Kuwait moves to a US dollar peg

In its latest economic brief, National Bank of Kuwait reports on the change in Kuwait's foreign exchange policy. After twenty seven years of linking the Kuwaiti dinar exchange rate to a basket of currencies, the Council of Ministers passed on October 13, 2002 a draft decree to change its policy to one where the KD would be fully linked to the US dollar.

The new mechanism came into effect on January 5, 2003 as part of Kuwait's commitment within a broader December 2001 agreement reached with the other five members of the Gulf Cooperation Council (GCC) to prepare for the adoption of a single GCC currency by 2010. All the other GCC members already adopt the dollar as an anchor for their currencies.

NBK writes that, on the surface, the change in policy regime appears to be significant, but in practice, little change is expected in the behavior of the KD exchange rate vis-a-vis the US$ or other major currencies. This was confirmed repeatedly by the governor of the Central Bank of Kuwait (CBK) who will be responsible for setting the parity as well as a band within which the exchange rate will be allowed to fluctuate.

On numerous occasions, the Governor of CBK indicated to the press that both the parity rate and the band will represent a smooth evolution of the historic behavior of the KD-$ exchange rate, whereby the band will also ensure a continuation of the relative stability of the KD against major currencies other than the dollar.

Currency regime aside, KD-$ stability derives from to the denomination of oil revenues in US dollars, as well as a major part of the country's foreign assets, not to mention the important volume of imports from the US. This stability will be supported in the future by the country's strong current account position and sizeable foreign reserves.

For almost six years, the KD-$ exchange rate has been fluctuating within a 3% band, between 300 - 309 fils per dollar. During the same time period the KD fluctuated between 20% against the pound sterling, 35% against the Japanese yen and 40% against the euro currencies, mirroring the movement of the dollar.

This occurred despite the fact that the prevailing policy regime called for linking the dinar to a basket of currencies, suggesting that the dollar had a dominant and varying weight in the formula used to set the exchange rate.

Thus, if the CBK were to maintain the same mechanism for setting the exchange rate from January 1st, 2003 onward while maintaining a 3% band around the parity rate, one should not observe any significant change in the behavior of the KD vis-à-vis major currencies including the dollar.

As for the parity rate, it is likely to be near its current level barring no major movements in cross-rates between the dollar and other major currencies. The $-KD rate has been fluctuating between 0.300 and 0.302 fils per dollar since October 13 when the policy shift was announced.

Of course, the CBK could initially choose a wider or narrower band. The Council of Ministers decree does not stipulate that the band cannot be changed once it is set. Irrespective of the initial size of the band announced on January 1st, what matters is the fact that the new regime is not a pure fixed peg, i.e. that the CBK will have some leeway in allowing the rate to change.

The new proposed regime is similar in essence to the European exchange rate system prevailing between 1975 and the time of the adoption of the single euro currency comes to mind. The latter purported to maintain relative stability among their currencies and by pegging them to the Deutsche mark within a 4.5% band around specified parity rates. The parity rates were adjusted several times to correct for misalignments in the monetary and fiscal policies of the different countries, and the band itself was widened to 15% in 1992.

According to the NBK report, up to the time the single currency was eventually adopted, the euro countries shifted their focus to aligning their policies and achieving greater integration among their markets. The GCC countries will need to follow the same path to prevent misalignments from leading to destabilizing capital flows under a currency union. This is of particular importance given the vast divergence among the GCC members policy, economic and regulatory environments.

Thus, Kuwait will be better off maintaining some flexibility in its exchange rate vis-à-vis the dollar and other GCC currencies, and thus some degree of freedom in responding to new developments and pursuing economic goals.

Once economic reforms and liberalization measures are in place and policies and regulations are better aligned among GCC countries moving to a fixed regime or single currency will be possible. This has always been the view of the CBK, which leads us to strongly believe that foreign exchange risk will not be eliminated under the new regime.