What revaluation will mean for the GCC

As the debate about the dollar-pegged currencies continues, it is worth considering how US quantitative easing affects oil-expecting countries in the region.

Gulf economies are currently on a recovery mode and their stock markets are not overheating. Paulo Vecina / The National

The US$600 billion (Dh2.2 trillion) quantitative easing (QE) announcement by the US Federal Reserve shows a classic "beggar thy neighbour" devaluation strategy that has drawn criticism from multiple financial heavyweights around the world.

For countries whose currencies are pegged or linked to the dollar, QE raises the prospect of increased capital flows. This liquidity boost in the emerging world will in turn result in asset bubbles and eventually higher inflation. In a wider sense, these countries are to some degree sharing the burden of inflation, particularly if they export a lot to the US.

So what does that mean for GCC countries with their dollar-denominated oil exports and dollar-pegged currencies?

This is reminiscent of the upward pressure the GCC currencies experienced in 2007-2008. The fixed foreign exchange policy strips the financial authorities of the power to use monetary tools - specifically interest rates - in fighting inflation.

Since all of the currencies are either loosely or completely pegged to the dollar, the GCC interest rates have to follow the Fed rates.

Inflation accelerated to double digits during the boom period and was more than 13 per cent in Qatar and Dubai. The central banks would have increased interest rates to curb this inflation but their hands were tied because of the peg.

However, the current environment is different. Even with ongoing QE, the GCC countries should not be affected as much as other emerging markets.

Currently, their economies are on a recovery footing, their stock markets are not overheating, and their interest rates are stable. Moreover, credit growth is subdued and private demand has declined across the region.

The property frenzy has subsided, wage inflation has softened and an abundant labour supply is available. With all these differences, it would be erroneous to expect huge dollar flows from the second round of the QE. That is, of course, not to say that there will not be an impact, but it will be both different and milder than what was witnessed a few years ago.

And so a return to pre-crisis inflation rates is highly unlikely before the end of next year.

Inflation in Saudi Arabia is now the region's steepest - climbing to about 6 per cent in August - because of domestic supply pressures rather than any acute import pressures.

In the UAE, inflation rates for the first nine months of this year stood at 0.6 per cent, while Qatar experienced a deflation of 3.2 per cent for the same period.

The GCC economies depend heavily on oil exports, and seeing that oil is priced in dollars, their economies are not vulnerable to domestic inflation.

On the flip side, a further dollar weakening will not bode well for the region, given the heavy dependence on imports of food, cars, luxury goods and other items from Asia and Europe. Sharp fluctuations in the dollar will increase variance in the import bills.

Higher revenues stemming from stronger exports to Asia and higher oil prices will provide a cushion, but the region remains prone to short-term price shocks.

The GCC economies are in the process of recovery, so maintaining the peg in the current low Fed rate environment is not at odds with the region's economic ambition and outlook.

With governments still struggling to re-engage the private sector in their development process and attract foreign investments, weaker GCC currencies would benefit tourism and manufacturing sectors.

However, although this may be the case at the moment, one can envision several developing scenarios in which the continued use of a fixed exchange rate could put a damper on the GCC's recovery.

Just as the GCC central banks were forced to lower interest rates in tandem with the Fed at a time when a contractionary monetary policy was needed, they may find themselves in the opposite situation if the continued QE results in a weakening of the dollar, forcing the Fed to raise rates.

Of course, circumventing such severe scenarios would necessitate a complete de-peg, which in the current debt markets environment and depth is not yet a feasible option.

The decades-old dollar peg has come under increasing calls for review.

High oil prices, falling interest rates and a declining dollar translated into a flood of liquidity in the region, driving up inflation and challenging the job of central banks in effectively managing monetary policy.

The revaluation would help to achieve greater currency flexibility, a critical pre-condition for monetary policy manoeuvrability. More importantly, the current situation is an opportunity to push forward a structural change.

In the event that a global slowdown materialises and oil prices decline, GCC surplus will shrink. The burgeoning wage bills and subsidies that have helped to ward off inflation will become increasingly difficult to sustain, making currency flexibility a critical policy tool.

However, any revaluation will benefit foreign investors, capital-intensive industrial projects, companies with external liabilities and GCC importers and regulators.

Moreover, it could allow a temporary dampening of imported inflation and help to bring real exchange rates closer to equilibrium.

On the other hand, a revaluation would impose significant and immediate valuation losses on the GCC's foreign assets, which would reduce the international competitiveness of those that have embarked on economic diversification through international acquisitions.

If substantial, a revaluation could generate sharply lower fiscal revenues in domestic currency and entail a significant adverse impact on the balance sheets of both the government and private sectors, including banks. Furthermore, as soon as the exchange rate is perceived as a policy instrument available to tackle inflation, expectations of further revaluations could encourage speculation, even if fundamentals are unchanged.

In fact, this was the case when Kuwait moved to a basket peg and, again in late 2007, when investors reacted to statements of GCC officials by transferring substantial deposits into the region, betting on an imminent currency revaluation.

Finally, if the revaluation was undertaken after a shift to a unified GCC currency, the new depth in the market would mitigate many of the issues discussed above.

However, as we have seen in the past few years, that project faces many hurdles that warrant their own discussion.

Walid Hayeck is head of asset management at The National Investor

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