NCB Capital releases report on 'GCC Currencies - A Square Peg for a Round Hole'

The report explains how the significant changes in the macro environment in recent years have changed key conditions required for hard currency pegs, increasingly making it look like trying to fit a square peg to a round hole.

The most appropriate policy response in their view would be a change of peg to a basket of currencies, simultaneously accompanied with a small one-time revaluation to offset part of the sharp loss in value of local currencies.

Mr. Bryan D'Aguiar, Head of Equity Research of NCB Capital said, "Any move towards a change of the peg to the US Dollar needs to be conducted in a transparent manner, with the components and weights publicly disclosed, in order to avoid speculative pressures."

A larger revaluation would be counter-productive, as it would impair budgetary balances and current account surpluses, in addition to translation losses on the large pool of dollar denominated assets that oil revenues have bought into.

Additionally a move to a free float would not be advisable at this time as the region lacks a well-developed debt market that helps transmit interest rate signals - an important pre-requisite for monetary policy to function effectively in a floating-exchange rate regime.

The report analyses other possible scenarios and highlights the beneficiaries and losers of each.

The report titled 'GCC Currencies - A Square Peg For A Round Hole' is the first in a new series called 'In Focus', aimed at providing investors with independent analysis, views and opinions on key issues facing regional markets.

The report highlights how the GCC central banks have the unenviable task of conducting independent monetary policy in a fixed exchange rate regime that allows for free capital flows. It describes how the decades old dollar-peg has come under increasing calls for a review as falling interest rates, a steady decline in the value of the US dollar against major global currencies, and increased economic prosperity driven by record high oil prices translate into a flood of liquidity into the region driving inflation and increasing the challenges to regulators in effectively managing monetary policy.

"We estimate that the Saudi Riyal, UAE Dirham and Qatari Riyal have effectively depreciated 40%, 37% and 47% respectively in nominal terms since 2002, in a period in which the USD slipped 78% against the Euro. In contrast the Kuwaiti Dinar's peg to a currency basket has limited its depreciation to 23%,"

according to Mr. Bryan D'Aguiar.

Interestingly, the report suggest that any revaluation would will not have a material impact on cushioning inflation in the short term, but would help achieve greater currency flexibility, a critical pre-condition for monetary-policy maneuverability. More importantly the current situation is an opportunity to push forward a structural change. In the event that a global slowdown materializes and oil prices decline, GCC surpluses will shrink. The burgeoning wage-bills and subsidies that have helped ward-off inflation thus far will become increasingly difficult to sustain thus making currency flexibility a critical policy tool.

Any revaluation would benefit global investors, capital-intensive industrial projects, companies with external liabilities, GCC importers and regulators. In contrast central banks would stand to lose as would exporters, investors, sovereign wealth funds, financial institutions and companies with dollar-assets, investments or foreign subsidiaries.