A Common Currency Peg in the GCC Area: The Optimal Choice of Exchange Rate Regime

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1 Loyola Universiy Chicago Loyola ecommons Topics in Middle Easern and Norh African Economies Quinlan School of Business A Common Currency Peg in he GCC Area: The Opimal Choice of Exchange Rae Regime Eisa A. Aleisa Inernaional Moneary Fund Shawka Hammoudeh Drexel Universiy Recommended Ciaion Aleisa, Eisa A. and Hammoudeh, Shawka, "A Common Currency Peg in he GCC Area: The Opimal Choice of Exchange Rae Regime". Topics in Middle Easern and Norh African Economies, elecronic journal, 9, Middle Eas Economic Associaion and Loyola Universiy Chicago, 2007, hp:// This Aricle is brough o you for free and open access by he Quinlan School of Business a Loyola ecommons. I has been acceped for inclusion in Topics in Middle Easern and Norh African Economies by an auhorized adminisraor of Loyola ecommons. For more informaion, please conac ecommons@luc.edu he auhors

2 A Common Currency Peg in he GCC Area: The Opimal Choice of Exchange Rae Regime Eisa A. Aleisa a1 Shawka Hammoudeh b Absrac: This paper examines he impacs of exernal shocks on he counries of he Gulf Cooperaion Council s (GCC) prospecive moneary union, while focusing on he opimal choice of he exchange rae regime. The resuls show ha oupu movemens in he GCC as a single bloc are driven in he shor- and long-run mosly by domesic shocks and by erms of rade in he long run as well. Shocks coming from boh he US dollar and he euro zones have small impacs. These resuls and he weak correlaions wih hose wo zones sugges ha GCC bloc should peg o a baske of currencies as a ransiory sep on he way oward a more flexible exchange rae regime. a Middle Eas and Cenral Asia Dep. (MCD), Inernaional Moneary Fund, Washingon, DC Phone: , Fax: , ealeisa@imf.org. b Lebow College of Business, Drexel Universiy, Philadelphia, PA Phone: , Fax: , hammousm@drexel.edu Key word: Shocks; variance decomposiion; impulse response; moneary union; currency baske. JEL Classificaion: E52, O52, C22 1 Errors and Opinions expressed in his aricle are hose of he auhors and no hose of he Inernaional Moneary Fund.

3 Common Currency Peg in he GCC Area: The Opimal Choice of Exchange Rae Regime 1. Inroducion The six members of he Gulf Cooperaion Council (GCC) Bahrain Kuwai, Oman, Qaar, Saudi Arabia, and Unied Arab Emiraes plan o inroduce a single currency in The plans for moneary inegraion beween hese six counries dae back o he incepion of he GCC in 1981, and he endorsemen of he unified economic agreemen in The process oward economic inegraion had gone slowly bu in 2001 i gained momenum, culminaing in he raificaion of a new economic agreemen. The new agreemen ses a specified imeable o achieve he requiremens of he moneary union. These requiremens include he harmonizaion of all economic policies, paricularly fiscal and moneary policies, he sandardizaion of banking regulaions and he meeing of he convergence crieria. In January 2003, he GCC counries formed a cusoms union and applied a common exernal ariff. On he same dae, hese counries formally pegged heir currencies o he U.S. dollar. The inroducion of he GCC single currency in 2010 will necessiae he creaion of a single GCC cenral bank, a single GCC moneary policy and he choice of a common GCC exchange rae regime. The choice of he ype of he exchange rae regime prior o 2010 is one of he key economic policies pending for he GCC counries. Should hese counries allow he new currency o be fixed o he U.S. dollar, o a baske of currencies where he dollar and he euro have he larges proporion or o le he currency floa subjec o possible exchange marke inervenions from ime o ime? Each choice has is own meris and drawbacks. In his paper we examine he opimaliy of making an exchange rae arrangemen. As a forward-looking sudy, his paper considers he GCC counries as a prospecive single moneary union, and hus consrucs weighed averages of wo key macroeconomic variables, namely real GDP and he price level across he GCC members. The objecive is o 2

