By Hassan Jivraj
In our 23 April blog post, we noted that all Gulf Cooperation Council (GCC) countries are set to increase their borrowing levels to shore up public finances and fiscal reserves. This borrowing binge has been in response to sliding oil prices and the economic disruption from the coronavirus pandemic.
As sovereign debt levels rise, all GCC governments are working on reducing their spending, while some have gone further and increased taxes as well as impose austerity on their citizens.
The worsening economic situation has raised questions as to whether these countries can continue their longstanding peg of their national currencies to the US dollar. It has also led to another question as to whether a liberal currency is even feasible.
Standing the test of time
GCC currency pegs date back to the 1970s and have been an important anchor of fiscal and economic stability in the region.
The pegs played a role in GCC economic integration in the early 2000s. Most notably, in 2003 when GCC states agreed to establish the Gulf Monetary Union (GMU), which sought to unite the bloc with a single currency by 2010. As part of the convergence criteria all members had to peg their currency to the US dollar.
However, the GMU failed to materialise due to several factors including the 2008 global financial crisis. There were three key reasons that led to its failure.
The most damaging was when Kuwait re-pegged to an undisclosed basket of currencies in 2007 in order to manage its inflation. Secondly, Oman was unable to adhere to the strict public debt criteria and subsequently withdrew from the project in 2006. Thirdly, was a disagreement between the UAE and Saudi Arabia over where the proposed central bank would be located.
Since 2010, the GCC has faced challenges including the Arab uprisings in 2011, the 2014 oil price crash and the 2017 Qatar boycott. In more recent times, the latest oil price collapse and COVID-19 have made the idea of a GMU a distant memory.
Nevertheless, Gulf currencies continue to be pegged to the US dollar and it remains integral their economies. It has provided stability in nominal and real exchange rates as well as inflation compared to other oil exporting nations. GCC states have maintained long-term economic growth as well as monetary policy stability.
This policy has stood through various oil price cycles over the past four decades. The US dollar remains the world’s reserve currency as well as the deepest and most liquid financial market. Through hydrocarbon exports, Gulf sovereign wealth funds have amassed significant amounts of US dollars.
This policy is also proved important politically. It highlights the political will of Gulf countries to defend their pegs and maintain close political and economic relations with the US. Gulf leaders continue to see the US as the most important security guarantor. This is despite American disengagement from the region and the growing influence of emerging powers like China and Russia.
Arguments for abandoning the peg
Gulf central banks’ policy mirrors the US Federal Reserve. In a future scenario where US interest rates increase, Gulf countries would be required to follow suit and raise their domestic interest rates. In this scenario, this could have a negative impact on their economies.
A liberalised currency regime allows national governments to increase or decrease interest rates to ease pressure on the money supply to their banks and financial institutions. It also eases overall borrowing costs.
Removing a pegged or fixed foreign exchange regime enables countries to intervene and control their own monetary and fiscal policies. For example, devaluing a national currency, make exports cheaper and more competitive. This would contribute towards economic growth.
Removing the peg improves the fiscal accounts for oil exporting countries like those in the Gulf. They would earn revenue from their hydrocarbon exports in US dollars and expenditure would be in liberalised local currency. This would enable governments to balance and manage their budgets more effectively.
De-pegging also eases pressure on a nation’s central bank foreign exchange reserves. This would provide additional fiscal buffers whether to pay for import-cover or other expenditure.
The realities
At present, it is not feasible for GCC states to abandon the US dollar peg.
Gulf economies continue to rely on the oil and gas sector both in terms of exports and revenue receipts. Oil and other major commodities continue to be traded in US dollars.
Only when non-oil sector exports increase, then a devaluation would benefit Gulf countries. At present, non-oil economic diversification is a long-term ambition of all GCC countries. Similarly, a devalued currency would only work when a nation has a comparative advantage in producing a particular good. Achieving a comparative advantage can take several years to realise.
Various studies have also suggested that de-pegged currencies in the GCC would do little to boost growth. While, a devaluation would raise oil receipts in local currencies, inflation and the cost of imports would rise. High levels of inflation would diminish the purchasing power of citizens and could lead to social unrest.
A devaluation in Gulf currencies could also lead to conditions for capital flight, a wider banking crisis, and other balance sheet problems associated with currency mismatches. Similarly, a liberal local currency regime would make debt servicing large amounts of foreign currency denominated debt, more expensive.
Defences up
Source: MUFG MENA Research, Bloomberg.
Mitsubishi UFJ Financial Group, a Japanese bank, calculates that GCC central bank reserves, sovereign wealth fund holdings and public sector banking deposits are estimated to be around $3.3 trillion (or 184% of GDP).
For example, Saudi Arabia’s currency reserves stand at around $444 billion. Some economists have argued that Riyadh needs to maintain reserves of $300 billion to keep the peg.
The kingdom’s sovereign wealth fund, the Public Investment Fund (PIF), has total assets of around $320 billion. However, there are risks that the fund is too reliant on government reserves. The PIF’s recent purchases of international assets have been funded thanks to $40 billion from the government’s foreign reserves.
Qatar, Kuwait and the UAE maintain comfortable fiscal buffers and are likely to use their reserves to defend their pegs. They are likely to preserve their US dollar pegs even if oil prices fall further than current lows.
Until non-oil exports form a significant part of the economy, the idea of de-pegging will become more realistic. Simultaneously, any currency reforms should be enacted with other economic and fiscal reforms.
Bahrain and Oman remain weak links
Inevitably, Bahrain and Oman are the weakest financial links in the Gulf. Both countries lack fiscal reserves and have a considerably higher break-even price than other Gulf monarchies.
Of all GCC states, Bahrain is the least able to withstand sustained pressure with regards to import cover and short-term debt to foreign exchange reserves, according to ING. It is estimated that Bahrain will run a $7.5 billion current account deficit this year and has $15 billion of short-term liabilities, according to Banks for International Settlements reporting banks.
Despite its junk credit rating and weak financials, Bahrain took advantage of global low interest rates and yield hungry investors. In early May, it managed to sell a $2 billion dual tranche bond.
The island monarchy received a $10 billion five-year aid package from Saudi Arabia, the UAE and Kuwait in October 2018. However, rising debt levels and lower oil prices as well economic contraction, will result in Manama requiring more financial support to defend its peg.
Similarly, Oman is in a precarious financial position. With economic disruption and depleted coffers, it has cut spending. In mid-May, authorities cut the budgets of government bodies and the armed forces by 5% this year. This follows a reduction in state budget by OMR 500 million (USD 1.3 billion) in mid-April. Authorities also instructed all government firms to rationalise spending, including a 10% or more cut in operational budgets and a rescheduling of projects. Adding to the budgetary difficulties, the Omani riyal fell to an all-time low in the dollar forward market in April.
In a recent report, S&P Global Ratings forecast that Oman will meet its funding needs totalling of almost $50 billion between 2020 and 2023. This will likely be done through external debt issuances, drawdowns of domestic and external liquid assets, domestic debt and other financial transactions.
S&P also noted that Oman’s Gulf neighbours are likely to provide financial support to Muscat. In 2011, Qatar, Kuwait, the UAE and Saudi Arabia pledged $10 billion to both Oman and Bahrain to support their economies. However, S&P concedes that the only realised disbursements Oman received came from Kuwait.
Oman’s independent foreign policy will remain a contentious issue among Saudi Arabia and the UAE, before any package is presented.
