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The Road to ‘Al Khaliji’ is Not Risk Free

Weak dollar could even end up destabilising the bond and credit markets, only when the first signs of some stability were on the verge.

Meanwhile, the Gulf Cooperation Council (GCC) plans to live up to its promise to finalise a roadmap for a single currency, likely to be called the “Al Khaliji” by January 2010 in a meeting on December 29-30 in Oman. The GCC summit would also finalise the modalities of setting up a GCC Monetary Authority.

One can argue the timing, but no use delaying the inevitable, as challenging conditions in the global currency markets might not change anytime soon. And the benefits are too many to ignore — reduced transaction cost, ease of movement of labour and goods, enhanced foreign investment potentials, to state a few.

But there are risks to be ware of.

By cutting its benchmark rates to virtually zero and promising to hold them there until the economy recovers, what the US Federal Reserve has created is near-perfect conditions for a one-way bet against the US dollar, and a possible round of competitive devaluations from Central Banks across the world.

The Bank of Japan responded by a cut of its own, bring its rate just a breath away from zero, and it would be interesting to see how long the European Central Bank can hold and see its currency appreciating in a world suffering recession.

The Fed’s decision has sent a clear signal that borrowing to short the dollar will remain cost-free for an extended period. As a result, the dollar risks replacing the Japanese yen as the new funding currency of choice for carry traders. To speculate against a currency, you need to be able to borrow it cheaply and in large amounts. The Fed has now guaranteed both. And going by the 10-year treasury yield, around 2.13 per cent, the bond market is predicting no threat of inflation or hopes of growth for years to come. So the zero rate policy is likely to stay in the US at least and dominate trading patterns in the currency markets.

What the Al Khaliji would do is knit together the six-member GCC into a trillion dollar economy which would be regarded as the world’s largest exporter of oil.

That will leave little room for escaping from the risk of Al Khaliji becoming a commodity currency, like the Canadian dollar or the Australian dollar. And because the six-member GCC would be an economy growing at a much faster pace than the economies of the funding currencies, for example, the United Stated and Japan, Al Khaliji risks becoming a carry trade – a currency speculators would hold to earn relatively higher interest rates. Key interest rates in the GCC are in the range of 1.50 per cent to 2.5 per cent.

What GCC policymakers need to do is to immediately start educating the market about how the new Monetary Authority will manage the currency? Will the unified Central Bank pursue an independent monetary policy? Will it target inflation or growth and employment?

There is an economic hypothesis called the “Impossible Trinity” which states that it is impossible to have all three of the policy imperatives — fixed exchange rate, free capital flow and an independent monetary policy – at the same time.

So the new Central Bank will have to make the choice and let the market know.

January 2010 may seem far away. But currency markets will start positioning themselves as soon as they get a definitive launch date for the currency. Understand, the currency markets were the first to identify that there was something wrong with the US economy. They had been selling the dollar since 2002, virtually without respite. The currency traders are the only ones in the global investment banking community that will go home this Christmas with their jobs and a much fatter bonus then any of their peers.

The GCC Monetary Authority would have to establish its credibility right away.

Most European Central Banks had a lot more in credibility when they decided to go for the ECB and the ECB kept euro as an electronic currency for almost four years before turning it into a physical one.

ovais@khaleejtimes.com