4 assess he impacs of erms-of-rade shocks and he dollar and euro zones shocks on he GCC economies, by focusing on which exchange rae regime would be opimal for his union. A growing consensus among economiss is ha emerging economies should move o a corner soluion; ha is, hey should consider eiher a fully floaing or a rigidly fixed exchange rae regime. Frankel (2000) argues ha inermediae exchange rae regimes are vanishing (or should be). Ye he quesion of wha ype of regime is appropriae for emerging economies sill remains a highly debaed issue. As mos of he emerging economies lack a well-developed financial marke and liquid financial insrumens, he role of moneary policy under a flexible regime may be limied. Even if a counry saisfies he deerminans for a flexible regime, many sill argue ha he gains from he credibiliy of ying he local currency o an inernaional anchor can be greaer han he benefis of adoping a floaing exchange regime. Ohers, however, endorse a baske peg as a superior alernaive o a bilaeral, rigidly fixed exchange rae regime. Since baske pegs end o be more flexible han bilaeral pegs, Gudmundsson (2005) argues ha he move from a bilaeral peg o a baske peg can be an imporan sep on he way o a flexible exchange rae regime. More recenly, he imporance of pegging he local currency o he price of he major expored commodiy began o surface. Frankel (2002, 2003a and 2003b), for example, argues ha counries who are specialized in he producion and expors of a mineral or agriculural commodiy can benefi from pegging heir currencies o he price of heir expored commodiy. He finds ha under he Peg Expor Price (PEP) proposal, counries ha suffered from a declining world marke in oil or in oher commodiies in he 1990s would have auomaically experienced currency depreciaion, and ha would have boosed expors when i was needed. The PEP can simulaneously deliver auomaic accommodaion o erms-of-rade shocks, while a he same ime helping hese counries mainain he credibiliy of pegging heir currencies o a nominal anchor such as he dollar or oher pegging arrangemens. In an empirical sudy of he alernaive exchange rae arrangemens and financial inegraion for GCC counries, Abed e al. (2003) compare he dollar peg o a dollar-euro baske peg as alernaive exchange rae regimes for improving he exernal sabiliy of he GCC counries. They sugges ha he baske peg dominae he dollar peg in improving sabiliy. They 3

5 also sugges ha as GCC expors become more diversified, a more flexible exchange rae policy such as pegging he prospecive common currency o a dollar/euro baske may become necessary for boh compeiiveness and sabiliy purposes. In addiion o he compeiiveness and exernal sabiliy reasons, Jadresic (2002) focuses on oher policy consideraions in choosing a currency peg for he GCC. Those consideraions include he credibiliy of he exchange and moneary policy sance, he effecs of exchange rae volailiy on financial markes, and ransacion coss arising from exchange rae volailiy. Jadresic finds ha hese consideraions dominae compeiiveness and exernal sabiliy. Fasano and Schaecher (2003) compare he condiions for creaing a successful GCC moneary union o oher moneary unions already in exisence (for example, he euro zone, CFA franc zone. ec). These auhors emphasize he need for he GCC members o develop an insiuional union framework (such as a decenralized cenral bank, common moneary insrumens, financial crises sysem ec) and o se some basic quaniaive benchmarks such as he European Union Maasrich Agreemens. Hammoudeh and Aleisa (2004) examine financial inegraion in he GCC sock markes. They find ha hese markes are coinegraed in he sense ha hey have muliple long-run relaionships. However, in erms of shor-erm dynamics, he auhors find limied causal relaionships among he GCC sock markes. The primary objecive of his paper is o invesigae he opimaliy of ying he proposed common GCC currency o he U.S. dollar or o a baske of currencies, and/or of having a more flexible exchange rae regime. Applying he heory of Opimum Currency Area (OCA) and using a srucural VAR model, we invesigae he roles played by erms of rade shocks, global shocks (he U.S. dollar zone and euro zone), and regional shocks in affecing he GDP of he GCC counries, by focusing on wha he opimal choice of he exchange rae regime is. We consider regional shocks o be he same as domesic shocks, since regional GDP is he weighed average of he GCC counries. To invesigae o wha exen GDP in he GCC area is influenced by he real oil price, he U.S., and/or European shocks, and domesic shocks, we aggregae wo key macroeconomic variables, namely real GDP, and he consumer price index (CPI) o invesigae he response of hese macroeconomic variables o he aforemenioned shocks. Specifically, we 4

