Currency Political Economy in the Gulf States

Submission Date: 22, June, 2018

Submitted by: Khalid Tasawar Student number: 10772979 Department: Political Economy Supervisor: Lukas Linsi

University of Amsterdam Amsterdam, the Netherlands

Words: 18,946

Chapter I ...... 1 Introduction ...... 1 Chapter II ...... 5 Literature review ...... 5 The transformation of currency exchange from Gold standard to flexible/fixed ...... 5 Theoretical explanation ...... 7 Exchange regimes: Fixed versus Flexible ...... 8 Political economy theory ...... 10 International Political Economy of Exchange rate regime ...... 11 Cooperation in International Monetary Relations ...... 12 Exchange rate regime: National (domestic) politics...... 12 Interest groups and Regime choice ...... 13 Political Institution and Regime Choice ...... 13 Chapter II ...... 14 GCC currency exchange rate regime and its implications ...... 14 Literature Economic arguments ...... 15 Literature Political Arguments ...... 18 Domestic politics ...... 19 International level politics ...... 20 The establishment of a common currency – The Khaleeji ...... 22 Chapter III ...... 24 Methodology ...... 24 Time frame ...... 26 Chapter IV ...... 27 Hypothesis 1: A political regime is associated with the currency exchange politics in the GCC countries...... 27 Hypothesis 2: Trade between the United States and the GCC countries force the Gulf States to remain pegged to the US dollar...... 27 Hypothesis 3: Oil economy forces the GCC countries to remain committed to the US-dollar peg...... 28 Results and Implication ...... 29 Hypothesis 1: ...... 29 Hypothesis 2 ...... 32 Hypothesis 3 ...... 37 Chapter V ...... 40 Analysis ...... 40 Conclusion ...... 51 Bibliography ...... 52 Appendix ...... 61

Chapter I

Introduction

In recent years, there is an external and internal pressure on the Gulf Cooperation Council (hereafter, the GCC) countries to change their currency exchange rate regime which is now pegged to the US dollar. The pressure originates from economic insecurity that includes lower purchasing power, real income and increased inflation. The inflation pressure has emerged in these countries due to an unstable oil price, a low US dollar value, a buoyant economic growth and an increasing import from Asia and Europe. The inflation rate has jumped from a single digit 0.2% between 1998 through 2002 on average in the GCC to a double digit between 9% through 10% by the end of the decade within the GCC countries. Additionally, the import price in the GCC countries have coincided with the consequent US dollar depreciation. Economists and politicians in the GCC consider the US dollar peg as the cause of the aforementioned problems. The GCC countries currency is pegged/fixed with the US dollar from 1980s. Exchange rate regime policies have a significant effect on almost all aspects of domestic and international economies of involved countries. Currencies and their values are central to the world economy. From the economic perspective, they affect international trade, investment, finance, migration, and travel. From the political perspective, they affect the "mass-consuming public, role of elections, organization of economic groups, power of particularistic interests, time horizons of voters and politicians, and responsiveness of political institutions to pressures along with virtually all other features of a national political economy" (Frieden, 2014, p.2). The prevailing exchange rate system often defines the international economic order. On a national level, "the exchange rate is the most important price in any economy, for it affects all other prices" (Frieden, 2014, p.9). For decades, it has been argued and confirmed that the exchange rate regime has a significant effect on macroeconomic outcome (Frenkel & Rapetti, 2010). The currency policy is the most important economic policy of a government, especially in an open economy, to the rest of world. In currency political economy, policymakers encounter two interconnected options. The first one is a fixed exchange rate regime, in which the monetary policy of a national currency is fixed to a commodity such as gold, a major currency or a basket of currencies. In

1 this case, the government has no authority on its monetary policy, meaning the governments with fixed currency regime will have a passive monetary policy. The second option refers to appreciation (high) or a depreciation (low) of the currency value. The latter phenomenon is only valid in a flexible/floating currency exchange regime. In the floating currency regime governments have the authority to intervene and influence demand and supply of their currencies, thus providing the local authority the autonomy to manipulate its currency value if needed. Currency exchange regimes are not restricted to these two. The IMF has classified at least eight types of currency regimes varying from purely floating to hard peg (IMF Report, 2016). The currency regime and level of exchange rate differs per country's national policy. These policies always involve trade-offs, and they have winners and losers, like all other policies. In the current era, all major currencies such as the United States dollar, the euro, the Japanese yen, the British pound, and the Indian rupee, are floating. These currencies, particularly the United States dollar, are widely traded. In contrast, some countries, especially the Gulf States, have fixed their currencies to the US dollar. This has recently been criticized and is also associated with slower economic growth (Setser, 2007; Buiter, 2008). In spite of association with lower economic growth, higher inflation rate and fierce political criticism, the GCC members have announced that they are committed to their fixed exchange rate regime. Therefore, it is a controversial issue for the economic and political science students/scholars. This paper attempts to explain the GCC currency exchange rate regime from political economy perspective since it has often been studied merely by economic scholars. The GCC countries are Bahrain, Kuwait, Oman, Qatar, Saudi Arabia and the United Arabs Emirates (UAE). GCC countries have adopted conventional fixed peg arrangements against the US dollar. This means that the fluctuation margin is ±1% or less and it is revised very rarely (OIC Outlook Series, 2012). A total of 16 countries have adopted this currency regime. However, many of them are small islands. Only Jordan, Turkmenistan and Venezuela have an annual GDP greater than 10 billion1 in this category. This, at first place, begs the question: why have GCC countries embraced the conventional currency exchange regime pegged to the United States dollar while having a dynamic economic system with an annual GDP of 32 billion through 650 billion.

1 Table 1 in the appendix contains the names of countries and their annual GDP.

2 Scholars have different views on the GCC currency peg to the US dollar. They have advanced certain alternatives to justify and provide a feasible answer to the implication of the fixed exchange rate regime. In this paper, the arguments posed by the different scholars are divided into four mainstream sections. Firstly, some scholars have advanced the argument that the oil economy is the dominant factor in provision of the US dollar peg since the oil price is determined in the US dollar. Furthermore, the GCC countries have embraced the US dollar fixed exchange rate regime to stabilize their economies and keep the inflation low (Khan, 2009; Kumah, 2009). Secondly, the US dollar is widely traded in the international trade market. It provides an advantage to the GCC countries to trade in the currency in which they have reserve and receive the oil revenue. This, obviously, lowers the exchange rate transaction costs for non- oil sector trade. Furthermore, the GCC countries have a significant amount of trade with the United States which is, of course, exclusively in the US dollar. Thirdly, some scholars argue that the type of political institutions determines the currency exchange regime type. Democratic regimes tend to favour a floating regime whereas the autocratic regimes tend to have a fixed exchange regime. Finally, the fourth group of scholars has argued that the GCC countries have planned to have a common currency, like the Euro, and the US dollar pegged currency is a great step toward achieving their goal. The GCC organization identified having a common currency as a core achievement of this organization. All these four hypotheses advanced by the scholars have faced the criticism that these factors might not be the reason for the implication and continuation of the fixed exchange regime. However, I argue that these four hypotheses did play a major role in determining the US pegged exchange rate regime but they cannot provide an answer to the question why are the GCC remained pegged to the US dollar. There is a less focused/studied issue that has an even greater and an essential effect on remaining committed to the current regime. This paper asks: why are the GCC countries committed to the US dollar-pegged currency exchange rate regime? In this paper, I argue that the monetary policy in the GCC has always been a more political (geo-political) dilemma than it is an economic dilemma. The political circumstances within and around the GCC countries is the most influential defining factor of their currency exchange rate regime. The thesis is divided into five chapters. The first chapter explains the relevant theories which verify and shed light on the GCC currency exchange rate regime from different aspects. Furthermore, it explains how the currencies and regimes emerged in the last century

3 and how the relevant countries to this research adopted their currency regime. In the second chapter, I attempt to elucidate briefly the relevant literature and the GCC implication of the exchange rate regime. Chapter three discusses the methodology of the paper that I have used for the research and, additionally, it further elaborates the timeframe of the research and provides a brief explanation of the concepts that have been used in this paper. In order to keep it more organized, I have added a chapter for hypotheses definitions and tests which is chapter four. In this chapter I have tested theoretically and empirically the conventional hypotheses suggested. Last but not least, chapter five discusses the analysis and conclusion; in this section, the GCC exchange rate regime has been discussed from different perspectives and an answer has been provided to the research question. Finally, I have provided an answer to the research question based on the existing literature and analyses. Moreover, I have suggested further research on the GCC peg to the US dollar.

4

Chapter II

Literature review

Due to the radical changes that currency exchange rate regimes have experienced in the last century, there is a substantial number of books, academic articles, and journals available on the subject matter. In response to the currency exchange rate regime changes the countries have accordingly adjusted their exchange rate regime policy either based on economic or political desire and necessity. In spite of the substantial pertinent literature, there are still limitations and gaps, particularly from the political economy aspect in the GCC. This research aims to cover the economic and political aspects of the GCC countries’ currency exchange rate regimes in the academic literature. This section forms a brief literature review of currency exchange rate regime transformation’s theoretical perspective and the GCC countries’ adoption of monetary policies. This covers the period from the 1970s to 2018. The work of prominent scholars in the field of currency exchange regimes and the GCC countries’ reaction has been taken into consideration. This section initially explains the transformation of currency regimes in the last decades and afterwards discusses the reaction of the GCC countries to the radical currency regime changes.

The transformation of currency exchange from Gold standard to flexible/fixed

In the last century, the world has experienced three landmark events in the international monetary orders. Almost all of the first half of the century the world was on the classical gold standard monetary system. In other words, it was a quintessential fixed exchange rate regime where governments were committed to exchange currency for a certain amount of gold at a defined rate. However, some countries abandoned the gold standard during the First World War which destabilized the exchange rate regime. This period was certainly chaotic and the world suffered two world wars and the Great Depression. A great part of this period is also called Interim instability (1914 – 1944) (Frieden, 2014; Wang 2009). World wars and the Great Depression both demanded an enormous amount of money to support the development of economies and the weapon industry. Thus, more gold was required to support these sectors. Since gold was very limited relative to rapid economic development and

5 requirements, expansion of international trade and the need of money in both world wars, many countries abandoned the gold standard because it prevented them from printing money and investing either in wars or expansion of the economies. As a result, printing money led to higher inflation and a pegged currency to minted gold was neither desirable nor workable (Wang, 2009). In the 1940s the gold standard was replaced by the Bretton Woods monetary system. The Bretton Woods system offered a modified fixed rate system. This new currency regime was initially linked to the US dollar and eventually to gold, as Frieden et al., (2006) explain: "Under Bretton Woods, currencies were fixed or 'pegged' to the US dollar and the US dollar was fixed to gold" (Frieden, Weingast, & Wittman, 2006, p.588). The gold price was fixed at $35 per ounce. Under this regime, the countries were able to change their exchange rate when it was needed after consulting with the IMF. This system is famously known as the flexible peg, as it was not firmly fixed as it was under the classical gold standard order. The international monetary system enjoyed a great success when the US Federal Reserve held three quarters of central bank gold in the world. At the launch of this regime, the US had monetary supremacy and was the only dominant force in monetary global order. The two major economies, Japan and Europe, had been ruined due to the devastating Second World War. However, with the economic recovery of these two major economies and a rapid increment in international trade, there was a high demand for liquidity in the form of US dollars. As Wang (2009) argues, an increasing demand for liquidity would only lead to outflows of US dollars (p.23). Immediately after an increase in international trade the amount of US dollar circulated in the global economy surpassed the gold reserve held by the United States Federal Reserve. In a couple of decades, the US had only 22% left of their previous gold reserve of 75%. As a result, the US Federal bank had to abandon the foreign banks convertibility of the US dollar to gold. Furthermore, the pressure of domestic problems such as high inflation, an increasing unemployment rate and a lower growth forced the government to take a different monetary policy path. The United States’ president Nixon announced on the 15th of August 1971 that convertibility of the US dollar into gold is suspended (Wang, 2009). All these events contributed to the failure of the Bretton Woods system and created an opportunity to a more independent monetary policy. The last radical changes in the monetary order happened in 1973 when the largest governments decided to adopt floating currencies. However, some countries have tended either to peg their currencies to a major currency or a basket of currencies (Frieden, et al., 2006). The new currency exchange rate regimes were classified by the IMF into at least eight

6 regime types. They are: “Exchange Arrangements with No Separate Legal Tender, Currency Board Arrangements, Conventional Fixed Peg Arrangements, Pegged Exchange Rates within Horizontal Bands, Crawling Pegs, Exchange Rates within Crawling Bands, Managed Floating with No Predetermined Path for the Exchange Rate, and Independent Floating” (Wang, 2009, p.17). In a broad view, there are two main types of the currency exchange rate regimes, fixed and floating, but within these regime types the IMF has defined eight sub- types of alternatives. My focus from this point forward will be on the current fixed (pegged) and floating (flexible) currency exchange rate regimes.

