Are you really hedged? (page 1 of 4)

The Gulf Cooperation Council currency pegs have been taken for granted in the region for many years with most policymakers stressing their benefits rather than their weaknesses. This confidence in the pegs has led many Corporate Treasurers and Finance Directors to focus largely on the USD-Europe and USD-Asia currency risks and the outlook for US interest rates, as these have largely determined local interest rates. Therefore, in most cases, these hedging activities have not hedged any USD-GCC risk, either in terms of the direct exchange rate implications or, more importantly in our opinion, the risk that local interest rates could deviate significantly from those in the US. The typical interest rate 'hedge', therefore, has been to hedge local currency floating interest rate exposure via a USD interest rate swap.

However, the key assumption underpinning this behaviour, that USD pegs will be here for the foreseeable future, is being increasingly called into question. The merits of regaining control of monetary policy are being discussed more widely, not just by us, but also by the region's policymakers. While Saudi Arabia continues to stress that the riyal's peg to the USD will remain at 3.75, in the past month officials from both the UAE and Kuwait central banks have indicated that an alternative model may be more appropriate once the GCC single currency is formed. This suggests that while USD pegs are not expected to be removed ahead of the single currency, the currency regime employed thereafter is anybody's guess - we favour the monitoring/tracking of the new single currency against a basket of currencies reflecting the region's major trading partners.

We have covered our rationale for a move away from the currency pegs at length in previous publications, but briefly here are some of the benefits of greater currency flexibility:

1) Gain control of interest rates - the US Federal Reserve focuses on the US economy when setting interest rates. Therefore, it should not be surprising that interest rates that are implicitly imparted on the region are rarely appropriate. One has to assume that a regional central bank, whose mandate it is to help deliver sustainable growth for the GCC economy, could do a better job;

2) Allow currencies to offset inflationary/deflationary pressures - by being pegged to the USD, regional currencies are at the whim of USD movements in determining whether the region will be importing inflation or deflation through the currency pegs. With the USD structurally weak, it would appear the former is more likely in the immediate future. Indeed, rising imported inflationary pressures were one reason why the Kuwaiti central bank pushed the dinar to the strong edge of its band, a move that riled the other GCC countries which do not have that flexibility embedded in their exchange rate system;

3) Encourage diversification of assets - diversification is always viewed positively when trying to manage the risk-reward trade-offs, especially when dealing with large sums of money. At the moment, there is a perceived over-reliance on USD assets, something that certainly appears the case with central bank reserves and something that may extend to the massive public sector assets, which we estimate to be in the order of USD 1-1.5 trillion for the region;

4) Encourage diversification of oil revenues - it is conventional for oil to be priced in USDs, but the GCC single currency area will have significant pricing power in this area.