Policy Briefing February 2018 Sustaining the GCC Currency Pegs: The Need for Collaboration Luiz Pinto Sustaining the GCC Currency Pegs: The Need for Collaboration Luiz Pinto The Brookings Institution is a private non-profit organization. Its mission is to conduct high-quality, independent research and, based on that research, to provide innovative, practical recommendations for policymakers and the public. The conclusions and recommendations of any Brookings publication are solely those of its author(s), and do not necessarily reflect the views of the Institution, its management, or its other scholars. Brookings recognizes that the value it provides to any supporter is in its absolute commitment to quality, independence and impact. Activities supported by its donors reflect this commitment and the analysis and recommendations are not determined by any donation. Copyright © 2018 Brookings Institution BROOKINGS INSTITUTION 1775 Massachusetts Avenue, N.W. Washington, D.C. 20036 U.S.A. www.brookings.edu BROOKINGS DOHA CENTER Saha 43, Building 63, West Bay, Doha, Qatar www.brookings.edu/doha Sustaining the GCC Currency Pegs: The Need for Collaboration Luiz Pinto1 From June 2014 to January 2018, oil prices This policy briefing examines the fundamentals plummeted from $115 per barrel to $68 per of the GCC currency pegs and the capabilities barrel, a 41 percent decline. Prices reached of monetary authorities to sustain them over a low of $28 on January 19, 2016.2 As a time. It argues that, although fixed exchange result, the oil-exporting countries of the Gulf rate regimes are still optimal for all the GCC Cooperation Council (GCC) faced the longest states, the ability of policymakers to support period ever recorded of monthly consecutive the pegs varies markedly across the region. The losses in foreign-exchange reserves.3 For the balance of payment pressures caused by lower 2015–2017 period, the GCC accumulated oil prices and heightened geopolitical risks have an estimated $353 billion in fiscal deficits, generated “peso problems” and increased the $76 billion in current account deficits, $270 chances of liquidity crisis and currency events, billion in foreign-exchange reserve losses, and particularly in countries with less financial a reduction of $213.3 billion in sovereign buffers and a lower ability to tighten fiscal financial net worth.4 policies over the short term. As the recent shock in oil prices has As a currency event in one of the GCC states been dominated by long-run structural may have a contagion effect on others, and transformations in the supply side of global given the asymmetries in economic size, reserve oil and gas markets, the sustainability of the adequacy, and macroeconomic imbalances fixed exchange rate regimes in the GCC has in the region, further regional financial been under question.5 In fact, over the last 43 cooperation is necessary. However, political and months, foreign exchange markets in some diplomatic disputes, amplified by the current GCC states were under considerable pressure. blockade on Qatar imposed by Bahrain, Saudi Spot markets were more volatile, and 12-months Arabia, and the United Arab Emirates (UAE), forward premiums spiked. During this period, make regional cooperation difficult. In the Oman and Bahrain reportedly requested GCC last section, this briefing introduces policy financial support to defend their pegs, Saudi alternatives for the creation of liquidity support Arabia imposed additional regulatory controls arrangements under the current scenario on forward market operations, and Qatar had of political divisions and presents possible to tackle a major financial shock produced by roadmaps for future developments under regional geopolitical events. different regional scenarios. 1 Luiz Pinto is a joint fellow at the Brookings Doha Center and Qatar University. He is also a co-founder and managing director of the advisory firm Brics Overseas. 2 Numbers reflect the Brent crude oil spot price, a global benchmark price for crude oil. Data was obtained from Bloomberg, accessed January 9, 2018. 3 Author’s calculation based on data from national central banks. 4 Author’s calculation based on data from national central banks and monetary authorities, the International Monetary Fund’s (IMF) Inter- national Financial Statistics (IFS) and World Economic Outlook (WEO), sovereign wealth funds, and Haver Analytics; best estimates from the Sovereign Wealth Fund Institute. 