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Gulf currency pegs seen surviving weak dollar

DUBAI - The Fed’s moves to pump money into the US economy may revive questions about the dollar pegs used for Gulf Arab currencies, but policy change in the conservative oil producing region seems to be a long way off.

Policymakers in the world’s top crude exporting region have long said that dollar pegs serve their hydrocarbon-heavy economies well as long as inflation stays under control.

As key Gulf economies continue to recover, inflation has started to pick up. In Saudi Arabia, Kuwait and the United Arab Emirates it has already hit 18-month highs, though it is still far below 2008 record peaks.

No wonder then that the weak dollar, which touched an 11-month low against a basket of currencies early this month in response to US Federal Reserve policy, has obliged Gulf officials to deny any risks to pegs in the region, which relies heavily on imports.

Even so, forwards now price in just 0.3 per cent firming in a year for Saudi Arabia’s currency compared with 2.7 per cent at the height of 2007 speculation that imported inflation would force the region to ditch its dollar pegs.

“The Gulf states should keep their dollar fixes for the foreseeable future,” Robert Mundell, the Nobel Prize-winning economist from Columbia University in New York, told Reuters.

“The only good argument for changing the fix would be if the dollar became unstable or it declined as the premiere anchor currency,” said Mundell, who has recently become an adviser to the United Arab Emirates central bank.

Some economists have warned that the Fed’s latest bid to kick start the US economy with a $600 billion injection could fuel inflation and put the credibility of the dollar at risk.

But as long as dollar weakness is offset by the shaky euro and dollar-denominated oil remains the key revenue earner for Gulf governments, greenback pegs — politically sensitive for strong US allies — look safe.

Apart from the inflation risks, speculation on pegs and a weaker dollar can be damaging for Gulf states which invest a large chunk of their foreign exchange reserves in US assets.

Back in 2007, when speculation on revaluation swirled, hot money poured into Gulf Arab countries, making Kuwait break ranks with fellow Gulf states and drop its peg in favour of a currency basket to fight inflation.

This summer, Qatar’s central bank slashed interest rates to keep speculative capital out of an economy growing at double digit rates, unlike the rest of the Gulf. However, the euro, at around $1.3740 on Monday, has lost ground to the dollar on worries about how the currency bloc can manage the problems of its weaker economies. Meanwhile, oil prices have cooled down after climbing to a two-year high of nearly $89 a barrel this month with 2008 peaks still distant.

Another factor limiting pressure on the dollar pegs is that the capital flows spurred by US monetary policy have largely bypassed Gulf economies trying to recover from the global credit crunch and local debt woes.

“We have not seen any significant plays from any of the hedge funds or real money guys out of Europe or America for the last month,” said Lyndon Loos, head of MENA forex trading at Standard Chartered in Dubai.

“If you get to double digits on the inflation side and see significant weakening in the dollar, say the euro above the 1.55 area, than pressure will be applied once again,” he said. But unlike in 2008, inflation mostly holds in low single digits in the Gulf, where banks exposed to debt restructuring are reluctant to lend.

“Even with the current phase of dollar weakness, a return to such levels of inflation is unlikely through to the end of 2011,” said John Sfakianakis, Banque Saudi Fransi’s chief economist.

Analysts forecast Saudi inflation at 5.3 per cent on average this year and 5.1 per cent next year, the highest in the Gulf but well below a 11.1 per cent record high in July 2008.

In the longer term, a move away from oil may change attitudes in the region, which is attempting to form a euro zone-like monetary union.

But given traditional conservatism on policy change, combined with relatively weak inflationary pressures, the dollar pegs may well remain 
for some time.

“This state of affairs should continue for a few more years — even though increasing diversification of its (UAE) economy, especially towards financial business, will increasingly warrant a switch to flexible exchange rates,” Mohammad Ishfaq, lead economist at Dubai Department of Finance, wrote in a research paper earlier 
this year.