Tackling the Credit Crunch
The dollar peg makes a revaluation of the GCC currencies and a tightening of monetary policy impossible, writes Matein Khalid

The GCC will not be immune from global economic, financial and monetary events in 2008. The biggest dilemma facing the region is the continued free fall in the US dollar, which has now fallen to a new low of 1.47 against the euro and to 2.11 against the sterling even while crude oil prices flirt perilously close to US$100. The collapse of the dollar, which began in early 2002 with Greenspan’s epic rate cuts in the aftermath of 9/11 and the explosive economic growth of China, threatens the economies of the GCC in ominous ways.

A depreciating dollar means the GCC countries import inflation because the existence of the currency peg in all the GCC states, apart from Kuwait, means the regional central banks have to follow the monetary policy diktat of the Federal Reserve even while the business cycles of the GCC diverge from the US, as they do now. The US economy is burdened with the fallout from the subprime meltdown and the credit crunch on Wall Street. This means the Bernanke Fed has been forced to cut interest rates to give lender of the last resort credence to US banks at a time when the interbank deposit and commercial paper markets shows ominous signs of systemic distress. The Fed has to slash interest rates even if it means a collapse in the dollar, a phenomenon that began with the September FOMC rate cut. But the GCC central banks need to tighten monetary policies to combat inflation rates, which have reached double digits in the UAE and Qatar and hit two decade highs in Kuwait, Bahrain, Oman and Saudi Arabia because of the liquidity tsunami in the banking system, food and cement price rises, property speculation, the threefold increase in rents and the most dramatic surge in money supply witnessed in the GCC for a generation. The dollar peg makes a revaluation of the GCC currencies and a tightening of monetary policy impossible.

Lower purchasing power
GCC central bank and sovereign wealth fund reserves are also invested primarily in dollars. The GCC states have been major and consistent creditors to the Euromarkets ever since the first petrodollar revolution in the 1970s. Abu Dhabi’s ADIA has invested an estimated US$800 billion and Kuwait US$250 billion in the global financial markets, with new sovereign wealth funds from Dubai and Qatar active in international mergers and acquisition deal making. A protracted bear market in the US dollar exposes the GCC to greenback devaluation risks and lowers the purchasing power of its offshore sovereign wealth – exactly the dilemma voiced by a top Chinese politician when he said that China should accumulate its reserves in euros, not dollars. It is a sad fact of international finance that the world’s reserve currency has been a disaster as a hard currency, having lost more than a third of its value against the euro, sterling, the Swiss franc and even Asian currencies as the Singapore dollar, Indian Rupee and South Korean won.

The other ominous global event I foresee in 2008 is the debacle in the global credit markets. Thanks to the revolution in derivatives and securitisation, Wall Street’s subprime woes cast their long shadow on the banking systems and financial markets of the GCC. One, as liquidity built up in bank balance sheets in 2006, some of the leading banks in the GCC invested billions of dollars in ostensible AAA rated collateralised mortgages. This means banks will have to write off such investments, as their global peers such as Citigroup, Merrill Lynch and Morgan Stanley have done. Two, losses in the subprime markets, the depositor run on Northern Rock, the gutting of money centre bank valuations on Wall Street and London, the failure of two German banks, several US hedge funds and mortgage lenders has injected a fear premium in the international capital markets. There is no way Middle East borrowers can borrow in the Eurobond market at razor thin spreads because the credit risk has suddenly spiked higher. Qatar’s Delta Two was forced to abandon its bid for British retailer Sainsbury because it simply could not borrow money with its syndicate banks at terms agreed before the subprime meltdown hit Wall Street in July. When bankers renegotiated the loan covenants, Delta Two could no longer pay the aggressive premium for Sainsbury. While GCC borrowers must pay higher interest costs in the offshore capital markets, lower rated borrowers may well be denied access to credit in the wholesale banking market. This will particularly hit retail banks in the region, who financed their high growth assets by borrowing in the Euro Medium Term Note (EMTN) market, a strategy whose risk potential was highlighted by the depositor run on Northern Rock, the first run on a UK bank since the Victorian age.

Surge in risk appetites
Yet, it is now clear that the crisis has escalated beyond US subprime mortgages into a global credit crunch. In the past, central banks created high-powered money to rescue financial markets and boost economic growth. This is no longer possible in the age of securitisation because hedge funds, offshore investors and off balance-sheet funds hold untold billions of distressed CDO and credit derivatives and yet have no access to the Fed or the ECB’s discount window. So, the credit shock will mean a surge in risk appetites, a dramatic fall in leverage, at least an 8-10 per cent contraction in credit. The endgame will be a surge in credit risk spreads for borrowers and a plunge in capital flows to the emerging markets. This is the reason I believe a replay of the 1997 Asian financial crisis could well happen next year, particularly since Asian, GCC and Latin American emerging markets now trade at bubble valuations. As international banks scramble to raise capital to Basel Two protocols, they will tighten lending standards and slash international credit lines. After all, when the world’s biggest bank (Citi), a US$2.4 trillion monster, loses 30 per cent of its share value in a single quarter, the shock waves from its distress are bound to reverberate across the international banking system. The SP Financial Index has now revisited its August lows. The ABX Index, the cost of insuring against default on subprime mortgages, suggests that there is no immediate light at the end of the credit crunch tunnel. All this means that a recession in the US economy, the first since the Silicon Valley crash of 2000, is now inevitable. A fall in foreign trade will follow a US recession as there is nowhere the Asian emerging markets can hide when the US economic supertanker begins to sink. This means a plunge in crude oil, emerging market indices and global property could well happen in 2008.

Three regional trends will define the GCC markets in 2008. One, the rise of institutional investors such as pension funds, sovereign wealth funds, mutual funds and hedge funds will replace the retail speculative investor as the GCC’s value setter in the capital markets. Two, GCC stock exchanges will deregulate and integrate with the global capital markets. This will increase the correlation of GCC markets like UAE and Qatar, favoured by global emerging markets fund managers to Western Indices. The US$4-billion D P World IPO, the emergence of new GCC international investment banks like Kuwait’s Global, KFH, Bahrain’s Seico and UAE’s Shuaa will only accelerate the process. Three, recession in the US will mean a global shakeout in the investment banking capacity. This will mean that the DIFC, King Abdullah Economic City and Bahrain Financial Harbour will need to broaden their appeal to Indian, SE Asian, Chinese and Russian financial institutions and not rely on the wounded banking goliaths of Wall Street, the City of London, and Zurich’s Bahnofstrasse. When hard times hit the global markets, the GCC financial strategists should strive to convert risk into opportunity.

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