Pressure mounts to drop dollar peg

Issac John (Deputy Business Editor)
Filed on February 6, 2008

DUBAI -The relentless decline of dollar over the past few months and Federal Reserve's interest rate cuts will force Gulf countries to revalue their currencies within months to stem spiralling inflation, currency analysts and experts said.

Speculation about a Gulf-wide revaluation is rising before a meeting between Saudi Arabia's advisory council, the Shura, and the finance ministry and central bank on February 17, according to Steve Barrow, currency strategist at Bear Stearns Co.

"It's going to be very difficult for central banks in the region to have adequate control of monetary policy, and hence inflation, when the Fed is slashing rates left, right and centre and the dollar is slumping,'' Barrow was quoted yesterday by Bloomberg. Inflation in the GCC has reached record high with Qatar reporting a record 14 per cent surge in Consumer Price Index, followed by the UAE, Kuwait and other countries. The regional average was 6.3 per cent in 2007, compared with 0.3 per cent in 2001, according to Merrill Lynch & Co.

Gulf-based analysts point out that most of the currencies of the GCC are undervalued against the dollar, based on their current-account balances, inflation and costs of goods and services. The UAE dirham was undervalued by 10-15 per cent and the Saudi riyal by 25-30 per cent, according to a report by Deutsche Bank AG.

"The dollar peg prevents nominal appreciation. Since the dollar itself has been falling, the result is rising domestic inflation. Some Gulf economies now have inflation rates of around 10 per cent," analysts said. Markets piled pressure on Gulf currencies last year as speculation mounted that more GCC countries would follow Kuwait and abandon links to the weak dollar partly to curb imported inflation.

Barrow's comments come in the wake of similar observations made by Standard Chartered, which said Gulf Arab oil producers could revalue their currencies together if the US dollar weakens further, with appreciations of eight per cent in the UAE dirham and Saudi riyal likely before April.

"The only way out for the GCC countries, unless the Fed reverses course soon or the dollar soars, is to adjust the currency regime with either a free float, revaluation or the adoption of a currency basket,'' Barrow said.

"Central banks can take other measures to try to limit the damage, such as raising reserve requirements, but we are sceptical that this works and we are also concerned that such tactics can adversely affect the banking sector,'' he said.

Analysts said the UAE, Qatar and Saudi Arabia, besides pegging to the dollar, also hold large caches of the currency. A decision to move from a dollar peg to a currency basket, such as Kuwait did in May, could encourage other countries with large dollar holdings to diversify, weakening demand for the greenback.

Calling the Gulf states to “loosen their ties to the dollar,”a leading analyst said nowhere are the dilemmas more acute than in the Gulf, where virtually all the oil-rich states peg their currencies to the greenback. The combination of soaring oil prices and the tumbling dollar is distorting their economies and fuelling inflation,” he said.

“The argument for linking to the greenback was to provide an anchor for the region’s economies, many of which are small, open and financially immature," the analyst said.

"In effect, the Gulf states import America’s monetary policy. The trouble is that a fixed currency makes it hard for oil exporters to adjust to swings in the price of oil. And monetary policy in the world’s largest oil-importer is not always right for those who sell the stuff."

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