Theoretical explanation

The theoretical framework will seek to explain why the governments choose either a fixed or a flexible currency exchange rate regime. In order to understand whether the government’s decision on the type of regime is motivated politically or economically, it is important to comprehend the advantages and disadvantages of both regimes. Moreover, this section will also address the existing dominant political economy theories from both perspectives, economical and political, on both the national and international level, in order to shed light on the government’s choice of commitment to the regime. In the recent decades, particularly after the collapse of the Bretton Woods system in the 1970s, the exchange rate regimes attracted some remarkable attention in international finance (Kato & Uctum, 2007). The exchange rate regime characterizes the mechanism by which the countries manage their currencies in the international arena and in respect to other countries. A fixed exchange rate regime is a commitment that governments make in order to keep and maintain a certain fixed parity of the currency against a basket of currencies or a single currency of another country. While a floating currency exchange rate regime is a commitment that governments make to leave the determination of the exchange rate to the market through the demand and supply mechanism. However, the government does also have some authority to appreciate and/or depreciate the currency in a floating regime. This will be explained briefly in the upcoming paragraphs. The classical and widely accepted theoretical literature claims that the most common criteria for determining a certain type of exchange rate regime is a country’s financial and macroeconomic stability against financial disturbance and shocks (Mundell, 1963). The traditional assumption is that the fixed exchange rate regime helps in achieving financial and

7 macroeconomic stability whereas the flexible exchange rate regime isolates the economy from financial disturbance (Friedman, 1953). Deciding between the two exchange rate regimes involve numerous arguments and counterarguments whether to establish a fixed or a floating exchange rate regime (Poirson, 2001; Edwards et al. 2003; Bergsten, 1999, Haggart, 1999; Sachs & Larrain, 1999). The arrangement of a fixed or floating regime requires in- depth macroeconomic consideration and it depends on a country’s objectives and goals. The next section explains in further detail the advantages and disadvantages of both types of exchange rate regimes.

Exchange regimes: Fixed versus Flexible

As mentioned earlier, in the taxonomy of exchange rate regimes, there are at least eight types of exchange rate regimes on the continuum from pure flexible to hard peg. However, for the purpose of this paper, my focus is merely on the two broad concepts/types, fixed and flexible. I try to concisely explain both types and their weaknesses and strengths. In an open economy, a fixed exchange rate regime provides “lower exchange rate risk and transaction costs that can impede international trade and investment” (Frieden & Broz, 2001. p.322). According to fixed exchange regime advocates, volatile exchange rates bear uncertainty in transaction costs and the costs of goods/assets traded internationally. Thus, stable currency provides an opportunity for risk-avert investors to trade and invest in a greater and desirable environment (Frieden & Broz, 2001; Beker, 2006). Fixing the exchange rate with a low inflationary country’s currency is meant to achieve a low inflation rate. The credibility of this argument is for the countries that experienced hyperinflation or are prone to hyperinflation, and furthermore, if the country is desperate for rapid disinflation. A country might achieve macroeconomic stabilization and/or achieve disinflation. However, the absolute guarantee of credibility cannot be promised. Therefore, a possibility of devaluation can create a vacuum for speculative attacks that result in currency crises (Beker, 2006). Bubula and Otker-Robe (2003) studied fixed and flexible exchange rate regime vulnerability for all IMF members for the period of 1990 to 2000 and concluded that approximately ¾ of crises in the studied reports were linked to fixed parities. Furthermore, a country with a fixed exchange rate reduces the uncertainty of exchange rate costs, but in doing so, it must sacrifice its monetary policy. An ideal situation would be to have financial market integration, exchange rate stability and monetary policy independence but Mundell (1962, 1963) explains this impossible trinity trade off (trilemma). The trade-off is famously known as the trilemma and the Unholy Trinity introduced by

8 Mundell-Fleming in the 1960s. Two of the three options are possible: financial integration, exchange rate stability, and monetary interdependence. It can either be financial integration with a fixed exchange rate or a monetary policy. If a government prefers a fixed exchange rate, it will have no monetary autonomy and its monetary policy will be dependent on the pegged currency. On the other hand, a flexible exchange rate regime provides a mechanism to absorb internal or external macroeconomic disturbances/shocks. The mechanism works through appreciation or depreciation of the exchange rate depending on the economic situation. Furthermore, a flexible exchange rate regime provides the autonomy of a monetary policy and greater flexibility of macroeconomic policy adjustment. Having monetary policy autonomy, governments can increase of decrease interest rate in order to decelerate or stimulate the economy. In addition to monetary autonomy, Broda and Tille, confirm that flexible currency exchange can absorb external shocks compare to the fixed exchange rate regime (2003). Additionally, Edwards and Yeyati empirically confirmed that flexible exchange rate regime can easily absorb external shocks, denoted by negative changes in exchange rate ratio or export and import prices (2005). In order to adjust export and import price; a country needs to have monetary policy which is only possible under flexible exchange rate regime. Evidence shows that financial integration has progressed to a phase in which capital mobility can be taken as a given both in developing and developed economies (Frieden & Broz, 2001; Edwards, 1999; Marston 1995). This simplifies the choice between stability and flexibility. A fixed exchange rate regime is beneficial to the countries that have experienced high inflation rates and other monetary disturbances. This means that a country prone to high inflation and monetary disturbances could be better off to peg its currency to a country’s currency which has a consistent lower inflation rate and is protected against monetary disturbances. However, as mentioned earlier, this renders a monetary policy ineffective and cannot guarantee the credibility. In fact, pegging a currency to a country with a low inflation rate is not the only solution to avoid high inflation risks. A country’s central bank independence “with price level or inflation target may be an alternative – its transparency makes it a common commitment technology in contexts where the alternatives cannot easily be mentioned by public” (Frieden & Broz, 2001, p.324). A floating exchange rate regime allows a country to have its own monetary policy and there is no obligation to adjust the monetary policy in line with other countries. This regime is important because it provides the opportunity to accommodate

9 domestic and foreign shocks. It furthermore provides the flexibility to accommodate external terms of trade and interest rates. Flexibility of a currency can be used as a great policy tool. In many developing economies that rely on a fixed currency regime, when there is an appreciation, caused by either inflation or huge capital inflow, it can harm competitiveness and threaten to create a balance of payment crisis (ibid). In a flexible regime, however, the government (in the form of the central bank) has the possibility to adjust the exchange rate in order to ensure competitiveness of the trade sector in the international market and avoid economic disturbances. To summarize, there is no optimal exchange rate regime for all regions and countries. The exchange rate regime depends on many factors including but not limited to, openness of a country, economic size, labor mobility, inflation rates and nominal shocks. In a broad sense, when the countries within a region are highly integrated and have similar economic disturbances, they might be better off with a fixed exchange rate regime. On the other hand, countries prone to volatility in terms of trade are generally better off with a floating exchange rate regime, having the autonomy of monetary policy. Now that we know the economic benefits of both types of exchange regimes, it is essential to understand the political implications of such decisions. As mentioned earlier, an exchange rate regime involves trade- off, creating a strong vacuum for interest groups and politicians to influence the government’s decision in choosing exchange rate regime.

Political economy theory

The exchange rate regime politics’ theoretical framework is mainly based on Jeffry Frieden’s Lawrence Broz (2001), Andrew Walter, and Gautam Sen (2008) writings. They are the prominent scholars of the exchange rate regimes in the political economy field. As explained earlier, monetary regimes tend to lean toward one of the two regimes: a flexible (floating) or a fixed (pegged) exchange rate. These ideal regime types can be both regional and global. Generally, there are two interrelated factors in international monetary system decision making – national and international political decision making. In this paper, I will look at national and international politics of these two regime types. Exchange rate regime policy, at the national level, is determined by the influence of interest groups, partisan pressure, the structure of political institutions, and the electoral incentives of politicians. At the international level, it involves strategic interaction, coordination and explicit cooperation between sovereign states (Frieden & Broz, 2001). As mentioned, there are two main levels

10 that contain different groups to lobby and influence the exchange rate regime for their own interests. This, as a result, involves, a trade off. One groups win will be at the cost of the second group. In the section below I will explain both groups’ interests in further detail.

International Political Economy of Exchange rate regime

On the international level, some countries have pegged (fixed) their currencies to that of a larger or economically stronger nation, as an example, several African countries had fixed their currencies to the French Franc and now some of them to the Euro (Broz & Frieden, 2006). As Walter and Sen (2008) argue, a fixed exchange rate regime requires strong coordination of both countries, the principle and the subordinate (agent). The subordinate country should follow the monetary policy of the principle country and adjust its economic policy to the principle. However, “The political problem is that large countries, whose policies have most impact on the rest of the world, have fewer incentives to coordinate macroeconomic policies. Others may simply have to bear the costs of adjustment that emanate from large country policies” (Walter & Sen, 2008, p.110). This means that the subordinate country, for instance, should adjust its interest rate according to the principle interest rate even if it is at the cost of national interests or financial disturbances. Frieden and Broz (2001) explain, coordination in international monetary relation is an important aspect in order to attract more countries to join the club. The more the countries fixed to a particular currency the better it would be overall, since the pegged currency policy would be similar to one another and its transaction costs would be low. The fixed exchange rate might live as long as both countries actively coordinate on its monetary policies. However, there is a well-known problem attached to a fixed exchange rate regime and the coordination of the countries that is international gain from cooperation could be at the cost of national interests (Frieden & Broz, 2001). In other words, with a fixed exchange rate regime, a country should give up its monetary policy which is a great policy tool for domestic politics in order to keep the import- and export-based market competitive. Giving up the authority of depreciation and appreciation of the currency harms some interest groups, increases inflation rates and slows economic growth down. This as a result could destabilize the internal stability. This will be explained further in upcoming sections.

11 Cooperation in International Monetary Relations

In order to have a fixed exchange rate regime, countries have to cooperate with one another. Pegged countries have to help each other in times of hardship and agent (subordinate) country should follow the monetary policy of the principle country. It requires explicit cooperation among the countries. There is often profit in international cooperation but at the national cost, a well-known dilemma in these situations. As mentioned earlier, having a currency fixed to a different currency comes at a cost. The first and most important one is that pegged country must give up its autonomy of monetary policy. The problem with fixing the currency to a foreign currency is not only on the side of agent but principle, too. Under Bretton Woods’ monetary system when European currencies were pegged to the United States Dollar, European countries put pressure on the United States to tighten its policy in order to decrease inflation, however, the United States denied to imply. The same problem happened when the Netherlands and other European countries currencies were pegged with the German’s Mark. The subordinates (agents), in the sense of currency, put pressure on the German government to restrict its policy in order to prevent inflation but the German central bank refused (Wang 2009). This problem is common in international monetary systems between the nations who opt to peg their currencies to a foreign currency.

