Are you really hedged?

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. While it will be subordinate to OPEC in terms of production quotas, it will have the power to price oil in different currencies if it so desires, whether that be EUR, the new single currency or the Chinese yuan. This would help reduce the volatility of hydrocarbon revenue receipts, albeit to a small degree;

5) Support the diversification of the economy - one of the biggest concerns is that greater currency flexibility will lead to a rapidly rising currency that will damage the non-hydrocarbon sector via reduced competitiveness. Given the need for extensive job creation in the region, this could be damaging to stability in the region and is why we would not advocate a free float of the region's currency. However, it is important to note that the peg to the USD is not a solution to this problem. If the USD were to rally significantly, then the region's non-hydrocarbon sector's competitiveness would deteriorate dramatically. This is why some sort of
monitoring/tracking of the currency against a trade-weighted basket of currencies makes most sense, in our opinion.

With these benefits in mind, and with at least two central bankers in the GCC talking of the possibility of a change in exchange rate policy after the single currency is adopted, then the assumption that the pegs will remain in place for the foreseeable future is rightly coming under increased scrutiny. While a change is not likely in the immediate future - as even the more proactive central bankers on this issue suggest that a lot of signposts need to change before policy can be shifted - those looking at hedging beyond 2010 should be aware of the risks that currency pegs may not be in place after that date.

QUATIFYING THE RISKS
It is obvious that the above analysis suggests there are increasing risks from not hedging against a potential removal of USD-GCC pegs and the associated divergence in local and USD interest rates. However, until we analyse the financial cost of these risks, making a rational decision of whether to bear these risks or hedge against them is difficult.

Taking the UAE as an example, looking at the implications of no change in local interest rates relative to their USD counterparts and USD-AED remaining at current levels indicates the borrower would be 30bps better off, on a running basis, using the USD curve than hedging in local currency. This reflects the fact that the 3yr AED IRS was 30bps above the USD equivalent when this calculation was made. This is the a priori cost of the more complete hedge.

If the AED weakens, or local interest rates fall relative to their USD counterpart, then the decision to use the USD IRS curve to hedge looks even better. For instance, if local interest rates fall 2% versus their USD counterparts and the dirham weakens by 10% against the USD, then under the current hedging convention the borrower would be 2.67% per annum better off than being unconventional (at least in a local context) and using the local currency IRS.

However, if the AED were to strengthen and interest rates were to rise, then the losses would start to mount. Assuming the reverse situation to the above, that is a 10% appreciation of the currency and an increase in local interest rates of 2%, then the borrower would be 2.47% per annum worse off by using the USD curve. Similar conclusions can be reached for those hedging SAR interest rate risk.

SO WHAT SCENARIO IS MORE LIKELY?
What is clear is that if the single currency was to be introduced today and the USD pegs were to be removed, the pressure would be for a stronger currency and higher interest rates, a costly scenario for those hedging via the USD IRS curve. The primary reason for the above is the fact that growth in the region is extremely strong and inflation is picking up in many countries. Indeed, even where inflation is not reported to be high or rising significantly, for example Saudi Arabia, we suspect this is due to under-reporting rather than an absence of inflationary pressures.

In this environment, there are two appropriate policy responses. First, one can raise interest rates to reduce the incentive of people to spend and increase the incentive for saving to slow the economy and reduce pressure on capacity constraints and thus inflation. Second, you allow the currency to appreciate to reduce imported inflation pressures. Meanwhile, the natural pressure on the currency, with oil prices so high and the 2006 current account surplus for the region expected to be 31% of GDP, is for it to appreciate in any case.

Fast forward to 2010 and naturally the situation becomes less clear in terms of outlook. With the long-term oil price forecast to be around USD 40 per barrel, if we assume this is what we will see in 2010, then the current account will likely comfortably remain in surplus and this will keep the bias for a currency appreciation intact.

However, what the monetary policy needs will be at that point will depend on what stage of the economic cycle we will be. While we are forecasting real GCC growth of 3.9% and inflation rate of 1.7% in 2010, this is clearly subject to a lot of assumptions and uncertainty. Therefore, we believe companies taking hedging decisions should be aware of the risks that the currency pegs may not be in place on a three and a half year time horizon and the potential financial consequences of this for current hedging techniques.

RISKS TO THE SINGLE CURRENCY TIMETABLE
It would be remiss of us not to highlight the risks that the single currency project will not go ahead on schedule, or even at all. While the region appears to be geared up to forming a single currency in 2010, a lot needs to be decided. The key political issue is likely to be who will be responsible for monetary policy decisions. Will it be based on the one country-one vote system of the European Central Bank? Or will it be GDP-weighted such that Saudi Arabia gets nearly 50% of the voting rights and therefore dominates the central bank's policy decisions? Naturally, the latter is unlikely to be acceptable to the smaller nations and as such leads to a real risk that the single currency project is delayed, or even shelved altogether. Some have even suggested that a single currency area without Saudi Arabia's participation is possible.

Does this mean the above analysis is academic? It may do, but we believe that if the single currency project is abandoned, then some of the more proactive discussants of exchange rate policy will pursue currency reform anyway, including Kuwait and the UAE (and possibly Qatar as well). Bahrain and Oman may be afraid to pursue such a shift in policy on its own given their small size and concerns that a change in policy will risk excessive speculation in their currencies, ultimately damaging their economies. Saudi Arabia will likely be one of the most reluctant to pursue currency reform, as indicated by its recent comments, but once the UAE and Kuwait have illustrated the benefits, even it may decide to follow.

The biggest risk to the currency reform outlook, in our opinion, would be continued short delays to the project, which would reduce the political freedom for countries to move independently. We have already seen the upset caused by Kuwait's 1% revaluation of its currency within its current policy framework. If a country were to change to a floating exchange rate system, then this would cause a lot of political problems and could even derail the single currency project altogether.

In conclusion, we believe the days of currency pegs in the GCC are numbered. Once the single currency is adopted, currently scheduled for 2010, we believe policymakers should track exchange rates on a trade-weighted basket as this is consistent with increasing the region's economic stability and with boosting the number of jobs being created in the non-hydrocarbon, private sector.

As such, those looking to hedge their currency and interest rate exposures over the next three and a half years and beyond should seriously review the implicit assumption currently pervasive in hedging decisions - that currency pegs will remain in place. There is a significant probability that this will not be the case. If currency reform were to happen today, the pressures would be for higher local currency interest rates and stronger currencies, especially against the USD. Such an outcome could hit borrowers hedging local currency interest rate risk through the USD IRS curve. Will this be the case when currency reform is actually embraced? Forecasting that far ahead is almost a lottery. But that is exactly why we believe people should be employing hedges that prepare them for the possibility that US interest rates and local interest rates will go their separate ways as currency pegs are replaced by a superior exchange rate system.