LONDON, 6 October 2007 — Global banking major Credit Suisse warns in its latest research paper on the GCC currencies published last week that “the credibility of the Saudi peg (to the US dollar) is clearly undermined” given the recent volatility of the greenback, and that the pure US dollar peg for GCC currencies is “not a sure thing anymore.”
Further weakening of the US dollar and cuts by the Federal Reserve (Fed) of US interest rates, adds the Swiss bank, have increased the “probability of a revaluation of GCC currencies”.
The Saudi Arabian Monetary Agency (SAMA) has repeatedly stressed in the last few weeks that the riyal-dollar peg would remain and that there would be no revaluation of the riyal against the weakening dollar. SAMA has also resisted following the Fed in cutting interest rates.
But analysts at Credit Suisse clearly believe that SAMA’s policy is not sustainable in the short-to-medium term.
“Even if we do not expect the peg to be abandoned very soon, the risk of a currency adjustment, as Kuwait did several times, has increased in recent months. Forward rates are pricing in an appreciation of 4 percent on a three-year horizon,” said the report. (In early September alone this increase was 1.75 percent.)
There is no doubt that domestic GCC macroeconomic conditions are putting strong additional pressure on inflation, beyond imported inflation. Huge spending on expansive infrastructure projects and the limited ability of the GCC economies to absorb the huge liquidity in the region “by means of restrictive monetary policies due to the US dollar peg”, according to Credit Suisse, are the major reasons for rising inflation in the GCC.
At end 2006, average inflation for the six GCC countries (Saudi Arabia, Kuwait, Qatar, UAE, Oman, and Bahrain) amounted to 6 percent - up from below 2 percent at end 2003. The UAE and Qatar are the worst affected. Because supply cannot keep up with demand in the expansive economy, the resultant bottlenecks in supply further fuel inflation.
Despite the suggestion by SAMA Governor Hamad Al-Sayari that inflationary pressures in the Kingdom is not caused by the burgeoning imports, which are all denominated in the US dollar because of the peg, analysts to the contrary reiterate that the US dollar peg does create additional inflationary pressure. For instance, the EU supplies the GCC with an important share of its imports. With the falling US dollar, these imports are becoming more expensive, thus fuelling inflation. As such, a currency revaluation, says Credit Suisse, “would help to contain imported inflation”.
Indeed, SAMA’s recent decision not to lower interest rates, it seems, has exacerbated the riyal’s difficulty. Saudi Arabia like the other GCC countries, because of the peg to the US dollar, is caught “between a rock and a hard place”. If these countries do not follow the US Fed, the “(currency) appreciation pressure increases, based on the arbitrage argument.” Capital flows from low rate countries such as US will flow into those with high rates such as Saudi Arabia. On the other hand, if the GCC states do ease interest rates, inflation pressures will increase because of stronger private domestic consumption.
Another problem is that GCC currencies are undervalued. Oil prices are expected to remain high, leading to sustained budget and current account surpluses. Ongoing economic reforms; increased role of the private sector and diversification of the economy, is making GCC economies more attractive to FDI (foreign direct investment) flows. All these point to an appreciation potential of GCC currencies as long as the US dollar peg persists. This has also led to speculation on the GCC currencies, which in the case of Kuwait has prompted the Central Bank of Kuwait to intervene several times to adjust rates to deter such market behavior.
There is no doubt that the euro is playing an increasingly bigger role in GCC imports demography. Kuwait, which in May 2007 abandoned its pure US dollar peg in favor of a basket of top currencies including the euro and the yen, argued that the weak US dollar against the major currencies posed a risk to the Kuwaiti dinar’s purchasing power and thus made non-dollar zone imports more expensive.
Credit Suisse suggests that Kuwait’s example may well be best-suited for the other GCC currencies. Revaluation however depends on the performance of the US dollar in the next few quarters. But with the US dollar in the meantime depreciating in recent months, the likelihood of revaluation has increased.
The currency markets’ volatility, however represents a major boost for equities in the GCC. With the peg likely to stay; GCC interest rates on a downward pressure; and inflation remaining relatively high, an environment of negative real interest rates will materialize. This situation will be positive for GCC equities, as local stock markets will become a major vehicle to absorb excess liquidity in the regional economies. A reverse scenario of a depeg and an interest rates rise, says Credit Suisse will have a minimal impact on equities, because valuations remain attractive, with UAE real estate and banking stocks offering the best potential.
The Saudi market, which now trades at a trailing price to earnings (P/E) ratio of around 16.4x, has rallied with recent strong performances that in turn have removed some of the uncertainties relating to undervaluation in the last six months. But less competitive corporate profit growth compared to say the UAE and Qatar in the first half of 2007, means that the Saudi market is most likely to show gains over the medium-term only.