Middle East to Abandon Dollar?

Rob Mackrill - Wed 30 Jan, 2008

We have a good idea what that means for the dollar, but what does it mean for the dollar-peg countries? (Dollar-Peg countries are those exporting nations that have fixed the exchange rates of their currencies to the greenback...). One region where things could change is the Middle East. The turn of the year saw the creation of a new Middle Eastern trade bloc, the Gulf Cooperation Council. The bloc numbers six Persian Gulf states: Saudi Arabia, Bahrain, United Arab Emirates, Kuwait, Qatar and Oman. Among this new blocs objectives is to promote trade among its 35m souls...and the creation of a single currency. The target for introducing the Khaleeji is 2010, less than two years away.

The Fed will ‘probably’ follow up with another 50 basis point cut today.

At least according to 48 of the 85 economists in this morning’s Bloomberg survey.
We have a good idea what that means for the dollar, but what does it mean for the dollar-peg countries? (Dollar-Peg countries are those exporting nations that have fixed the exchange rates of their currencies to the greenback...)

One region where things could change is the Middle East. The turn of the year saw the creation of a new Middle Eastern trade bloc, the Gulf Cooperation Council. The bloc numbers six Persian Gulf states: Saudi Arabia, Bahrain, United Arab Emirates, Kuwait, Qatar and Oman. Among this new bloc’s objectives is to promote trade among its 35m souls...and the creation of a single currency. The target for introducing the “Khaleeji” is 2010, less than two years away.

That seems a pretty short time frame given that, presently, all but one of these booming petrodollar States have their own currencies pegged to the US dollar. Some for a very long time -the UAE’s dirham has been pegged for 30 years.

This has worked well in the past with an international oil export trade priced in dollars, delivering economic growth and stable prices. But $90 plus oil and a sickly greenback have upset the apple cart. Their respective economies are totally out of whack. If one is the yin the other is the yang. The oil and gas rich Gulf economies are booming while America’s is indebted, in trouble and according to the likes of Merrill Lynch, in recession.

And what these Gulf States are finding too is that they have an inflation problem. Saudi reported inflation at 6.5% in December, a 16-year high. At 9.8% inflation is at a 20-year high in the UAE. Merrill Lynch thinks that could accelerate to a 20 year high of 12% this year. Qatari inflation is even higher and Merrill’s see hitting 14.5% in Qatar this year. Oman’s inflation rate rose to 4.7% to June 2007 on the back of increased European and Asian import costs up from 3% in 2006 and a negligible 0.2% in 2005.

The question for the GCC is how to tackle it. Breaking with dollar peg is one way according to some...a move which would spell bad news for the dollar. Hans Redeker, chief currency strategist at BNP Paribas, had this to say on the subject of Saudi Arabia breaking its dollar peg in The Telegraph last month:
“This is a very dangerous situation for the dollar, Saudi Arabia has $800bn (£400bn) in their future generation fund, and the entire region has $3,500bn under management. They face an inflationary threat and do not want to import an interest rate policy set for the recessionary conditions in the United States”
The comment followed Saudi Arabia’s unprecedented decision not to cut their interest rates in response to a 0.25% cut in US interest rates last December. Given their inflation pressures, we can understand why. Further dramatic Fed cuts this year will only up the ante for the Saudis. Are they near breaking point?

Not forgetting 15 of the 19 September 11 terrorists were Saudis, Saudi Arabia has long been a loyal US ally and supporter of the dollar, not least because it owns so many of them. It recently defended the continued sale of oil in dollars within OPEC against militant members, Iran and Venezuela, calling for a basket of currencies. But on Monday it was reported the Saudi finance minister and central bank governor will attend a meeting on February 10 to discuss the peg and what they intend to do about it. Could this herald change?

For its part the UAE pledged continued allegiance to the peg at the start of the year following a review. Their central bank governor, Sultan Bin Nasser al-Suwaidi, took the view the dollar peg was not the root cause of their inflation problem. Not a view shared by Merrill Lynch. Measures such as price subsidies, rent controls, allowances are doomed to failure. Price controls always are. The currency pegs are the main source of inflation throughout the region, they say, though diversification from over-dependence on the US is helping.

The problem is they are stuck between a rock and a hard place, says Barbara Nestor, an economist at Commerzbank AG in London:

“They are trying to avoid depreciating further the dollar, and therefore their dollar assets.''

But one of the GCC states has broken with the dollar peg. In May 2007, the Kuwaiti dinar swapped the dollar for a basket of currencies including the yen, the euro and the pound instead.

Did it get inflation under control? Not yet it seems. It started well enough when inflation dipped in the following couple of months after revaluation but it didn’t last. Inflation has been on the rise in recent months, reported the National Bank of Kuwait last December. It hit 5.3% in the third quarter against 3.1% in the whole of 2006. The dinar has appreciated more than 5% against the dollar since.

So we’re not even past the first month of the year and the US Fed has instigated an emergency 0.75% cut with possibly a further 0.50% today. It amounts to a huge and unwelcome easing for the GCC. As economist Monica Malik at Egypt’s investment bank EFG-Hermes told Bloomberg recently:

“The currency peg is not working for the Gulf states any more... The big benefit was being pegged to a hard, stable currency. You don’t have that stability because the dollar is structurally weak.”

So could now be the time for these pegs to be kicked away as GCC inflation threatens to get out of control and they lay down plans for their own single currency? Watch out for the UAE and Qatar, say Merrill’s. They have the highest inflation and could be the next to go. 

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