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Huge private holdings make central banks less effective

The UAE central bank has been hinting at a currency reserve diversification up to 10 per cent from April this year. The central bank's board met five times this year, and the issue is likely to come up in September when the bank is likely to take a decision.

“The central banks are less important (in GCC) relative to Emerging Asia. The UAE central bank holds foreign reserves worth just $23 billion. A 10 per cent diversification into euro thus accounts for a small $2.3 billion. That pales in comparison to Emerging Asia, which is accumulating reserves worth an average $32 billion every month.”

In the Gulf states, it is the private investment arms that manage the bulk of reserves. According to the report, Abu Dhabi Investment Authority (Adia) is estimated to hold $300-$600 billion. Also, Kuwait Investment Fund (IF) is estimated to hold $130-$250 billion against central bank reserves of $2.3 billion.

The exception is the Saudi Arabia Monetary Authority (SAMA). SAMA is believed to manage the lion’s share of foreign exchange reserve assets. Its balance sheet reports near $200 billion worth of foreign assets, but the actual figure is likely higher. “This makes SAMA worth listening to when it talks about diversification,” the report said.

The GCC is preparing for monetary union in 2010. For this reason, Kuwait switched to a dollar peg from a basket peg three years ago.

That switch was intended to bring its currency in line with other dollar pegs in the region to simplify the convergence process.

The move towards monetary union makes it unlikely that any GCC member will break with the dollar peg before 2010. According to the report a basket peg makes more sense than a dollar peg.

“Two thirds of the region’s imports are denominated in auras and yen. A basket peg would protect the GCC from sudden dollar weakness and a spike in import prices. The logic of a basket peg also grows as the share of reserve assets held in dollar falls.”

Although dollar peg is the most likely outcome of the monetary union, RBS report does not rule out the possibility of a basket peg that is heavily weighted towards euro and yen. There are also concerns about the impact of a basket peg on oil revenues. During periods of dollar weakness, the local currency value of oil revenues would potentially fall. This is a problem for those GCC members that increasingly use oil revenues to develop their non-oil sectors.

Inflation represents the biggest threat to monetary convergence between now and 2010. The dollar pegs mean nominal currencies do not appreciate in response to a positive terms-of-trade shock. The risk is that higher oil revenues spur domestic demand and inflation in turn. That risk is higher as the GCC is spending a larger share of its oil revenues at home relative to earlier oil price booms.

As a result most of the GCC is experiencing faster inflation. This ranges from low-single digits in Saudi Arabia to a high 15-20 per cent rate in the UAE. Asset price inflation is a major driver of inflation currently, mainly through higher rents. A change in the dollar peg would be less useful in curbing this type of ‘home-grown’ inflation.

However, the report notes that the bigger risk is imported inflation. “This was a problem in 2005 after earlier dollar weakness. Prices subsequently stabilised on the resumption of dollar strength. However, a more prolonged period of dollar weakness would spur imported inflation again given that the GCC imports the bulk of its goods.”

In the absence of independent monetary policy, the region’s central banks can only stand back and watch a spike in prices. In the case of GCC the flexibility of controlling the home grown inflation is less in the GCC to offset the imported inflation. However, the reports sees see limited inflation risks for the time being.

“Imported inflation is still modest."

Moreover, asset price inflation is already easing especially as property prices soften on abundant new supply in some economies. If that trend persists it will help offset any future acceleration in imported inflation.