GCC Monetary Union: Progress to Date and Outstanding Issues

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1 Report Series GCC Monetary Union: Progress to Date and Outstanding Issues Highlights The UAE s late-may announcement that it had decided against joining the GCC single currency for the time being is a serious blow to the GCC Monetary Union project. The UAE is the region s main trading hub and the bloc s second biggest economy, accounting for around a quarter of GDP. The announcement appears to have been triggered by the recent decision to locate the GCC Monetary Council, the precursor to a regional central bank, in Riyadh. However, the UAE is also understood to have misgivings about the form that the future central bank might take, preferring a looser, more decentralized central bank structure possibly involving the retention of national currencies than the more centralised and autonomous model that is currently envisaged. It is difficult to judge at this stage the potential political commitment that might exist to work around these complications and to put the currency union back on track in the foreseeable future. This would certainly be in the interests of all parties since the GCC has much to lose from the UAE s non participation, while the UAE has much to gain from greater integration with its neighbours. Other issues clouding the horizon include the new challenges arising from the global financial crisis and economic recession and the varying efforts of the GCC states to come to grips with it. The crisis has highlighted the sense that the fiscal and monetary convergence criteria agreed by the GCC as a basis for monetary union may at times prove more difficult to sustain than originally envisaged as in the case of the Eurozone. The Eurozone s efforts to cope with the downturn will continue to be keenly watched by the GCC. Office of the Chief Economist Economics Department Samba Financial Group P.O. Box 833, Riyadh Saudi Arabia ChiefEconomist@samba.com ; Ext (Riyadh) (London) This and other publications can be Downloaded from All of these issues are substantial and further time and discussions will be necessary to put currency union back on track. This means that the January deadline is unlikely to be met, though we do not regard this as a matter of concern: GCC currency union should be seen as an evolutionary step rather than an abrupt break with past practice. The broader process of economic integration among the GCC countries, of which currency union would be in the nature of a final step, has been under way for many years. Considerable progress has been made toward the harmonization of domestic and external policies and in liberalizing intra-regional trade as well as labour and capital movements. If progress on economic integration can be maintained that should be helpful in preparing for a common currency, if need be at a later stage.

2 GCC Key Macro Indicators and Forecasts GCC e 2009f 2010f Real GDP Growth (% change) Nominal GDP ($ billion) , Nominal nonoil GDP ($ billion) CPI (avg. % change) Government spending (% change) Budget Balance (% GDP) Current Account Balance (% GDP) Population (million) Saudi Arabia f 2010f Real GDP Growth (% change) Nominal GDP ($ billion) Nominal nonoil GDP ($ billion) CPI (avg. % change) Government spending (% change) Budget Balance (% GDP) Current Account Balance (% GDP) Population (million) UAE e 2009f 2010f Real GDP Growth (% change) Nominal GDP ($ billion) Nominal nonoil GDP ($ billion) CPI (avg. % change) Government spending (% change) Budget Balance (% GDP) Current Account Balance (% GDP) Population (million) Kuwait e 2009f 2010f Real GDP Growth (% change) Nominal GDP ($ billion) Nominal nonoil GDP ($ billion) CPI (avg. % change) Government spending (% change) Budget Balance (% GDP) Current Account Balance (% GDP) Population (million) Continued on next page

3 GCC Key Macro Indicators and Forecasts (concluded) Qatar e 2009f 2010f Real GDP Growth (% change) Nominal GDP ($ billion) Nominal nonoil GDP ($ billion) CPI (avg. % change) Government spending (% change) Budget Balance (% GDP) Current Account Balance (% GDP) Population (million) Oman e 2009f 2010f Real GDP Growth (% change) Nominal GDP ($ billion) Nominal nonoil GDP ($ billion) CPI (avg. % change) Government spending (% change) Budget Balance (% GDP) Current Account Balance (% GDP) Population (million) Bahrain e 2009f 2010f Real GDP Growth (% change) Nominal GDP ($ billion) Nominal nonoil GDP ($ billion) CPI (avg. % change) Government spending (% change) Budget Balance (% GDP) Current Account Balance (% GDP) Population (million) Sources: IMF, IIF, national sources, Samba

4 Table of Contents Introduction 5 Preparations for Monetary Union 6 Institutional Preparations 7 Policy Convergence 11 Choice of Exchange Rate Regime 14 Box 1: Pros and Cons of Possible Exchange Rate Regimes 17 Outlook 18 4

