Last Updated: Sun Jun 26, 2011 21:37 pm (KSA) 18:37 pm (GMT)

Gulf currency trade: To peg or not to peg? Financial Analysis by Eman El-Shenawi

And when it comes to foreign currency trading, markets can price Gulf currencies against the dollar through its fixed, or pegged, rate.  (File photo)
And when it comes to foreign currency trading, markets can price Gulf currencies against the dollar through its fixed, or pegged, rate. (File photo)

Imagine a man, walking. A ball and chain is gripped around his ankle, tying him down. He tries to walk and indeed he can, but the chain will only take him to a certain pace. At times he may be able to run, but can’t.

But the real poser lays here: the man is actually reliant on this enigmatic ball and chain to function, despite its bounding burden. And so the story begins.

“Pegging” is a term that applies to currencies that are tied to one another. And one of the world’s most prominent pegged relationships is between Gulf currencies and the United States dollar.

And when it comes to foreign currency trading -- the buying of one currency and the selling of another -- markets can price Gulf currencies against the dollar through its fixed, or pegged, rate.

The foreign exchange market has a volume of $4 trillion in average daily trading. Fixed currency trading is edged on by the governments (central banks) that set and maintain the official exchange rate for their currency, creating a more stable currency that other countries can peg to.

While this means that the relative value of Gulf currencies does not change, or remains steadily pegged to the dollar, this has been a controversial economic issue over recent years following the dollar’s weak and volatile performance as compared to other currencies. In reality, no exchange rate is wholly fixed or pegged; market pressures are the main influence changes in the exchange rate.

Policymakers in the top crude exporting region have long said that dollar pegs serve their hydrocarbon-heavy economies well. This is providing that inflation stays under control.

But analysts have warned that Gulf central banks’ reserves should be more diversified in the long run, as any United States debt default would put downward pressure on the dollar and fuel inflation.

The United Arab Emirates, Saudi Arabia, Qatar, Oman and Bahrain make up the dollar-pegged Gulf. Kuwait, the sixth Gulf Corporation Council member, solely dropped its dinar currency peg in 2007, in a blow to then talks about a potential GCC single currency union, which would have followed in the footsteps of the European Union.

Kuwait’s central bank had said that the dollar's 2007 slide against other currencies had forced it to break away from fellow Gulf States to contain inflation from the rising cost of some imports. Kuwait switched its exchange rate mechanism to a basket of currencies instead, meaning a portfolio of several currencies with different weightings.

A basket is considered by many countries to be a safer bet. It can be made up with a mix of currency pegs -- to the Euro, British pound and dollar all together, perhaps. Pegging to this mix is generally thought to minimize risks of single currency fluctuations.

The GCC’s erstwhile wish to have a single union currency had never really developed beyond a few discussions between the majority of the Gulf club; all but Oman, which had dropped out of monetary union plans in 2006, followed by the UAE in 2009. And alongside Kuwait abandoning the dollar peg, efforts to team-up became messy.

Kuwait’s concerns about the dollar still echo now. This year, the US debt situation has revived concerns about the strength of the dollar.

While the US debt -- currently standing at $14.3 trillion (almost equal to the US gross domestic product) – is not proving to be a major problem for the dollar now, analysts say that it could lead to currency weakness in the long-term if the deficit situation is not resolved.

“(The risk) is a concern for countries that have investment denominated in the US dollar. It will lose value,” Khalid Al Khater, a Gulf central banker told Reuters.

So while the majority of Gulf currencies could be on the road to becoming pegged to a weaker dollar, the US currency remains special to them. The majority of the Gulf States have large shares of US trade, with oil — priced in dollars — their primary source of government income.

Mr. Khater said that any loss in dollar value “will put more downward pressure on the US dollar exchange rate against other major currencies so there will be more inflationary pressure.”

And the Gulf is already expecting to meet bigger inflationary pressures in the coming months, rooted in the weak dollar, higher global food costs, and increased government and social spending in the wake of regional unrest.

Some analysts suggest that Gulf currency be de-pegged from the dollar, exploring other alternatives, like a peg to gold, in light of the steady performance of the yellow metal in the last decades, as compared to oil and US dollar value.

But the Gulf’s reliance on its petrodollar wealth is what gives the dollar-peg credibility in the region, with oil actively working an important catalyst for global markets.

“The dollar peg serves as an adjustment for volatility and supports oil exports priced in dollars,” says John Sfakianakis, Chief Economist at Banque Saudi Fransi.

“Crude oil exports still account for nearly 90 percent of total exports and the non-oil sector is gradually picking up. Most of the Gulf’s international trade transactions, including imports, are therefore still in dollars,” he adds.

Mr. Sfakianakis says that although Gulf currencies are likely to appreciate in the event they float and de-peg from the dollar, this is likely to discourage capital investment from both private and public sectors that generally prefer to make dollar-pegged investments.

He adds that Kuwait’s dollar de-peg to mainly curb inflation has not proven entirely worthwhile.

“The experience in Kuwait, where the currency is now managed against a trade weighted basket, shows that the dollar accounts for at least 65 percent of the currency basket and inflation remains a problem.”

Providing that a peg’s bare meaning is linked to currency stability, recent global financial disruptions have made for ironic conclusions. The US dollar is now in danger of becoming weaker and “stable” is a word to describe the country’s economic situation at the moment.

Increased speculation about the fate of the dollar in light of the US deficit, could make investors scramble to get their money out if the situation worsens, converting it into foreign currency before the local currency is devalued against the peg.

This is stuff of which financial crises are made of--and could make Gulf currencies re-consider their dollar pegs. But at a time when the Euro and British pound are also experiencing some wear and tear, it is unlikely that the Gulf will have anything considerably safer to peg to.

Above all, let us not forget the “relationships” the countries have with one another. After all, currency agreements are not emotionless, or distant from any friendly ties countries may have.

“The Gulf countries are key US allies,” said Mr. Sfakianakis. “They are unlikely to want to undermine confidence in the dollar in the immediate future.”

And let us not forget that once upon a time, even the dollar had a chain and ball in its track. It was pegged by gold in the 18th century, while now it is backed by“faith” in the government’s ability to honor and back the currency.

And so the Emirati dirham, the Omani rial, the Bahraini dinar, the Saudi riyal and the Qatari riyal have all been sharing this faith in the dollar too. So far.

(Eman El-Shenawi, a writer at Al Arabiya English, can be reached at: eman.elshenawi@mbc.net.)

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