6 will ry o answer he following wo quesions: (1) o wha exen do he GCC economies influence and o wha exen are influenced by real oil prices?; (2) is he business cycle of he GCC area as a bloc relaed o is rading parners (paricularly he US and he Euro areas) economic aciviy in such as a way ha a moneary policy s move by hese parners a a paricular ime would happen o be he righ policy for he GCC area oo? The balance of he paper is organized as follows: secion 2 provides an overview of he opimum currency area. Secion 3 presens an overview of he GCC economy. Secion 4 describes he benchmark model for he GCC as a prospecive single bloc and idenifies he relaive impacs of he domesic and exernal shocks. Secion 5 examines he esimaion resuls of he benchmark model. Secion 6 describes an alernaive model as a robusness check on daa aggregaion in he firs model and secion 7 examines he esimaion resuls of his alernaive model. Secion 8 provides he main conclusions. 2. The Opimum Currency Area The lieraure on he heory of OCA pioneered by Mundell (1961) and subsequenly by McKinnon (1963) and Kenen (1969) suggess several crieria ha can be used in examining he suiabiliy of a common moneary arrangemen. The crieria include symmery of he underlying macroeconomic shocks, facor mobiliy, openness, fiscal redisribuion schemes and real wage flexibiliy, among ohers. More recenly, some auhors emphasized he need for a supra -naional governmen body o conduc inerregional ransfers (De Grauwe, 1997). Frankel and Rose (1997, and 1998), Corsei and Peseni (2002), and De Grauwe and Mongelli (2005), examine he endogeneiy of he opimum currency area. These auhors findings confirm ha moneary unions lead o significan increases in rade inegraion. For example, Frankel and Rose (1997 and 1998) argue ha even if a counry does no mee he crieria of he OCA ex ane, he increase in rade wihin he moneary union resuling from he inroducion of he common currency may qualify his counry o saisfy he OCA crieria ex pos. 5

7 The GCC economies seem o be fairly inegraed in erms of economic srucures and rade. They have a remarkable degree of moneary and fiscal convergence, low inflaion in all member saes and narrow shor-erm ineres rae movemens. These members have highly open economies and a high degree of labor and capial mobiliy wihin he GCC region. Furhermore, he GCC counries have over ime esablished a broad range of insiuions o suppor he economic inegraion process. The aforemenioned facors suppor he view ha he GCC is more likely o experience symmeric shocks, hus reducing he likeliness of asymmeric shocks and he need o resor o nominal exchange rae adjusmens. Forming a moneary union among he GCC counries would enail some coss, bu membership in a currency union may provide greaer poenial benefis o hese saes. There are key benefis ha can be achieved from such an arrangemen. Firs, a single currency would eliminae he ransacion coss associaed wih using differen currencies among he GCC counries, and his cos eliminaion would minimize he magniude of price discriminaion beween heir markes. Second, one can expec some efficiency gains associaed wih enhanced rade and increased capial flows as a resul of abandoning a mulipliciy of currencies. Even hough each GCC counry follows a fixed exchange rae sysem, a common GCC currency is more credible han jus having a fixed rae sysem for he individual counry. Third, a common GCC currency would induce naional price convergence and would imply a common real exchange rae for all members. There may be welfare gains from less uncerainy abou fuure real exchange raes. Fourh, a single currency would promoe beer policy formulaion and coordinaion of naional economic policies. A decenralized sraegy for economic policies among he six markes will creae healhy compeiion ha should promoe he bes policies. Equally imporan, he inegraion of he GCC capial marke will deepen he widh and breadh of he financial marke, enabling domesic invesors o diversify heir invesmens and giving firms efficien access o raise capial. However, membership in a common currency union will reduce policy independence, ha is, membership in a moneary union prevens member saes from implemening counry-specific moneary and fiscal policies in response o counry-specific disurbances. 6

