Currency Union – eRutledge | Arabian Gulf Economics

What’s post petrodollar?

First published in:

Rutledge, E. J. (2018, September 15). A reserve system that also admits Euros and renminbi seems most likely. Gulf News. https://gulfnews.com/business/what-comes-after-the-petrodollar-1.604366

America’s overdependence on foreign credit is no exception to the old adage that too much of a good thing is ultimately bad. It is safe to assume that over the next decade or so, the dollar will depreciate considerably and will no longer be the sole currency used for oil invoicing. Whilst IMF-governed SDRs (special drawing rights) would be the more egalitarian and macro-economically sensible alternative, the more likely is a tripartite reserve and oil invoicing system — dollars for the Americas, euros for Europe and surrounding states and renminbi for much of Asia.

At present, however, a realistic alternative to the dollar has yet to emerge, either as a reserve currency or as a universally acceptable unit in which to settle cross-border trade. At least two-thirds of all central bank reserves are held in dollars, four-fifths of all international trade transactions are settled in dollars and some 45 per cent of global debt is denominated in it. The government-issued euro bond market is less deep and far less liquid than its US counterpart and only recently have the Chinese started to encourage foreign investors to acquire renminbi. Nevertheless a majority of observers contend that the dollar will devalue considerably in the coming decades, either by default or design.

A range of reasons is proffered including the huge US fiscal and current account deficits (net US external debt grew by more than $1.3 trillion in 2008) and the fact that China — in order to enhance domestic consumption and purchasing power — is now gradually beginning to strengthen the renminbi. More fundamentally, and as the recent economic crisis has again highlighted, there is an inherent instability in having a dominant sovereign currency doubling up a global reserve currency. All of this leads to a series of unknowns: what if anything will replace the incumbent petrodollar? And, will the transition be gradual and multilaterally managed? Or will it be sharp and unfold in a mercantilistic haphazard manner?

In the 1960s Yale economist Robert Triffin argued that an international reserve system based on the sovereign currency of the dominant economy would always be unstable.

The Triffin dilemma
Firstly, because the only way for all other economies to accumulate net assets in the dominant currency is for the dominant economy to perpetually run a current account deficit. Secondly, while the dominant economy would be able to detach interest rate decisions from exchange rate implications, all other open economies would be constrained somewhat by the resulting appreciation or depreciation of their currency vis-à-vis the dominant currency.

Such exchange rate uncertainty has, in my view, become far more acute in the decades following the collapse of Bretton Woods. For as international trade increases and becomes an ever greater component of open economy GDP compositions, exchange rate fluctuations and uncertainties have an ever greater impact. Shock transmission — both positive and negative — can now be globally felt pretty much instantaneously thanks to the liberalisation of cross-border capital flows, widespread deregulation of domestic financial markets and advances in telecommunications. The ‘search for yield’ in cross-border currencies tends to result in too much credit creation and in turn, leads to asset/stock price bubbles — in other words a cycle of boom and bust.

With the noted exception of the US, all open market economies essentially have two choices when it comes to exchange rate regimes — neither is optimal, both have associated economic costs.

Two choices
One choice is the ‘free float’, yet this invariably causes uncertainty for both exporters and importers in the given economy and results in its output either being undervalued or overpriced. The other choice is a fixed, managed or crawling peg to the anchor currency. Yet, in order to maintain the peg the given central bank must effectively outsource key monetary policy decisions (in most cases to the Federal Reserve). When the business cycles of the US and the given pegging economy are out of sync, the latter is unable to use interest rates to dampen or foster economic activity; consider the Gulf’s recent era of double-digit inflation.

According to a former French foreign minister, the US has an ‘exorbitant privilege’ in that it is permanently receiving transfers from the rest of the world in the concrete form of seigniorage revenues and also by being able to employ a truly independent monetary policy.

The fact that oil has been priced in and sold in dollars since the foundation of Opec is also highly significant. For if oil, critical to all economies, can only be purchased in dollars, all nations have a strong incentive to accumulate dollars. Indeed it has been argued that the US government effectively prints money (on paper which has virtually no intrinsic value) to purchase the oil, not to mention all the other dollar-denominated commodities, its economy requires.

This state of affairs has been compared to a credit card that attracts customers by offering low interest and deferred payments, and two prominent American economists, Fred Bergstena and Barry Eichengreenb have both recently written in the respected Foreign Affairs journal warning of the problems of this set-up. While neither sees the dollar losing its hegemonic status in the short term, both stress the negative impact of such high levels of debt. A penchant for ‘cheap’ Asian imports has had a detrimental impact on domestic US manufacturing and it is the case that most of the foreign credit funds consumption rather than productive investment. Nevertheless many American officials are happy with the status quo as it enables the average citizen to live beyond his or her means, and government budget deficits to be financed by oil-exporting Middle Eastern countries.

Future scenarios
Even if those who argue that it is in America’s self interest to reduce dependency on foreign credit are dismissed, recent events suggest a gradual dollar de-leveraging process will take place regardless. Indeed, in the absence of another real estate price boom or another ‘0-per-cent finance consumer-fuelled boom’, an export-led recovery is by far the most viable longer term US growth strategy, and a weaker dollar would facilitate this.

Concern over the magnitude of the US’s debt and the evident instability of the current global monetary system, has led many to look for alternatives. Some projections indicate that by 2030, the US will be transferring as much as 7 per cent of its entire annual output to the rest of the world in the form of debt repayments (debt erosion by way of dollar devaluation is a possible response yet this would hurt all of those outside of the US with dollar-denominated assets).

China’s central bank governor, Zhou Xiaochuan, made the headlines earlier this year when he suggested a supra-national currency based on the IMF’s SDRs could eliminate the ‘inherent risks of credit-based sovereign currency’. This cannot simply be discounted as posturing for China has over $800-billion-worth of liquid dollar reserves: Any move by the People’s Republic would have ramifications for all other dollar holders.

The most utopian — yet least likely — future scenario would be the implementation of some form of supranational currency, seigniorage would be equitably distributed and self interest would give way to the collective interest. This would result in a fairer deal for developing economies, as according to José Ocapoc, in order to maintain pegs or insure against capital flight such states have little choice but to transfer resources to the rich industrialised world — a phenomenon that the UN has called ‘reverse aid’.

The concept of a supranational fiat currency is not new, at the very least it dates back to Keynes. He argued that the international community should set up a unit of exchange to act as a reserve currency and even suggested that it be named the Bancor. The IMF’s SDR facility is not too dissimilar and a recent UN commission headed by the economic Nobel laureate Joseph Stiglitz has advocated a greatly expanded role for SDRs. Earlier this year the G20 did agree to create an additional $250 billion in SDRs; taking their share of global reserves from under 1 per cent to about 5 per cent.