Exchange rate regime: National (domestic) politics

The national government is the only entity to decide whether to fix its currency to a foreign currency or to allow it to float. These decisions have significant effects on the political and economic situation of a country. However, such decisions are not taken merely by government bodies, depending on the countries’ constitution and political regime, but also by interest groups, the electorate and politicians. As a result, like all other policies, this also involves tradeoff between groups within the country. There are different views about which groups are strongly involved in trade off or decision making but, the most widely accepted interest groups by political economy scholarships are: “the role of interest groups, partisan pressure, political institutions, and the electoral incentives of politicians” (Broz & Frieden, 2001, p.322). For the sake of this paper, I will only focus on the groups relevant to this research, for instance, interest groups and political institution. The next two sections explain why the electoral incentives of politicians and partisan pressure are irrelevant to this paper.

12 Interest groups and Regime choice

As mentioned earlier, currency exchange rate regime implication involves trade-off. It always has winners and losers, the same like all other policies. A policy which is optimal for a country as a whole might not be in the interest of a particular group. Groups heavily involved in international trade, particularly groups that are producers of exportable goods as well as international merchants, would prefer stability (fixed exchange rate regime). This policy lowers the risk of daily volatility of exchange rates (Broz & Frieden, 2001). In contrast, groups largely involved in domestic economic activities such as transportation, construction and services along with import-competing producers of goods should favor a floating exchange rate regime. The domestic traders are highly sensitive to macroeconomic policies and therefore it is in their best interest to have a government with monetary policy autonomy. This applies to import-competing traded goods, too (ibid). Exchange rates therefore encourage groups to lobby and influence policy makers in favor of a certain type of exchange rate regime.

Political Institution and Regime Choice

In addition to interest groups, political institutions play a significant role in exchange rate regime choice, too. Scholars such as Leblang (1999) and Broz (2002) argue that the political regime type is highly correlated with the type of exchange rate regime particularly in the developing countries. Autocratic or monarchy regimes tend to favor a fixed exchange rate regime for credibility purposes (Broz & Frieden, 2001). As mentioned earlier, interest groups, electoral and legislative institutions have significant effect on determining an exchange rate regime. “In countries where the stakes in elections are high, politicians might prefer floating exchange rates, so as to preserve the use of monetary policy as a tool for building support before elections” (Broz & Frieden, 2001, p.329). This is valid only in a democratic country where elections are being held. In this research, the concept of the autocratic regime is conceptualized as the absolute or active constitutional monarchy. The term autocratic regime is used as a synonym to the absolute monarchy regime and vice versa.

13

Chapter II

GCC currency exchange rate regime and its implications

In the previous section, I briefly reviewed the theoretical framework of the currency exchange rate regime, and its advantages and disadvantages in the context of the national and international political and economic decision-making. Additionally, I reviewed dominant theories on how interest groups and institutions on a national and international level influence governments’ choice of exchange rate regime. This section will review the existing literature about the GCC and its currency exchange rate regime implication. In the last radical changes in currency regime in the 1970s many major countries opted to float their currencies. However, some countries decided to peg their currencies to one of the major currencies. The Gulf countries were among those that tended to fix their currencies to a major currency, particularly the United States dollar. Within the context of currency exchange rate regime politics, I will attempt to explain the political and economic desire/benefit of the GCC peg to the US dollar from the existing literature. From 195 countries recognized by the United Nations only a total of 16 countries have a fixed exchange rate regime to the US dollar. However, many of them are small islands and only Jordan, Turkmenistan and Venezuela have an annual GDP greater than 10 billion in this category aside from the GCC countries. This begs the question: why have the GCC countries embraced a conventional currency exchange rate regime pegged to the United States dollar while having a dynamic economic system with an annual GDP of 32 billion through 650 billion? The existing literatures’ answers vary and are mostly focused on trade, the oil economy and the political institution type. This section explains the literature briefly and provides a concise history of the GCC countries’ steps towards the fixed exchange rate regime to the US dollar. The Gulf States, except Kuwait, have been pegged to the US dollar now for more than three decades. Only from 2003 to 2007 all the Gulf States were exclusively pegged to the US dollar. In fact, Kuwait's dinar is heavily weighted on the US dollar (Sturm & Siegfried, 2005). This means that the appreciation or deprecation of the US dollar has almost the same effect on Kuwait as on the rest of the GCC members. In 2003, the GCC countries formally adopted the US dollar as their monetary anchor until Kuwait abandoned the peg in 2007.

14 From the beginning of the modern exchange rate regime era in 1973, the GCC countries have changed their exchange rate regime within the fixed exchange rate regime category. Saudi Arabia’s riyal was initially pegged to the IMF’s Special Drawing Rights (SDR) basket of currencies with a fluctuation margin of +/- 7.5 percent. In 2003 Saudi Arabia pegged its currency to the US dollar (Alkharief & Qualls, 2016). The UAE’s dirham has been in circulation from 1973 and since then the value of the currency is unofficially pegged to the US dollar. The currency is officially pegged to the US dollar since February 2002, however, buying and selling was fixed from 1997 to the present at the rate of 3.6725 dirham per dollar (Ishfaq, 2010). The Omani riyal is fixed to the US dollar from the start of the post-Britton Woods era. Oman has initially fixed its currency in 1973 at the rate of 2.895 USD per Omani riyal. In 1986 Oman took the initiative to change the price to 2.6008 USD per riyal and it has since then remained unchanged (Al Raisi, Pattanaik, & Al-Raisi, 2007). The Bahrain and Kuwait currencies have experienced a different root of currency exchange rate regimes. Both countries initially used Gulf rupees which was equivalent to a British Pound Sterling in 1961. In 1980, Bahrain pegged its currency to the IMF’s SDR basket and eventually in 2001 pegged its currency officially to the US dollar. Kuwait is an exceptional case in the GCC because of its current exchange rate regime pegged to a basket of currencies whereas all other GCC state members are pegged to the US dollar at this moment. As mentioned earlier, Kuwait’s basket of currency is heavily weighted by the US dollar (Sturm and Siegfried, 2005). It is an ongoing academic debate whether the GCC countries should drop the current fixed exchange rate regime. I have tried to concisely explain prominent scholars’ work on the economical and political aspects and the reason behind the pegged currencies in the following section.

Literature Economic arguments

Some scholars have advanced the argument that the oil economy is the dominant factor in the provision of the US dollar peg since the oil price is determined in the US dollar. The oil revenue constitutes the major part of the government’s budgets in the GCC countries. Moreover, the GCC countries have embraced the US dollar fixed exchange rate regime to stabilize their economies and keep the inflation low (Khan, 2008; Sturm, Strasky, Adolf & Perschel, 2008). Khan (2009) further argues that a fixed exchange rate to the US dollar has helped the GCC countries to avoid nominal shocks from geopolitical risks feeding affecting

15 the economy. Additionally, it has helped the GCC countries to maintain competitiveness in the international arena in spite of trade shocks relating to oil price fluctuation (Kumah, 2009). In contrast, some prominent scholars such as (Setser, 2007) argue that the US dollar pegged currency has not helped to keep inflation low or/and has not provided any solutions for fiscal problems. Additionally, some of the Gulf countries’ major incomes are from non-oil sectors, too. Moreover, Setser (2007) argues that oil-exporting economies, pegged to the US dollar, make a policy mistake because these economies require a different monetary policy. They would be better served by an exchange rate regime that “assures their currencies depreciate when the price of oil falls and appreciate when the price of oil rises” (p.1). It is widely believed that this strategy, the fixed exchange rate regime, has worked in the last decades in initial developing phases. However, now that the GCC has become a dominant Asian trade partner (oil and goods), its economy diverges from that of the USA. This provides an opportunity for other alternative regimes. As Khalid Al Khater, the director of research and monetary policy of the Qatar Central bank stated: "We in the GCC need more than an outdated four-decade-old simple uni-instrument, uni-tool macroeconomic policy framework" (Gulf News, 21, May, 2013, p.1). He further said that this system was suitable four decades ago in the developmental stages but because the economic world has changed, the GCC should adjust itself to the new currency regime. He presented this at the Doha Economic Forum, fully aware that it would have an economic and political effect on the ties between Qatar and the United States. Furthermore, many economists and bank directors in the GCC countries have urged to drop the US dollar peg and consider a more flexible exchange rate regime to better manage inflation rates and risks (Gulf news, 21, May, 2013; Buiter, 2008). Furthermore, some recent economic developments in the GCC as well as in the global economy necessitated a shift in internal and external economic order. The GCC countries, in some views, should adjust their macroeconomic policy including their exchange rate regime. In the first years of this decade, rapid economic growth which was facilitated by higher oil prices and revenue has caused inflation in the GCC countries. The inflation rate skyrocketed from 0.2% between 1998 through 2002 to 10% by the end of the decade. This differs per country within the GCC. In fact, some members are running an even (a) higher inflation rate than the mentioned figures (Mohaddes & Williams, 2011; Sturm et al. 2008). The common assumption which is widely believed among economists is that the fixed exchange rate regime has played a fundamental role in inflation rate increment.

16 The persistent depreciation of the US dollar against other major currencies such as the Euro and the Japanese Yen has increased the cost of import goods in the GCC countries. This has affected the prices ranging from the basic needs such as food, to domestic wages and the housing market. As Setser (2007) argued that the GCC countries are making a policy mistake because the inflationary pressure of the US dollar peg is believed to have been further broadened and accelerated the inflation through the volatile oil price in the US dollar and the persisting US dollar depreciation. Clearly the United States and GCC countries diverge in the business cycle (Sturm et al. 2008). The GCC countries cannot diverge from the economic policy that the US is implementing because of its peg to the US dollar. Indeed, this situation of the GCC countries reflects the unholy trinity of Mundell, the open economy, fixed exchange rate regime and monetary policy independence. In addition to the fierce comments from economists and policymakers on the current currency exchange rate regime, the currency of Bahrain, a member of the GCC, is facing the most risk of de-pegging from the US dollar. According to the Institute of International Finance (IIF), public debt in Bahrain is projected to rise to 83% of the GDP in 2018 and the next upcoming years, compared to 18% in 2008. The country is required to take necessary measures such as having its monetary policy authority back and managing the inflation rate. According to The Financial Times’ report on Bahrain economic condition to balance its budget the price of oil approximately "needs to reach $99 a barrel for Bahrain to balance its budget, about $37 above its current level" (Blitz & Wheatley, 2017, p.1). In addition to high inflation and debt, there are other reasons to de-peg that includes the emerging change in investment and trade patterns in the GCC countries. This is closely related particularly to Oman and Bahrain because of their limited natural resources compared to the other members of the GCC. Hence, these countries should boost their non-oil sectors such as tourism and the financial sector. In doing so, a flexible regime is important to ensure competitiveness in the international trade arena (Sturm et al., 2008, Iqbal 2010). The country has asked its neighbours for financial assistance but there has yet to be any positive response. However, some analysts argued that Saudi Arabia will bail out Bahrain rather than jeopardise its own peg. “The authorities know that de-pegging will cause speculation to rise in other countries. It is not that much effort for Saudi Arabia to support Bahrain," (Blitz & Wheatley, 2017, p.1). In addition to the oil economy or pricing the oil in the US dollar, some scholars advances the factor of trade between the United States and the GCC. The US and GCC trade has a longer history that the creation of the GCC. The US enjoyed commercial exchanges

17 with Oman from the 1700’s and onwards. The first treaty was signed between the US and Oman in 1833 which is named the Roberts Treaty. The last half century the most dominant trade components were oil and gas. The United States is by far the world’s greatest consumer whereas the GCC countries are the greatest producers (Anthony, 1999). Anthony (2009) further argues that:

along with the GCC's sale and America's purchase of oil, there are concomitant commercial components in the energy relationship that translate annually into billions of dollars for both sides. These include energy research and technology development; oil and gas exploration and production; the construction and operation of fuel storage tanks and marine terminals; reservoir and onshore as well as offshore drilling platform maintenance, pipelines, pumping stations, refineries, shipping, marketing, and management and operations (Anthony, 1999, p.2).