8 3. An Overview of he GCC Economies Alhough some of he GCC counries have o some exen been successful in diversifying heir producion base, oil coninues o be he key elemen of heir oupu (Table 1). In his able, he oil secor sill accouns for abou 31.6% of he GCC s real GDP over he period I should be noed ha much as diversificaion away from oil is considered o be an imporan elemen for he GCC area s economies, diversificaion of governmen revenues is also imporan. As is always he case, falling oil prices exer pressure on he local currencies, making he proposed new currency vulnerable o developmens in he world oil marke. Thus, policies o diversify governmens revenues are as crucial as he diversificaion of he GCC economies. In erms of openness, Table 1 shows ha he GCC counries have highly open economies as evidenced by he high raios of impors and expors o GDP. This able also shows ha he GCC counries have an average growh rae of abou 3.8% over he period , and ha heir inflaion raes are sable over his period. Moreover, Table 2 shows ha he GCC counries no only have sable and low inflaion, bu also he individual counry inflaion raes have significan correlaions averaging around 50%. The overall inra-rade beween he GCC counries is fairly limied. The individual members expors rade paerns wihin he GCC region and wih oher counries and regions are provided in Table 3. This able also shows ha, excep for Saudi Arabia, GCC expors o he res of he world are concenraed in Asia. In conras, GCC impors seem o be concenraed in he European Union, followed by Asia as demonsraed in Table The Benchmark Model and Mehodology Consider a hree-variable VAR, open-economy model o examine he opimal choice of an exchange rae regime for he GCC counries as a prospecive moneary union. The hree variables are global oupu (real GDP of he US and /or he European Union), real oil price, and regional oupu (as he geomerically weighed average of he GCC real GDPs). The model can be wrien as an infinie moving-average process in he shocks, 7

9 X = Aiε i= AL ( ) ε (1) i= 0 h g r where he vecor X = [ y y y], (represening raes of change in real oil price or erms of radey, global oupu h g y, and regional oupu r y ) is subjec o hree muually uncorrelaed srucural shocks wih finie variances (he erms of rade shocksε h, he global g shocks (U.S. dollar zone or euro zone) ε, and he regional shocksε r, denoed by he h g r vecorε = [ ε ε ε] ), and AL ( ) is a marix whose elemens are polynomials in he lag operaor L. We make he following assumpions: (1) only oil price shocks have a long-run impac on oil prices; (2) global variables are affeced only by global shocks in he long run; and (3) regional shocks have no long-run impac on global oupu Idenificaion of he shocks Assume ha he covariance-saionary vecor average process in he srucural shocks: X can be wrien as an infinie moving X = Aiε i= AL ( ) ε, (2) i= 0 where AL ( ) is a marix whose elemens are polynomials in he lag operaor L., le us denoe he elemens of AL ( ) by aij( L ). The ime pah of he effecs of a shock inε j on variable i afer k periods can be denoed by ω ijk (). Addiionally, le A (1) represen a marix of long-run effecs whose elemen are a ij(1) ; each elemen gives he cumulaive effec of a shock in ε j on variable i over ime. Similarly, A0 is he marix of he conemporaneous effecs and is consisen wih ω ij(0). Given he model srucure, he long-run effecs of he shocks can be summarized in a marix form, 8

