GCC fixed exchange rate regimes are here to stay

Sizeable foreign reserves underpin currency systems

The sustainability of the fixed exchange rate currency systems in the GCC is starting to be questioned, due to the weakness of oil prices. There are important reasons to believe that low energy prices could undermine the credibility of pegs in the region.
Oil-related products are the main export of Gulf countries, thus, oil prices affect export revenue heavily. The historically persistent current account surplus of the region could actually turn into a deficit, draining foreign reserves of central banks and putting pressure on the pegs.
When fixed exchange rate regimes are under pressure, currencies are prone to suffer speculative attacks as devaluation or the shift to a free-floating regime becomes more likely. Free-floating regimes have several advantages, but would also be an issue for Gulf nations, as currency risks for cross-border trade and investments would be introduced.
Also, devaluation expectations could trigger sizeable capital outflows that would put GCC currencies under further pressure. The effect of low oil prices is already evident in exports revenue throughout the region, and even in the balance of payments (BoP) in Q1 2015. Saudi Arabia and Qatar registered a BoP (current plus financial account balances) deficit of 14 per cent and 21 per cent of GDP respectively, mainly due to a current account deterioration.
Holdings of foreign reserves are the guarantee that makes a fixed exchange rate credible. Saudi Arabia has the largest volume of central bank reserves in the Gulf, both in absolute and relative terms, enough to finance about three years of its imports and nine years of a BoP deficit of 10 per cent of its GDP.
Considering only central bank reserves, the rest of the GCC countries appear to be in a much meagre position. However, sovereign wealth fund assets, usually not included in central bank reserves, could be used for monetary policy purposes.
A portfolio reshuffle, from foreign assets to GCC-currency-denominated assets, could offset a current account deficits through the financial account and boost central bank reserves. Currency regimes in Kuwait, the UAE and Qatar look even more robust than in Saudi Arabia when SWF are accounted for. These countries would be capable of financing BoP deficits of 10 per cent of their GDP for 35, 32 and 16 years respectively.
Even Bahrain and Oman, could withstand relatively long periods of low oil prices, since they could finance up to one year of imports with their national reserves, and five years of an equivalent BoP deficit. Compared similarly-sized economies without floating currency systems such as Singapore or Hong Kong, Gulf states seem well-positioned in terms of reserves.
Authorities in the GCC have enough resources to guarantee the fixed exchange regime in the medium run. However, exchange rate adjustments will also depend on the evolution of oil prices in the long run, and the potential benefits and risks of a devaluation. We expect oil prices to recover gradually in the next 12 months in our baseline scenario. Also, the uncertainty that a devaluation would cause in inward investment would be likely to hurt Gulf nations, which are hoping to boost foreign investment as a strategy to diversify their economies.
Overall, a devaluation looks unlikely. Even so, Gulf countries should implement further long-term reforms to improve the sustainability of their economies and currency regimes. Diversification is particularly important as it would shield the BoP from oil price volatility. Advancing towards a more integrated GCC currency system could also improve financial stability, as the relatively weak reserves position of the smaller countries in the region could undermine the credibility of the whole bloc in case of pressure on the currency system.
Jordi Rof is an economist at Asiya Investments Company. Views expressed by the author are his own and do not reflect the newspaper's policy.