5 Aasim Husain et al., “Global Implications of Lower Oil Prices,” IMF Staff Discussion Note, July 2015, https://www.imf.org/external/pubs/ ft/sdn/2015/sdn1515.pdf. 1 ORIGINS OF THE CURRENCY PEGS IN THE GCC EcoNOMIC FUNDAMENTALS OF THE GCC CURRENCY PEGS The current exchange rate regimes in the GCC are a product of the collapse of the Sterling Area Traditionally, exchange rate regimes in the late 1960s and the par-value system in are constrained by the monetary policy the early 1970s. While most countries moved trilemma—a tradeoff between exchange rate toward greater exchange rate flexibility following stability, monetary independence, and capital the disintegration of the Bretton Woods market openness. In this sense, fixed exchange System in 1971–73, the GCC states opted to rate regimes are only sustainable if they are anchor their currencies to a stable international combined with capital controls or with a reference. After a period of Gulf-wide currency passive monetary policy. As globalization tends revaluations and adjustments during the oil to make comprehensive capital controls ever boom and following the depreciation in the more ineffective or undesirable, currency pegs value of the U.S. dollar (USD) in the 1970s, are often associated with limited monetary Bahrain, Qatar, and the UAE hard-pegged their independence. Under fixed exchange rate national currencies to the USD at the current regimes with full capital mobility, central banks rates of 0.38, 3.64, and 3.67, respectively, have to observe the interest parity condition between October 1978 and November 1980. (i.e. follow suit with changes in the interest rates Oman adjusted its hard peg to the USD to the of the issuer of the anchor currency). If business current rate of 0.38 after devaluing the Omani cycles within the “currency area” are not rial in January 1986. Saudi Arabia hard-pegged synchronized, the costs of maintaining interest to the USD at the current rate of 3.75 Saudi rate parity can rise, producing pro-cyclicality riyal just after a smooth devaluation between and high volatility in inflation and growth. June 1981 and June 1986. Finally, by fixing the Kuwaiti dinar to an undisclosed currency basket GCC states faced this “mundellian trilemma” in which the USD clearly had a dominant during the period of high growth in the 2000s position, Kuwait was the only country in the and especially during the peak of the international region to rely on a “softer peg” to the USD. financial crisis in 2007 and 2008, when their central banks were not able to control inflation In 2003, amid GCC discussions about the and non-hydrocarbon GDP growth, despite the possibility of creating a common currency quantitative measures they took. It was in this by 2010, all members decided to officially context that Kuwait decided to move back to a transform their de facto peg to the USD into slightly more flexible peg in 2007. a de jure peg. Kuwait, however, re-pegged to an undisclosed currency basket in 2007 in However, despite the aforementioned issues, response to inflationary pressures caused by the petro-pegs have served the GCC states well. depreciation of its real effective exchange rate. Inflation expectations have been anchored, real Ultimately, the monetary union did not move effective exchange rates have remained stable, forward because Oman opposed the public debt and balance sheet risks and transaction costs limit set as a condition for integration, and the have kept low. By providing nominal stability, UAE objected to the dominant position Saudi the exchange rate regimes of GCC states have Arabia wanted to play in the proposed regional boosted the credibility of monetary authorities central bank. Current political and diplomatic and favored long-term GDP growth. In fact, over disputes within the GCC make the prospects the long run, the GCC outperformed advanced of further pursuit of a monetary union unlikely economies and emerging markets both in terms in the future. of GDP growth and monetary stability. 2 Sustaining the GCC Currency Pegs: The Need for Collaboration A closer look at the fundamentals of GCC 5. GCC governments exert indirect economies would support the idea of fixed control over the assets of entities that exchange rate regimes based on conventional are technically sovereign by extension. pegs to the USD as the optimal macroeconomic Those include the non-state assets policy framework. The reasons are grounded in of firms and individuals whose main eight main points: activities are national and rely on kinship of the royal families and their 1. As small, open, oil-dominant economies prime allies and connections. This in which per capita hydrocarbon makes the liabilities of the public sector production is high, GCC states tend de facto limited by assets that are private to have large and structural fiscal and but “sovereign by extension.” current account surpluses, allowing them to accumulate sizable war chests and hold 6. Fiscal policies are efficient in rebalancing positive net international investment the economy while the political risks of positions.