DIFC economic note recommends pegging GCC common currency to a basket of currencies

Titled 'The Exchange Rate Regime of the GCC Monetary Union', the DIFC Economic Note suggested that while the peg of GCC currencies to the US dollar should be maintained for the time being, the new unified currency should be pegged to a basket of currencies at the launch of the Gulf Monetary Union on 1 January, 2010.

Dr. Nasser Al Saidi, the Chief Economist of the Dubai International Financial Centre Authority said:

"The historic GCC Monetary Union will need to be accompanied by a re-assessment of the exchange rate policy that links the currencies of GCC member states to the US dollar. Managing exchange rates against a basket of currencies rather than a single currency will allow adequate flexibility to tailor monetary policy that can address domestic conditions and withstand external shocks. The GCC Common Currency can be an important building block of the emerging post-Bretton Woods global financial architecture. The Gulf Central Bank, (GCB) and currency union in the GCC will be crucial in helping member countries face up to the challenges posed by globalization and the current international financial turmoil."

According to the DIFC Economic Note's analysis, "the trade, output and inflation inter-linkages of the GCC economies with their major trade and economic partners suggests that a common GCC currency should be based on managing a basket of currencies comprising the US dollar, the Euro, the Japanese yen and potentially the British pound." According to it, the weights of an optimal currency basket should be 45% for the US dollar, 30% for the Euro, 20% for the Japanese yen and 5% for the British pound.

The unified currency, The Note said, should be pegged to a basket of currencies with an intervention band of 5% around the central parity. This intervention band could be progressively widened as the GCC Common Currency gains credibility in international markets and the monetary policy framework of the Gulf Central Bank is well understood by the public and tested in its daily operational mechanisms.

Switching the peg to a basket of currencies is necessitated by the fact that the US dollar has constrained the monetary policy independence of GCC countries, The Note said. The peg to the dollar has also limited the options of Central Banks in addressing the global financial crisis that started in August 2007, in particular the contagion and spillover effects on the banking sectors, financial markets and the real economy.

Similarly, the lack of monetary policy independence prevented an effective response to the surge in inflation over the period 2003-2008 and has stood in the way of containing the volatility of the real effective exchange rate, the DIFC Economic Note said.