5 Introduction In December 2001 the GCC member countries signed an Economic Agreement that laid out specific steps that would need to be taken in order to establish a GCC Monetary Union by January The terms monetary union and currency union are often used interchangeably. In fact, currency union is a stage (typically the final one) of a broad-ranging process of economic and financial integration known as economic and monetary union (EMU). 1 From this process and the final establishment of the single currency itself should flow significant economic benefits, including a more forceful presence on the global economic stage, increased intra-regional trade, better price transparency, enhanced labour mobility, economies of scale, an improved business climate, and the strengthening of capital markets. The UAE s decision to opt out of the single currency is a serious jolt to GCC monetary union Saudi Arabia Source: Samba and IIF Trade to GDP Ratio (2007 estimates; percent) UAE Kuwait Oman Qatar Bahrain but it might not be a mortal blow. In early May GCC rulers agreed that the location of a GCC Monetary Council (the proposed forerunner of a regional central bank) will be Riyadh. They also confirmed that Riyadh will be the site of the central bank itself. The agreement appeared to represent an important milestone, and rekindled hopes that the basis for monetary union could be in place by the January deadline. These expectations were quelled by the UAE s announcement, just a few weeks later, that it would not be joining the single currency. 2 The announcement appears to have been triggered by the GCC s decision to overlook the UAE as a site for the Monetary Council. The UAE was the first country supposed to host the central bank, and we believe we had the right to do so. It did not happen the Foreign Minister said, referring to the UAE s application, made some years earlier, to host the central bank or equivalent body. The UAE is also understood to be uncomfortable about the proposed format of the central bank, preferring a looser arrangement possibly involving the retention of national currencies than the unitary and autonomous institution that is currently envisaged. The UAE s announcement is clearly a blow to the GCC monetary union project given the country s economic weight and importance as a trade hub. However, the issues about which it is unhappy do not appear insurmountable and could yet be resolved (see Outlook). Nor should the UAE s decision distract from the progress that has been made in the broader process of GCC economic integration over the past few years. Though far from complete, these efforts have laid important foundations for a potential monetary union at some point in the future. This paper will consider the achievements to date, as well as the issues that must be resolved before a single currency can be delivered. It will also evaluate the merits of the various currency regimes that have been mooted, along with the short and medium term prospects for the monetary union project. 1 The European EMU consisted of a number of phases, beginning in 1990 with the abolition of exchange controls and culminating in 2002 when euro notes and coins were introduced. 2 The UAE joins Oman in opting out of the single currency, though both countries apparently remain committed to other aspects of monetary union, such as the common market. 5

6 Table 1: Stages to EU Monetary Union Stage 1 Stage 2 Stage 3 July 1990 January 1994 January 1999 Complete freedom for capital transactions Increased cooperation between central banks Free use of the ecu (forerunner to euro) Improvement of economic convergence Establishment of European Monetary Institute Ban on credit to public sector Increased cooperation of monetary policies Strengthening of economic convergence Process leading to national central bank independence Source: European Central Bank Irrevocable fixing of conversion rates Introduction of the euro Conduct of single monetary policy by European System of Central Banks Introduction of intra-eu exchange rate mechanism (ERM II) Entry into force of Stability and Growth Pact Preparations for Monetary Union The experience of the EU and others in forging a monetary union highlights a number of steps that were taken well before any single currency was launched. These can be divided into institutional and policy preparations. Some are prerequisites to a functioning monetary union; others are simply desirable. This section starts with a summary of the institutional and policy convergence criteria, followed by a more detailed analysis of progress to date and outstanding issues. The required institutional preparations include the following: A Common Market and Customs Union This is regarded by many as integral to a successful currency union. If the object of a single currency is to further economic integration between the GCC states, then allowing the free movement of goods, capital and labour forms the platform on which this can be achieved. The GCC have signed a number of agreements on this aspect of monetary union, but implementation has lagged. A GCC Central Bank The Eurozone s experience indicates that a well-resourced and institutionally coherent central bank is the lynchpin of a successful currency union. Although it has been agreed that the forerunner of the GCC Central Bank, the Monetary Council, will be located in Riyadh, the UAE s announcement that it will be opting out of the single currency indicates that there is much still to be resolved about the remit and composition of both institutions. Data Provision Consistent, timely and comprehensive data are important to the smooth running of a monetary union project. In general, this remains an area of weakness in the GCC Eurozone: Average Consumer Prices (annual percent change) Source: IMF France Germany Italy The GCC has decided that the necessary policy convergence will be based on those underpinning the European EMU process. They include: Low and Stable Rates of Inflation Inflationary pressures rose sharply in the GCC during , though divergence also became an issue as Qatar and the UAE experienced significantly stronger rates than their peers. Fiscal Convergence GCC governments have reacted to the ongoing global financial crisis with different fiscal strategies. Some of these involve substantial fiscal stimulus plans, which could trigger the re-emergence of inflationary pressures. Low and Stable Public Debt Generally, debt levels have not been an issue for the GCC and most countries appear to have debt stocks well below the European EMU limit. Nevertheless, a lack of transparency has raised some concerns. 6