In most of these areas the United States was the most important producer and the leader in the world as well as in the GCC countries. After the 1970’s and 1980’s bilateral contract between the GCC and the United States the trade increased to 300% (Anthony, 1999). The United States’ private companies have invested billions of dollars in the six GCC countries. Accordingly, it is argued that the exchange rate regime fixed to the US dollar is beneficial to the GCC countries and have increased trade among these countries as a result of contracts and fixing its exchange rate to the US dollar. Now that we know the economic arguments for the fixed exchange rate regime, it is important to understand the political arguments from the existing literature that pave the way/lead to my research.

Literature Political Arguments

This section discusses the political desire and necessity of the GCC and the US behind the fixed exchange rate from the existing literature. Political and economic decisions are interdependent, particularly in the case of the exchange rate between the United States and the GCC countries. The GCC’s political desire is divided into domestic and international politics. At both levels, the national and international level, interest groups influence the choice of the exchange rate regime politically. I will explain the existing literature on domestic politics first and subsequently the international level politics between the GCC countries and the United States.

18 Domestic politics

First of all, scholars have advanced the domestic political argument on the role of institutions. Broz (2002) argues that democratic countries tend to have a floating exchange rate regime rather than a fixed one. On the other hand, autocratic (monarchy) countries favour a fixed exchange rate regime (ibid). This claim has also been confirmed by scholars such as Bearce and Hallerberg (2011). They studied the relation between political regime and exchange rate regime and concluded that the political regime has strong positive correlation with the exchange rate regime. Hence, based on these arguments one can say that the GCC countries’ political regime has a significant effect on choosing their exchange rate regime. The second domestic political economy argument advanced by Feldman’s (2008) research article is that the rapid rise of the economic growth in the GCC was accelerated by the high oil price and there was an increasing concern about the adverse effects of the inflation which will blunt the achievement of the economic surge. The loss through inflation has generated political tension and sparked calls to drop the current exchange rate regime pegged to the US dollar and favour a more responsive exchange rate regime to the current economic condition of the GCC countries (Feldman, 2008). The recent reports released at the beginning of 2008, predicted further increase of the inflation rate and prices of the basic needs such as food. This report had ignited a wave of speculation that the GCC members might drop their current permanent link to the US dollar in order to block speculative attacks on the GCC currencies, increasing inflation rates or the rise of the prices of basic and fundamental needs (prices) (ibid). To be more specific, according to many scholars, increasing inflation rates in the last decades was due to the US dollar peg in the GCC countries, and this created domestically social tensions as the purchasing power of citizens, particularly among those whose incomes are below the average income in the GCC countries, decreased (Ramady, 2009). The governments are trying to raise the wages and subsidized some sectors but the inflation rate at some point reached a peak that the governments could not fund. Furthermore, some countries for instance Bahrain, cannot fund its public and private sector in order to make up for inflation rate losses (Sergie, 2018). As long as the governments in the GCC countries could and will cover the inflation costs, the problems will not be grave but the government’s sovereign funds are not unlimited. Soon the government would stop increasing the wages and subsidizing other public sectors. This will create instability within the GCC countries. According to the Chatham house

19 organization report there are ongoing calls for an increase in wages in order to cover inflation. They also mentioned that people are taking more revolutionized ways and challenge the governments of the GCC countries (Chatham house, 2012). In the last couple of years, the oil price reached its lowest point of the decade and that affects the total government revenue. The consequences of a lower revenue affects the government’s spending to limit inflation rate effects. As long as the price of oil falls or stays under the 100 US dollar per barrel for some countries, the political instability and sparked calls to change the currency exchange rate regime will increasingly challenge the GCC governments. Furthermore, the forecast for the years to come show that the US dollar will depreciate which will as an external effect increase inflation in the GCC countries which concerns the governments and rulers of the GCC countries. As the existing literature argues from domestic political perspective, there are many voices in all the GCC countries against the current exchange rate regime permanently linked to the US dollar, yet nothing significant has happened. In fact, this concerns the governments about the tension that is generated and the stability of the domestic economy. However, changing exchange rate regime according to some scholars implies an important trade-off on an international level between the GCC countries and the United States which I will here call international level politics. The next section explains, using the existing literature, the effect and possibility of the change of a currency exchange rate regime from the international politics perspective, the perspective of the GCC’s and the United States’ interests.

International level politics In political context, the scholars are dived into different groups and focus on different political phenomena. The first group advances the argument that countries who are not militarily well equipped and depend on an ally country for their security would stock a bulk of reserve of the protector’s currency. The GCC countries have extensively reserved US dollars in order to guarantee their security against any potential risk. The GCC countries almost exclusively reserve in the US dollar while no other oil exporting countries do, for instance Iran and Russia do not reserve exclusively in the US dollar. They are stronger from the military perspective and therefore have the option to choose whatever currency they find beneficial (Eichengreen et. al, 2008). According to (Eichengreen et. Al, 2008) the GCC countries have fixed their currency exchange rate regime to the US dollar to have the opportunity to influence the United States’ political decisions through their massive US dollar reserve and get the security guarantee from the United States.

20 The United States is concerned about, due to internal and external pressure on the GCC countries, the possibility that one of the five member states would de-peg its currency. This would be the first step towards dollar the end of the US dollar peg era in the GCC countries. As a result, it would decrease the dollar’s demand and would signal loss of faith in the United States currency hegemony (Feldman, 2008). Feldman further argues:

A loss of faith in the dollar is often perceived as a threat to the national interests of the United States, since the dollar's standing is one of the sources underlying American power. The fact that the United States pays for its imported goods in the currency that it itself issues gives it a unique status in the financial system, and this standing allows it to finance its domestic and international activity easily. The willingness of countries such as China and Saudi Arabia to receive dollars for their product, and their willingness to use these dollars to purchase bonds issued by the American government allows the United States to maintain low interest rates and cut funding costs on its “double deficit” (budget deficit and balance of payments deficit). In addition, the willingness of the world’s economies to accumulate dollars gives the US the ability to increase the rate of dollar printing without generating internal inflationary pressure (Feldman, 2008, p.6).

The possibility that the GCC countries would drop the peg to the US dollar became even more intriguing when Michael McConnell, the U.S. National Intelligence Director, briefed the Senate’s committee in 2008 on the consequences. As he said “Departing from familiar security issues, McConnell surprised the committee when he declared that the decline of the dollar could have considerable impact on the US national security. He noted that the decrease in the value of the dollar in 2007 prompted Syria, Iran, and Libya to ask their oil importers for non-dollar currencies and contributed to Kuwait's decision to stop linking the local currency to the dollar. These trends, he contended, might gain momentum and spill over to other oil exporters, should faith in the US currency continue to decline” (Feldman, 2008, p.1). Based on the arguments above some scholars have aruged that "there is a belief that the peg is preserved at the behest of US pressure" (Jumean, and Saeed 2011, p.1). In other words, the United States might push the GCC countries to stay pegged to the US dollar. Whether the United States puts pressure on the GCC to remain their currency pegged to the US dollar will be further discussed in the analysis section.

21 In addition to the domestic and international political and economic arguments that I explained, some scholars alternatively make a good case for the monetary union of the GCC. The scholars argue that having the US dollar as an anchor currency to the GCC is an important and essential phase in the process of establishing a common currency or monetary union. Furthermore, the GCC countries can achieve further economical and political integration through a monetary union. I consider a common currency to be an economical and political phenomenon, and therefore, have created a sub category for the Khaleeji.

The establishment of a common currency – The Khaleeji

In 2001’s economic agreement between the GCC members, they agreed on a long-standing ambition to establish a common currency by the year 2010. The GCC is a homogenous region and has many factors that could lead these countries to deepen economic integration like in the European Union. The GCC member states have many things in common, including cultural backgrounds, language and religion which make further integration relatively easier. In addition, these countries all have a fixed currency exchange rate regime pegged to the US dollar. The GCC countries agreed on creating a Common Currency by the year 2010. However, Oman could not meet the target by the defined date, thus the officials have announced its temporary withdrawal from the pact with a proposal that they will join the union at a later date. Shortly, Kuwait de-pegged its currency from the US dollar which made the common currency more complex because the US dollar was seen by many a good platform for a common currency pegged to the US dollar (Buiter, 2008). Kuwait’s decision was mainly to reduce the inflation rate and pressure. The common currency would have many economic benefits, including but not limited to, omitting the exchange rate costs between the countries, creating strong economic ties between the countries, and lower transaction costs. However, it is not only an economic or monetary issue but it is more dominantly a political and constitutional issue. It demands the surrender of national sovereignty involved in monetary and economic policy. It subjects countries to a supranational authority (Buiter, 2008; Raison, 2011). Due to high inflation rates in the GCC countries and Kuwait de-pegging its currency from the US dollar, the Gulf Cooperation Council could not achieve establishing the common currency yet. This paper asks why are the GCC committed to the US dollar-pegged currency exchange rate regime. In this paper, I argue that aside from economic and political contract

22 between GCC and United States the geopolitics plays an important role to keep the US dollar-pegged exchange regime. My contribution to the literature will be to add a geo- political aspect to the US dollar fixed exchange rate regime in the GCC region.

23 Chapter III

Methodology

This research paper explains the GCC countries’ currency exchange rate regime’s political and economic perspectives. To be more specific, this paper focuses mainly on the question of: why are the GCC countries committed to the US dollar-pegged exchange rate regime. As briefly explained above, there are two main reasons for pegging a currency to either a basket of currencies or a single major currency. The first and most common argument is macroeconomic policy, inflation rate stability and encouraging international trade and investment (Frieden & Broz, 2001). However, in the case of the GCC, some economists and politicians have argued that the current exchange rate regime does more harm to GCC countries’ economy than good. The GCC countries have pegged their currencies in order to stabilize the economy and keep the inflation rates low, but in reality the inflation rate has gone from 0.2% to almost 15% in some individual states within the GCC in the last couple of years. The second argument is that it is the political force that has kept these countries dollar- pegged. The latter argument contains a gap that requires further research. The reasons and motivation behind the political force has not been studied yet. Therefore, this paper will look at the reasons behind it thoroughly. There is only a limited number of studies and data available on the political aspect of currency exchange for many reasons, including the GCC’s secrecy about their political contracts and political institution system which also allows the rulers to be in a position where they have to provide accountability to no one. The paper has initially tested conventional hypotheses which are broadly used as the main reason, to peg the currency in the first place and now to remain pegged. These hypotheses are political institution, trade and the oil sector economy. The hypotheses will be analysed and tested in order to see whether they force the US-dollar peg to remain. The most suitable and best method to obtain a possible answer is to use case study in the context of the GCC. Through the qualitative case study, I will look at whether it is a political force that keeps these countries with the US dollar pegged or is this due to economic reasons? If it is political, what political issues are these? Eventually, is the political agreement at the cost of national interest? Such questions will be answered and discussed in the analysis and discussion section. The qualitative case study is the most suited research method for this project because it provides the opportunity to explore and comprehend complex issues. Furthermore, it

24 enables a researcher to analyse the data within a specific context. The GCC exchange rate policy is a complex phenomenon since it has multiple aspects of influence and requires in- depth and close study. Through the case study, a researcher can go beyond quantitative statistical outcomes. It provides a framework to understand behavioral conditions through the actor's perspective. In this context, each state can be considered (as) a single actor. Yin (1984) explains the case study as “an empirical inquiry that investigates a contemporary phenomenon within its real-life context; when the boundaries between phenomenon and context are not clearly evident; and in which multiple sources of evidence are used" (p.23). However, the method has its flaws so it cannot be generalized. In a case study, it is often nearly impossible to generalize the results since each actor/agency has a different setting. The problem of generalization will not affect my research since the purpose of this paper is merely to study the GCC and not to generalize it. As mentioned in the above paragraph, this paper will look at the case closely both at the national and international level economics and politics. I will use primary and secondary data such as policy papers, research papers, newspapers, journals, books, and other available resources to identify the variables affecting the currency exchange rate regime policy in the GCC. Therefore, it is necessary to use explanatory cases study in order to explain why the GCC as a whole use a fixed currency exchange rate regime despite all critiques and the tough economic situation in some member states. This paper considers the GCC countries’ currency exchange rate regime as one case because of the nature of their political institutions, economics and political policies. The GCC as the intergovernmental organization aims to coordinate and integrate all members’ political, economic and cultural aspects. A political threat to one member is considered a threat to all. All the GCC countries, except Kuwait, have been pegged to the US dollar for more than three decades. However, it is argued that Kuwait’s basket of currencies is heavily weighted on the US dollar because of its oil export. Therefore, the currency exchange rate regime affects Kuwait’s currency in the same way as it does the other GCC countries’. This research uses Saudi Arabia as the main actor in defining the macro-level political and economic policies for the entire GCC. Saudi Arabia is financially and militarily as big as the five other GCC members combined. Furthermore, Saudi Arabia, as the leader of the GCC, has often taken the initiative to sign political contracts with the United States on behalf of the GCC and later lobbied with the rest of the GCC to join the contract with the United States. Hence, it is logical to focus on Saudi Arabia as the main actor and other countries as the shadow cases or

25 sub-actors. Of course, I will discuss the other five GCC members when required. Due to the limited number of words of this paper, I cannot discuss each member state individually.