10 y h a 11 (1) 0 0 y = a (1) a (1) 0 g y a (1) a (1) a (1) r ε h ε g ε r (3) Noe ha he marix of he long-run effecs is he lower riangular marix. 5. Empirical Resuls of Benchmark Model We esimae he benchmark model for he prospecive GCC union as a single bloc using he aggregaed quarerly daa. The daa were colleced for he period 1980:01 o 2003:04, from he U.S., he European Union counries, and he six GCC counries. The daa are aken from he IMF s Inernaional Financial Saisics CD-Rom daabase. Due o he lack of quarerly daa on he GCC GDPs, we use he Ginsburgh mehod o exrac quarerly GDP from annual daa 2. The daa for he US includes he real GDP and he price level proxied by he US CPI, for he European Union he real GDP and he price level (proxied by Germany CPI), and for he GCC counries he real oil price, he weighed average of he individual real GDPs and he weighed average of individual price levels. Due o he unavailabiliy of quarerly daa on he individual CPIs for all GCC member counries, we use he CPIs for Saudi Arabia, Bahrain, and Kuwai as a proxy for he whole GCC counries s weighed average CPI, consiuing approximaely 75% of he weigh of he GCC. Therefore, we proxy erms of rade by real oil price (crude oil price deflaed by he US CPI), he GCC real oupu by he weighed GCC real GDP, he global oupu by he U.S. real GDP and/or European Union real GDP, he global price level by he U.S. CPI and/or, he German CPI for he European Union, and he GCC CPI by he weighed average of he CPI s of Bahrain, Kuwai and Saudi Arabia. To properly specify he empirical model, an imporan sep in consrucing he model is o es for uni roos and saionariy of he variables used. The resuls of Augmened Dickey Fuller (ADF) and KPSS ess are presened in Table 5. The ADF es saisics indicae ha he presence of a uni roo in he oupu levels (for he U.S. real GDP, he European Union real GDP, 2 Oil producion index was used as reference o exrac he quarerly GDP. 9

11 and he GCC real GDP), he real oil price level, and he price levels (for he U.S. CPI, he German CPI, and he GCC CPI) canno be rejeced. Similarly, he KPSS es rejecs saionariy for all variables a he convenional significance levels 3. Hence, i is appropriae o model he variables h g r in he firs differences. Noe ha he vecorx = [ y y y] makes up he VAR which is esimaed wih five lags. The AIC diagnosic ess indicae ha five lags are appropriae for Commen [LCoB1]: Eisa wha ess? AIC? residuals o approximae whie noise. The dynamic effecs of he innovaions can bes be undersood by carrying ou he variance decomposiions (VDC) and impulse response funcions ypical for he VAR mehods. Table 6 repors VDC of forecas errors for only he regional oupu because he aim of his paper is o examine he impacs of erms of rade shock and global shock (he US and he European impacs) on he GCC economies as a single bloc. We do no repor he resuls for he global oupu and he real oil price as hese wo variables are explained by own global and real oil price shocks, respecively. The VDC resuls in Table 6 (he dollar zone) demonsrae ha domesic shocks explain he bulk of he regional oupu movemens 4. Terms-of-rade shocks seem o have a negligible impac on he regional oupu in he shor run, bu in he long run, hose shocks accoun for over 33 percen of he forecas error variance compared o 55 percen for he domesic shocks. Global shocks seem o have a modes impac in he long run accouning for abou 11 percen of he forecas error variance. An ineresing aspec of he resuls is ha he impacs of global shocks in he dollar zone are modes despie he dominan role played by he dollar in he economies of hese counries (for example, he bulk of heir oil expors is denominaed in dollar erms). Bu he erms-of-rade shocks seem o explain a sizable proporion of he GCC regional oupu movemens in he long run, and he business cycles of he GCC counries as a bloc do no appear o be driven by he oupu movemens in he U.S. Similar o he dollar zone, he VDC resuls for he euro zone in Table 6 show ha he erms-of-rade shocks seem o have negligible impacs in he shor run. In conras, hey explain over 21 percen of regional oupu movemens in he long run, sill significanly lower han in he 3 The uni roo resuls are available upon reques. 4 We consider regional shocks as domesic shocks since he regional oupu is he weighed averages of he GCC individual real GDPs. 10

