Currency Quakes
The recent turbulence in the GCC currency markets is explained by a series of events, writes Matein Khalid

Foreign exchange markets in the Gulf are on the edge after a succession of events have escalated the risks of imminent, seismic changes in the Gulf’s currency peg regimes. One, Kuwait abandoned its four-year dinar peg to the dollar in May 2007, moving to a basket of currencies in which the weighting of the dollar is rumoured to be 70 per cent, not coincidentally the proportion of the dollar held in international central bank hard currency reserves. Kuwait’s decision to abandon the dollar peg was prescient because it preceded the credit crunch, the bank runs and failures that forced an emergency Fed lending of the last resort and ignited inflation psychology in the financial markets. This meant a worldwide run on the dollar, particularly against the Euro, Swiss franc and gold. The Kuwaiti dinar has appreciated 2 per cent against the dollar since the peg was abandoned. Interestingly, Kuwaiti central bank governor Sheikh Salem Al-Sabah stated that domestic inflation fell by 0.5 per cent since May, proving the strong linkage between imported inflation and dollar currency pegs in the Gulf.

Two, the GCC common currency project has clearly lost momentum. Oman has opted out of the 2010 monetary union pipeline because of concerns on budget deficit and government spending restrictions. Now even the UAE central bank governor Sultan Al Suweidi has publicly stated that the deadline for monetary union has been postponed to 2010. This is ominous because the whole idea of the GCC currency peg was to facilitate convergence on the path to monetary union. But if the GCC common currency is a chimera, the political and monetary logic of the currency pegs falls apart.

Dollar woes
The dollar woes accelerated after the September 18 FOMC discount and fund rate cut, a clear signal that the Federal Reserve was unnerved by the credit crunch on Wall Street and the tangible systemic risk in the banking system. While the September US payroll data has given a temporary relief to the dollar, the broader fundamental scenario is clearly greenback negative. Consumer spending cannot remain immune from the deflation shock of a housing recession and consumer spending is two-thirds of US GDP growth. Moreover, the interbank market has still not returned to normal, with three-month LIBOR trading 60 basis points above the Fed’s overnight borrowing rate and bank credit risk (as expressed by the TED spread or the Treasury Eurodollar yield spread) at its highs. So the likelihood of slowing US economic growth, additional rate cuts by the FOMC and the increasing desire of Japanese, Russian, Chinese and Arab central banks to unload excessive dollar reserves all argues that dollar selling will remain the default option in the global foreign exchange market in 2008. Of course, the wild card is geopolitical risk in the Middle East, upside surprises in US economic data or another panic driven asset market contagion. The next milestone for the dollar is if the Fed will cut rates to 4.5 per cent at the October FOMC. Of course, the ECB will not raise rates either and if the politicians in Berlin and Frankfurt do not ease rates in October, the dollar could temporarily rise to 1.35. However, long term, the dollar’s path of least resistance is decidedly lower.

Three, the linkage between imported inflation and the currency peg is most pronounced in the smaller, more open economies in the Gulf, particularly Qatar and UAE. The UAE share of imports from the EU is no less than 30 per cent, meaning the revaluation of the Euro from 0.85 cents four years now to 1.40 now has been a macroeconomic disaster for the Gulf’s fastest growing economy. The rise in the Euro was all the more painful because it coincided with a liquidity tsunami and an unprecedented property boom in both Dubai and Abu Dhabi. For instance, M3 money supply has grown by more than 20 per cent in the past year in the UAE.

It is, of course, necessary to point out that a one-time revaluation of the UAE dirham, particularly a modest 3-4 per cent adjustment, will not exactly solve the inflation dilemma faced by UAE policymakers. After all, rents have tripled in Dubai since 2004 and the price of everything from cements to foodstuffs has surged, meaning a 20-year high in domestic inflation estimated at 12 per cent. Empirically, rent caps have not been successful in containing domestic inflation. So the UAE central bank must execute an independent monetary policy if it must proactively act to contain the inflation surge that threatens the global competitiveness of the UAE. Four, the pressure on the GCC currency pegs (particularly UAE and Qatar) has been accentuated by the fact that monetary policy imperatives in the US and the GCC now diverge to an exceptional degree. The US faces a consumer slowdown, retail and auto sales softness, financial distress, real estate deflation and high probability of recession risk.

The GCC peg
The macroeconomic realities in the GCC are exactly the opposite. Real GDP growth as high as 8-10 per cent, record inflation rate, breakneck bank credit and money supply growth, a GCC current account surplus that is an incredible 30 per cent of GDP, a surge in wages, rents, a construction boom that has made the UAE second only to China in consumption of cranes, huge government spending on real estate and infrastructure projects with crude oil prices at a record $80. Real interest rates in the GCC, thanks to the peg, are excessively negative, leading to speculative excesses in the property market and bank loan books. Yet, the currency peg eliminates monetary policy as an inflation fighting mechanism for the GCC central banks. The cost of adhering to the peg has simply become too painful as the economic cycles of the GCC and the US diverge.

But will a modest revaluation of the UAE dirham or Qatari riyal solve the Gulf’s inflation malaise? I doubt it. Purchasing power parity suggests the GCC currencies are undervalued by 25-30 per cent, the most undervalued currencies on the planet with the exception of the Chinese Yuan. Moreover, GCC central banks have not responded to the Fed rate cuts with commensurate falls in local money market rates. In essence, the existence of the pegs and higher money market rates has now made the Gulf currencies a classic destination for hot money carry trade speculators. Why did the GCC central banks not mirror a 50 basis point cut? My hunch is the GCC central banks expect the Fed to pause next month. They thought the September rate cut was a knee jerk response to banking crises on Wall Street and Europe. In essence, the GCC central banks were buying time. But if the credit crunch deepens and the Fed is forced to cut the overnight borrowing rate down to zero (as happens during systemic banking crises such as after the 1990 Iraqi invasion of Kuwait and the 2000 Silicon Valley tech bubble burst), all bets are off. GCC currency pegs will be history.

The abandonment of the GCC currency pegs can have enormous consequences for the region. After all, FX translation losses for regions banks and sovereign investment agencies will be colossal. Moreover, regional corporates have been lulled into complacency by the existence of the currency pegs, some dating back to the 1980s. The central banks of the GCC also do not have a track record of independent monetary management. After all, as Paul Volcker proved in the 1980s, successful inflation fighting requires positive real rates of interest. Can the Gulf live with a three-month money market rate of 10 per cent? That will mean recession and a collapse in the leveraged property markets across the region. Hundreds of banks and financial institutions will also be doomed, as happened with US savings and loans. Yet the Chicago School and Milton Friedman argue that inflation is a monetary phenomenon and can only be combated by choking the money supply. Inflation never has a pretty endgame. This is a lesson investors, savers and central bankers in the GCC have learnt in the past three years.

Matein Khalid is a renowned investment banker based in Dubai

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