How will the US dollar's decline affect the GCC?

At the moment of writing the Euro was worth 91 US cents, still along way short of USD1.19 in 1999, but a recovery on 85 cents last autumn. It is the same story for other major world currencies. The US dollar appears to be slipping into decline.

For financial markets are adjusting to a US current account deficit of more than USD400bn, and the lack of investment funds flowing into the United States to finance it. Under these circumstances a sharp correction in the overvalued US dollar is inevitable.

That the US dollar is over-valued is evident from price purchasing parity. Take The Economist newspaper's Big Mac Index, which benchmarks the price of a MacDonald's hamburger around the world. It shows 35% overvaluation. For the record the same Index showed that the Euro was overvalued at its launch in 1999 when most commentators thought that the reverse was true.

Now the GCC states all have currencies pegged to the US dollar, apart from Kuwait whose basket of currencies is more widely spread. That means a falling US dollar drags down all the GCC currencies.

Generally a sharp fall in the value of a currency creates inflation, because it requires more cash to buy anything not priced in US dollars. For example, the price of a Japanese car in the UAE will go up if the US dollar falls, the same would be true of foodstuffs from Europe.

In a healthy economy rising prices are past on to the consumer who then passes them on to employers in terms of higher wage costs. So inflation is not usually a good thing for business. It also distorts asset prices, and encourages people to take out large debt positions on property in the hope that inflation will erode the debt while asset prices will rise. Conversely, inflation is usually extremely bad for share prices, although not always.

Normally higher inflation in the United States would be met by higher interest rates from the Federal Reserve. But until the US domestic economic recovery is established, the Fed may well prove unwilling to act. Indeed, a devalued US dollar might be seen as a part of its economic stimulus package, as it will vastly improve the competitiveness of US exports.

However, at some point a falling US dollar would be checked by a rise in interest rates, and so this movement on the currency market probably does herald an end to the current regime of very low interest rates. Rising interest rates are bad for bonds and shares as well as for companies and people with large debts.

In such an uncertain economic climate the initial impact of devaluation is negative with share values and company profits suffering a hit. But this does lay the groundwork for a sustainable recovery. This is the classic J-curve effect, with things getting worse before they get substantially better.

But against a background of strong oil prices, economic reform and high domestic liquidity, the GCC may not have too much to fear from a decline in the US dollar. However, global investors might well be advised to consider whether to bring funds back to the Gulf region.