12 U.S. dollar zone. As is he case in he dollar zone, global shocks appear o have insignifican impacs on regional oupu variaions in he shor run, bu hey have greaer effecs in he long run reaching abou 15% in six years compared o 11% for he dollar zone. Thus, domesic shocks appear o explain he bulk of regional oupu movemens similar o he dollar zone. To sum up, he business cycle of he GCC counries as a bloc does no seem o be driven by oupu movemens in heir rading parners, specifically he U.S. and he European Union. Furhermore, he erms-of-rade and domesic shocks appear o explain a sizable proporion of he regional oupu movemens in he GCC counries. Figure 1 provides he resuls of he impulse response funcions (IRF) analysis. The lef panel of his figure shows he responses of regional oupu o he euro zone global and domesic shocks, while he righ panel displays he responses of he regional oupu o he same shocks wih he global shocks emanaing from he dollar zone. This figure shows ha a posiive one sandard deviaion shock o he real oil price (erms of rade) leads o a sligh increase in regional oupu. While he response of he regional oupu o a posiive sandard deviaion shock o he global shocks (euro zone) leads o a sligh increase in regional oupu, he response o he U.S. shocks seems o be negaive. Overall, he responses of regional oupu o hese shocks are insignifican. The responses o boh he dollar and euro zones shocks seem o be consisen wih he views ha ighening money supply in hese zones will lead o conracion in global oupu growh, which hen leads o a decrease in oil prices. Posiive domesic shocks lead o a sligh increase in regional oupu. The resuls from he assessmens of boh he effecs of he dollar and euro zone shocks sugges ha he GCC counries seem o be mainly driven by he erms-of-rade and domesic shocks. In fac, coninuing o peg he local GCC currencies o he U.S. dollar may be oo cosly. I could lead o a condiion in which he U.S. moneary policy changes may ac as a desabilizing force for he GCC economies. 6. The Alernaive Model 11

13 We consruc an alernaive model for each of he six GCC counries and for he dollar and euro zones o be employed as a robusness check on he sensiiviy of he resuls of he benchmark model o he quarerly daa generaion and selecion. We follow he same procedures proposed by Bayoumi and Eichengreen (1994) in which hey examined he feasibiliy of he Norh American Free Trade Area (NAFTA) as a common currency area. Using a bivariae VAR wih a vecor of he variables X for he firs logarihmic differences of oupu and price for each of he counries and zones, he alernaive model can also be expressed as an infinie-moving average process of wo ypes of shocks, demand shocksε d, and supply shocks, ε s. The model can be wrien in he following form: X = Aε + Aε + Aε +... = AL ( ) ε (1) X where = [ y p ], AL ( ) is a marix whose elemens are polynomials in he lag operaor L, he marix Ai represens he impulse response funcions of he wo shocks. Denoe ha he framework implies ha supply shocks have permanen effecs on he level of oupu bu demand shocks have emporary effecs (Blanchard and Quah (1989), Bayoumi (1992), and Bayoumi and Eichengreen (1994)). If he vecor shocks has he form X is saionary, hen he bivariae model in he srucural y C 11( L) C 12( L) εd p = C 21( L) C 22( L) εs (5) where y and p represen he logarihms of oupu and prices as indicaed above, ε d and ε s are muually uncorrelaed demand and supply shocks, respecively, wih zero means. The shocks can be idenified by imposing he resricions ha supply shocks have permanen effecs on he level of oupu, bu demand shocks have only emporary effecs. Supply and demand shocks have permanen effecs on he price level. These assumpions can be represened by he resricion ha he coefficiens in C 11( L ) sum o zero; he resricion is equivalen o 12

