Gulf states urged to move beyond 'fear of floating'

"The ideal approach is to move beyond 'fear of floating' and introduce greater exchange rate flexibility," writes Serhan Cevik from Morgan Stanley Research Europe, author of a report, Middle East & North Africa: Supersize Middle East. "With inflation targeting, that would help to deal with the inflation threat and, more importantly, motivate structural reforms and diversification efforts."

In a telephone interview Cevik said: "The UAE needs to depeg and should consider revaluing as well," adding that a floating regime is a better option than a fixed exchange rate. But if resistance to adopting a full float is too great, adopting a "more flexible version" of a fixed exchange rate, such as shifting from a dollar-peg to a basket of currencies as Kuwait has done is an option, he said.

"The pain threshold is much higher in the Gulf region because countries can accommodate short-term balance of payments imbalances longer than elsewhere," he added, "and it is very difficult to say what the pain threshold is."

The report emphasises the challenges the dollar's "precipitous decline" presents to countries with pegged exchange rate regimes, including the macroeconomic imbalance of burgeoning current account surpluses and "significant currency depreciation" in real terms. Saudi Arabia, for example, has a current account surplus of 27.5 per cent of GDP but its real exchange rate has declined by 25 per cent since the start of 2002.

"There is one simple reason behind this intriguing case of exchange rate misalignment (not just in Saudi Arabia but also in the rest of the Gulf region) and that is the exchange rate regime pegged to the US dollar," the author writes.

"Although we are worried about currency misalignment relative to economic fundamentals, the immediate threat arises from the inflationary consequences of weaker exchange rates."

Although Cevik acknowledges the difficulty in generalising inflation dynamics across the MENA region, there are two common underlying factors fuelling inflation, he said - the oil windfall and expansionary economic policies which have led to overheating and the rise in food prices because of the higher weight of unprocessed food in the indices. He writes: "But the problem is not just because of overheating and higher food prices. While the dollar's fall is disinflationary in some countries, others with pegged currencies end up with higher inflation. In other words, exchange rate regimes that were once considered to be the 'anchor of stability' have become a major source of macroeconomic imbalances."

For pegged exchange rate regimes to work the synchronisation of monetary policy and business cycles is required, but now "the US and GCC business cycles are diverging," explains Cevik. "For the time being, risks to growth outweigh inflation risks in the US, while Gulf countries face the opposite risk profile. Consequently, rate cuts would lead to further overheating and higher inflation," he writes and adds that because the Gulf countries do not have well-developed debt markets they cannot effectively sterilise "speculative" capital.

For these reasons, Cevik argues: "Economic and financial risks call for the realignment of exchange rates, which is already justified by economic fundamentals. Incremental currency adjustments could be a start, but not necessarily a sustainable solution."