With Oman keen on currency competitiveness, Kuwait
looking at revaluation, and interest rates too low, doubts arise, Caroline Grady, Economist, Deutsche Bank AG, tells Financial Review
The GCCMU process appears to be stumbling. How do
you interpret the level of commitment to the project, and how important is it economically for the region?
Officially the GCC remains committed to adopting a
common currency. However, the lack of concrete progress at the shortened April Central Bank meeting in Medina, on top of conflicting statements from GCC officials during recent months, does suggest that a delay to the 2010 date is increasingly likely.
Very little is known about the institutional and technical
mechanisms that need to be put in place for the common currency (in terms of a common decision-making apparatus, money circulation, intervention mechanisms, etc.), and this tends to take a substantial amount of time to organise.
We attribute part of the delay to doubts about the benefits of a common currency.
With a de-facto common exchange rate policy in place in the GCC for the past two decades (i.e. the US dollar pegs), the transition costs to a common currency are currently low, but we would expect the costs to increase over time as the GCC falls short of being an optimal currency area.
Reflecting different timelines for exhausting energy reserves and prospects for non-oil sector growth, the six economies are set to diverge structurally going forward.
This will make it increasingly difficult for these countries to follow fiscal policies that are consistent with a common monetary policy.
In terms of the potential benefits of a currency union, the GCC also performs poorly. Intra-regional trade is very low (around five per cent of total exports), suggesting little benefit from reduced transaction costs.
Other benefits such as achieving greater credibility in
monetary policy or establishing a monetary and fiscal policy anchor, are also minimal, particularly given the absence of an appropriate anchor to ensure sustainable
fiscal convergence.
Oman seemed to make a decisive break from the timetable. Can you explain the reasons and pressures that may be involved?
Oman's much lower level of oil reserves means a much greater need to promote its non-oil economy. This suggests Oman's economic cycle may become less correlated with the oil price going forward, and that the economy may begin to diverge structurally from the rest of the GCC.
This makes the costs of a common GCC monetary policy rise over time in Oman. The reasons given as behind Oman's decision to delay amounted to that it did not think it could meet the required convergence criteria on time.
But as these criteria are not entry criteria such as under 'Maastricht' (for European Monetary Union), failure to meet the criteria is not in itself a reason not to join.
Moreover, Oman currently performs better than Qatar and the UAE, who do not meet the inflation criterion. Political factors were therefore also likely to have been a factor behind Oman's decision to delay.
The decision to adopt a common currency will remain a political one across the GCC. While the GCC's planned monetary union is under discussion, the market has speculated about revaluation.
Can you explain why the case of Kuwait is most acute, and how the issue has been handled there?
Kuwait has historically had more currency flexibility than the rest of the GCC, with a peg against an undisclosed currency basket until end-2002 and a -/+ 3.5 per cent band around a central parity against the US dollar currently.
The one per cent revaluation in May 2006 to the strong end of the band, combined with continued statements from Kuwaiti officials highlighting concerns that the weakness in the US dollar is leading to imported inflation as well as a loss in purchasing power (Euroland is the main source of Kuwait's imports), suggests domestic preference for a stronger currency.
The comments by National Bank of Kuwait deputy governor Nabeel Al-Mannae recently that Kuwait was unhappy with the amount of speculative capital coming into the country was a way of verbally intervening to halt upward pressure on the currency.
The interest rate cuts that followed this statement were also an effort to make it less attractive to hold local currency exposure.
But with a fully liberalised capital account, Kuwait has
limited tools to prevent speculation (Kuwait specifically ruled out the use of capital controls), and the rate cuts have not proved enough to discourage speculation.
How do you read the pressures for revaluation generally, both in terms of the other countries specifically, and in terms of the economic issues and market activity?
Despite the lack of progress at the April meeting, the bigger picture has not changed in that the GCC will continue to feel the effects of the weaker US dollar on both inflation and the import bill.
Potential for revaluation in Kuwait, and to a lesser extent the UAE, will therefore remain. And with oil prices expected to remain firm, current account surpluses will also remain large.
An official announcement that the 2010 deadline is being pushed back may also open the door further for realignment in the run-up to a common currency.
A move by Kuwait is likely to be necessary before the UAE could follow suit, given comments from the UAE Central Bank governor that the UAE wouldn't revalue alone.
Revaluations in the remainder of the GCC countries are unlikely, with countries such as Oman keen to maintain the competitiveness of its non-oil exports, and others such as Saudi Arabia keen to ensure stability is maintained.
To what degree is this entire discussion related to the
high oil price environment and what are your assumptions about how it may evolve in future?
The sustained rise in oil prices since 2002 is a key
element in the discussion behind the need for stronger exchange rates within the GCC. The GCC states have recorded substantial terms of trade gains during recent
years, but this has not been reflected in real exchange
rate appreciation.
To the extent that real appreciation has occurred
recently, this is a consequence of rising inflation rather than nominal appreciation.
In contrast, flexible exchange rates would likely have led to nominal appreciation during recent years, reflecting the huge current account surpluses that have been recorded.
This would have also helped to dampen any emerging inflationary pressures and preserve purchasing power.
Our Deutsche Bank oil price forecast assumes a WTI
average of $62 a barrel in 2007 and $55 a barrel in 2008, suggesting that while external surpluses in the GCC are likely to have peaked they will nevertheless remain large.
Currency appreciation itself would not materially affect these surpluses, as oil is priced in US$. Any narrowing of the surpluses, to the extent that it materialised, would come mostly from the import side.
There are different opinions on how the respective economic and monetary policy issues of the GCC states (e.g. overheating, inflation, interest and exchange rates) could best be resolved.
What is your feeling about how policy might progress?
With US dollar pegs likely to remain in place (albeit
possibly at slightly stronger rates), monetary policy will effectively remain in the hands of the Fed.
This could mean the GCC continues to import a monetary policy that is likely too loose for most, if not all, of the GCC. With oil prices also set to remain fairly high, the burden will continue to fall on fiscal policy to moderate any demand-side pressures.
Commitments to large-scale investment projects will, however, mean authorities will have to balance significant fiscal spending plans with the need to control domestic liquidity and inflation.
The opinions or recommendations expressed in this article are those of the interviewee and are not representative of Deutsche Bank AG as a whole. DB does not accept liability for any direct, consequential or other loss arising from reliance on this article.
Interview by Andrew Shouler, Financial Editor
