Gulf Co-operation Council currencies

The currencies of the six states of the Gulf Co-operation Council (GCC - Saudi Arabia, Kuwait, the UAE, Qatar, Bahrain and Oman) are dull fodder for economists and traders, and that is just the way the region's central banks like it to be. The region's currencies have been pegged against the US dollar at unchanged rates for a generation. There was a brief flurry of interest in valuation adjustment in the late 1990s, when oil prices in the low double-digit range left the region facing large fiscal and current account deficits, prompting speculation that the pegs could break.

However, determined use of reserves and a recovery in oil earnings soon pushed the issue off the agenda. A renewed interest in currency pegs is derived in part from evidence that the GCC is approaching its self-appointed task of introducing a single currency in 2010 with greater intent and urgency than sceptical regional observers had anticipated.

In particular, rumours that the region is considering pegging the new currency to a basket, rather than just to the US dollar, has led those with local currency exposure to reassess their long-term hedging strategies.

However, 2010 is still a long way off and excitement on the currency markets has cooled as central bank governors have stressed that they expect the new currency to be pegged to the US dollar, at least in the first instance.

The new story circulating in the markets is that Gulf officials are considering shifting the value of their pegs against the US dollar upwards to compensate for the decline in the value of the US dollar. In late October, some traders began to bid up the spot value of the Saudi riyal (the most actively traded Gulf currency) amid rumours that the central bank would shift the peg. However, no revaluation took place and those who had anticipated a revaluation were left to cover their losses.

Despite the reluctance to change, GCC policymakers could have their hands forced next year if the US dollar's decline is as precipitous as it might be. This would have a direct bearing on those with local currency exposures. The Gulf currencies are losing value, dragged downwards by the US dollar. On a nominal trade weighted basis, the Saudi riyal is now worth almost 10% less than it was in 2000. In real terms, the decline has been even more marked, falling by close to 20%.

Similar declines have occurred across the region, with even the UAE dirham falling by 6% in real effective terms since the start of the decade, despite rising inflationary pressures.

These averages also do not fully capture the true impact of the decline on the region's economies. The GCC's export profile is dominated by the oil sector, which accounts for roughly 70% of overall earnings - a figure that rises further still when other hydrocarbons are included.

As prices for these commodities are set in US dollars on the international market, the import side of the equation takes the full brunt of currency shifts, boosting import prices from non-US dollar denominated trading partners with little commensurate increase in export competitiveness to offset it.

If it were not for the peg to the US dollar, the GCC economies would not have had to bear this cost. Over the past five years, the GCC has generated a cumulative current account surplus of some US$575 billion, with forecasts suggesting this year's surplus will be over $210 billion - the equivalent of 29% of GDP.

In Kuwait, the current account surplus will equate to 45% of GDP, but policymakers will nevertheless see their currency barely holding its value this year.

As the US economy slows next year and easing inflation concerns lead interest rates to fall, the US dollar is set to weaken further. Therefore, if import costs are rising so sharply and there is no positive bearing on export competitiveness, why should there be such resistance to revaluing the US dollar pegs to cut costs and allow GCC currencies to reflect more accurately the strength of the region's vibrant, fast-growing economies?

The answer lies partly in the region's trade structure, which reduces the GCC's exposure to the weak US dollar. The US itself is the region's most important single source of imports, ranking in the top four in a list of importers for each Gulf state and heading the list for Saudi Arabia and Kuwait. The prominence of other US dollar-pegged economies in the import breakdown - led by China, but including intra-regional trade partners - also insulates the GCC economies against the weakness of the US currency.

Moreover, the GCC - like the rest of the world - has been able to benefit from falling prices for a range of imported goods. An increasingly sophisticated financial sector has also been able to provide local corporates and other importers access to a greater range and depth of hedging tools to smooth out some of the currency volatility.

Revaluation of GCC currencies against the US dollar would also lead to significant losses for local government and corporates. In each of the six GCC states, public finances are dominated by US dollar-denominated revenues from the state-owned oil industry.

To allow the local currencies to appreciate would yield less income for each barrel of oil sold. Furthermore, across the Gulf it is commonplace for savings and investments to be held offshore, with many holding US dollar-linked assets. A revaluation would immediately undermine the value of these holdings.

In the view of HSBC Research, there will be no change in the region's currency regimes before 2010. Only a catastrophic collapse in the US dollar's value would force Gulf policymakers to seriously reconsider the value of their currencies and, even then, it would not be immediate.

This report was compiled by Peter Calleya, manager, Corporate Strategy and Research, HSBC Bank Malta plc, on the basis of economic research and financial information produced by HSBC International Bank.