Problems with multilateralism
There are of course various problems with multilateralism — mercantilist self interest being a predominant one — one only need consider the recent debacle at the UN’s Climate Change summit at Copenhagen to get an idea of the likely difficulties agreement on a new global form of exchange is likely to be. More practically though, SDRs are not as yet legal tender, nor are they backed by debt markets and for a reserve currency to work a deep and liquid market is deemed essential.

Another possible future scenario would see increased competition between the various emerging currency blocs, tit-for-tat protectionism and the potential for considerable currency and exchange rate instability.

Much of this could arise over the thorny issue of oil invoicing. The petrodollar standard, it has been argued, is the ‘Achilles heel’ of the dollar’s continued hegemonic status. China needs more oil and, going forward will want to purchase some of this with its strengthening renminbi, this entails ending the exclusivity of the petrodollar standard.

If a transition to a tripartite invoicing system were not to take place consensually and gradually, oil could suddenly become very expensive in dollar terms and this would disproportionately impact on American consumers and its economy alike. This alongside the need to transfer income overseas to pay off debt could erode Americans’ standards of living. In different ways both Bergsten and Eichengreen have argued that if the US does not soon begin to address the issue of overdependence on foreign debt, its ability to pursue autonomous economic and foreign policy objectives will become increasingly difficult.

The most likely future scenario is piecemeal and gradual dollar devaluation — this is both in the interests of the US and all of its counterparts. Those with dollar assets do not want to see these lose value too precipitously and neither the Europeans nor the Japanese want their currencies to appreciate any more than they have done so recently. In the longer term the current reserve ratio of 60/30 — dollar/euro will probably recalibrate to 40/40/15 — dollar/euro/renminbi.

In the past decade China has pretty much made all it can out of being the world’s factory and now needs to ‘move up the value chain’. In order to increase household incomes and boost domestic private consumption a stronger renminbi will be needed. This will boost domestic consumption and purchasing power, a stronger currency would make foreign assets cheaper to acquire. It would also turn the renminbi into a potential reserve currency and, at the same time, enable it to take on a more prominent role on the global stage.

Russia’s central bank confirmed in a recent report that it had increased the share of euros in its reserves from around 42 per cent to more than 47 per cent in 2008 and that it intended to further reduce its dollar holdings in the coming period. Its proximity to the Eurozone is no doubt a key rationale, as it seeks to hedge against increasingly expensive euro-denominated imports it is logical to consider holding more euros in reserve, and invoicing the Europeans in euros for their oil needs.

Yet as Stiglitz contends, a move to a dollar-euro duopoly would still result in global imbalances and disadvantage poorer nations who would continue to need to hold large amounts of developed world’s currencies in reserve either in order to maintain exchange rate pegs or in an endeavour to hedge against economic downturns. Similarly, a tripartite reserve system — comprising of dollars, euros and renminbi — while more distributed, would still fall short of a well regulated and suitably tradable supranational fiat currency.

Despite this shortcoming, from the perspective of the GCC, if a tripartite reserve system were to emerge each of the currency blocs would have the strength and thus ability to purchase commodities such as oil in their currency. This would be no bad thing for the Gulf’s oil exporters as it would enable them to build up a more diversified savings portfolio and possibly even pursue a more independent monetary policy.

Bio:
Emilie Rutledge is Assistant Professor of Economics at the United Arab Emirates National University

Your dinar is in the oven

Blog Publications Reports

First published in:

Rutledge, E. J. (2007, November 2). Your dinar is in the oven. Gulf News. https://gulfnews.com/business/sectors/investment/your-dinar-is-in-the-oven-1.210866

It now seems inevitable that the GCC’s monetary union project will be delayed. The ground has already been prepared, so to speak

The central bank governors of the bloc’s two largest economies, Saudi Arabia and the UAE, recently said that the 2010 deadline is “very ambitious” and that the project may be postponed to “2015 or beyond”.

Few will be surprised. In conjunction with the lack of tangible progress, there has recently been a series of setbacks. The first was Oman’s decision to opt out; clearly a psychological, if not economic blow. The second was Kuwait’s decision to revert back to a trade-weighted exchange rate peg. Between 2003 and mid-2007 it had aligned itself with all other states by officially pegging to the dollar (albeit with a small band of flexibility).

Potentially the most significant setback, however, was a collective decision in September which permitted member states to tackle inflation independently. If this translates into diverging monetary policies, it will jeopardise (even further) the stability of bilateral exchange rates, one of the few monetary convergence areas where the GCC has been doing well.

It may well be the case that the current oil price boom has dampened the desire (need) for economic integration and consequently a single currency – the pinnacle of integration – has been placed on the back-burner. The GCC’s commitment to MU was strongest in 2001 at the tail-end of a protracted period of low oil prices, lacklustre GDP growth and declining per capita incomes in many states.

It is possible that an announcement will be made just prior to or during this December’s GCC summit. Probable reasons for the delay include the fact that the timeframe is (now) too tight, and/or that diverging inflation rates of approximately 10 per cent – Qatar and Saudi Arabia’s official inflation rates were 11.8 per cent and 2.3 per cent respectively in 2006 -make the task of meeting this convergence criterion too difficult.

Little preparation
While the first argument may now be true, it is only so because so little has been done to prepare for the monetary transition; for instance, no agreement has yet been reached on the mandate and role of a GCC central bank let alone its location, neither have convergence criteria/targets been officially agreed upon and endorsed.

The second argument holds more weight, but if regional commitment to MU were strong enough, inflation rate differentials could be tackled. In the years prior to the euro’s launch there was also considerable inflationary divergence, but post-Maastricht this decreased rapidly from a high of 20 per cent to around 1 per cent by 1999.

Although most participating states have outsourced their monetary policy to the Federal Reserve and subsequently aren’t able to use interest rates to reign in inflation, there are other ways. These include holding back on fiscal spending (staggering government financed infrastructure upgrades), implementing more extensive price controls (for instance rent-caps) and absorbing liquidity through the issuance of bonds.

If and when an announcement does come, it is more likely to be a deferral than a complete abandonment. This will partly be for face-saving reasons, but primarily because GCC MU has been such a long-standing ambition, first mentioned in 1982 and more recently recommitted to in the New Economic Agreement of 2001.

Turning to the question of whether a delay matters, in many respects the short-term answer is no. A postponement will not harm current levels of economic growth and neither will it deter capital retention. In addition, many analysts argue that a GCC MU would only have marginal utility, because a) intra-regional exchange rates are already reasonably stable, and b) intra-regional trade is seen to be limited. Thus, participating economies would only see small gains from two key MU advantages: the elimination of exchange rate risk and the reduction of transaction costs.