7 Interest Rate Convergence GCC interest rates have traditionally been aligned by dint of their pegs to the US dollar. Some divergence was triggered by the onset of the global financial crisis, though rates have generally moved down. Kuwait remains something of an outlier owing to its peg to a basket of currencies. Now we will consider progress in meeting these institutional and policy criteria in more detail. a) Institutional Preparations Common Market and Customs Union The experience of the EU suggests that a key ingredient of a successful monetary union is a well-functioning common market. Indeed, without the free movement of goods, labour and capital many believe that the MU project would be ill-advised, since most of the benefits of monetary union would remain elusive, while many of the costs and stresses would be amplified. The GCC Common Market provides for enhanced mobility of goods, labour and capital. On January the GCC launched its common market, much of which had already been agreed in the terms of the 2001 agreement. The agreement provides GCC citizens equal treatment in all economic activities, especially freedom of movement and residence; work in private and government jobs; pension and social security; engagement in all professions and crafts as well as all economic, investment, and service activities; real estate ownership; capital movements; tax treatment; stock ownership and formation of corporations; and education, health, and social services. Crucially, however, full implementation of the common market will require the adoption of national laws and regulations. Progress on this front has been slow. A high degree of labour mobility between member states of a monetary union is important because in the absence of flexible exchange rate and interest rate policies to offset asymmetric economic shocks, the onus will be on labour markets and wages to adjust in order to maintain full employment. The same argument applies to the GCC bloc s competitive position with other countries, assuming that the chosen exchange rate is a fixed peg. However, informal barriers to labour mobility remain substantial. Notwithstanding the launch of the common market, labour mobility among GCC nationals is limited and is likely to remain so. Familial and cultural ties remain strong, while informal barriers to the employment of one GCC national in the public sector of another GCC country are formidable. Other incentives for GCC nationals to stay in their own countries include land grants, subsidized building loans and marriage grants. With regional population growth still high (over 3.5 percent per annum) and budgets under pressure, national governments have been wary of employing large numbers of other GCC citizens in their own public sectors. Indeed, they have for some years been attempting to wean their own nationals away from the high wages and other benefits that public sector employment brings, by 7

8 encouraging them to seek work in the private sector. However, progress to date has been halting, with high wage demands and inadequate training posing significant entry barriers to private sector employment. Expatriate labour is still extremely flexible Fortunately for the GCC, expatriate labour remains extremely mobile. Unlike the EU, the GCC benefits from a cheap and flexible supply of foreign labour, largely but not exclusively employed in the private sector. Employment legislation is minimal: there is no minimum wage, unions are illegal, and most expatriates are employed on short term fixed contracts. Immigrant labour is still prevented from moving directly from one GCC country to another. However, history shows that when economic conditions in one GCC state have deteriorated, expatriate labour has responded by returning to their countries of origin before entering another GCC state offering better economic conditions. yet this could be undermined by national labour policies. Free movement of goods within the GCC has been challenged by the signing of separate FTAs. There has been better progress on capital mobility. Table 2: GCC Stock Markets Listed stocks Open to GCC nationals Percent of companies Source: Emilie J Rutledge, Monetary Union in the Gulf, Routledge 2009 The flexibility of the GCC labour market could yet be undermined by government efforts to promote the participation of nationals in the workforce. Governments have put pressure on private firms to employ more nationals either by applying quotas and reserving some vocations for nationals alone, or by raising the cost of hiring expatriate labour. Such measures, though enforced sporadically, have created unease within the region s private sector, and have the potential to erode competitiveness over the long term. There are also outstanding barriers to accelerating the free movement of goods. In 2003 the GCC agreed on an integral element of the common market a customs union. The union stipulates a common external customs tariff of 5 percent; common customs regulations and procedures; elimination of all intra-gcc tariff and non-tariff barriers; and a single entry point where customs duties are collected. On paper, this represented an important milestone on the path to full monetary union; however, implementation has been hampered by unilateral actions. In 2004 Bahrain signed its own free trade agreement (FTA) with the US, and Oman followed suit in These decisions appeared to go against the spirit of the 2003 and 2001 agreements, which state that member states would negotiate collectively on external trade deals. More practically, while these individual FTAs remain in force, the third and final stage of the customs union abolishing the customs functions of the intra-gcc border offices cannot be completed. This is because the other GCC states would still have to levy tariffs on US goods arriving as intra-gcc imports from Bahrain and Oman. The decision of these two states to pursue their own bilateral trade deals may in part reflect frustration with the delays that multilateral trade negotiations have been subject to: for example, the planned GCC-EU free trade agreement has been in negotiation for almost two decades. The two sides are still feeling for a final agreement, though it does seem likely that they will find a way around a long-running sticking point, that of human rights. (Outstanding issues related to tariffs and quotas are not thought to be insurmountable, but they will take time to work through.) More progress has been made on capital mobility. Capital market integration is desirable for monetary union because it allows members to hold claims on 8