14 C 11() k = 0 (6) k= 0 Placing his resricion in equaion (5) conveys ha he cumulaive effec of εd on y is zero. As menioned above, he wo shocks are demand shocksε d, and supply shocksε s. This resriced framework implies ha supply shocks have permanen effecs on he level of oupu bu demand shocks have emporary effecs. 7. Empirical Resuls of he Alernaive Model Table 7 presens he correlaions of supply and demand shocks beween each of he six individual GCC counries and he U.S. and he European Union. On he supply side, Bahrain and he Unied Arab Emiraes show moderae correlaions wih he U.S. Kuwai seems o show insignifican negaive correlaions, while Qaar displays high correlaions wih he U.S. Similarly, he resuls also display low negaive correlaions beween he GCC counries and he European Union. While Oman and he Unied Arab Emiraes show negaive correlaions wih he European Union, Kuwai seems o display posiive correlaions. On he demand side, Qaar and Oman show high posiive correlaions wih he U.S., bu Bahrain, Kuwai, Saudi Arabia, and UAE display negaive correlaions wih he U.S. Overall, he GCC economies seem o have insignifican correlaions wih he US, excep for Qaar. This resul, in conjuncion wih exernal shock impacs (or he lack hereof) cass doubs on he suiabiliy of pegging he proposed GCC common currency o a composie baske wih he dollar and he euro holding he larges shares. 8. Conclusions As he GCC counries are aking very imporan seps owards forming a moneary union and inroducing a single currency in 2010, his paper examines he relaive impacs of domesic and exernal shocks on he region s economies hypohesized as a single bloc. We have consruced weighed averages of key macroeconomic variables of he GCC counries o shade 13

15 some ligh on he srucural properies of he GCC area as a single economic sysem. This sudy has applied srucural VAR mehods primarily o invesigae he roles of erms of rade, he dollar, and euro zones, and regional (domesic) shocks on he GCC as a prospecive single economy, focusing on he opimal choice of exchange rae regime. The resuls show ha domesic shocks explain he bulk of GCC oupu movemens. Equally imporan, he erms-of-rade shocks paricularly in he long run play an imporan role in explaining GCC oupu movemens. Despie he acual dominan role of he dollar and he srong exising rade beween he GCC counries and he European Union, global shocks (he dollar and euro zones) seem o have a modes impac on prospecive GCC union s domesic oupu. The business cycles of hese counries as a single bloc do no appear o be driven by oupu movemens in he US and he EMU regions. Moreover, he correlaions beween each of he GCC individual counries wih he U.S. and he European Union seem o be weak and cas doub on he opimaliy of a composie baske of he dollar and he euro as an anchor for he GCC proposed common currency. To sum up, he resuls from he assessmens of boh he effecs of he dollar and euro zones sugges ha he GCC economies seem o be driven by erms-of-rade and domesic shocks. In ha sense, a more flexible exchange rae regime may be more suiable o he GCC area. Ye as hese counries are in he process of forming a moneary union and plan o inroduce a single currency in 2010, one mus iniially consider he benefis arising from he credibiliy and sabiliy of he new currency. In such a case, i migh be opimal o consruc a baske of currencies where he U.S. dollar and he euro should have he larges shares. In ha sense, a peg o a baske of currencies is more flexible han ha of a bilaeral peg, and i would be an imporan sep on he way owards a more flexible exchange rae regime. 14