Nevertheless, even if the potential trade benefits arising from a GCC MU are initially small, they should not be discounted. If hydrocarbons are factored out, intra-GCC trade is not as insignificant as often assumed – it stands at around a fifth of the total. In addition, trade gains resulting from currency unions are often considered “endogenous” – trade will increase as a result of the union, regardless of its level prior to the union.

In addition to the direct (as a consequence of MU) benefits there are a range of indirect (as a result of the necessary preparations and policy reforms in the lead-up to MU) benefits, and it is these that will be bring the most advantages to the GCC.

Indirect benefits will arise from the creation of a GCC common market, establishing a pan-GCC economic data-gathering institution, tasked with collating and standardising national statistics in order to measure monetary and fiscal convergence, and the implicit need for budget transparency and accountability. Many of these institutional and policy reforms necessary in the lead-up to MU, or the process of preparing for it, are likely to enhance business sector confidence, encourage greater levels of intra-state investment, deepen financial markets and encourage more FDI. These outcomes would all be beneficial for the GCC’s economic diversification endeavours.

Not seeking to downplay the prudent investment and diversification measures all states are making with their current oil windfall revenues, private sector job creation remains one of the biggest challenges facing the region. In order to defuse the “unemployment time-bomb”, hundreds of thousands of non-oil dependent private employment opportunities will need to be created during the next decade.

Therefore any policy including MU that is seen to aid and abet private sector confidence and growth should be seriously entertained. Of course a GCC common market and statistical agency could exist without there ever being a “Gulf dinar” in circulation. But if the intention to form a single currency acts as a catalyst, a carrot on a stick if you will, why not use it?

Insight

“For governments of the region struggling with declining currencies and domestic inflation, there are decisions on the table. “Given the UAE’s rapid and sustained economic growth, nominal appreciation of the dirham is required to allow the real exchange rate to move towards equilibrium value,” says Syed Basher, a regional economist. Simply, that means revaluation. The arguments about the dollar peg have been simmering for some time, given that exchange and interest rates seem too low for the region’s hothouse conditions. In an HSBC survey issued last week, 39 per cent of regional executives were reported as saying that removing the dollar peg would have a beneficial effect, compared with 18 per cent saying the opposite. A Gulf News poll last week produced results suggesting that 62 per cent of residents want a GCC single currency. Of course, that doesn’t necessarily mean the issue is coming to the boil. Saudi Arabia this week tightened banks’ reserve requirements while cutting official interest rates in line with the Fed. It was a demonstration of a monetary dilemma which, obscure as it might seem, impacts all those working in this region. But we all know what they say about those who can’t stand the heat.”
— Andrew Shouler, Deputy Managing Editor, Gulf News

Single currency at a crossroads

Blog Publications Reports

First published in:

Rutledge, E. J. (2007, May 26). Single currency at a crossroads. Gulf News. https://gulfnews.com/business/sectors/investment/single-currency-at-a-crossroads-1.179874

Oman’s decision late last year to opt out of the GCC currency union was undoubtedly a political setback, but Kuwait’s unilateral decision early last week to revert back to an undisclosed basket peg represents a potentially far more complicated technical obstacle

A GCC single currency minus Oman would be, and could still be, a perfectly viable and potentially advantageous union. Oman only contributes five per cent of the GCC’s total GDP. However, Kuwait’s decision to peg to a basket of currencies weighted by the country’s main trading and financial partners could complicate the bloc’s monetary convergence process.

The fixing of bilateral exchange rates is a relatively minor issue compared to other currency union prerequisites. Establishing a common market and a pan-GCC central bank is going to take concerted effort and political will. So too will working towards and sticking to a set of commonly-agreed convergence targets for inflation, fiscal deficits and debt. Yet stable bilateral exchange rates – all six pegging to the dollar – had been one of the GCC’s few currency union related success stories. The latest decision by Kuwait seems to have jeopardised even this one.

However, before the currency union is written off, several factors need to be considered. The first is this: for many years, even before Kuwait’s move to a dollar peg in 2003, all GCC currencies had been remarkably stable vis-a-vis one another. It is not given, therefore, that Kuwait’s move will cause its dinar to fluctuate widely against the bloc’s other currencies. Secondly, the European Monetary Union (EMU) countries only insisted on bilateral exchange rate stability two years prior to the electronic launch of the euro. The GCC, therefore, still has time to reach a consensus on the issue. Therefore, the appreciation of the Kuwaiti dinar does not necessarily preclude achieving stable exchange rates in preparation for monetary union – a key criterion for monetary union. Nevertheless, it indicates Kuwait’s desire to remain flexible and to retain national autonomy over its exchange rate policy.

Whose interest?
Again we must ask, as we did after Oman’s surprise announcement, will Kuwait’s move be a catalyst for other states to put their own sovereign interests before the bloc’s ‘common interest’? Before Kuwait’s unilateral decision, the GCC central bank governors meeting in Riyadh last month had highlighted the diverging interests on how to proceed with their respective and ‘collective’ currency peg(s). With the dollar hitting an all-time low against the euro and pound, the issue of a collective revaluation was said to have topped the agenda.

However, leaders were unable to agree on how much their currencies should collectively revalue by, and as a consequence, agreed to keep exchange rates unchanged. Obviously, and with the benefit of hindsight, this was much to the disappointment of some participants. But it is not only Kuwait that seems to be questioning the utility of attempting to act collectively.

According to one official at the recent Riyadh meeting, the decision to maintain the status quo was to safeguard the stable bilateral exchange rates in preparation for the currency union.

However, if all states had agreed to, say, a 15 per cent revaluation, this would have meant that bilateral exchange rates would still have been stable. A more likely reason for keeping rates the same was disagreement on the merits of a revaluation per se.

The discord is in large part due to the increasing divergence in inflation rates within the GCC and differing economic development strategies. According to some estimates, Saudi Arabia’s inflation rate was only 2.3 per cent in 2006 while Qatar’s was 9.2 per cent.

Criteria
The GCC had provisionally agreed to accept EMU-style convergence criteria back in 2005. Part of this necessitates keeping inflation rates within two per cent of the best performing economies. But now even these are being increasingly questioned.

His Highness Shaikh Mohammad Bin Rashid Al Maktoum, Vice-President and Prime Minister of the UAE and Ruler of Dubai, said on his trip to Seoul that the UAE government would have to reassess its commitment to the currency union if it were deemed not to be in the best interests of the national economy.

Qatar is now arguing that the bloc should instead focus on core inflation, which strips out the impact of soaring rents, rather than headline inflation – the conventional measure. Kuwait’s decision has again highlighted the bloc’s diverging interests and differing priorities. It seems clear that finding consensus on joint monetary policy is becoming more, not less difficult as the 2010 deadline draws nearer. There is a strong possibility that Qatar and the UAE will at some point revalue; until then the jury’s out.

