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Revaluation risk may squeeze dollar further

Speculation about the dollar peg hogged the headlines in recent sessions after Saudi Arabia kept interest rates unchanged despite the Federal Reserve slashing benchmark rates by a half percentage point last month.

Saudi Arabia later said it was keeping its riyal currency tied to the dollar, although that has not prevented the market from speculating that one of the Gulf countries could revalue its currency in the near term.

Yesterday, one-year forwards in currencies such as the dirham, the United Arab Emirates' currency, were pricing in a roughly 0.7 per cent rise in the local unit versus the dollar. On Tuesday, markets had priced in a 0.8 per cent revaluation, the highest in more than a decade.

"One concern here is that the Gulf States would transfer its stock of assets that are dollar-based into other currencies. That would be a reserves transfer and could hurt the dollar," said Teis Knuthsen, head of forex research at Danske Bank in Copenhagen.

The Gulf states, most of which are members of the Organisation of Petroleum Exporting Countries, invest nearly 25 per cent of their oil revenues, or so-called petrodollars, in dollar-denominated assets, according to a study by the Federal Reserve Bank of New York early this year.

The euro would be the biggest beneficiary should Gulf states shift reserves since the eurozone is one of the Arab region's biggest trading partners. Eurozone exports to all oil producing nations, including those in the Gulf, had climbed $77 billion to hit $167 billion from 2002-2006, the NY Fed study said.

Further adding to revaluation talk has been the dollar's generalised weakness, which was exacerbated by the Fed's rate cut. That has led to risks of rising imported inflation for the Gulf States.

Saudi Arabia, for instance, has an inflation rate of 3.8 per cent, Oman's is 5.9 per cent and the United Arab Emirates' is as high as 7.7 per cent.

If the dollar drops further and Gulf currencies fall with it, the region will import inflation from its trade partners in Europe, whose euro currency has surged to record highs against the dollar. Analysts say this means calls for flexible exchange rates are not that outlandish.

Except for Kuwait, which in May dropped the dollar peg in favour of a basket of currencies to ward off imported inflation, the remaining five states of the six-nation Gulf Cooperation Council (GCC) have kept their currencies linked to the dollar.

The United Arab Emirates, Saudi Arabia, Oman, Bahrain, and Qatar have agreed to keep the dollar peg until monetary union in 2010. By keeping the peg, the Gulf currencies have become undervalued against the dollar by about 20-25 per cent, according to ING estimates.

Implications for global capital flows

"The Opec states' defection from the dollar could potentially have far greater implications for global capital flows," said Jan Amrit Poser, head of research at Bank Sarasin in Zurich.

"With ($3.5 trillion), the currency reserves of the oil-producing nations are roughly three times the size of China's, and their current account surplus of $500 billion is more than twice as high," he added.

A diversion of even part of this financing base would further undermine the dollar, which has been hammered by the large and growing US current account deficit, analysts say.

Already, Qatar's $50 billion sovereign wealth fund has cut its exposure to the dollar by more than half to around 40 per cent of its portfolio over the past two years.

To be sure, not everyone in the currency world believes in the dollar would be hit that hard by a Gulf revaluation.

"Even if they do de-peg, they're not going to move in a speedy manner. They're going to be slow and gradual and therefore this is not a near-term threat to the dollar," said Divyang Shah, head of global FX research at Commonwealth Bank of Australia.

"If you allow too much flexibility or build expectations for too much flexibility, then you get more inflows and more inflation problems," he added.

Still, some analysts are convinced the UAE will be the next country to revalue after Kuwait given high inflation and a diversified economy less reliant on crude.

"The Gulf pegs are considered sacrosanct, but markets are betting against them because the dollar is in a broad decline and there's more pressure than usual, so the local authorities may be a little more open to an adjustment," said Chris Turner, head of global forex strategy at ING Capital Markets.