Currency revaluation back on the agenda

This is the first time that the US Treasury's global currency outlook has examined the GCC and it recognizes the obvious inflationary pressures that the dollar-peg is putting on the Gulf States.

'We believe the addition of the GCC to the summary and expanded section in the report shows the US is comfortable with the US dollar effect of GCC forex regime change,' said Merrill Lynch.

'We believe this gives an implicit US green light for change.'

Its analysts argue: 'Some adjustment to real effective exchange rates in the region - especially in the UAE and Qatar - is taking place through rising prices.' But they believe revaluation would be a far better option and dampen inflation.

GCC revaluation call

However, Merrill Lynch has been a cheerleader for revaluation for sometime and has recommended dirham deposits to its UAE clients against Central Bank declarations that no revaluation was imminent or even under consideration.

Is this wishful thinking on the part of Merrill Lynch and a case of making rather too much out of a report from the US Treasury which just happens to consider a serious issue in currency markets?
It is easy to be dismissive.

But inflation remains a mounting problem across the Gulf States and is highest in the UAE and Qatar.

The primary cause is the rising cost of accommodation due to supply constraints, according to central banks.

However, even they concede that imported inflation due to an undervalued currency is the second most important cause.

Gulf countries are all running double-digit inflation, and wholly inappropriate low interest rate regimes due to the dollar-peg. A move to a basket of currencies like Kuwait - which enjoys lower inflation than the other Gulf States - is widely recommended by economists.

Gulf economic bust to come

They argue that the maintenance of the current exchange rate regime stands ultimately to damage Gulf economic interests by producing a boom-to-bust economic cycle of significant proportions.

For very high inflation levels distort investment into real estate and financial services, starving other sectors of resources, and then inflate asset prices to bubble levels that are unsupportable in even the most minor setback such as a dip in the oil price.

This is the sort of magnified economic cycle typical of emerging markets and something that the industrialised economies sought to avoid until the 2000s. However, in recent years the explosion of credit in industrialised countries has now left them exposed to a similar downswing.

Preemptive action by Gulf central bankers to keep the region's economic boom under some kind of control through revaluation and currency reform is therefore something local business and finance ought to welcome.

See also:
What will a GCC currency union look like in 2010?
When will the global financial crisis impact the Middle East?