DUBAI (Reuters) – No matter how convincing a case a sinking dollar, soaring inflation and U.S. interest rate cuts may appear to make for Gulf Arab currency reform, the oil producers are not quite ready to tinker with their dollar pegs.
Concerns over the future of their dollar assets, fears about what a move would mean for their alliance with Washington and questions over how effective any new currency regime would be in controlling inflation are forcing central banks to tread softly.
With Gulf states preferring to act together on currency policy as they prepare for monetary union, investors betting on revaluations could find they have to wait a year or more before they are vindicated.
“I don’t think that change is imminent,” said Simon Williams, regional economist in Dubai at HSBC. “Some states may be persuaded by arguments for change but I don’t sense that they are on the brink of acting.”
Speculation that Saudi Arabia and four neighbors would ditch fixed-exchange rates has been mounting since Kuwait severed its dollar peg in May to contain inflation.
Since then case for currency reform has only grown stronger.
The dollar has extended a record-breaking slide on global markets, plunging more than 16 percent against the euro and almost 13 percent against a basket of major currencies since Kuwait’s May 20 move, driving up the cost of many Gulf imports.
Inflation has surged across the region, almost doubling in five months in Saudi Arabia to a 27-year high of 8.7 percent in February. The combination of rising prices and falling purchasing power triggered riots by migrant workers in the United Arab Emirates and Bahrain.
And Gulf central banks have been cutting interest rates to deter bets on currency appreciation as the Federal Reserve slashed borrowing costs by 3 percentage points since September to stave off U.S recession after a mortgage market meltdown.
With more Fed cuts and dollar weakness looming it is little wonder investors expect Gulf pegs to crumble in months. Forward contracts showed investors expecting the Qatar riyal and UAE dirham will rise 4.2 percent and 3.3 percent in a year.
“There have been several arguments made against a revaluation — however we do not find them compelling and we dismiss them,” Standard Chartered Bank said in a March note.
“We view rising inflation as the biggest risk to achieving sustainable growth. Monetary policy needs to tighten,” said the bank that expects Qatar and the UAE to revalue as early as April.
Compelling as the case for reform may be, it is not that simple.
For one thing, the dollar peg is only one strand in a web of diplomatic, economic, political and security interests that bind the Gulf Arab oil producers to the United States.
The Gulf states, most hosting U.S. military bases, share Washington’s suspicion of Iran, including of Tehran’s nuclear program, and fears about Islamic militancy.
After Al Qaeda leader Osama bin Laden, battling to overthrow the U.S.-allied Saudi monarchy, criticized dollar pegs as “unjust and arbitrary” in a December video, economists said the Gulf’s commitment to pegs could strengthen.
Even if there were no political overtones to currency reform, any attempt by the Gulf, with its $1.2 trillion in state funds and reserves, to shun the dollar, could deliver a kick in the teeth to a U.S. currency battered by flurry of bad news.
“They cannot act in a way that is negative to the dollar,” said John Sfakianakis, chief economist at Riyadh-based SABB Bank, an HSBC affiliate.
“The United States provides security to the region and that does not come at zero cost. Iran is a huge factor and they are all scared because all of them are exposed,” Sfakianakis said.
Besides, the bulk of the Gulf state funds are probably invested in U.S. assets. Anything that hurts the dollar, would also hurt the Gulf.
Then there are concerns about whether any new currency regime would help contain inflation, driven in part by a surge in state spending of record oil and gas revenue.
Achieving consensus on any spending restraint in the UAE, a federation of seven highly autonomous emirates will be difficult, said Malcolm D’Souza, head of treasury at the National Bank of Ras al-Khaimah.
“The central bank is watching the situation but it may not have the power to do anything,” he said.
There is fear of change. Governments still see the pegs as a source of stability. Saudi Arabia fears currency fluctuation would deter investment when it is wooing foreign capital to create jobs, the vice central bank chief said last month.
The Saudis, who ran budget deficits throughout much of the 80s and 90s fear any appreciation of the riyal would reduce the local currency value of dollar-denominated oil revenue.
Qatar and UAE, with the biggest inflation problems, are reluctant to break ranks with Saudi Arabia, the largest Arab economy, a move that could effectively kill off plans for regional monetary union by 2010.
Both Qatar’s prime minister and the UAE central bank governor have called since November on the region to move together toward currency reform, although the UAE has since backtracked on those remarks and now toes the Saudi line.
So Gulf States will likely wait before pressing ahead with any reform, watching perhaps for a period of dollar stability, less frenetic market speculation or more importantly signs of serious discontent at home.
“Currency reform will happen at the point when it becomes politically difficult to maintain the status quo,” said Caroline Grady, an economist at Deutsche Bank, which expects the UAE and Qatar will start tracking currency baskets this year.