Kuwait revaluation is not a sign of things to come

Currency reform has once again hit the headlines, albeit from an expected source. In May, the Kuwaiti central bank announced around a 1% revaluation of the dinar against the USD. Avid readers of the Middle East Focus will realise this should not be a surprise. We have been arguing for some time that the dinar would be revalued, although we slightly over-estimated the size of the move. Markets, confused by the move, have been extrapolating this move to the rest of the GCC.

Given our focus on currency reform in the GCC, one might expect us to join these calls. However, we believe such speculation is wide of the mark. To understand our rationale for this view, one needs to put Kuwait's move into context. Before shifting to a currency peg against the USD in January 2003, Kuwait managed its exchange rate on a trade-weighted basis. This model still holds some sway at the central bank. USD weakness has previously resulted in two adjustments in the USD-KWD rate - in September 2003 and in January 2005 - and the recent sharp USD sell-off has clearly raised concerns that the resultant trade-weighted weakness of the KWD (with most of its imports coming from Europe and Asia) will lead to increased inflationary pressures. Therefore, given our USD outlook for the rest of the year, one cannot rule out the risk of Kuwait making a further change this year, although this is not a central scenario for us as the dinar is now trading at the strong end of its band against the USD.

However, extrapolating this to the rest of the region is a different matter altogether. While Kuwait has acted in this manner before, the rest of the GCC has not. Therefore, the mindset is not present to consider a one-off adjustment at this juncture. The Saudi Arabian Monetary Agency, the focus of much of the speculation, has already indicated as much and is the biggest advocate of the new single currency, due in 2010, being pegged to the USD. Therefore, it would be strange for the Saudi government to be one of the first to advocate greater currency flexibility in any shape or form.

Another point that must be highlighted is that a repegging of exchange rates is not currency reform as we define it as it still leaves monetary policy to be delegated to the US Federal Reserve. Our main argument for a move towards floating exchange rates or some form or another - most probably including a monitoring of the trade weighted exchange rates - is the need for the region to seize control of monetary policy. We suspect those suggesting greater flexibility in regional exchange rates are looking at emerging pressure from the West for greater exchange rate flexibility and are likening the situation to that in China 2-3 years ago.

Looking at the international context, the US is clearly concerned that half of its deterioration in the current account deficit has been caused by higher oil prices in recent years. However, a regional currency revaluation would not help significantly as oil is priced in USDs. Indeed, given the need to diversify their economies, the GCC countries need to focus on ensuring that the current account surpluses caused by high oil prices do not result in a currency appreciation that crowds out the private sector. Of course, it can be argued that pegging themselves to a collapsing USD is possibly ensuring this is being avoided by too wide a mark - hence our view that the region should focus on a reference to a trade-weighted basket and not peg itself to the USD.

However, we believe those playing up the chance of revaluations in the GCC are making a similar mistake to that made by many when looking at China - that is attaching too high a weight to international demands and largely ignoring the local context. Therefore, while currency reform is likely to rise on the agenda - as we have argued for over two years now - this will be a gradual process and is unlikely to be a response to an unwarranted call from the West, but more due to a domestic need and capacity to implement reform.