Kuwait's new dollar peg has dangers (page 3 of 3)

Should these arguments prevail and KD rates become strictly equal to $ rates, NBK's report suggests that CBK would be stripped of an important monetary policy tool to manage capital flows as it had done in the past. More importantly, it would lose sovereignty over monetary policy, whereby it could no longer use its tools to pursue domestic economic objectives besides pegging the KD exchange rate to the dollar.

It is this latter argument that is typically used by opponents of fixed exchange regimes, who are concerned that domestic conditions could vary from US conditions which typically guide US Fed policy and dollar rates. This is also the rationale presented by CBK for opting to maintain a margin for fluctuation for the KD/$ exchange rate. NBK concludes that it would logically follow that the CBK will also choose to allow rates to diverge when market conditions warrant that.

The current environment provides a prime example of the dangers inherent in the convergence of monetary policies when economic and market conditions diverge in two countries. While the US and other advanced economies have been in recession during the last two years, economic growth in Kuwait has been robust. The stock market has also been among the best performing worldwide, gaining 76% over the past two years.

Aside from strong oil revenues, ample liquidity and the lowest interest rates in over 40 years caused credit growth to accelerate, contributing substantially to increased activity in equity and real estate markets. Further reductions in interest rates could only add fuel to asset price inflation and possibly develop a speculative bubble which would have to eventually burst, putting the financial and banking sectors unduly at risk.