Time frame

In the 1970s the United States' suspension of the convertibility of the United States dollar to gold has opened a new era to the free-floating exchange rate regime. Major economies have rapidly changed their currency exchange rate regime from a flexible gold order, Bretton Woods, to a free-floating (flexible) exchange rate regime while some small countries tended to fix their currency to a major currency or to a basket of currencies. From 1973, the Gulf states have been pegged, first to IMF SDR and eventually adopted the US dollar fix exchange rate regime. Therefore, this paper will mainly focus on the period of 1973 to the present.

26 Chapter IV

In order to get a feasible answer to the research question, this research paper will test the following hypotheses:

Hypothesis 1: A political regime is associated with the currency exchange politics in the GCC countries.

The common assumption regarding the relationship between the political regime and the currency exchange rate regime is quite varied. Broz (2002) argues that autocracies tend to have a fixed currency exchange rate regime rather than a floating one. Autocratic regimes, in fact, value currency exchange rate regimes that provide a higher degree of stability of the exchange rate because failure of the exchange rate stability can generate inflation, reduce foreign investments and reduces purchasing power of citizens as well as job security to name just a few (Walter & Sattler, 2010). Institutions and the political system do matter in deciding on the currency exchange rate regime. Democracies tend to favour flexible exchange rate regimes based on two main factors. The first is voter pressure and financial contribution, and the second one is collective interest groups’ (private interests’) pressure. Governments are subject to these two groups in a democratic regime, whereas in an autocratic regime, governments are, to a certain limit, subject to private interests groups only. Thus, a fundamental difference between democratic and autocratic regimes' exchange rate policy is setting the currency exchange rate regime by electoral pressure. It does not mean that there is no pressure at all, there are still interest groups such as businesses and different sectors who have a particular interest in the exchange rate regime. To be more specific: the import-based businesses involved in international trade and investment would prefer stability (fixed exchange rate) in order to prevent the risk of volatility. However, the export-based businesses would rather lobby for a flexible rate in order to compete in the international market.

Hypothesis 2: Trade between the United States and the GCC countries force the Gulf States to remain pegged to the US dollar.

The classical belief among academics is that a fixed exchange rate boosts trade between the countries, and particularly of the country who has pegged its currency to that of the principle.

27 This means that pegging a currency to the US dollar will foster bilateral trade between the United States and the country who has pegged its currency to the US dollar (Klein & Shambaug 2006). In addition, the countries who are pegged to a single currency, in this case the US dollar, will also have an increase in bilateral trade (ibid).

Principle Country

Subordinate X Subordinate Y

Figure 1: Trade model

As shown in trade model (figure 1), when subordinate countries are pegged to the principle country, their trade increases. However, this has a sub-effect on both subordinate countries since they are both pegged to the same country, they also achieve an increment in internal trade, in this case, between X and Y (Frieden, 2014; Anthony, 1999). Furthermore, Klein & Shambaug (2006) argue that “we find that with few controls pegging appears to increase trade by as much as 80%. These are clearly over-estimates and when more appropriate controls are included, the results are 40% with country effects or 20% with country pair fixed effects” (Klein & Shambaug, 2006, p. 27-28). Frieden (2014) and Damaceanu, (2007) have confirmed that having a pegged currency or a union currency increases the trade between countries up to 30%. He further states that some scholars even argued that it increases trade with more than 100%, of which he is sceptical.

Hypothesis 3: Oil economy forces the GCC countries to remain committed to the US- dollar peg.

Some economists argue that it is the oil price that keeps the GCC countries pegged to the US dollar since the oil price is determined in the US dollar. Furthermore, the fixed exchange rate to the US dollar eliminates the mismatch between the real revenue in the US dollar from the oil sector and the local currency. Additionally, it helps oil-based economies against strong fluctuation and economic shocks. However, there are different views on these assumptions. Setser (2007) argues that the peg to the US dollar eliminates the apparent mismatch between the oil revenue and the local currency. But it fails to diagnose the fiscal problem.

28 Oil-exporting countries’ fiscal problems stem from extensive fluctuation in the oil price (ibid). In the past two decades, the crude oil price was between $12 and $112 per barrel that translates into strong swings in the overall economy of the oil exporting countries (Statista.com). Countries heavily relied on the oil export revenue had to suffer extensively from these strong price fluctuations. In fact, the fixed currency exchange rate regime does not help with fluctuations because it is not the source of volatility in the oil exporting countries’ economies. However, a different exchange regime, particularly a floating currency exchange rate regime, could reduce the volatility in the oil sector (Setser, 2007, p.6). Overall, countries who have pegged their currencies to the United States dollar are not at ease but experience more difficult times. Most of the time the US dollar is depreciated when the price of oil rises, and the US dollar is appreciated when the price of oil has fallen. Thus, in fact, it made it more difficult for oil exporting countries (ibid). Moreover, when the price of oil was high but the value of US dollar was depreciated against other currencies, oil exporting countries had a more difficult time because their external purchasing power was decreased, in spite of having a greater domestic economy or income. The next section tests the introduced hypotheses empirically and theoretically in order to understand which of these hypotheses are the significant determinants of the fixed currency exchange rate regime?

Results and Implication

In this section, I will try to apply the hypotheses in the GCC to find out whether these hypotheses provide the answers to the research question.

Hypothesis 1:

The first hypothesis discusses the effect of the political regime type on the currency exchange rate regime choice. The widely believed theory is that democratic countries tend to favor a flexible currency exchange rate regime where the electorate, interest groups and politicians have influence. While autocratic regimes prefer a fixed currency exchange rate regime because of two reasons: first, autocratic regimes value exchange rate stability and credibility. Others authors argue, based on their empirical and theoretical researches, that autocratic regimes have a positive association with currency stability whereas democratic regimes are

29 associated with a less stable currency regime (Bearche & Hallerberg, 2008: 2011). However, these arguments have mixed and complex results and Simmons and Simmons and Hainmueller, 2004 did not find such an effect in democratic or autocratic regimes. Secondly, there is no pressure from the electorate, political parties or certain actors like politicians and activists. The royal family members are the only major principle political actors allowed by the government. Political participation and activities are limited outside of the royal families and political activities are very limited in the GCC countries. The political activity in these countries can be considered as a treason against the King and have the ultimate punishment. Furthermore, there are no elections for any important positions such as ministers or provincial governors, however I am not implying that there is absolutely no political or economic pressure. Interest groups (businesses) do have some political influence in the GCC countries. Although, in case of the GCC countries, for instance the United Arab Emirates, interest groups are often either state-based companies, the family members and relatives of the rulers of each state or close allies of the Emir. The structure of these countries, especially the UAE states, are neopatrimonial, meaning that it implies neopatrimionism “which implies that the regime is organized around the ruler as an individual, maintaining other members of the elite in a relationship of personal dependence on his grace and good favor” (Hvidt, p.400). Extensive projects or investments in Dubai and many other GCC countries are government led. The private investors might be financially strong but are politically weak. Therefore, the Emir of every state has the authority to introduce or lead new mega projects annually. The Emir has the authority to favor anyone and any project which happens in Dubai and in any other neopatrimonial society. In the case of Saudi Arabia, ministries are allocated to princes. This means that there will not be much disturbance from within the government apparatus. In fact, this is not only the case in Saudi Arabia or the UAE but in the entire GCC. This means that major business and political institution are either run by the rulers, their families, relatives or close allies. Having this in mind, it is rational and beneficial to have fix exchange rate regime in order to eliminate income differences, lower transaction costs and create risk-avert market for the international investment. This hypothesis explains/confirms that the monarchy or autocratic governments prefer a fixed currency exchange rate regime. However, this does not explain why the GCC countries have pegged their currency to the US dollar instead of the Euro or any other currency. It is certain that there is no major political pressure from the government apparatuses, business or citizens to keep the US dollar pegged.

30 The table 2 below shows that the political regime does have a significant effect on the type of currency exchange rate regime, particularly the monarchy. More than 75% of the countries have a fixed exchange rate regime. Three countries have fixed their currency exchange rate with a basket of currencies, including Kuwait. Monaco and Vatican City have the Euro for a legal tender whereas Liechtenstein has the Swiss franc as the legal tender. Only Thailand with a monarchy political system has a floating currency exchange rate regime.

Table 2: Political regime and its exchange rate type

Country Regime Type Exchange rate regime type Remarks Bhutan Monarchy Pegged with Indian Rupees Bahrain Monarchy Pegged with the US dollar Brunei Monarchy Anchor: Singapore dollar Convertible Currency board arrangement at a fixed rate Jordan Monarchy Pegged with US dollar Kuwait Monarchy Basket of Currencies Liechtenstein Monarchy Swiss franc Monaco Monarchy Euro Morocco Monarchy Basket of Currencies Oman Monarchy Pegged with the US dollar Qatar Monarchy Pegged with the US dollar Swaziland Monarchy Pegged with South African Rand Thailand Monarchy Floating Tonga Monarchy Basket of Currencies Saudi Arabia Monarchy Pegged with the US dollar UAE Monarchy Pegged with the US dollar Source: IMF report (2016) However, the argument that more than 75% of the monarchy regimes are pegged with a basket of currencies or with a single currency only answers/confirms the first part of the hypothesis which is the political institution type’s effect on the currency exchange rate regime. The second and more important part in the light of this paper is fixing (pegging) a currency to the US dollar. Only Jordan, in line with five GCC members, has a US dollar peg. It is worth mentioning that Saudi Arabia has a strong influence on Jordan, the same as on the

31 other GCC countries. There is no empirical data available to support political regime effect on remaining pegged to the US dollar. Since the type of regime has no significant effect on fixing a country’s currency exchange rate regime to the US dollar, therefore, it can now be said that this hypothesis can be rejected. In other words, the political regime type has no impact on the US dollar as a peg currency but it rather has an effect on the type of currency exchange rate regime: fixed or floating. In order to find the reason and motivation behind the GCC’s peg to the US dollar, it is necessary to examine the next two hypotheses which might provide a feasible answer to the current US peg of the GCC countries.