16 References Abed, G. T., Erbas, S. N, Guerami, B., 2003, The GCC Moneary Union: Some consideraions for he Exchange Rae Regime, IMF Working Paper, No 66. Bayoumi, T. and Eichengreen, B., 1994, Moneary and Exchange Rae Arrangemens for NAFTA, Journal of Developmen Economics, 43, pp Corsei, P., and Peseni, P., 2002, Self-Validaing Opimum Currency Areas, NBER Working Paper No. 8783, pp De Grauwe, P., 1997, The Economies of Moneary Inegraion, 3 rd ed. Oxford. De Grauwe, P. and Mongelli, F., 2005, Endogeneiies of Opimum currency Area: Wha Brings Counries Sharing a Single Currency Closer Togeher? ECB Working Paper No Fasano-Filho, U., and Schaecher, A., 2003, Moneary Union Among he Member Counries of he Gulf cooperaion Council, IMF Occasional Paper, Inernaional Moneary Fund, Washingon D.C. Frankel, J., and Rose, A., 1997, Is EMU More Jusifiable EX Pos ha EX Ane? European Economic Review, 41, pp Frankel, J., and Rose, A., 1998, The Endogeneiy of he Opimum Currency Area Crieria, Economic Journal, 108, pp Frankel, J., 2002 Verifiabiliy and he Vanishing Inermediae Exchange Rae Regime, NBER Working Paper No Frankel, J., 2003a, Proposed Moneary Regime for Small Commodiy-Exporers: Peg he Expor, Kennedy School of Governmen, January, RWP No Frankel, J., 2003b, Experience of and Lessons from Exchange Rae Regimes in Emerging Economies, NBER Working Paper No Gudmundsson, M., 2005, The Role of he Effecive Exchange Rae in Moneary Frameworks: The Inernaional Experience, BIS Working Paper. Hammoudeh, S., and Aleisa, E., 2004, The dynamic linkage of he GCC Sock Markes, Conemporary Economic Policy, January, 22(1) pp Jadresic, E., 2002, On a Currency for he GCC Counries, IMF Policy Discussion Paper (PDP/02/12), Inernaional Moneary Fund, Washingon, D.C. Kenen, P., 1969, The Theory of Opimum Currency Areas: An Eclecic View. In: Mundel, R.A, Swooboda, A. K., ed., Moneary Problems in he Inernaional Economy, Universiy of Chicago Press, Chicago. McKinnon, R., 1963, Opimum Currency Area, American Economic Review, (Sepember), pp Moudell, R., 1961, The Theory of Opimum Currency Area, American Economic Review, 51(4), pp

17 Table 1. Seleced Macroeconomic Indicaors for he GCC counries ( ) Counry/Region Bahrain Kuwai/1 Oman Qaar /1 Saudi Arabia UAE /1 Share of GCC GDP (%) Real GDP by Secors (%) Non-oil Oil Governmen 0.1 n/a 19.2 n/a 23.2 n/a % of Oil In Toal Gov. Revenues Real GDP Growh Rae (%) Inflaion Rae (%) Curren Accoun Balance Curren Accoun/GDP (%) Share in World Oil Producion (%) Expors wihin he GCC/ Impors wihin he GCC/ Expors/GDP (%) n/a Impors/GDP (%) n/a Noes: 1/ Non-oil secor includes he governmen secor. 2/ In % of oal expors 3/ In % of oal impors wihin Sources: IMF DOT, Moneary Agencies and cenral banks. 16

18 Table 2. Correlaions of inflaion Bahrain Kuwai 0.51 Bahrain Kuwai Oman Qaar Saudi Arabia Oman Qaar Saudi Arabia UAE UAE

19 Table 3. Direcions of GCC counries expors Counry/Region Bahrain Kuwai Oman Qaar Saudi Arabia UAE 5 Wihin he GCC Unied Saes European Union Japan Asia (ex. Japan) Expors/GDP (%) n/a 5 Non oil expors for he 2 nd quarer,

20 Table 4. Direcions of GCC counries Impors Counry/Region Bahrain Kuwai Oman Qaar Saudi Arabia Wihin he GCC Unied Saes European Union Japan UAE Asia (ex. Japan) Impors/GDP(%) n/a Table 5. Uni Roo and Saionariy Tess Tes p y GCC y US y Euro h ADF Saisic KPSS Saisic

21 Table 6. Variance décomposiions Percen of forecas error variance aribued o shocks Horizon (quarers) h ε g ε Regional oupu Dollar zone r ε Euro zone

22 Figure 1. Response of regional oupu (Euro zone ) (Dollar zone) 0.18 Terms of rade Terms of rade Global (Euro zone) 0.10 Global (dollar zone) Regional 0.04 Regional

23 Table 7. Correlaions of supply shocks: he GCC counries wih he US and he European Union Correlaions of supply shocks Counry/Region Bahrain Kuwai Oman Qaar Saudi Arabia The US UAE EMU Correlaions of demand shocks The US EMU