An inconvenient truth

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First published in:

Rutledge, E. J. (2007, May 5). An inconvenient truth. Gulf News. https://gulfnews.com/business/sectors/investment/an‐inconvenient‐truth‐1.177129

A historical analysis of GCC economic performance reveals little evidence of any economic convergence taking place. Inflation differentials between the five economies remain high, and in fact have widened since the beginning of the recent oil price boom

At the summit of GCC central bankers held last month in Riyadh, little progress was made in terms of making preparations for the Gulf common currency. Despite the 2010 launch date fast approaching, all the central bank governors could do is urge GCC leaders to expedite the process.

In reality, as Saudi Arabia’s central bank governor Hamad Saud Al Sayyari recently admitted “the original target [date]…has become tight.” In fact there has been little tangible progress since the signing of the 2001 GCC New Economic Agreement. The policy preparations for establishing a viable currency union.

Customs union
In 2003 a milestone in GCC economic integration was reached with the launch of the customs union, harmonising external tariffs to five per cent and removing intra-regional ones. However, the signing of bilateral free trade agreements (FTAs) with the US by Bahrain and Oman meant that the final stage, involving the abolition of customs collection functions at intra-GCC border offices, could not take place as scheduled at the end of 2005. The issue has yet to be resolved, and the finalisation of the customs union was set back by two years.

The final communique of the 2006 summit said that a common market would be in place before the end of 2007. Without the common market, many of the benefits of a single currency will not be realised. Despite the fact that GCC leaders are taking some pro-active steps, such as enacting legislation to facilitate the free movement of labour and capital, it is doubtful whether it will come into being this year.

In addition to the delay in the customs union at the 2004 summit, it was agreed by the GCC leaders that the deadline for completing a unified pension and social security system could be as late as 2010.

It is hard to envisage how a single monetary policy and currency for a regional bloc can be implemented without a single central bank. In 2005, after consultations with the European Central Bank, the GCC announced their intention to establish a regional central bank. However, more recently they seem to be backtracking to their original plan to retain national central banks and for governors to convene on a regular basis to decide on monetary policy for the bloc.

Controversial
The establishment of pan-GCC institutions requiring the devolution of some national decision-making powers, also appears to be a sticking point. Even the potential location of a GCC central bank seems to be controversial.

The IMF considers the creation of a GCC Statistical Agency to be of serious urgency for the currency union project. Yet, creating a ‘Gulfstat’ is not even on the agenda.

Without improved and harmonised data for the region, it will be hard to judge any progress in meeting convergence criteria and to make monetary policy decisions based on the economic conditions across the bloc. At a meeting of GCC central bank governors in 2005, it was provisionally agreed that they would adopt convergence criteria mirroring those of Eur-ope’s Maastricht criteria. However, they have yet to be officially endorsed. Instead, the GCC leaders called for more time at the 2005 summit, and disagreement over the targets remains. The fiscal and monetary convergence criteria include inflation and interest rate convergence targets, capping budget deficits at three per cent of GDP and keeping government debt to below 60 per cent of GDP.

While there are no problems in terms of exchange rate stability and interest rate convergence – not surprising considering the long standing de facto pegs against the dollar – there would have been difficulties in meeting all the other criteria. A historical analysis of GCC economic performance reveals little evidence of any economic convergence taking place.

Inflation differentials between the five economies remain high, and in fact have widened since the beginning of the recent oil price boom. Analysis shows that there are two inflationary blocs within the GCC, experiencing significant inflation rate differentials: a low-inflation bloc (Bahrain, Oman and Saudi Arabia) and a high-inflation bloc (Qatar, Kuwait and the UAE).

Here, the onus will be on Qatar and the UAE in particular to tackle their respective inflation rates – somewhat hard without independent interest-rate setting powers. Qatar now argues that it is better to use core inflation as a convergence target, rather than headline inflation CPI, which does not include the soaring price of property and rents.

Some of the inflationary pressures in the UAE, Qatar and Kuwait are due to the collective peg against the dollar, which is dropping fast against other international currencies, many of which are important trading partners for the region, like the euro-zone. Controversy over the dollar peg has appeared to suggest disharmony, with the UAE and Kuwait calling for a more flexible exchange rate regime, but Saudi Arabia and Bahrain preferring to stick to the dollar peg.

Uncertainty regarding the future choice of exchange rate regime for the region was undoubtedly a factor in Oman’s decision to opt out of the currency union.

Deficits
In the past budget deficits have frequently breached the three per cent to GDP ratio, sometime reaching double digits. Only in the case of Saudi Arabia did this translate into large levels of public debt, reaching as high as 102 per cent of GDP in 1998. Since then, Saudi Arabia has used its recent oil windfall to pay back a lot of debt, and it is now well within the criterion, but the cyclical nature of GCC fiscal policy leaves government budgets highly vulnerable to oil price swings.

The GCC states must adopt prudent policies if they are to be able to meet such convergence criteria. Meeting convergence criteria as well as creating pan-GCC institutions will inevitably require concerted political will. The degree of political commitment among GCC leaders with regard to the process of economic integration and the single currency may have come into doubt.

Indeed, issues such the slow progress to date, the signing of bilateral US FTAs and Oman’s opting out tend to suggest a lack of political motivation. It seems that as oil prices have risen, like so many times before, economic reforms are put on a back burner, particularly those that will inevitably entail some adjustment costs.

Yet, without the aforementioned policy preparations, the viability of the currency union project as a whole may be called into question. The self-imposed deadline is quickly approaching. The GCC leaders may choose to acknowledge that, in order to ensure a viable and sustainable currency union, a more realistic timetable and credible launch date for the single currency needs to be adopted. Otherwise, the economic integration project would be vulnerable to losing considerable credibility, and confidence in the economic policymaking of the region could be affected.

Gulf monetary union, fading away

Blog Publications Reports

First published in:

Rutledge, E. J. (2006, December 16). Gulf monetary union is a cracking project? Gulf News. https://gulfnews.com/business/sectors/investment/gulf-monetary-union-is-a-cracking-project-1.179198

Although few observers will be surprised if the GCC’s planned single currency (perhaps ‘Gulf Dinar’) doesn’t come into circulation on schedule in 2010, most will have been by Oman’s decision to unilaterally opt out

This surprise is primarily because Oman, the poorest member of the bloc, looked set to reap considerable dividends from entering into a monetary partnership with its economically larger and wealthier neighbours.

In 2005, the Sultanate’s GDP per capita income was 63 per cent of the GCC average and its economy constitutes just five per cent of the GCC’s total GDP. Evidence from the euro zone reveals that increased intra-regional FDI, combined with structural grants and subsidies, fostered a process of catch-up, which has helped reduce income disparities between member states.

