Kuwait's new dollar peg has dangers (page 1 of 3)

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.