Hypothesis 2

The second hypothesis explains the trade relationship between the United States and the GCC countries. The amount of trade that these countries have might be the motivation behind the US dollar pegged currency. According to Damaceanu (2007) an important factor of international trade between the countries is the price of import and export. The exchange rates regime decides these prices and therefore, the exchange rate regime has an important and major influence on international trade. The relation between the exchange rate and international trade is co- dependent. They both influence each other. Damaceanu (2007) studied the effect of fixed and floating exchange rate regimes on international trade by four different disciplines: mathematic, economics, history and computer science. After studying this theoretically and empirically he concluded that a fixed exchange rate regime increases trade between the countries. He further adds that the highest trade that the world has experienced was during the Bretton Woods system when the currencies were fixed. This claim has been confirmed by other scholars such as Frieden, (2014) and Anthony, (1999). To test whether the GCC countries’ trade has increased with the United States, I used data from the IMF, WTO, GCC and some other databases. Additionally, I used some data from scholars who have researched the GCC trade relationship with the United States. In fact The West, which consists of the entire continent of Europe as well as North America, along with Australia and New Zealand formed only 18% of the GCC’s exports and 45% of its total imports in 2013 (The Economist, 2014). However, this does not hold up anymore, because the GCC’s share of trade shifts towards Asia and Europe alone.

32 The GCC countries’ relationship is growing with emerging economies whereas the share of trade between the GCC and The West as a whole is falling. The West, only Europe’s share remains constant. China as the biggest competitor is taking the share of The West and growing its trade and investments with the GCC countries (The Economist, 2014). According to the Economist report: “In 2013 total trade flows from the West were just over US$393bn, led by Europe, which accounted for over one-half (US$249bn). GCC exports were dominated by hydrocarbons and petrochemicals, and imports by machinery, industrial products, and precious stones and metals. In 2013 US exports to Arab nations grew by 7.5%, compared with export growth of 2% to global markets, and the UAE and Saudi Arabia accounted for one-half of exports, with the UAE positioned as America’s top partner, importing goods to the value of US$24.6bn. The main GCC imports from the US were transportation equipment, computer and electronic products, and non- electrical machinery” (The economist, 2014, p. 18). The graph 1 below shows the percentage rate of trade within the GCC from 2002 to 2017. The graph starts from a 20% import and 12% export increase because the years 2001 to 2002 were significantly higher yet not the peak.

33 Figure 2: Import and Export fluctuation

Import and Export fluctuation within the GCC 60

40

20

0

-20 PERCENTAGE -40

-60

-80 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 Imports % 12.91 -2.4 37.7117.1512.5740.4726.56 -57.9 13.3840.2812.25 33 -2.85 -11.9 -13.9 -10.3 Export % 20.9915.5623.4245.67 -10.3 43.5627.14 -52 12.7713.1551.5521.29 -1.13 -30.8 -18.5 -14.5

Source: International Trade Statistic Database The GCC trade with each other experienced strong fluctuation, especially during 2007 to 2012. However, the fluctuation can be seen in the entire two decades. There is a no strong increment in the GCC’s internal trade when the GCC announced officially that they are exclusively pegged to the US dollar. In fact, from 2014 it has decreased annually from -2,85 to -10.3.

34 Figure 3: GCC Trade with the world

GCC Trade Value (Import and Export) from 2001 to 2017 450,000,000

400,000,000

350,000,000 GCC & EU 28 Export 300,000,000 GCC & EU 28 Import

250,000,000 GCC & Asia Export GCC & Asia Import 200,000,000 GCC & USA Export 150,000,000 GCC & USA Import 100,000,000 GCC & China Export 50,000,000 GCC & China Import

0

Source: International Trade Statistic In the graph 2 above I have compiled the data from 2001 to 2017 to see whether the trade between the United States and the GCC has increased. The graph (number) shows that the GCC export to the United States has barely increased in almost two decades whereas China’s trade has doubled in the same period. Of course, as shown in the graph, Asia as a whole is the winner because of the GCC’s trade relations. On the other hand, import from the US has decreased and it is slightly less than China’s. Again, Asia as a whole has more than the combined import share of Europe and the US.

35 Figure 4: GCC total trade

GCC Total Trade (Import + Export) with Countires and Continents

800,000,000

700,000,000

600,000,000

500,000,000 GCC & EU 400,000,000 GCC & Asia 300,000,000 GCC & USA GCC & China 200,000,000 Linear (GCC & EU) 100,000,000 Linear (GCC & Asia)

0 Linear (GCC & USA) Linear (GCC & China) -100,000,000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 Years GCC & EU 18,53 18,67 21,84 27,62 51,67 39,64 83,52 105,7 53,40 61,29 76,22 134,5 148,2 152,3 129,4 114,1 127,4 GCC & Asia 50,99 46,84 50,17 72,65 181,3 119,7 297,4 414,1 164,1 209,6 284,4 623,6 690,0 715,8 494,6 427,9 437,8 GCC & USA 10,54 8,583 9,291 10,95 18,35 16,13 29,19 38,25 21,99 23,49 27,18 58,19 61,60 60,80 56,43 55,30 52,22 GCC & China 4,005 4,443 4,359 10,04 19,34 16,76 34,86 52,14 26,23 35,44 51,40 78,01 87,52 123,4 87,25 75,79 83,24 Source: International Trade Statistic The GCC total trade graph shows that China’s total trade has surpassed the United States’ total trade with the GCC in 2005. Furthermore, the forecast linear shows that it is increasingly expanding its trade. Last but not least the graph shows the trade trend within the GCC countries. To summarize, the GCC countries have significantly higher trade with the Asian countries than with the United States. China is increasingly becoming a more influential partner in the GCC and has surpassed the United States’ trade share a decade ago. On the other hand, within the GCC trade has decreased in the relative terms from the trade volume that they had in 2001 and 2002. From 2012 onwards, the trade rate has consistently been falling down within the GCC countries. It can be now concluded that the suggested hypothesis should be rejected because the US dollar peg neither preliminary increased trade between the GCC and the United States nor among the GCC members. As the theories explained that trade and the currency exchange rate regime are bivalent. In other words, they depend on each other. The GCC countries have by far more trade with Asian countries, particularly China, Japan and India. On the second level, the GCC members have by far more trade with Europe than with the United States. Now that it is confirmed that trade does not play a significant role in determining the reasons for the US dollar peg in the GCC, this opens debate to the last hypothesis about the effect of oil economy which could be the reason for the US dollar peg in the region.

36

Hypothesis 3

The hypothesis explains whether the oil price is the reason and motivation behind the US dollar peg in the GCC countries. The oil revenue constitutes a major part of the GCC members’ government expenditures. In 2011 and 2012 oil constituted around 60% of Kuwait’s GDP revenue and around 50% of Saudi Arabia’s and Oman’s GDP. In the 1980’s the oil revenue accounted for around 80% of the GDP of the members of the GCC, except Bahrain. The graph shows the oil revenue percentage in the GDP of individual members. The data range from 2000 to 2016 and have been gathered from the World Bank’s database. The exact values and tables will be attached in the appendixes. Since it constitutes a great share of the GDP, a valid case can be made for the idea that the oil price could be the reason for the US dollar peg. Figure 5: Oil revenue

Oil Revenue GDP Percentage in GCC 70

60

50

40

30

20

10

0 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016

Saudi Arabia Qatar Bahrain Kuwait Oman

Source: The World Bank Database Before providing the answer to whether it is the reason and motivation or not, it’s necessary to know how the oil market works. Oil is the most traded good, according to the International Energy Agency’s website’s 2016 reports, 97 million barrels per day was traded and consumed in 2015 which accounts for around 7 billion dollars at today’s price of $73 per barrel. Keeping in mind that the greatest oil exporter is Saudi Arabia and the biggest consumer is the United States. This means that the GCC countries, particularly Saudi Arabia,

37 have a remarkable foreign currency reserve which is mostly in the US dollar (Momani, 2008). The GCC countries provide more than 30% of the entire world’s oil. Oil supply throughout the world is organized by the Organization of the Petroleum Exporting Countries (OPEC) and its mission is to coordinate policies and the supply of oil with the oil exporting countries. The organization has 14 members and more than 50% of the members are Middle Eastern countries. To answer the hypothesis empirically, I have gathered data of the 15 countries who export the most oil beside the GCC members and the United States. The GCC members and the United States are not listed in this list below. Theoretically scholars argued that the oil sector pegged to the US dollar does have its advantages, such as the elimination of mismatches and transaction costs to the local currencies. However, Frankel (2003) and Setser (2007) offered an alternative argument to eliminate the mismatch and boost economic growth. They suggested that oil exporters should rather have a basket of currencies which includes more than one currency and the oil price, too. In doing so, the fluctuation caused by the oil price will be controlled. Setser (2007) further argues, that the GCC countries make a monetary policy mistake by pegging their currency to the US dollar because empirical data have shown that when the price of oil increased the US dollar was depreciated and vice versa. This has generated domestic monetary instability and increased inflation in the GCC countries. Moreover, the table 2 below shows that there are only three oil exporting countries who have pegged their currency to the US dollar. Out of these three countries, two countries are special cases. The first one is Iraq, whose currency exchange rate regime has changed when the United States invaded the country. The second one is Venezuela which currently runs 13,800% of inflation according to the IMF online database. Only Kazakhstan, besides the GCC countries, is pegged to the US dollar. Hence, we can safely say that the currency exchange rate regime commitment has been derived from a different force than merely the oil price as some researchers have argued. Therefore, it can now be said that the oil price economy does not play a significant role in the determination of US-pegged currencies and the suggested hypothesis can be rejected. This does not mean that the oil sector has absolutely no effect. Indeed, it does have a certain effect and influence but the importance in this case is overrated by some scholars. Yet, the GCC countries remain pegged to the US dollar and they priced their oil in the US dollar.

38 Table 1: Table 2: Oil exporters currency regime

Country Oil – export (bb/day) Currency regime Remarks Russia 4888000 Floating Iraq 3301000 Peg to USD Since the invasion Canada 3201000 Floating Nigeria 2231000 Other Angola 1745000 Other Venezuela 1548000 Peg to USD 13,800% inflation Kazakhstan 1466000 Peg to USD Norway 1255000 Floating Mexico 1193000 Floating Algeria 1146000 Peg to Basket Iran 1042000 Peg to Basket United Kingdom 862000 Floating Colombia 859000 Floating Libya 834100 Peg to Basket Brazil 619100 Floating Source: CIA: The World Factbook

39 Chapter V

Analysis In this section my focus is on the current debate on the reasons and motivation of the GCC countries that have remained committed to the US dollar peg. As I explained in the literature review and hypotheses, some authors have called the oil sector the reason and motivation and others have argued for trade and political institutions as the defining factor of the US fixed exchange rate regime in the GCC. My argument is that the combination of the aforementioned factors did play a major role in determining of the US dollar peg decades ago but the main force that drives the holding on to the US dollar peg is a strong political (geopolitical) will and necessity. I will briefly discuss the geopolitics in the region and the political relation between the United States and the GCC countries and their effect on both countries’ political and economic situation. Understanding the geopolitical situation helps to illuminate why the GCC members remain the fixed exchange rate regime peg to the US dollar. A currency exchange rate regime is, in simple terms, mainly a contract between two or more countries based on cooperation, interaction and mutual interests (Momani, 2007). The conventional economic argument is that the fixed exchange rate regime lowers inflation risks, stabilizes macroeconomics and prevents the economy from the external shocks and financial disturbances (Walter & Sattler, 2010; Mundell, 1963). The countries should have extensive and regular policy coordination. This policy coordination could be at the cost of national interests, meaning that a pegged country should give up its monetary policy that could harm domestic interest groups and foster political rhetoric against the ruler and the government. The failure of exchange rate stability can generate inflation, reduce foreign investments and consequently reduces purchasing power of citizens, job security and real income (Walter & Sattler, 2010). In this section, I will examine whether the US dollar peg has helped the GCC countries to lower their inflation rate and protected them from external shocks. The graph shows that the inflation rate between 1998 and 2002 was 0.2% on average before officially announcing the entire GGC will be exclusively pegged to the US dollar. From 2003 to 2018 the average inflation of the GCC is 3.3% with individual years as high as 10% and individual countries as high as 15%. Bubula and Otker-Robe (2003) studied economic crises of all IMF members from 1990 to 2000 and warned countries with fixed exchange rates that ¾ of the crises were linked with fixed parities.