Indicating that the general lack of preparation was behind Oman’s decision, Deputy Economy Minister Abdullah Al Hinai said that the 2010 deadline was unfeasible because key prerequisites such as a common market have yet to be established.

However, last week’s final GCC summit communique stated that leaders had agreed to finalise the customs union and ensure that all requirements of a common market will be fulfilled by the end of 2007. Furthermore, the main reason for the delay in the finalisation of the customs union was the unilateral decision by Oman, preceded by Bahrain, to sign a free trade agreement with the US. Bahrain’s move in particular was met with considerable disquiet, and was considered to be against the spirit of previously signed GCC economic agreements.

The imperative to diversify is much stronger in these states nevertheless and, if one looks at the time it is taking the GCC as a bloc to negotiate an FTA with the EU, their decisions to act unilaterally are more understandable. Policymakers in Muscat cannot afford the luxury of taking years to implement economic reforms.

In many respects, Oman’s announcement was the only concrete decision made regarding currency union at last week’s summit. GCC leaders did not officially approve the euro-style convergence targets which central bank governors had agreed upon amongst themselves. Nor was any decision reached on the mandate for, or location of, a GCC central bank.

At the 2001 GCC summit convened in Muscat, leaders set out in unambiguous terms their intention to establish a currency union, yet apart from Kuwait’s move to the dollar-peg and the launch of the customs union in 2003, little progress has taken place.

Oman is perfectly justified in not wanting to join an ill-prepared monetary union, but instead of opting out altogether it could have set preconditions; not committing to join, for instance, until a common market was successfully up and running.

Decision timing
Why then, has it made such a decision now? Earlier this year the GCC states provisionally agreed on several convergence targets, including capping budget deficits at three per cent of GDP, public debt at 60 per cent of GDP and all states holding enough foreign exchange reserves to cover four months’ imports. It is hard to see how any of these targets could have contributed to Oman’s decision, as it was unlikely to face any serious difficulties in meeting them.

In 2005, Oman’s fiscal surplus stood at 11 per cent of GDP, public debt is well under the limit, and its foreign exchange reserves covered more than five and a half months’ imports. The Oman-US FTA, signed in late 2005, demonstrated Muscat’s desire to integrate further into the global economy and diversify its economic base. It also revealed that Oman is unwilling to compromise what it perceives as its optimal national economic interests. It indicates that the loss of some economic policy-making sovereignty, necessary for a viable currency union, may be too high a cost for it to bear. The most likely reason why Oman has opted out now, however, is a conflict of interest on the future choice of exchange rate regime for the unified currency. Oman’s economic diversification strategy going forward may well be best served by a relatively weak currency.

On the other hand, states such as Kuwait and Qatar are suffering from “imported inflation” due to the declining dollar, and are likely to want any future unified currency to strengthen vis-à-vis the dollar. By being part of a stronger unified currency, Oman’s nascent non-oil export oriented industries will suffer because its products will be less competitive. And as a tourist destination, Oman will be less attractive to higher-end European visitors if euros buy fewer Gulf Dinars than they currently do Omani riyals.

There is, of course, a real danger that by opting out Oman could ultimately lose out. Oman has significant trade levels with several GCC states, and if a Gulf Dinar does come to fruition, it will continue to face transaction costs and exchange rate risks, regardless of it being a member of any future common market. Last year, Oman received just 3.6 per cent of the total GCC FDI inflows. It may receive even less in the future, as international investors are likely to buy Gulf Dinar-denominated assets as a hedge against the possibility of the currency being used to invoice oil and gas sales.

Likely union
A currency union among the other five states remains a distinct possibility, and would be economically viable. They are on the way to meeting many of the optimal currency area criteria conditions which economists argue are necessary for a given region to be suitable for currency union. Yet, and as with the euro zone, political commitment is by far the most important criterion. As the deadline approaches, necessary reforms which will involve devolving some decision-making powers to pan-GCC bodies, coordinating economic policies, improving data transparency, exercising fiscal restraint and opening up budgetary plans to outside scrutiny, may be deemed politically unpalatable.

Consequently, Muscat’s move may become a catalyst providing a convenient excuse for other states to follow suit. A more likely eventuality is a collective agreement to defer the launch date by a few more years. Following Oman’s announcement, Saudi Arabia’s Finance Minister, Ebrahim Al Assaf, declared that the five remaining states could “extend the 2010 deadline if faced with more obstacles.”

The dollar declines, while the euro shines

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First published in:

Rutledge, E. J. (2006, May 28). The dollar declines, while the euro shines. Khaleej Times. https://www.khaleejtimes.com/business/the-dollar-declines-while-the-euro-shines

The dollar is once again losing value, and has depreciated by seven per cent against the euro since the start of the year. How far it will go is anybody’s guess, but the odds are, it will fall further.

Li Yong, China’s Vice-Minister of Finance, has talked of a possible further 25 per cent fall. According to some estimates the amount the United States now owes to the rest of the world now stands at $3 trillion. This, not anything else, is the prime reason for the dollar’s decline.

Although the Federal Reserve does not want to see the dollar collapse, it probably views any dollar devaluation as a convenient way of partially reducing the US’ huge current account deficit. If the dollar declines so will the ‘value’ of the deficit. However, a falling dollar does not bode well for the GCC. It will exacerbate inflation as European and Japanese goods become more expensive and it will also result in a depreciation of the ‘real’ value of the region’s reserve holdings. In addition, because oil and gas are priced and sold in dollars the GCC also stand to loose some revenues in this respect also.

Nevertheless, we have seen only a limited response to these currency conundrums in the form of Kuwait’s decision to allow its currency to appreciate marginally against the dollar. There has been talk from several of the region’s central bankers about a possible realignment in their foreign reserve holdings but as yet no concrete action has been announced. For the time being at least, any speculation that other GCC states were about to follow Kuwait’s lead have been discounted. Both the Saudi Arabian Monetary Authority and the Central Bank of Oman came out and publicly defended the status quo.

Apart for arguments such as ‘providing stability’ and ‘eliminating intra-regional exchange rate risk’ (all 6 GCC states are pegged to the US dollar, albeit Kuwait maintains a more flexible band within which to fluctuate), there is another argument for maintaining the dollar peg. And that is that the collective peg is an interim step towards forming a single GCC currency in 2010. Having a joint peg is a good thing, as it eliminates exchange rate risk within the bloc, but it could just as easily be achieved with a joint peg to the euro or a trade weighted basket of currencies.

