'D' is for diversification (page 2 of 2)

Now some in Congress are apparently trying to block Bush's nuclear deal with India, in part because of India's relationship with Iran. And they are also threatening to block the bilateral trade deal with Oman. While the UAE has been keen to stress that talks with the US on its proposed trade deal will resume shortly and will hopefully conclude by mid-year, the authorities must during concerned that any deal agreed during these negotiations may face similar treatment to Oman or the DPW issue.

This is clearly encouraging the already emerging trend of countries in the region diversifying their trade and investment ties to other countries or regions. For instance, the GCC is expected to start trade negotiations with Japan and India while its talks with the EU are expected to conclude in May. Meanwhile, many companies are not waiting for trade agreements to be in place. UAE-based property developer, EMAAR, is the best example of this with its decision to focus on investments in the rest of the Middle East, North Africa and South Asia. Indeed, EMAAR has recently announced its decision to invest between USD 5-10bn in the next few years into Turkey. At the national level, Dubai has indicated that it intends to invest USD 20bn into Morocco, again largely in the area of property development with EMAAR involved.

The final area of diversification is the desirability or need for countries to diversify their economies away from an over-reliance on the hydrocarbon sector. The level of pressure deviates from one country to another, but very young populations require a large number of jobs to be created across the region. Naturally of greater concern are the poorer and more populous nations such as Saudi Arabia and Iran, although it is an issue that will need to be addressed across the region.

The interesting thing to note is that all of these areas of diversification are consistent with plans for greater currency flexibility. The development of local currency bond markets would increase the incentive to borrow locally rather than expose themselves to the currency risk of borrowing in international capital markets. This would also have the benefit of helping to develop the local financial systems in the region.

FX diversification makes sense from a portfolio management point of view, but especially in the case of a floating currency, especially were this to follow a trade-weighted basket mechanism that we have been suggesting for some time now. (see, for example, Middle East Focus: The case for currency reform - December 2005)

Finally, the diversification of trade both geographically and away from a commodity that is priced in USDs would suggest that the peg to the USD will make less sense economically going forward. We are not suggesting that this change is going to happen soon. Indeed, we would likely need to see the GCC single currency successfully attained (we have recently seen an agreement on the establishment of a Gulf monetary council as a prelude to a GCC central bank being formed) before governments would feel comfortable depegging their currencies from the USD.

That said, at the margin, there are indications of a desire to not follow the Federal Reserve automatically in its hiking cycle and have independent monetary policy settings to a minor degree. Following the latest US interest rate hike, Saudi Arabia made the decision not to follow suit. This, of course, can be explained away as 1) it merely removes a premium to US rates that had been added in 2005 and 2) it was in response to stock market vulnerability. However, it does indicate there are circumstances under which alternative policy settings would be considered. As the above developments become more pronounced, these situations are only likely to increase in regularity and severity such that independent monetary policy settings, and thus a removal of the USD pegs, become inevitable.