40 Figure 6: Inflation rate percentage

Source: IMF online database In line with many scholars my empirical analysis also confirms that the peg to the US dollar has not helped the inflation rate in the GCC. Furthermore, it prevents the currency appreciation and depreciation necessary to be competitive in the international trade market. With a low oil price, a falling value of the US dollar and a current US monetary policy that is counterproductive to Gulf interests, the GCC countries’ peg to the US dollar is now deemed to be a problem. In particular, inflation has become a serious domestic issue, particularly because most of the arid Gulf countries are highly dependent on food imports. Because of rising inflation, a number of GCC countries has faced domestic pressure to loosen the dollar peg. Consequently, the IMF has cautioned that unless oil exporters adopt an exchange rate regime that varies with the price of oil, oil exporters will continue to face adjustment through inflation. Jeffrey Frankel has also suggested that the oil-exporting countries consider a peg to a basket of currencies that includes the price of oil (2003). Prominent economists, including former Federal Reserve Chairman Alan Greenspan and Nobel Laureate Professor Joseph Stiglitz, are recommending that the Gulf States consider a revaluation of their currencies to stop the rising tide of inflation in the region. However, the Gulf peg to the dollar has prevented these necessary economic adjustments (Momani, 2008). The worst is yet to come, as the currency trade forecasts and Donald Trump's policy predicting that the dollar will become depreciated, meaning that the GCC will suffer higher inflation. In the literature section, I emphasize that the US dollar is persistently losing its

41 value against the major currencies such as the Euro and the Japanese Yen. The weaker dollar means that the GCC countries’ consumers import inflation with every European or Asian product (Blitz and Wheatley, 2017). The UAE has more than 4% inflation and Bahrain’s debt exceeds 100 percent of its gross domestic product (Sergie, 2018). The GCC members are in dire need of a flexible currency exchange rate regime where they can have autonomy of monetary policy to increase/decrease their currencies’ value and interest rates independently. The effect of inflation can be better understood when the inflation effect is broken down into different sectors. A significant part of the inflation in Saudi Arabia is driven by a rise in housing rates (18 percent) and food prices (13 percent). The rise in food prices in the other GCC countries is higher, as they import even more of their food than Saudi Arabia. Indeed, food riots have erupted in Saudi Arabia, the UAE, and Kuwait. The GCC countries have funded their public sectors from the sovereign fund in order to keep the inflation effect tamed in addition to the wages increment. The inflation rate that the countries are running requires at least 100 US dollar per barrel of oil to fund and cover the inflation costs. Domestically, the GCC countries face two problems in relation to the inflation caused by the currency exchange rate regime by some accounts. First, the government should fund the inflation without an increase in production. Second, as mentioned, the oil price should be at least 100 US dollars per barrel for five members and 113 US dollars for Bahrain. The oil is now priced at 73 US dollars per barrel, which is significantly lower than the desired and required level. Moreover, at the domestic level, senior officials and the directors of the UAE and Qatar central bank have called upon the government to de-peg the US dollar since it is an outdated system that is unresponsive to the current economic situation (Gulf news, 25, August, 2016). As stated, the peg to the US dollar does more harm economically to the GCC than good. Yet, the GCC is committed to remain fixed to the US dollar. I have tested three hypotheses which were conventionally argued to be the possible reasons to remain pegged to the US dollar. The hypotheses’ conclusions are as follows: I have briefly discussed the effect of the political regime type of the GCC hypothesis and have come to the conclusion that the autocratic monarchy (political regime) is not the reason behind the GCC countries’ fixed currency exchange rate regime to the US dollar. There is no absolute or constitutional monarchy that has fixed its currency to the US dollar except for Jordan. There, Saudi Arabia has the utmost influence and has had to bail Jordan out financially during hard times. In short, there is no empirical support for a political regime being the cause of the US dollar-peg in the GCC.

42 I further studied the trade hypothesis concerning trade between the GCC and the United States. One of the conventional arguments, in addition to political regime, is that the GCC countries have adopted the US dollar-peg because of the currency status in the international market and the GCC trade with the United States, which is also exclusively in the US dollar. However, the data show that the trade between the United States and the GCC is by far less than the rest of World’s. The Asian countries trade accounts for more than 50% of their entire trade with the World and just below them, the European Union consists of around 25% of trade. Thus, economic researchers argue that it would be more efficient to peg the currency either to the Euro which accounts for almost 16% - 20%, depending on the year, of the trade, or to a basket of currencies containing at least the currencies of their top three trade partners (the Chinese renminbi, the Euro, and the Japanese yen) (The economist, 2014). The last hypothesis I will present is considered to be the most important reason for the currency exchange rate regime by a broad range of offers; the oil price determination in the US dollar and the oil sector economy. The data of hypothesis three showed that the oil price is not the reason and motivation for the the US dollar peg. Iran sells its oil in Euro’s and Iraq used to sell its oil in Euro’s too before the 2003 invasion by the United States. There is no strong correlation between the oil price determination and the GCC’s fixed regime to the US dollar. At this point, it has been explained that neither oil, nor trade or political regime has any significant effect on the commitment of GCC’s currency exchange rate regime. In short, it can be now said that the GCC countries suffer economically from the US dollar peg. In spite of national and international financial institutions, scholars and bank directors, the GCC members, particularly Saudi Arabia and the UAE, have rejected any proposition against the peg (Momani, 2008). This begs the question of why are the GCC countries committed to the US dollar at such a high economic cost, but first, it is imperative to explore why the oil price is determined in the US dollar. The short answer would be based on two arguments; first, the US dollar is the most traded currency in the international trade market and second, is to sustain US dollar demand in favor of the United States. This suggests that it is beneficial merely for the United States’ economy rather than the GCC countries. However, this is not the entire story, as political economy theory explains that the pegging of a currency to a foreign currency requires policy coordination and mutual interests. Moreover, a reserve of a currency is a great tool to emphasize and implement strategic, diplomatic and military power. When a country has strong military power, the weaker country will reserve the stronger country’s currency and will conduct its cross-border transactions using the currency of the hegemon. Having the

43 hegemon’s currency in reserve will give the weak country a political leverage through which the country can influence the hegemon’s political view and actions in the region (Kindleberger 1970, Strange 1971, 1988, Kirshner 1995, Williamson 2012, Liao and McDowell 2016). Keeping this in mind, I will look at why and how the oil is priced in the US dollar. In fact, pricing the oil in the US dollar was a purely political decision between the United States and the Kingdom of Saudi Arabia. It goes back to the 1970’s, when the United States, by the representative Secretary of State and Secretary of Treasury, Henry Kissinger and William Simon, had several meetings with the Al Saud family in the Kingdom to reach a powerful agreement. These meetings were in response to an oil embargo on the United States and some other western countries which particularly hit the United States hardly. The embargo was a counteraction in response to the US aid to the Israelis during the Israel and Arab war. The oil price had quadrupled, inflation soared, the stock market had crashed and the overall US economy was in a plunge (Wong, 2016). The agenda of these meetings was strictly kept secret within the inner circles of President Nixon. The documents were released in 2016 by a request of the Bloomberg news agency. The president had advised his staff not to return without an agreement. It was an important agreement for the United States, not only because not coming to an agreement would jeopardize the US economy but also because it would provide an opportunity for the Soviet Union to further and deepen its influence in the Arab world. The goal of the meetings was to end the embargo and to persuade Saudi Arabia to price their oil exclusively in the US dollar and to invest their billions of oil revenue in the United States to finance the US’s debt in exchange for military equipment and military aid against any potential aggression (Wong, 2016). After long rounds of negotiation both parties succeeded to come to an agreement. Saudi Arabia agreed to price its oil in the US dollar. Since Saudi Arabia had a strong influence on the other GCC and OPEC members, Saudi Arabia managed to price the oil for the entire OPEC in the US dollar. Furthermore, Saudi Arabia agreed on investing in the US’s economy, on the condition that Saudi Arabia’s Treasury purchase stayed strictly secret, which it had until May 2016. Having their oil priced in the US dollar and having only state-owned oil exporting companies, the GCC countries have a massive amount of US dollars earned from oil to invest and recycle. They have invested their petrodollars in the United States dollar-based assets and securities, especially in the Treasury Bills, which has consistently supported the US dollar. The GCC had the advantage and possibility, based on the signed 1973 oil agreement

44 conditions, to buy US Treasury bills that were not yet publicly announced to help finance the US debt. Furthermore, the US agreed to not publicize the GCC investments. This coordination has benefited both parties. In recent years figures were announced, but critics argue that the figures are not accurate and the amounts might in reality be at least double or more than the numbers that were publicly announced (Wong, 2016). According to Statista.com (2017) bonds held by Saudi Arabia were worth around 150 billion and those of the UAE around 60 billion; as mentioned earlier, however, they have secrecy contracts with the United States so it could be much more than this. Additionally, Saudi Arabia announced in 2014 that it has around 750 billion US dollar in reserve which was mostly accumulated from the oil sector. After September 11 2001, however, there has been a domestic pressure on the US government to again limit, disclose and scrutinize the Gulf States’ investments in the United States. The domestic pressure has not had any result as of yet and might have no effect on the relationship between Saudi Arabia and the United States. Supposedly, it will also not have any effect on powerful political agreements made behind closed doors. For many decades, this coordination was beneficial to both parties. However, the domestic politics and economic situations, especially in the GCC, have changed. Gulf citizens demand more investment in their future and home countries rather than putting money into the West’s banks. Furthermore, tension is increasing within the United States, particularly from the Senate, to block or prevent further GCC countries’ investments in the US. Additionally, the US’ monetary policies are counterproductive to the Gulf States. To act on its own economic interests the GCC should de-peg its currency from the US dollar but this will harm the US economy and hegemony. De-pegging would also mean that the price of oil will no longer be in US dollars (Kimberly, 2018). It means that the demand for and value of the US dollar will fall remarkably which will trigger a similar security and financial issue as that of 2007, when the decrease in the value of the US dollar prompted Iran, Iraq and Venezuela as well as non-OPEC members Russia and Malaysia, based on political dispute with the United States, to change the oil price from the US dollar to any other currency in order to undermine and harm the United States hegemony and the US dollar hegemony as a currency. This will drop the US dollar’s value massively since 97 million barrels of oil is traded every day. The demand for the US dollar will fall extensively and speculative attacks on the US economy might follow. The GCC countries, especially Saudi Arabia and the UAE, will directly reject any proposal against the US’ economy and hegemony. Any decision made on the subject of de-pegging should be agreed to by all GCC

45 members (Bonds & Loans report, 2017). So Why the GCC members would reject the proposal? The simple answer would be geopolitics and the GCC’s security. To understand how important the GCC’s security is, it is necessary to briefly review the geopolitics in the Middle East to see how serious the GCC’s security threat actually is. The GCC countries have always been weak from the security perspective compared to other countries in the region. The GCC countries are scarcely populated while rich in natural resources. For example, Saudi Arabia has a population of 32 million and Kuwait around 4 million while they are ranked 1st and 6th among oil exporting countries worldwide. Saudi Arabia alone produced a 15.9% share of the world’s oil in 2017 (The World Bank database). The GCC countries have always been unstable. The region will remain highly unstable, at least in this decade, with a war-torn Afghanistan, fragile Iraq with Iranian support, war-torn, fragile and hostile Syria, hostile Iran, war-torn, fragile and hostile Yemen and an unresolved Israeli-Palestinian conflict to name a few (Momani, 2008). In fact, the instability goes back to at least the 1960’s and early 1970s’ (cold) war in the region. In 1967, Saudi Arabia saw secular revolutionary Arabic nationalism led by the Egyptian President Gamal Nassir as the greatest threat to its survival. The kingdom was under strong threat from all sides and rumor of a coup on the King was widely whispered. The Saudi air forces were reportedly defecting with their jets to Egypt. The CIA has warned the Saudi Arabian king of his regime’s vulnerability. Saudi Arabia would not be able to resist an uprising without changing its foreign policy (Riedel, 2017). Saudi Arabia is rich but vulnerable to threats from the Soviet Union and other Arabic nations in the region; had less chance of survival without the security guarantee of the United States. Under the rubric of the 1970s’, the United States guaranteed Saudi Arabia protection against any internal and/or external threat. Before February 1979, Saudi Arabia and Iran managed to have a relationship without conflict for their mutual interest to avoid potential threats from Egypt, the Arabian Peninsula, and the Soviet Union. However, after the Iranian Islamic revolution in 1979 their relationship deteriorated massively, when Iran’s spectacles and rhetoric of revolution alarmed the GCC’s leaders, particularly the Saudi Arabian rulers. The revolutionary leaders in Iran condemned Saudi Arabia and accused them of being a puppet of the United States in the region. Iran claimed that they took all of their instructions from the US, ranging from the oil pricing in the US dollar to the sell-out of Palestine. Iran began to adopt an offensive policy initially against Saudi Arabia and subsequently against the entire GCC. They called on Shia Muslims all over