Happy creditors no more? For many years Asian central banks, particularly those of China and Japan, have been willing to finance US deficits despite the risks, in order to support their own export-led growth models. However, the scale of financing (subsidising) required to sustain the US’ current account deficit may soon exceed their absorptive capacities. A law of diminishing returns also comes into play; there comes a point when alternative economic growth models look more appealing that accumulating ever greater numbers of underperforming US Treasury Bonds.

The current situation is somewhat perplexing, the country that controls the world’s de facto reserve currency, also happens to be the world’s largest debtor. In any other walk of life, you would be forgiven for being somewhat wary if lending to someone with huge debts. The US like any other debtor may be tempted to use (or not do anything much to prevent) devaluation to reduce external deficit, and this is hardly a desirable trait for a reserve currency.

The dollar has been the dominant reserve currency for at least the past half century and will no doubt continue to be one for some time to come. It can however no longer take this role for granted. One thing is constant in history and that is nothing remains the same forever. Back in the early 1990s after a period where the dollar devalued considerably, many economists at the time speculated about the dollar’s role as the world’s de facto reserve currency. The dollar, nevertheless rebounded, and continued to play its role, in part because there was no viable alternative.

This has changed. Today we have the euro (tomorrow perhaps, even the Yuan). In general for a currency to qualify as a reserve one it needs to meet several criteria including being backed by a large economy, which itself has free flows of capital, open and deep financial markets and low inflation. The euro zone has all of these characteristics and to top it all, it runs a current account surplus.

Those who switch first stand to gain the most: It is now estimated that the US’ deficit consumes no less than two thirds of the worlds total current account surplus. Joseph Stiglitz, a former head of the IMF, recently pointed out that there is obviously something peculiar about a global financial system in which America borrows more than $2 billion each and every day from other countries (in March the US’ Trade Deficit was $62bn) whilst lecturing them on fiscal responsibility.

One could view the current state of affairs as a bit like the classic ‘prisoner’s dilemma’. If any one Asian central bank switched its reserves into euros tomorrow it would undoubtedly benefit vis-à-vis the others, but if they all attempted to switch at the same time they would collectively see the value of their reserves fall considerably, as the resulting run on the dollar would adversely affect all that hold it in reserve.

Reactionary tendencies will probably mean that the GCC dollar peg remains for the time being but there is a strong and growing argument for a move away from too much dependence on the dollar. If Gulf central banks were to buy euros today with some of their dollars reserves, they would get far better exchange rates than if they were to wait for Asian central banks to make the move first.

It is surely worth the while of the GCC’s central bankers to seriously consider alternative options to the current status quo, it would be a shame if the considerable economic achievements of the past few years are washed away by maintaining a rigid dollar peg that may be extremely expensive to maintain and cause unnecessary inflation.

Bio.
“Emilie Rutledge is an economist with Gulf Research Centre” (2006).

To peg or not

Blog Publications Reports

First published in:

Shouler, A. (2006, May 1). To peg or not to peg: that is the question. Gulf News. https://gulfnews.com/business/sectors/features/to-peg-or-not-to-peg-that-is-the-question-1.235046

(HASSAN AMMAR/AFP/Getty Images) — Calls to scrap the GCC’s fixed relationship with the dollar have to reckon with the alternatives

If you are invited to a presentation about corporate ethics hedging, it may take you a moment to grasp the concept. Since ‘ethical investment’ has become an established term, the phrase actually trips off the tongue. However, I’m glad to say it didn’t sound right when I heard it down the telephone. It suggested something implicitly like the route to an Enron-type result. Even if a company wanted to ‘hedge’ its ‘ethics’, would there be anyone proudly advertising such a service, let alone a well-known and reputable institution?

Better, of course, to hear clearly what you’re being told. Corporate FX hedging is the name of the game, and Standard Chartered Bank is talking that book. The much-awaited US dollar slide may be under way, and there is business to be had in offering protection against such foreign-exchange risk exposure.

That’s not the most interesting bit of the bank’s recent research report, however (in case you were wondering). It’s not even the second most interesting bit which, to me at least, was the forecast of the British pound falling even against a falling dollar over the course of the year. (The idea that the UAE dirham might still rise against sterling makes dollar-equivalent earnings less troubling to a British expat.)

And, on an infinitely bigger scale, that is the kind of issue which is the real story. It’s about not only risk, but real returns, to the Gulf countries as a whole.

Standard Chartered Bank recommends that the proposed GCC single currency should de-peg from the US dollar. It is not alone in that. The Dubai Chamber of Commerce and Industry implied as much in an economic bulletin a year ago, saying that floating would allow independent policy-making and avoid the same fate as the dollar.

The Gulf Research Center in Dubai has been discussing the issue on and off for some while. Indeed, many have wondered aloud on this topic, while not all committing to a verdict. But the bank has repeated it, again, and argued a case.

Decision time?
If such a decision came, it would undoubtedly be a bold step, with significant implications. The currency itself may still be some way off, with occasional rumours that the 2010 deadline is in doubt. Yet, though timing is undoubtedly important (and especially so if the problem to be resolved is here and now), that’s actually not the key point. Why, in fact, suggest such a radical step for a region whose currencies have mostly been pegged to the dollar for decades, which has not been especially troubled in doing so, and indeed now appears to be flourishing?

The bank’s reasoning, amid its carefully-defined research, boils down to two points, both easily accessible.

First, it is not in the best interests of the Gulf countries for their currencies to go down with the (apparently) sinking ship which is the dollar. While exports are mostly dollar-denominated, imports are substantially in other currencies, which would therefore become more expensive. That’s clear enough, leaving aside for the moment the incendiary topic of whether oil should continue to be priced in dollars.

Second, running domestic monetary policy in line with US policy (i.e., setting interest rates in parallel to the US Federal Reserve) always runs a risk, namely that the policy stance is inappropriate (too lax or too tight) for local conditions. The trade-off between the confidence generated by the fixed relationship on the one hand and policy inflexibility on the other is the core conundrum, and an increasingly live issue now, when interest rates seem considerably too low for the Gulf’s rampant economies.

They explain it further. The decline of the dollar against the euro through 2000-2004 increased the GCC’s import bill. The subsequent decline against Asian currencies too, projected to continue, represents a further “threat to the bottom line”. That currency mismatch applies also to budgets, where revenues are also mostly dollar-denominated, but spending frequently is not.

At the moment, whereas the dollar peg brings useful certainty vis-à-vis the dollar, with the hydrocarbon sector still so dominant it means that the impact of oil-price fluctuation is imparted fully to the real economy. Some form of currency float would allow the exchange rate (and interest rates) to take some of the strain.

Moreover, “Forex diversification is likely to become an increasingly important theme going forward” at the global level, so that having 90 per cent + of reserves in the dollar “is not necessarily appropriate any more”. A couple of diplomatic euphemisms there. In layman’s terms, if Asian central banks, Russia and others are going to flee the dollar, it may be better to be with them rather than trying to hold the fort.

