GCC: Full steam ahead to monetary union (page 3 of 3)

Some officials appear to favour a continuation of the USD peg. Other officials have indicated a floating currency may provide the GCC countries with significant benefits. We concur as such an arrangement would allow the authorities to either denominate oil sales in the new local currency or even a portfolio of foreign currencies, rather than be attached to a still structurally weak USD. This should ensure greater stability in terms of the region's spending power in international markets.

Therefore, our favoured route is for the new GCC currency to be floating, possibly with reference to a trade-weighted basket of currencies. However, for a region used to a USD peg, and thus stability, this may prove to be a step too far, at least initially.

What is clear is that the historical confidence in currency pegs versus the USD is likely to diminish until further clarity is provided. This could have significant implications for hedging behaviour in the region. In the UAE, for example, most companies hedge their dirham interest rate exposure using the US dollar swap curve as it is a slightly cheaper way to hedge. However, as the possibility of greater exchange rate volatility looms, this becomes more risky as companies become more exposed to the currency mismatch of such behaviour.

Also, with inflation in the region generally higher than that in the US, it would make sense for the divergence in US and regional interest rates to widen over time. Of course, it is tempting to continue to hedge in USDs as 2010 is still a long way off. However, this has to be balanced by the fact that the markets will likely move well before that date depending on market expectations of what form the new exchange rate mechanism will take. Therefore, over time, we expect local currency hedging instruments to become increasingly important and liquid.