46 the GCC to revolt against their corrupt governments and to fight enemies of Islam (Zweiri, 2016; Telhami, n.d.; Entessar, 1987). Moreover, the revolutionary leader of Iran declared the United States to be the enemy of Iran as well as Islam. These policies and accusations of Iran exacerbated internal conflicts between Shia and Sunni Muslims within the GCC countries, particularly Saudi Arabia (Chubin & Tripp, 2014). Saudi Arabia tried to strengthen its relationship with the United States initially to prevent and contain the Soviet Union, and resist Arab nationalism led by Egypt, Syria and Iraq (Bahgat, 2006). From 1979 and onwards, Saudi Arabia has used the United States as a protection shield against its enemies and also used its relationship with the US to influence other countries in the region through the United States’ foreign policy. The United States has proved to follow through on its security guarantee when Iraq invaded Kuwait and threatened Saudi Arabia’s oil rich provinces. The US-led coalition helped freeing Kuwait and protecting Saudi Arabia from Iraq’s transgression (Momani, 2008). The list of evidence of the United States providing protection when needed to the GCC members on various occasions goes on and on. Additionally, the United States provided the GCC members with advanced military technology, ranging from tanks to advanced fighting jets. Saudi Arabia alone has bought a 115 billion dollars’ worth of weapons and ammunition only in 2017 from the United States whereas the total goods trade was around 43 billion dollars between the GCC and the United States. It is not mentioned in any trade databases or reports because weaponry transactions are based on political contracts and it is exempted from the goods trade. 115 billion dollars in weaponry alone accounts for more than a 12% share of the entire world trade with the GCC. Saudi Arabia buys 18% of the world’s weapons and more than 50% of them are from the United States. Consequently, the UAE is the second largest weapon buyer/importer from the United States after Saudi Arabia. Both countries are the second and third largest arms importer worldwide after India in 2016. According to the World Economic Forum the flow of arms to Asia and Oceania and the Middle East between 2008–12 and 2013–17 increased, while there was a decrease in arms going to Africa, the Americas and Europe. In addition to the 1970’s contract between the US and Saudi Arabia, other members of the GCC have also signed security contracts with United States (Anthony, 2006). The contract included “the following provisions. Each of the GCC signatory countries would allow the United States to pre‐position military equipment within its territory. The purpose would be to enhance the effectiveness of potential defence contingencies requiring its utilisation. The agreements also provided for regular consultation on and exchange of

47 defence‐related information as well as the periodic holding of joint training exercises and field manoeuvres” (Anthony, p.16). The mutual interests have worked for both countries, they have both achieved what they needed, and the United States receives billions of US dollars to circulate in their economy whereas the GCC gets the necessary security protection. Moreover, the GCC countries have used the US dollar reserve and oil export policy to influence the U.S.’ foreign policy in the Middle East as well as some internal US policies, too. The GCC countries lead by Saudi Arabia have used their position as a leverage in political issues, as we will see in the following situation: During President Obama’s administration, the members of the American Congress wanted to pass a bill to hold Saudi Arabia liable in the US court for the 9/11 terrorist attacks. Saudi Arabia warned Obama’s administration that it would sell off hundreds of its billions of US dollars’ in reserve as well as assets if the bill passes and the Kingdom would be held responsible for the attack. The Obama’s administration has lobbied within the Congress in order to try to block and kill this bill. Furthermore, the State Department, the Pentagon and other officials have warned the policy makers / congressmen about the fallout of economic and diplomatic relation, should this bill pass (Mazzetti, 2016). The minister of foreign affairs of Saudi Arabia delivered the message personally stating, “Saudi Arabia would be forced to sell up to $750 billion in treasury securities and other assets in the United States before they could be in danger of being frozen by American courts” (ibid, p.1). The threat worked at the time and the bill was blocked. Additionally, Saudi Arabia was concerned about the role of Israel in the region for they feared that their money would either directly or indirectly end up in the assistance that the US provides to Israel. The US provided Saudi Arabia with the certainty that their fear of being threatened by Israel in the years to come was unnecessary. The relationship between Saudi Arabia and the United States got so close that Israel had been concerned about its own security in the region (Wong, 2016). Furthermore, Fareed Zakaria, a prominent journalist and global political analyst reported on recent speeches by President Trumps on Islam in Saudi Arabia in which the US President showed empathy for the Muslim victims of terrorism. President Trump stated that “no discussion of stamping out this threat would be complete without mentioning the government that gives terrorists . . . safe harbor, financial backing and the social standing needed for recruitment.” With this statement, he was referring to Iran as evil and the terrorist groups’ sponsor that poses a threat to Saudi Arabia’s and the Middle Eastern region’s security and stability. In fact, more than 94% of terrorist attacks that took place after September 11

48 2001 were either related to Al Qaeda, Islamic State or any other terrorist group were Sunni Muslims, while Iran is a Shia majority country and fights Sunni militant groups. The report is based on the Terrorism Database by Leif Wear of King’s College London. The speech concludes that President Trump and his administration have taken Saudi Arabia’s line on terrorism which blames any sort of attack in the region on Iran and its allies (Zakria, 2017). According to Fareed Zakaria, Saudi Arabia played President Trump by donating a hundred million dollars to Ivanka Trump’s cause and to some other contracts between Saudi Arabia and the President on behalf of the US government. After the meeting and contracts, the United States have drafted their policy in accordance to the line of Saudi Arabia and therefore against Iran and its allies in the Middle East. As Zakaria puts it “I thought that Trump’s foreign policy was going to put America first, not Saudi Arabia” (Zakria, 2017). Recently, the United Arab Emirates and Saudi Arabia, in a collective action on behalf of the GCC interest, lobbied with President Trump to put sanctions on Iran and withdraw from the nuclear deal signed during the Obama administration. Before any sanctions were announced by President Trump, the U.A.E minister of state for foreign affairs said that Iran will soon realize its limits, stating that “there has to be a new deal with new boundaries that extends restrictions on Iran’s nuclear program and addresses its ballistic missile program and “regional meddling” (Fattah, 2018). However, The European countries have tried to protect the contract signed between the US and Iran supported by all other countries involved. Yet, it has not worked in favor of Iran. The United States announced, that if any country goes against the US sanction on Iran, the US will response back hard. Hence, the EU avoids pushing against the sanctions on Iran. The GCC members lobbied against Iran’s nuclear deal during President Obama’s administration but could not get what they desired. While their efforts failed in President Obama’s era, they have found a stronger ally in Trump’s presidential win. Now, the GCC countries together with Israel forced Iran back into a corner with Trump’s new sanctions and the withdrawal of the nuclear deal. On the 8th of May 2018, Trump announced that he would re-impose the former sanctions which were lifted off of Iran during the Obama’s administration. The news had a catastrophic effect on Iran’s economy and the oil price worldwide (Fattah, 2018). It can be said that the Gulf States had required military support from the United States for the last fifty years and will continue to do so in the future too. The GCC countries requires protection more than ever. Therefore, it can be argued that the coordination is of a mutual interest. For the GCC it is only rational to stay pegged and continue using the

49 hegemon as a protection shield. The GCC’s currency exchange rate regime involves an economic and geopolitics trade-off. On the one hand, the GCC countries face domestic pressure due to the economic situation caused by the US-dollar peg. On the other hand, if the GCC members act on their economic interests and prevent internal pressure, they have to give up on the US’s protection shield. This might bear problems that will not be easily solved. As the political economy theories argue, the fixed exchange rate regime requires coordination and mutual interests. The GCC’s case finds itself in a mutual interest relationship. Both parties are interdependent in this case and they should cooperate and coordinate their policies. However, the coordination in international relations comes at a cost.

50 Conclusion

I shall now return to my research question: why are the GCC countries committed to the US dollar-pegged currency exchange rate regime? The answer lies in geopolitics and the instability in the Middle East. First of all, the Middle East is very fragile at the moment and more war-torn than ever. Second, Iran’s offensive policy has further exacerbated against the GCC members. Iran supports parties in Yemen and Iraq opposite to the parties Saudi Arabia and the GCC members in general support. Iraq and Yemen share a border with almost all of the GCC members, which destabilizes the latter’s internal security and poses a great threat. The GCC members have neither sufficient nor advanced enough military equipment (despite their massive weapon imports). The GCC members’ population combined is around 51 million whereas Iran has a population of more than 82 million. Although there are many and strong rationales that de-pegging the currency from the US dollar is beneficial to the GCC members’ economy, the reality is that the security and political necessities are greater. Like all other policies, the decision to remain pegged has its advantages and disadvantages. The disadvantage is that the GCC inflation rises and Bahrain’s debt exceeds 100% of its GDP. The inflation rates are now at 3 to 4 % which is not as bad as last 2007 and 2008. Moreover, Bahrain is a small economy with an annual GDP of only 31 billion. Saudi Arabia could bail out Bahrain on any given day without any burdens. As many economists and political analysts have argued and predicated. To answer my research question I can argue, based on the existing literature and analyses, that favoring the US dollar is a rational political decision for the members of the GCC. Any step towards de-pegging would disturb their relationship with the US and eventually destabilize the GCC countries’ security. Therefore, as long as the security threat exists to the GCC countries and the US military remains strong in the region, the GCC states will keep their peg to the US dollar in place. This will keep the GCC countries safe under the security umbrella of the hegemon, the United States of America. Based on the analysis and conclusion drawn, the following topic for further research is recommended: Further research is required to determine the political and economic domestic pressure on the GCC countries and what the consequences of this pressure could be. Additionally, I recommend a comparative case study research for individual GCC members that would provide a better picture of current pressure.

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59 Online Database links

Inflation rate data http://www.imf.org/external/datamapper/PCPIPCH@WEO/BHR/KWT/OMN/QAT/SA U/ARE

US dollar Index https://tradingeconomics.com/united-states/currency

GCC trade with the world and within the GCC data https://www.trademap.org/tradestat/Product_SelProduct_TS.aspx?nvpm=1|||||TOTAL|||2| 1|1|3|2|1|1|1|1

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The World Bank data: GDP share in natural resources https://data.worldbank.org/indicator/NY.GDP.NGAS.RT.ZS?end=2016&locations=SA-QA- BH-KW-OM&start=1970&type=shaded&view=chart

Statistic database: Statista https://www.statista.com/statistics/262858/change-in-opec-crude-oil-prices-since-1960/

60 Appendix

Table 1: US dollar pegged countries

Country GDP Remarks Arbua 2,58 billion USD The Bahamas 9,04 billion USD Bahrain 31.86 billion USD Barbados 4,59 billion USD Belize 1.76 billion USD Curacao 3 billion USD Sint Maarten 1.39 billion USD Eritrea 2.06 billion USD Iraq 171.5 billion USD Jordan 38.65 billion USD Oman 66.29 billion USD Qatar 152.5 billion USD Saudi Arabia 646.4 billion USD Turkmenistan 36.18 billion USD UAE 348.74 billion USD Venezuela 344.33 billion USD No data available from 2015 onwards

61