Exchange Rate Policies in the Gulf

Like hundreds of other decisions taken by the Organization of Petroleum Exporting Countries since it was formed 47 years ago, the decision taken two weeks ago not to respond to American urgings to boost oil production came in for heavy criticism by the U.S. administration. In many previous cases, OPEC refrained from open confrontation with the U.S. This time, however, the cartel chose to rebuff American claims with unprecedented forcefulness. The President of OPEC, Chakib Khalil, argued that nervousness in the oil market stemmed from the “mismanagement” of the American economy and that the jump in oil prices reflects, not inadequate supply, but rather the weakness of the dollar and the prevailing uncertainty in the financial markets.

That response and Khalil’s focus on the sad state of the dollar are not coincidental. They reflect the deep frustration of the oil producers – especially those in the Gulf – with the damaged caused to their economies by the erosion of the dollar. True, the Gulf states are experiencing extraordinary economic growth due the rise in oil prices (which is partly due to the falling dollar), but that growth is accompanied by inflation which is expected to accelerate as long as the dollar keeps falling and the U.S. Federal Reserve Bank maintains low interest rates. Official inflation statistics for February show that the annual rate of inflation in Saudi Arabia is 8%. In the United Arab Emirates, the figure reached 11% in 2007, and in Qatar it was over 14%. Bahrain and Oman, oil producers which do not belong to OPEC, also suffer from high inflation rates.

The tight linkage between the value of the dollar and the inflation afflicting the Gulf oil producers stems, among other things, from the exchange rate policies of the Gulf states. Local currencies in those states are pegged to the dollar, so a weakening dollar leads to real erosion in the local currencies and causes the prices of imported goods to rise. By the same token, pegging local currencies to the dollar forces the Gulf states to adopt the monetary policy of the U.S. Federal Reserve, which has been trying recently to extract the American economy from a crisis by aggressing lowering of interest rates. As a result, the Gulf states, rather than raising interest rates in order to cool economic growth and combat inflation, are forced to follow the Fed and lower interest rates. Lacking effective monetary instruments of their own, local governments have to respond to the blow to real wages of their citizens by raising wages in the public sector and expanding subsidies on a variety of goods. In other words, Gulf states pursue a cyclical (rather than counter-cyclical) policy, which many economists argue is prescription for further inflation.

The publication of recent inflation figures, along with growing signs of recession in the United States, strengthened those voices in the Gulf calling for central banks to emulate the example of Kuwait, which decided in 2007 to decouple the dinar from the dollar and link to instead to a basket of currencies. The central banks of Qatar and the UAE have denied rumors to the effect that they intend to end the dollar peg in their countries. But they have also admitted that recent developments oblige them to reassess exchange rate policies.

Any announcement of a change in exchange rate policies by a Gulf oil producer would be the last thing the United States needs right now. Such a step would indicate a permanent decline in demand for the dollar by any state that decided to delink. Worse, it would signal an additional loss of confidence in the American currency. Consequently, the prospect of a change in exchange rate policies would not only pose economic challenges; it would also imply political dilemmas.

Of the six Gulf Cooperation Council members (Saudi Arabia, Kuwait, UAE, Oman, Qatar and Bahrain), Saudi Arabia has been the most outspoken advocate of the current exchange rate policy. In November, Saudi spokesmen poured cold water on Iranian President Mahmoud Ahmadinejad’s claim that oil should no longer be priced in dollars because the dollar had become “worthless piece of paper.” More recently, official Saudi representatives have tried to play up the advantages of pegging local currencies to the dollar. For one thing, they claim that dollar-linkage has served the caused of economic stability in the Gulf states for many years and that it is necessary to attract foreign direct investment. Moreover, Saudi Arabia holds billions in dollar-denominated assets and it therefore has no interest in any measure that could further damage the American dollar.

However, notwithstanding Saudi declarations to the effect that any change in exchange rate policies would be decided unanimously by the five GCC members still linked to the dollar, it is entirely possible that one of the other members will find it increasingly difficult to withstand the economic and political pressures resulting from inflation and will choose to delink. Inflation in the smaller Gulf states is more sensitive to changes in the value of the dollar than it is in Saudi Arabia because more of their food is imported. Consequently, regimes there cannot remain indifferent to double-digit rises in the prices of basic foods.

A further fall in the value of the dollar would intensify the domestic political pressure by many groups demanding a change in exchange rate policies, though it is also likely the pace of high-level American visits to the Gulf states would also pick up. The way in which the Gulf states deal with the contradictory political pressures will have a short-term impact on the value of the dollar and on the performance of the global economy. Beyond that, any change in exchange rate policies would also have longer-term economic and political implications, because it could mark a significant first stage in the reassessment of the dollar-pricing system for oil.

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