9 each other s output, thereby partially insuring themselves against asymmetric shocks. Put another way, if one state were hit by an economic downturn, the income from assets held in other member states would help to soften the financial impact of the downturn. More obviously, capital market integration allows firms and entrepreneurs freer (and hence cheaper) access to a larger pool of resources. Capital market integration also enables investors to better manage their risk exposures. Regional stock markets are virtually fully-open to all GCC nationals Since 2005 some progress has been made in implementing Article Five of the 2001 Economic Agreement, in which the GCC states agreed to unify their investment-related laws and regulations, accord national treatment to all investments owned by GCC natural and legal citizens and integrate financial markets in member states, and unify all related legislation and policies. In 1985 the proportion of listed companies open to investment by any GCC national was only 25 percent; by 2005 that figure had risen to 98 percent. There are now numerous GCC-wide investment funds available to GCC investors in a range of asset classes, including equities, fixed income, property, hedge funds and Shariah-compliant funds. Company cross-listings have also grown, albeit from a low base. but regulatory frameworks still need to be harmonized. Nevertheless, there are still significant barriers to further integration of GCC capital markets. Most importantly, GCC states have different regulatory frameworks, a situation that imposes significant transaction costs and hinders the flow of capital between markets. Similarly, an integrated cross border payments system has not yet been established. Such a system would facilitate cross border payments between businesses (and individuals) and would provide a major fillip to broader economic integration. We understand that the GCC Secretariat has been working hard to harmonize regulatory regimes and develop a cross-border payments system; however, to date few details of progress have been released. GCC Central Bank Central bank will be the cornerstone of monetary union. The Eurozone experience indicates that a well-resourced and institutionally strong central bank is at the heart of a successful monetary union. The bank would not necessarily decide on the type of exchange rate regime, but it would be at the forefront of the effort to ensure that the regime was credible and durable. As such, it would have sole responsibility for setting interest rates for the bloc as a whole, and ensuring an adequate supply of liquidity. In early May at a GCC summit in Saudi Arabia it was decided that Riyadh would be the base of the Monetary Council, and that this would evolve into the GCC s central bank. The choice of Saudi Arabia appears to reflect its economic weight (its economy accounts for around 40 percent of GCC GDP), as well as the fact that it has fared better than other Gulf states during the ongoing global financial crisis. However, the UAE appeared to be disappointed with the choice of Saudi Arabia, and its representatives at the meeting expressed reservations about the decision. A few weeks later the UAE foreign ministry announced that the UAE would not be signing up to the single currency at this stage. 9

10 The UAE appears to have two key concerns: The UAE is uncomfortable with the proposed central bank model. Degree of Monetary Autonomy. Though publicly-available details are thin, it is understood that the proposed GCC central bank would be a unitary body, with full responsibility for managing the single currency. The bank would require full cooperation from the constituent member country central banks to ensure that monetary policy is appropriately administered, and that financial supervision and regulation are consistently and transparently implemented. (The EU s European System of Central Banks provides the template.) It is understood that the UAE (and possibly Qatar) prefers a more decentralised system, possibly involving a mobile Monetary Council, and a system where domestic currencies are retained. Leadership of the Monetary Council/Central Bank. The choice of Riyadh, which already hosts the GCC Secretariat, as the location of the Monetary Council appears to have unsettled the UAE. Saudi Arabia itself is keen to allay any concerns that the central bank will be an overtly Saudi institution, and it may well cede Governorship to another Gulf country (possibly the UAE itself). Similarly, voting rights must also be agreed: the European EMU model is based on equal voting power regardless of economic weight, and this might be the most appropriate formula for the GCC. Other issues that the Monetary Council must address include: Development of regional money markets. Deeper money markets would be helpful in allowing the central bank to influence money supply and market interest rates. Data harmonisation. The Monetary Council will need to ensure that the quality and timeliness of GCC data are improved if the single currency is to function effectively (see below). Management of foreign currency. It is not clear to what extent existing GCC central banks will need to cede management of foreign exchange to a regional central bank. A related, but less serious issue is distribution of seigniorage revenues (the profit generated by minting coins). Naming and design of the single currency. The symbolic importance of this issue should not be underestimated. Exchange rate regime. Most importantly, the Monetary Council will be at the forefront of discussions about which exchange rate regime to adopt. A peg to the US dollar remains the most likely option (see separate section, below). Resolving these issues will take time. The GCC Secretariat has been working on a number of the technical issues, and some are understood to be well advanced. However, it is worth noting that the forerunner to the ECB, the European Monetary Institute, spent four years carrying out technical research and other monetary preparations prior to the electronic launch of the euro. 10

