US in overall trade at 10 percent, a currency basket with a dollar share of 70-80 percent can hardly be termed “trade weighted.”
As the de-pegging has taken place after a considerable period of dollar devaluation, possible technical recoveries of a fundamentally tarnished dollar in the short-run could even weaken the Kuwaiti dinar in comparison to other GCC currencies until the dollar resumes its downward trend. Furthermore, the influence of imported inflation, which was given as a reason for de-pegging by Kuwaiti authorities must not be overstated.
High inflation rates in smaller Gulf countries, especially in the UAE and Qatar, can be mainly attributed to local investment booms and corresponding capacity constraints, and would need to be tackled accordingly.
Finally, it has to be kept in mind that a change of the peg does not necessarily decide the currency allocation of oil savings — these are mainly managed by sovereign wealth funds like the Kuwait Investment Authority (KIA) and the Abu Dhabi Investment Authority (ADIA). Central banks play a marginal role in comparison.
The one in Kuwait, for example, manages only $10 billion, while KIA’s assets are gauged between $160 and $250 billion. In the UAE, this difference is even more pronounced with the central bank managing $25 billion and ADIA about $500-$600 billion. The necessary reserve adjustments by the Kuwaiti central bank after the unpegging will therefore be miniscule on an international scale.
Much more interesting is what the big investment agencies are doing. Since they do not publish reports with size and composition of their assets, one can only rely on informed guesses.
The picture so far is that the GCC countries have taken some diversification steps in their asset allocation but it would be premature to speak of a wholehearted flight out of the dollar, which still accounts for well over 60 percent of overall assets.
The GCC countries had to buy a lot of depreciating dollar assets just to keep up this ratio in comparison to appreciating assets in other currencies and have been, in fact, instrumental in financing the US deficit in recent years.
As they depend on the US for security, political pressure to continue to do so is likely to be high.
In sum, Kuwait’s decision to move away from the dollar undoubtedly has its merits — it tries to ease imported inflation and ensure long-term stability of the currency.
Given the magnitude of the problem of the US deficit, even more courageous steps than merely reducing the dollar share in the currency basket to 70-80 percent would be an option. A free-floating unified GCC currency further down the road would be a case in point. But with the apparent lack of GCC coordination in the recent un-pegging, such a solution seems to be far away.
Dr. Eckart Woertz is the program manager, Economics, at the Gulf Research Center in Dubai.