“We believe the dollar is overvalued, and therefore could be subject to a significant correction,” says Standard Chartered. While that forecast appears cannily hedged itself, the warning is clear. The recommendation is that the planned GCC currency “should be marked against a trade-weighted basket instead”.

At one level, the logic is compelling. The idea that the Gulf region selling oil lucratively at $70 and in huge surplus should be tied to the dollar, with America in chronic deficit and buying expensively at the same price, does have a ring of absurdity about it. But is it as simple as that?

Stepping back, a barrage of advice has come over the years from the IMF (the same IMF which last week called for dollar devaluation). The outcome, however, has been inconclusive. While agreeing that a more flexible exchange rate policy may become desirable as the GCC economies become more diversified and integrated with world markets, it has generally found that a trade-weighted basket peg would be no better than a dollar peg in procuring stability, and the flexibility versus credibility debate becomes no clearer, though a euro/dollar combination may offer a reasonable alternative.

At the Gulf Research Center, economist Emilie Rutledge seems more convinced. As the “GCC’s economies are maturing and diversifying rapidly” the current inability to set their own monetary policy “is far from optimal”. Additionally, “as a longer-term investment the euro looks more promising than the dollar”.

She raises the further matter of the creation of a single GCC currency (the ‘Gulf dinar’) itself creating downward pressure on the dollar, as the oil-producing countries will invest more at home instead of (as previously) in dollar assets. The dinar may itself attain reserve status, especially if oil were priced in the same terms, though there would be “political disquiet” from the US in that event which is another understatement. It should all give further pause for thought.

Wouldn’t the GCC states be prejudicing the value of their own existing reserves if they (effectively) acted against the dollar, whether by diversifying their assets, de-pegging, or pricing oil differently? In an environment of very high oil prices, could it actually be done without serious revaluation, which would jeopardise emerging non-oil activities and, ironically, call for (entirely inappropriate) lower interest rates? Not pegging risks the GCC tent being blown about by a potentially storm-force wind.

Standard Chartered Bank’s analysis suggests that flexibility will be manageable. The authorities could still offset current account inflows by capital outflows (though less into dollars), and would simply have to judge whether the exchange rate or interest rate were their priority.

So there it is. I’m not entirely convinced, but perfectly well accept that the GCC may have outgrown the peg. Meanwhile, it’s worth remembering that no exchange-rate regime on its own delivers a definitive economic framework. Fiscal control and structural matters remain beasts which have to be tamed for a successful, overall strategy.

Also, we are still talking about 2010. By my calculation, that’s getting on for four years away. The dollar might still be ‘weak’ and the euro ‘strong’. We cannot know. But, won’t the markets have moved on a bit by then?

On the practical side, the European Central Bank is offering the GCC states advice, and their technocrats are probably among the least objectionable of the EU’s infrastructure. Whether the euro will appear in the policy mix is then an intriguing issue. Europe does not have much call for an even higher dollar exchange rate, but it does like gestures denoting prestige.

There’s another idea I could mention. If the GCC is on the lookout for another possible fix, like a ready-made US dollar & euro basket, it could consider a fairly heavyweight international currency which already fits that description. Despite the fact that it has been threatened with expiry, including by ministers and (almost hysterically) by so-called experts in its own country, it’s been around a very long time and it still works. It is far less volatile historically than either the dollar or the euro (see chart), because its balance of payments is relatively evenly exposed to both. You may even have heard of it. It’s called sterling: the British pound. Snag is: Standard Chartered do say it will fall faster than the dollar. Maybe. Anyway, it’s just a thought.

Insights

“Of course, de-pegging would imply appreciation of all GCC currencies. In 2005, the combined current account surplus of the six GCC states is estimated at approximately $160 billion, with net foreign assets in the banking system (excluding reserves accumulated in stabilisation funds) at approximately $260 to $300 billion. With a positive outlook for crude oil prices over the medium term in addition to capital inflows, all GCC states will have significant appreciation pressures on their currencies. There is an important point to note here, though. If the bulk of foreign currency inflows is channelled directly to central banks or stabilisation funds and re-invested abroad, then appreciation pressures could be mild. De-pegging GCC currencies will not likely have a negative impact on the USD. Since GCC countries do not have enough investment opportunities domestically to absorb petrodollars, they will continue to find their ways into US Treasuries even after a revaluation. In addition, unlike the case of China, currency revaluation in the GCC will not imply a decline in exports and a decline in accumulation of reserves, since crude oil exports are denominated in USD and are not sensitive to exchange rate movement. In fact, an appreciation of the GCC currencies could help resolve global imbalances by making US imports cheaper and reducing the deficit. A shift in the demand for the USD by reallocating reserves, however, could indeed de-stabilise it. An outright exit from the USD by global central banks could indeed lead to its collapse. The cost of [the resulting] abrupt shock to interest rates in the US could be large. It could indeed lead to a global slowdown. I think that most GCC countries will opt towards a gradual shift in reserves.”
— Hany Genena, Senior Economist, EFG-Hermes

“De-pegging does make sense [for the GCCs], to run their own monetary policy. The inflationary situation at the moment throws that into very sharp relief. A lot of preparation would need to be done, including stopping pricing oil in dollars. Otherwise it risks compounding the volatility of the local currency value of oil revenues. The authorities would also have to guard very carefully against the kind of substantial appreciation pressures that there would undoubtedly be at the moment if the currency were floating.”
— Simon Williams, Economist Intelligence Unit

“The key here is for the region to do what is best for the long-term sustainability of the region’s economic performance. We believe that authorities still have time to diversify reserves quietly before the new single currency comes into effect. Forex reserves in fact are not the issue. The bigger issue is the investment agencies who are clearly large even in a global context. They would likely be discreet in their diversification efforts. However, the impact on the value of the dollar would be there for all to see. [The interest-rate, exchange-rate trade-off] is a real challenge for the region, especially when taking into account the need to diversify the economies in order to create jobs for the hugely-expanding labour markets. In the short-term, this may create a conflict between managing the boom (higher interest rates) and help boost the diversification process (by ensuring a competitive currency). Clearly, the situation would need careful monitoring and managing. On the issue of what currency to price oil in, we see no reason why an alternative currency/ies could not be used. If the GCC countries were to pursue a trade-weighted exchange rate target, then imagine the UAE, for instance, exporting to Europe. This would mean the importer would need to hedge its euro/dollar exposure and the UAE exporter would have to hedge its dollar/GCC exposure. Why not transact in either the GCC single currency or euro, which removes the need for one counterparty to hedge? If [oil pricing] were in euro, the UAE would be able to naturally diversify its reserves away from a structurally weak dollar. Alternatively, it could price oil in dirham, and then make a rational investment decision as to what to do with that money.”
— Steve Brice, Standard Chartered Bank