11 Data Another important but often overlooked area of preparedness is data provision. Consistent, timely and comprehensive data are vital to the proper functioning of monetary union, not only in enabling the central bank to perform effectively, but also in allowing policy makers to gauge whether constituent economies meet convergence criteria (see below). Data timeliness and coverage need to be improved. In general, monetary data provided by the region s central banks are timely and comprehensive. However, real economy data, which are typically produced by other government agencies, are often patchy, produced only on an annual basis, and subject to severe time-lags. The techniques deployed to measure GDP are often antiquated, while consumer price baskets tend not to reflect typical purchasing habits (in the process of European EMU, a Harmonized Index of Consumer Prices was established long before currency union was effected). Capital account data are often lacking, while even current account definitions have not been standardised across the region. Fiscal data suffer from differing accounting practices and in some cases do not capture substantial off-budget spending. This is a particularly important area of disclosure since fiscal policy is and will likely remain the principal driver of domestic demand in the GCC. b) Policy Convergence The fiscal and monetary criteria agreed at Maastricht in 1992 were designed to ensure that all prospective members of the EU achieved a high degree of fiscal and monetary convergence prior to formation of the single currency. Low and stable rates of inflation, broadly aligned interest rates, stable individual exchange rates, moderate fiscal deficits, and sustainable (and stable) levels of public debt were enshrined as prerequisites to joining the euro. Table 3: Convergence Criteria Criterion Maastricht GCC Exchange rates Fluctuations within normal margins for two years; no devaluation against any other member state s currency Long-term stability of GCC exchange rates means that this criterion has not been an issue Foreign reserves No such criterion To cover four months of imports Long-term rates must not Interest rates exceed a margin of 2 As Maastricht, but for short term percentage points over the rates (3 months) average of the three lowestinflation members Inflation rates Must not exceed more than 1.5 percentage points of the average of the three lowestinflation members As Maastricht Fiscal deficits Government debt Must not exceed 3 percent of GDP Must not exceed 60 percent of GDP Source: Emilie J Rutledge: Monetary Union in the Gulf; Routledge, 2009 As Maastricht when OPEC basket oil price is $25/b or more As Maastricht 11

12 The relevance of the Maastricht criteria has been questioned by some. Following a protracted period of debate it was agreed that the European EMU convergence criteria would be used as the basis for GCC monetary union (with minor modifications see table). However, the suitability of the European criteria has been challenged on two counts. First, some argue that since the GCC has had a history of low and predictable inflation, robust fiscal and debt positions, and fixed exchange rates the European criteria lack relevance. Others argue that because the GCC is likely to adopt a fixed peg to the dollar, and since monetary policy will effectively be determined by the US Federal Reserve, those European criteria designed to keep interest rates low and stable have little relevance. The region s fixed exchange rates do indeed mean that one of the most challenging aspects of monetary union preparedness has already been met; 3 however, the deterioration in economic conditions over the past year has made the other criteria increasingly relevant (see below). Second, while it is true that under a fixed peg to the dollar the criteria aimed at keeping interest rates low and stable would lose their relevance, one cannot assume that a fixed peg will be adopted since GCC ministers have said that all exchange rate options remain on the table (see Section 3). For these reasons, we will consider the GCC s progress in meeting all the EMU criteria. Price stability has become more of an issue over the past few years. Low and stable rates of inflation are considered crucial to the success of a monetary union project. In conditions of price volatility, interest rate management becomes extremely difficult. If one country is subject to high or volatile inflation rates, then the region s central bank would be obliged to keep interest rates high for the entire bloc regardless of whether high rates impaired growth prospects in other countries. In the past two years, price stability has become an issue in the GCC. The surge in domestic demand, combined with spiraling prices for global commodities (especially food and construction inputs) and a weak US dollar put sustained upward pressure on consumer price indices throughout the region. Average inflation climbed from 3.1 percent in 2005 to 6.7 percent in 2007 and further to 11.5 percent in GCC: Consumer Price Inflation (average, percent) Source: IMF, Saudi Arabia UAE Kuwait Qatar IIF, Samba Oman Bahrain The convergence criteria state that no country should have an inflation rate 1.5 percentage points above the average of the three countries with the lowest rates. The UAE and Qatar have been in breach of this criterion since 2004 according to official figures (which may understate the true level of inflation). In 2008 Qatar and the UAE endured average inflation rates of 16 percent and 14 percent respectively, 6-8 percentage points above the average of the lowest three. Inflation also picked up in the period in the other GCC states, though the rise in the average meant that these states did not breach the mandated limit. Recently, inflation has begun to moderate as softer global commodity prices and weaker domestic activity have taken the heat out of local indices. Nevertheless, it seems likely that Qatar at least is still in breach of the inflation criterion (its end-2008 inflation rate was almost 14 percent), while severe time 3 The exception is Kuwait, which reverted to a basket peg in It is understood that the dollar weighting is at least 70 percent, and fluctuations against other GCC currencies have therefore been moderate, with an 8 percent depreciation over the past year. 12

