Case for flexible rates in the GCC
by Bhavin Patel
Countries in the Gulf Co-operation Council running currency pegs have faced significant devaluation pressures since the 2014 oil price collapse. Persistently low prices have led to worsening terms of trade for these net oil exporters, forcing their central banks to deploy reserves to maintain their exchange rates.
Bahrain’s dollar peg is the most vulnerable. Foreign reserves have fallen by 40% since 2014 and remain the lowest in the region, at $3.4bn, equivalent to only two months of import cover. Additionally, Bahrain is contending with unsustainable debt levels, as the central bank continues to lend to the government to finance spending, and the country continues international bond issuance. Total government debt rose to 82% of GDP in 2016, while the fiscal deficit reached 18% of GDP.
Rising bond yields reflect the market perception that Bahrain is susceptible to a devaluation. This raises concerns for other GCC states, which would face higher borrowing costs if Bahrain were forced to restructure its debt.
The biggest challenge to the peg came in November following Fitch's revision of the country’s credit rating from a stable to a negative outlook. Bahrain had to ask for foreign currency aid from Saudi Arabia and the United Arab Emirates to support its currency peg and prevent the risk of contagion. GCC countries would do well to take the collapse of the dollar peg in oil-dependent Angola on 4 January as a warning.
The region’s central banks have dismissed the possibility of abandoning dollar pegs, which historically have been advantageous for stabilising oil revenues. The dollar remains the global currency for pricing oil, so pegging to it allows GCC countries to anchor expectations on inflation and exchange rate pathways. A regional peg also hedges against exchange rate risks in intra-GCC trade.
Flexibility and diversification
As the region diversifies away from oil, the long-term benefits of sustaining the fixed exchange rate regime will continue to decline. The dollar peg prevents GCC countries from using monetary policy as a tool for demand management, and commits them to following US policy at a time when the Federal Reserve is raising interest rates. Additionally, it limits their capital account openness, depriving them of important sources of non-oil funding. These factors should be re-evaluated if the region wants to support growth in finance, tourism, technology, manufacturing and other sectors.
A rapid change to a flexible regime is improbable, given that the institutions needed to support a free foreign exchange market are underdeveloped in the region. A long-term shift in line with the diversification of export revenues would be more effective, involving transitionary regimes with the aim of forming a monetary union, once economic and political conditions allow.
One option would be a peg to a currency basket, weighted to GCC countries’ largest trading partners. This composition would partly resemble the International Monetary Fund’s special drawing right, with the dollar, euro, renminbi, yen and sterling all featuring, but with different weightings reflecting each economy’s relative importance as a trade partner. Kuwait adopted a similar approach after it broke its peg in 2007 following substantial dollar depreciation and rising inflation.
Moving away from dollar pegs and towards a basket of currencies, before pursuing flexible exchange rates, would strengthen GCC trade links with Europe and emerging markets in Asia, and help diversify the economy away from oil.
This would grant GCC countries greater control over domestic demand, production and consumption. The dominance of the dollar as invoice, investment and anchor currency in the region should begin to subside as diversification efforts accelerate in 2018.
Bhavin Patel is Economist at OMFIF. Back