“We do not make recommendations, but I am not entirely sure whether a change of policy would help fix the problem. I don’t really see an alternative regime that would be superior. If you have a flexible exchange rate, and it rises with capital inflows which create higher credit and inflation, then interest rates are raised, then the exchange rate rises again ? [It is a vicious circle.] Practically, it may be better to endure the peg. It is the price paid for a less-than-perfect policy regime [like any]. Any country with high commodity dependence has this issue. In the case of Norway or Canada, the ratio is lower than here. The UAE [and GCC] are a special case, with a huge exchange-rate ‘overshoot’ and ‘undershoot’ possibility. In any case, it is unwise to shift from a fixed system to flexible without the rest of the policy framework and banking system being ready. Change could mean GDP would become even more volatile.”
Pierre Cailleteau, Sovereign Risk Unit, Moody’s

High time for a single GCC currency

Blog Publications Reports

First published in:
Al Jazeera

Rutledge, E. J. (2005, October 3). High time for a single GCC currency Al Jazeera. https://www.aljazeera.com/news/2005/10/3/high-time-for-a-single-gcc-currency

There has been a fair amount of scepticism towards the proposed Corporation Council for the Arab states of the Gulf single currency, not just in terms of the likelihood of it actually being launched but also with respect to the economic benefits it is expected to provide

In terms of appropriateness, as all member states have similar economic structures – export-orientated economies – the single currency should be viable and not be that difficult to implement.

According to monetary theory, key benefits of currency union include the elimination of transaction costs and the generation of greater levels of trade between member states.

With regard to these theoretical benefits, reactionary economists argue that, as all six sovereign currencies are pegged to the US dollar, transaction costs are already effectively non-existent.

They also point out that a single currency would not stimulate much new intra-Gulf Cooperation Council trade as most of the region’s trade involves exporting oil and gas to Asia and Europe, not trading goods with one another.

For currency union to be effective, there will need to be a single independent central bank along with a GCC monetary authority.

Fiscal budgetry
These institutions would need to have the authority to set fiscal budgetary restrictions, and require member states to provide timely and transparent data including national accounts.

Many doubt, when push comes to shove, GCC leaders will actually defer to a supranational institution. A federation of existing central bankers would probably lead to a weak currency and increase the likelihood that it will stick with the dollar peg.

Much of the potential success or otherwise depends on two things: a strong independent central bank and what exchange rate mechanism the region’s policymakers decide to adopt post 2010.

It seems that at present there is little appetite – at least publicly expressed – to move away from the dollar peg, let alone consider invoicing future oil sales in Gulf dinars.

Reasons given for maintaining the status quo include the fact that the dollar is the de facto currency of international trade and that Opec oil sales are invoiced in dollars.

It is also a fact that GCC governments hold vast sums of dollar-denominated assets, such as US Treasury bonds. A move away from the dollar would see more uncertainty as to the value of these assets.

However, the dollar peg is not the optimal choice for the region’s economies.

As GCC economies mature and attempt to diversify away from dependence on hydrocarbons, the utility of the dollar peg needs to be critically examined.

Even if the current arrangement is kept as a convenient convergence tool up until 2010, once launched GCC leaders should seriously consider viable alternatives such as a managed free float or a loose peg to a trade-weighted basket of currencies.

Key problem
One key problem with the dollar peg is that it effectively means that GCC central banks have outsourced their decision-making powers on interest rates to Alan Greenspan of the US Federal Reserve.

Not having independent monetary policy tools can be problematic, particularly in terms of combating inflation and encouraging growth.

As a consequence decisions on whether or not to cut, hold or hike rates are based on economic conditions in the US and these are not always the most appropriate for the GCC.

It is often the case that the US economy will grow robustly when oil prices are low while GCC economies will either experience low levels of growth or stagnation.

Conversely when oil prices are high the pace of US growth eventually slows, and US interest rates have been low for several years now in an attempt to stave off recession.

These low interest rates which the GCC central banks have to track, are now exacerbating inflation in the GCC and leading to the overvaluation of some stock-market and real estate-assets.

There is also increasing concern over the size of America’s federal debt, which is almost $8 trillion. Its budget deficit this year alone is expected to be $600 billion. In recent years the US economy has been characterised by substantial budgetary deficits. It consistently spends more than it earns.

As a result, the US is becoming more and more dependant on foreign countries willing to hold dollars in their reserve accounts and buy its Treasury bonds.

Essentially the US Federal Reserve prints paper – Treasury bonds and dollar bills – and swaps these for commodities such as oil and consumer items such as Chinese household appliances.

The weakening dollar has also resulted in GCC imports from Europe becoming more expensive. When launched in 2002 a Saudi riyal was worth €0.29 euros; today it is worth only €0.21 euros.

This means that it has become 32% more expensive for GCC states to import goods from the eurozone, which happens to be the region’s largest import partner. Unlike the US, the eurozone does not run large trade deficits, and the European Central Bank imposes strict limits on government deficits.

If GCC states were to start shifting some of their dollar-denominated assets into euro-denominated ones prior to currency union, it would provide a good hedge against the expected downward decline in the dollar.

Even more significantly if, post-currency union, the GCC decided to allow the purchase of oil in euros along with the Gulf dinar and other currencies, they would see their euro assets appreciate massively, as a greater number of oil-importing nations would hold higher levels of euros in reserve and therefore increase its value.

Long-term value
Iran’s decision to open an oil and associated derivatives market in March 2006 is interesting, not least because it plans to invoice contracts in euros, not dollars.

It is not likely that many energy traders will leave New York or London and set up shop in Tehran, but Iran’s move does highlight a rising concern over the long-term value of the dollar.

If the dollar continues to decline against the euro, more states will increase the percentage of euros they hold in their reserves because the euro will be a better store of future wealth, and major oil suppliers will prefer to sell at least some of their oil for euros or currencies other than the dollar.

A strong, independent, single GCC currency is likely to attract increased levels of foreign direct investment to the region and facilitate the invoicing of some oil and gas sales in Gulf dinars.

Not only would this provide the region with substantially higher seigniorage revenues but it would also result in the Gulf dinar becoming, albeit a minor, reserve currency with a host of associated benefits, especially for the region’s non-oil financial sectors.

The currency could well be viewed by some Arab and Islamic states as a more “acceptable” reserve currency than that of the US dollar.

The notion that it would be too difficult to set up a market for invoicing oil sales in any currency other than the dollar is quite frankly ridiculous, and is largely being propagated by those with a vested interest in the current petrodollar hegemony.

Bio
“Emilie Rutledge is a British economist who is currently based at the Gulf Research Center in Dubai” (2005).