13 GCC: Fiscal Balance 40 (percent of GDP) Source: IMF, Saudi Arabia UAE IIF, Samba Kuwait Qatar Oman Bahrain Looming fiscal deficits are not a problem in their own right lags in data mean that the inflation situation in the UAE is difficult to determine. Until recently, the fiscal criterion was not a problem. All GCC states have recorded large budget surpluses in recent years, with the 2008 surplus ranging from 7 percent of GDP in Bahrain to a sizeable 34 percent in Saudi Arabia. However, the situation in 2009 is likely to be markedly different. The intensification of the global economic crisis is having an important impact on the GCC s fiscal situation in two distinct ways. First, the slump in global economic activity means that oil prices have shed around $100/barrel since their peak in mid Second, government spending has not necessarily been reined in to fit with the new reality. Rather, a number of GCC governments have ramped up spending in an effort to offset the impact of credit dislocations in their own markets. From a growth perspective this makes sense, and similar strategies are being pursued across the globe. However, we forecast that three of the six GCC states will record sizable fiscal deficits this year, well in excess of the 3 percent of GDP limit. We expect a deficit of 6.7 percent of GDP in Bahrain, 7 percent of GDP in Oman, and a substantial 15.4 percent of GDP in Saudi Arabia. It is important to stress that all the GCC states are structural surplus countries. That is, they typically run decent sized fiscal surpluses, and only move into deficit when policy makers decide to stimulate local growth by ramping up spending. Currently, these three states (Oman, Bahrain and Saudi Arabia) are in countercyclical mode and deficits are to be expected. In addition, Saudi Arabia s projected fiscal deficit, though large, can be comfortably financed through domestic public sector savings and would therefore have little impact on domestic interest rates but they do point to a possible lack of coordination under a single currency. GCC: Interrest Rates (Average for 3M desposit; percent) 0 Feb-08 May-08 Aug-08 Nov-08 Feb-09 Source: Sama Saudi Riyal Bahraini Dinar Qatari Riyal Kuwaiti Dinar Omani Riyal UAE Dirham Nevertheless, the diverging fiscal positions hint at possible problems that could emerge under conditions of GCC monetary union. The importance of maintaining fiscal discipline would be accentuated under a region-wide fixed peg since it would be the principal means of controlling domestic demand. Failure to bring spending under control could lead to further inflationary problems, and thereby put upward pressure on the region s real effective exchange rate, eating into the competitiveness of the nonoil export sector. Large debt stocks have the potential to create financing strains and thereby push interest rates higher. Under the GCC s criteria, central government debt should not exceed 60 percent of GDP. Available data indicate that none of the GCC states has public sector debt stocks above this threshold. However, a lack of transparency gives some cause for concern. Dubai, for example, has built up a considerable debt stock during its rapid economic expansion of the past decade. Taken as a whole, the UAE s public sector debt stock is likely to be well within the mandated limit, but a lack of transparency surrounding the exact size of Dubai s public debt has unsettled potential investors. Traditionally, GCC interest rates have moved together, reflecting the predominance of fixed pegs to the US dollar. With the onset of the global financial crisis, movements have become more haphazard as individual states have responded unilaterally to liquidity problems in their own markets (abetted 13

14 by a lack of appetite among global currency traders to seek arbitrage opportunities). Nevertheless, since the turn of the year, movements have been in the same direction down and GCC short term rates are again broadly in line with each other. The exception is Kuwait, where average short terms rates in 2008 were more than two percentage points higher than the average of the three lowest inflation economies (thereby breaching the Maastricht criteria). This asymmetry stems from Kuwait s basket peg, which means that interest rates must follow movements in component currencies. The spread between the euro component of the basket and the dollar component widened sharply in 2008 as the US Fed cut policy rates much more aggressively than the ECB. However, Eurozone rates have since come down sharply and Kuwaiti rates have followed suit. In early May Kuwaiti short terms rates were well within the prescribed limit. Liquid foreign assets are more than adequate. The GCC has also stipulated that member countries have foreign exchange reserves equivalent to four months of imports (this is not a criterion of the European EMU). The rationale is based on the fact that reserves can provide a buffer against balance of payments strains an important consideration under a fixed exchange rate regime. GCC central banks foreign exchange reserves are often below the four months limit. However, in most cases official foreign assets are substantial, and these include a sizeable cash element. Bahrain s foreign asset position is less robust than its neighbours (the data picture is clouded by its role as an offshore banking sector) but its import needs could be easily supported by other member states if necessary. European policy makers made sure that the convergence criteria were taken seriously by all prospective members, and those countries that failed to meet them on schedule were forced to defer entry (Greece). It is not clear what sanctions will be deployed by the GCC if convergence criteria are not met. According to the GCC Monetary Union Unit if a given state cannot meet one or more of the criteria then a meeting will be held to discuss possible measures to deal with the infringement. Comments by various GCC central bank governors indicate that they are relaxed about the varied policy responses exhibited in the wake of the intensification of the global credit crisis. Indeed, some have even suggested that country-level responses have been more appropriate and effective than a coordinated approach. Choice of Exchange Rate Regime Fixed peg to the dollar promises familiarity and continuity One of the most important decisions in the formation of a monetary union is the choice of exchange rate regime. The GCC members agreed in 2003 to peg their individual currencies to the US dollar and to maintain the parity until the establishment of full Monetary Union in A decision on the exchange rate regime for the single GCC currency would be made then. The most plausible prospective exchange rate regime is a fixed peg to the US dollar. The dollar peg has a number of advantages. First, the new GCC central bank would inherit a well-functioning anchor and associated monetary framework no mean consideration given the institutional limitations noted 14

