Kuwait's new dollar peg has dangers

As a matter of policy, domestic interest rates in Kuwait have tended to exhibit a high degree of correlation with US dollar rates over the past two decades.

This linkage stemmed primarily from the prevailing exchange rate policy that, up until the beginning of 2003, pegged the Kuwaiti dinar to a basket of currencies of the country's major partners in trade and financial relations, with the US dollar having a dominant weight.

The recent move to link the KD exchange rate to the dollar is unlikely to change the relationship between interest rates for the two currencies, nor does it imply the need to maintain strict equality between these rates in the future.

With interest rates at their lowest in nearly 40 years, any further reduction in KD interest rates would fuel speculative trading in the local stock market that has already witnessed major advances in all indices over the past two years. There is a real danger of a stock market bubble that would eventually burst not unlike 1997 or even 1982.

Though KD interest rates followed movements in US dollar rates in the past, they were rarely at parity with them. Over the past decade, KD interest rates have generally been higher than dollar rates. The positive differential has generally been viewed as a premium necessary for maintaining exchange rate stability and for managing the outflow of surplus liquidity in light of free capital mobility and low absorptive capacity in the country.

Generally, a positive differential in favor of the KD suggests downward risk for its exchange rate vis-à-vis the dollar (and vice-versa). In such a case, the spread is typically wide enough to stem capital outflows and at the same time provide borrowers with no incentive to borrow cheaper dollars when their future cash flows to be used in debt repayment are KD denominated.

The NBK brief states that despite the shift in exchange rate policy to linking the KD to the dollar as of the beginning of 2003, KD and dollar interest rates need not converge as the new regime (examined in an earlier NBK Economic Brief) will maintain a margin for the KD-$ exchange rate to fluctuate within.

Theoretically, the interest differential could be as wide as the band around the parity exchange rate set by the Central Bank of Kuwait (CBK), which allows for a margin for fluctuation in the KD/$ exchange rate of +/- 3.5% around the parity of 299.63 (or a total of 7%). Most likely, the spread in the current environment will fluctuate between 0.5% and 1.5% depending on domestic market conditions.

In its economic brief, NBK reviews Kuwait's interest rate policy over the past two decades. The report notes that up until 1986, KD interest rates were generally lower than dollar rates. A bad debt overhang arising from the stock market crash in 1982 followed by a collapse in oil prices in 1986, not to mention political problems that led to the dissolution of the national assembly that year, prompted the CBK to bid for KD funds in the interbank market to stem capital outflows and pushed KD rates above dollar rates.

The CBK also used other measures including guaranteeing depositors funds and shareholders equity in banks. The spread fluctuated between positive and negative territory until the Iraqi invasion in 1990. Both lending and deposit rates were tied to the discount rate at the time.

Following the liberation of Kuwait, the CBK maintained higher domestic rates in line with its objective to restore and maintain confidence in the KD and prevent capital flight. For much of 1992 and 1993, the CBK maintained a high differential between domestic and $ interest rates. The policy worked and the value of the KD was stabilized.

By late 1993 the CBK allowed the differential to start narrowing with no negative impact on the KD/$ exchange rate. Indeed, the KD appreciated against the dollar for most of 1993 and 1994 despite the narrowing differential.

NBK's brief presents a chart showing that the CBK attempted to keep a 1% - 1.5% differential in favor of KD interbank placements with one-month maturity between 1994 and 1999, when it let the differential narrow and even turn briefly negative. But since March 2001, the spread widened again.

In general, the CBK has been taking market conditions into account in guiding interest rate movements. Between 1994 and 1997, the Kuwait Stock Exchange was shooting up with annual gains in excess of 39%, while credit growth averaged 36% per annum.

The CBK kept interest rates high to stem excessive speculation in the local stock market, while encouraging private capital to stay home to meet growing credit demand associated with privatization and the bad debt settlement program that were squeezing liquidity.

With the collapse in oil prices in 1998 and the Asian crisis, the prices on the KSE plummeted and remained depressed for 3 years, with many initially criticizing the restrictive monetary stance as an impediment in the quick revival of the market. By early 1999, the CBK followed a more accommodative policy that was facilitated by vast inflows of compensations to the private sector from the UN for losses due to the Iraqi invasion.

Even as the domestic money supply shot up and $ LIBOR rates rose, the CBK kept the discount rate steady helping guide KIBOR rates lower. This caused the spread between KD rates & $ rates to stay between zero and 0.5 percent until 2001.

Since that time, dollar rates have fallen more sharply than KD rates. Again domestic economic and financial conditions that were quite robust prompted the CBK to ease rates slower in Kuwait to prevent and already buoyant market from over-heating.
NBK expects that UNCC payments to the private sector to be completed in a year or two.

Consequently, excess liquidity in the market is likely to be slowly absorbed. Add to this the uncertainty surrounding the Iraq situation, domestic conditions are likely to remain in favor of a positive interest rate spread in favor of the KD.

Given that CBK's interest rate policy aims at managing capital flows, it tends to monitor the spread in rates on customer deposit in domestic and foreign currency. The graph below shows these spreads generally followed the interbank market, though were mostly lower.

Currently, deposit rates are market determined. However, prior to February 1995 the CBK imposed a minimum rate that banks must pay on deposits linked to the discount rate. Lending rates on the other hand continue to be tied to the discount rate through a ceiling imposed by the CBK.

The ceiling is 2.5% above the discount rate on loans and facilities of less than one year in maturity; and 4% above the discount rate for loans with maturities longer than one year. This ceiling is not binding since most borrowers with good credit risks borrow below the ceiling.

With the recent move to link the KD to the dollar, there has been some speculation that interest rates on the two currencies would have to converge. Arguments for equality between KD and dollar interest rates range from the fact that a positive spread would imply potential depreciation in the KD, which need not be the case under the new exchange rate regime, to more extreme interest arbitrage once foreign banks enter the market.

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.