A new Middle East currency regime looks inevitable

For as long as most currency analysts have been in the business what has become known as the Bretton Woods II framework has governed the recycling of the US dollar.

In brief, the dollar allows export orientated economies like China to peg at an undervalued exchange rate, and the resulting US current account deficit is financed by the same nations buying US treasury bonds. But this has not been working since this summer.

As recently as June, foreigners bought $100bn in US securities, but this dropped to $20bn in July, negative $71bn in August and $27bn in September. Therefore the crucial recycling of money to support the value of the US dollar has broken down, and we have all seen the result in the falling value of the greenback against other currencies, and it may well get worse.

Chaos coming

What will emerge from the ensuing chaos in financial markets? Further severe dislocations in equity and bond markets do now look inevitable. It is similar to the transition from the pound sterling to the US dollar as the reserve currency in the last century.

Then the pound went through a series of agonizing devaluations - from which it never fully recovered. In the UAE the new federation was initially part of the sterling area on gaining independence in 1971, but when its own currency the dirham emerged a couple of years later the sterling link was dropped in favour of the US dollar.

Gulf countries face a similar choice today. The most likely agenda is first a (preferably coordinated) revaluation of GCC currencies to offset inflation and falling expatriate salaries. Then a shift towards a basket of currencies to value their currencies (again preferably following a united approach based on the existing Kuwaiti model), and a period of floating inter-GCC currency rates.

Gulf riyal

The final stage would be to create a single currency for the GCC, probably with the facility for other Middle East countries to join or align their currencies with the dominant 'Gulf riyal'. The model here is the creation of the euro and the successful extension of the euro bloc to Eastern Europe, greatly aiding economic integration.

There are those who argue that without greater political cooperation it is impossible to have a single GCC currency. But the European Union seems to have managed it despite having many more languages, cultures and diverse economies. The anchor in Europe was the strength of the German economy and for the GCC it would be the great hydrocarbon wealth of the region.

However, currency union does not have to be rushed. The deadline of 2010 is clearly unobtainable and 2015 might now prove more practical.

Greater thought should be given of how to structure the new currency, and in particular whether some type of gold standard should be included to automatically stabilize the management of the new unit and provide an inflation-proof currency.

See also:
Revalue dollar peg, Leaders told
UAE banking sector strong, says IMF
Why revaluation should be top of the UAE agenda to beat inflation