15 above. The peg is reasonably straightforward to administer and does not require the institutions necessary for an independent monetary policy. Second, market participants are already familiar and for the most part comfortable with the peg. GCC countries individual pegs are well-established and have provided a degree of stability and comfort during times of oil price weakness or regional political stress. Third, the bloc s dominant export, oil, is already priced in US dollars. Fourth, the GCC s flexible labour markets should be enough to support international competitiveness (assuming this is not impaired by national labour policies see above). however, it would provide little flexibility to cope with terms of trade shocks. The main disadvantage of a dollar peg is that monetary policy must move in lock step with the US. Over the long term, there has been increasing convergence between the business cycles of the GCC and the US, meaning that US monetary policy has been appropriate for the GCC. However, recent years have witnessed a sharp divergence: between 2006 and the first half of 2008 the US economy slowed sharply while GCC export earnings and domestic demand continued to surge. The peg meant that the GCC authorities were obliged to reduce interest rates at a time when raising them would have been more helpful. Under such circumstances the GCC authorities must rely on fiscal restraint (and to a lesser extent tighter prudential regulations) to manage domestic demand. The peg also means that GCC countries cannot defend against imported inflation by allowing the nominal exchange rate to appreciate. 4 Both these frailties were exposed in when a failure to rein in public spending, and a surge in trading partners inflation fed quickly into domestic price growth. By mid-2008 annual consumer price growth was in double digits in most GCC countries. Following the onset of this period of high inflation, a number of alternative exchange rate options were mooted, mainly by analysts, but occasionally by GCC policy makers themselves. In principle, a managed float would allow more flexibility however, interest rates do not play a key role in determining investment or consumption in the GCC. A managed float has been proposed by some. Its advocates argue that this would allow the countries to absorb large adverse real shocks more easily than a fixed exchange rate regime. As such, sharp swings in oil prices could be offset by changes in the nominal exchange rate, thereby imparting some stability to the local currency value of export earnings. Similarly, the impact of higher import prices could also be blunted by exchange rate adjustments. Beyond this, an autonomous monetary policy would allow appropriate monetary responses to domestic demand conditions. Thus if demand was in danger of overheating, nominal interest rates could be adjusted accordingly. The credibility of the float would be underpinned by the GCC s vast stock of foreign assets. One serious drawback of a floating exchange rate is the weak monetary transmission mechanism in the GCC. Private investment and consumption decisions tend not to be made on the basis of real interest rates, but rather on actual and expected government spending. Thus, even a fully independent GCC monetary policy would likely have only a marginal role to play in regulating domestic demand. This could well change with the development of 4 Although in the long run higher inflation in trading partners would tend to be offset by depreciation of their currencies against the US dollar. 15

16 deeper and more sophisticated capital and credit markets, but for the moment fiscal policy is the key determinant of domestic demand. Volatility would also be a problem. Increased volatility is another drawback of a floating rate. Large swings in oil prices (a feature of this commodity) would likely have an impact on the stability of the exchange rate. Active intervention by the central bank would be required to avoid negative knock-on effects for prices, nonoil output, and corporate and fiscal planning. A further complication is the choice of nominal anchor under a float. Both of the two main options monetary targeting and inflation targeting require the use of sophisticated market-based monetary operations, central bank independence, policy transparency and a detailed and timely data flow. These elements are currently missing and it would take some time for them to be established. Pegging to the price of oil would keep the real exchange rate in equilibrium but nominal volatility would likely be acute. A basket peg has also been proposed but this would impart little flexibility. An alternative version of the floating rate is a peg to the export price of oil. The main argument in favour of this regime is that it delivers automatic accommodation to terms of trade shocks, while simultaneously retaining the credibility-enhancing advantages of a nominal anchor. Its proponents argue that enabling the exchange rate to move in line with the price of the region s dominant export would allow the real exchange rate to achieve equilibrium and would also decouple oil exporters monetary policies from those of oil importers. Its detractors note that the price of oil is not truly exogenous, since the oil production policies of the GCC countries themselves influence the price. The volatility of oil prices would also present problems, forcing potentially sharp day-to-day swings in the exchange rate, making planning difficult. Oil price volatility may also make it difficult to identify permanent shifts in the GCC s terms of trade, and appropriate policy responses. Similarly, the volatility of the nominal exchange rate would likely frustrate policymakers efforts to support nonoil sector competitiveness. A further alternative is a peg to a basket of currencies. Supporters of this mechanism claim that a basket will provide the stability of a fixed peg and some of the flexibility of a floating rate. Whereas a peg to the dollar transmits all of the volatility of oil prices to oil earnings, a peg to a basket reduces volatility, benefiting external trade, investment and balance sheet stability. However, a basket peg does not bestow an independent monetary policy; rather, local interest rates would have to follow a basket of interest rates. In addition, the central bank would have to actively manage foreign exchange operations and foreign exchange risk, which might be challenging in thin financial markets. A basket where the relative weights and composition of the currencies remains undisclosed can complicate assessment of exchange rate risk and lead to unexpected behaviour: for example, Kuwait s move to an undisclosed basket in May 2007 resulted in strong demand for the dinar, large capital inflows, and a surge in liquidity. Perhaps partly for this reason the 16

