Inflation puts the dollar pegs in focus

Interest rates rose across the Gulf at the end of March after the US Federal Reserve raised rates by a further 25bps to 2.75% - Gulf interest rates broadly track US rates due to currency pegs to the US dollar. As we have written elsewhere we expect US rates to reach 3.75% by September. This means that Gulf rates will also continue to rise throughout 2005. However the surprise decision by the Saudi Monetary Authority (SAMA) to raise rates by 50bps, 25bps more than the Fed, highlights the risk that rate rises in the Gulf may outpace US rate increases.

We have long cautioned that Gulf central banks could raise interest rates more aggressively than the US in order to cool booming local economies - regional growth is currently at a ten- year high. High oil prices, strong domestic investment and a weakening dollar have left the region awash with liquidity. Saudi M3 money supply growth hit a 10-year high of 17% in 2004. While liquidity has been good for investors, helping lift equity and real estate valuations across the region, it has also pushed up rentals and the cost of living. Inflationary pressures have been compounded by the weakening dollar, which has increased the cost of imports.

We estimate that the cost of living for expatriates in Dubai rose by at least 8% y/y last year. According to the Qatar Chamber of Commerce and Industry, inflation in Qatar rose by 9.5% y/y in 2004. Official numbers in Saudi Arabia shows inflation well contained but probably do not capture the full extent of price rises in the Kingdom. Kuwait's Central Bank Governor Sheikh Salem Abdulaziz al-Sabah also warned in early March about growing inflationary pressures. It is a similar story across the rest of the region.

As a result, investors should prepare for higher Gulf interest rates in the short term. However there is a limit to how far Saudi and the other Gulf States can raise interest rates compared to the US given their currency pegs to the US dollar and open capital accounts. This presents something of a dilemma, especially if the pace of US interest rate hikes is insufficient to deal with domestic liquidity pressures in the Gulf.

Unfortunately the other commonly used central bank policy tool of sterilising FX inflows (ie issuing short-term debt to mop up excess liquidity) is not currently an alternative option as the region's money markets are not developed enough to allow this to be done effectively. Moreover in Saudi Arabia's case the government's desire to reduce domestic public debt runs counter to the use of sterilisation.

This leaves only one real option, exchange rate adjustment. Gulf currencies have been pegged to the US dollar at a fixed rate, for a considerable period of time - in some cases rates they have not changed for twenty years. Could a combination of a three-year dollar bear market and high domestic inflation prompt a change? Kuwait's decision to revalue its currency by 2% against the dollar in January certainly showed that it is possible. While Kuwait has traditionally had the most active FX policy in the Gulf (before January 2003 the KWD traded within a +/-2.5% band) the move underlines that the risk of other revaluations in the Gulf cannot be entirely discounted.

A more dramatic abandoning of the US dollar peg and moving to a basket of currencies or a flexible exchange rate is also possible, although probably not in the near term. This would not be done lightly. Across the Gulf, dollar pegs have successfully provided broad based macroeconomic stability for the last twenty years. The pegs have endured both periods of dollar strength and weakness largely unchanged.

However the dollar's continued decline of the last three years has led to increasing debate about the continuing efficacy of the USD peg. So far any discussion of abandoning it has been linked to a single Gulf currency, something that is at least five years away. Saudi Arabia, the largest Gulf economy, appears to remain opposed to any switch from the dollar but the consensus across the Gulf may be shifting. During recent pan-Gulf discussions, the UAE officials publicly declared that any new currency would probably be floated soon after its launch.

Investors, institutions and corporates are unlikely to need to worry about the USD peg going anytime soon. But if they are looking at hedging medium- to long-term risk they need to follow these developments carefully. A switch away from dollar pegs would certainly mean higher local interest rates for one. The international implications - particularly in terms of the pricing of oil - could also be far reaching. One thing is clear, however, Gulf countries will continue to seek more flexibility in their monetary policy in order to manage the current economic boom and attendant inflationary pressures.