17 Box 1: Pros and Cons of Possible Exchange Rate Regimes Fixed peg to dollar Pros: Provides a credible and easily understood anchor, and simplifies trade and financial transactions, accounting and business planning. Long standing dollar pegs have assured the stability of regional cross rates, making a transition to a regional fixed peg comparatively straightforward. Cons: No flexibility to adjust to real shocks. Monetary policy must move in lock step with that of the US, which might be at times inappropriate to local needs. Dollar weakness can be quickly transmitted to domestic prices (imported inflation). Managed float Pros: Absorbs real shocks (such as negative or positive change in terms of trade) and may become more appropriate as globalization increases. Potential to nurture competitiveness of nonoil sector. Cons: weakness in interest rate transmission likely to impair effectiveness of float. Institutional weaknesses may inhibit adoption of either inflation targeting or monetary targeting. Maintaining exchange rate objectives in face of large swings in oil prices would likely require frequent and heavy interventions by GCC central bank. Could complicate budgetary accounting and business planning. Peg to Oil Prices Pros: simultaneously delivers accommodation to terms of trade shocks, while achieving credibility by attachment to nominal anchor. Would allow real exchange rate to move in line with price of the dominant export. Cons: Price of oil is partly determined by policies of GCC themselves, so anchor effect would be diluted. Rising oil prices would mean real appreciation, impairing competiveness of nonoil export sector. Would likely mean excessive volatility, hampering decision-making and increasing transaction costs. Basket peg Pros: Useful halfway house offering some nominal flexibility to contain shocks, while retaining main anchor properties of a fixed peg. In short run, basket peg can help contain imported inflation. Cons: Does not bestow monetary independence, and would not address the management of oil price volatility or the rise of liquidity stemming from high oil prices. An undisclosed basket invites speculation and could complicate business planning. 17

18 GCC: 3M Forward Prices to Dollar Note: negative values represent expectations of an appreciation, and vice versa Jan-07 Oct-07 Jul-08 Apr-09 Source: Bloomberg QAR AED SAR KWD adoption of the basket did not have any noticeable downward impact on inflationary pressures. 5 Since mid-2008, the dollar has strengthened and inflationary pressures have begun to subside. Consequently, much of the heat has gone out of the exchange rate debate. In fact, speculative pressures on GCC exchange rates reversed: as funds previously betting on a revaluation of GCC currencies were withdrawn and some GCC countries came under current account pressure, so spreads on forward rates began to suggest large devaluations. (By early 2009 liquidity conditions had improved and forward rates had stabilised.) Outlook Global market turmoil may have hardened belief in the peg. The recent turmoil in the global economy and the shifting sands in international financial markets and capital flows have heightened the challenges facing GCC policy makers as they survey the road to monetary union. Notwithstanding the stresses on the Eurozone in recent months, which will not have escaped the attention of the policy makers in the GCC, the severity of the disruption in the global economy may well have reinforced the belief in the Gulf that continued reliance on fixed intra-gcc exchange rates and completion of the process of currency unification is the preferred way forward. At the same time, it is most likely the dollar peg continues to be the preferred exchange rate regime for the bloc in the foreseeable future. Faith in the peg is understandable and, as outlined above there are a number of good reasons why it may be adopted, not least the familiarity that it enjoys. In particular, interest rate transmission signals are weak in the Gulf, given the preponderance of actual and expected government spending on consumption and investment decisions. If changes to nominal interest rates have little impact on the spending patterns of firms and households, then much of the advantage associated with a floating exchange rate is lost. However, a flexible regime may be more appropriate in the longer term. This may change, however, over a longer time horizon, as regional financial and capital markets broaden and deepen, thereby enhancing the potential advantages of a more flexible exchange rate at a later stage. In such conditions, a flexible exchange rate would help encourage a more robust, diversified and competitive non-oil export sector, which in turn could provide the spur to sustainable employment growth. There are, however, more immediate issues weighing on the outlook for currency unification. First, as we have seen, the ongoing global economic crisis has prompted varying fiscal and monetary responses from GCC states. While these measures make sense from an individual country perspective, they are likely to mean that the convergence criteria are breached in a number of GCC countries this year and probably next. Second, and related to this, the GCC authorities will be watching how the 5 In any case, the heavy dollar weighting means that Kuwait s exchange rate fluctuations have been modest. 18