Will the GCC finally dump the dollar: controversy continues throughout the Gulf

Kracker find...really good read on the outline of this whole problem:

Will the GCC finally dump the dollar: controversy continues throughout the Gulf about the merits of the US dollar, despite the support shown for the greenback this summer by governments in the GCC and in the Organisation of Arab Petroleum Exporting Countries (OAPEC).

October 1, 2009

After much speculation last year about the possibility of Saudi Arabia, Bahrain, Qatar, the UAE and Oman shifting their riyals, dinars and dirhams away from their official links--or pegs--to the US currency, the arguments for such a move have been heard once again, not least because the world's new economic giants, China and India, are also looking for an alternative to the dollar. French president Nicolas Sarkozy's attack on the dollar, along with calls for a new reserve currency from Russia, Brazil and other countries at the G8 Summit in Italy in July, raised the global temperature another notch.

Part of the recent debate has been fuelled by reports that the Gulf's sovereign wealth funds (SWFs) have seen the value of their holdings plummet by some $100bn to $1.1 trillion in the first six months of this year alone (see story page 36). While some of that loss is due to the decline in global asset prices as a result of the worldwide financial crisis and recession in many developed economies, much of it, according to respected international economic analysts, is due to losses incurred on the GCC's massive investments in the US, particularly US Treasuries, other government bonds, equities and real estate.

At present, the Arab oil exporting countries of the Gulf are the largest international investors in the American stock market, and among the largest buyers of its government bonds, as well as having invested an estimated $25bn in the past few years directly in banks, corporates and real estate. Together, the Arab oil producing countries hold more US dollars in their foreign currency reserves than any other nation except China. Given that the currencies of the GCC states are set at fixed, official rates to the dollar, and that Kuwait's is also partially linked to it, the GCC has not seen its holdings in the US depreciate in value to the same extent as other foreign investors, particularly the Chinese and European central banks.

Crude oil, the region's predominant export, like investments in the US, is also priced in US dollars on international markets, and while some of the greenback's appreciation in the past year helped to ease the dramatic slide in the price of crude since it reached a peak of more than $140 a barrel in July 2008, the gains have not been enough to offset the losses. Although oil prices are now recovering some lost ground, several GCC governments still face current budget deficits because of the sharp fall in their oil revenues. Kuwait-based OAPEC, which accounts for almost two thirds of the world's oil reserves, reported this summer that the Arab producing countries' losses last year amounted to more than $123bn, or about one fifth of their total oil income.

Arab oil export earnings increased in 2008 to a record high of about $618bn in current prices last year as a result of higher prices and production, the report said. But in 1995 dollar prices, the earnings stood at only $494.6bn.

The real income, OAPEC explained, "was calculated on the basis of the dollar's purchasing power, the GDP deflator in industrial countries and inflation rates worldwide".

In other words, the dollar's gains were not enough to offset the higher cost in 2008 of GCC imports from Europe and Asia because of exchange rate losses against the dollar and rising prices in general, as well as the decline in what the US currency will buy during the past 14 years.

So, in addition to increasing pressure to remove their currency "pegs" to the dollar, OAPEC and other oil exporters are coming under pressure from many in the oil industry, as well as in their own countries, also to change the way that their crude oil exports are priced. The consensus is that the dollar should be replaced by a basket of currencies, including the euro, yen and pound sterling: that gives the US currency much less weight. Such a move would have huge implications not only for the dollar but also for all those consuming countries which currently have to convert their euros, yen, or local dollars into the US currency to buy the oil and gas they need to import. This could, in effect, add a "premium" on top of the cost of the oil itself, and could make the current global slowdown much worse, some economists fear.

The most talked-about downside of the peg emerged last year, when most of the GCC economies experienced record levels of inflation, often in double digits, after decades of stable prices. Although officials were careful to point out that the prices of many vital goods and services, such as foodstuffs, steel and other commodities, as well as rents and housing, were either rising around the world or were the product of specific local conditions, the clamour to remove the dollar's link to riyals, dirhams and dinars grew. Given that much of the region's imports are priced in euros, yen and other currencies that had been appreciating against the dollar, the rapidly rising inflation was caused, it was argued, by "imported inflation", i.e. by the need to use depreciating dollars earned from oil exports to purchase goods and services in more valuable currencies.

This year, that argument has lost some of its punch, both because of the dollar's relative appreciation vis-a-vis currencies like the pound sterling and the Australian dollar (but noticeably not the euro and yen) and because regional inflation is moderating rapidly as a result of the global downturn. Nevertheless, economists in the Gulf and elsewhere remain mindful, as do GCC officials, businessmen and bankers, that the Gulf's link to the US dollar limits the GCC's own policy-making abilities. When times are turbulent, as in the past two years, these limits can be a source of increased political and social strains, as well as causing financial and economic upheaval at home.

"We ... think there is a need for more flexibility in the medium- to long-term perspective for this region and that it should regain some of its independence in monetary policy," maintains Philippe Dauba-Pantanacce, senior economist at Standard Chartered Bank in Dubai. Policies set by the Federal Reserve in Washington are aimed at governing the US economy and not the GCC states, he and others point out. The dramatic lowering of interest rates by the Fed last year was appropriate for the US given the global downturn, but it did not suit Saudi Arabia, Kuwait, Bahrain, Qatar, the UAE or Oman, most of which were experiencing very high growth, excessive demand, a shortage of skilled manpower, goods and services. In many cases, such as in Dubai, infrastructure was overwhelmed, and housing, utilities, health and educational services struggled to cope.

As Dauba-Pantanacce and other regional economists have pointed out, this led to a considerable loss of purchasing power for local citizens, residents and foreign workers, leading at times to intense, coordinated demands for higher salaries and wages to compensate for the loss of income. "I think that for this region, it is important to acknowledge that the region has reached a critical size in terms of economic indicators and GDP that should lead this region to more independence," Dauba-Pantanacce added.

Nasser Saidi, chief economist for the Dubai International Financial Centre, has long advocated replacing the US dollar peg with a basket of currencies that could include the euro, yen and sterling as well as the dollar. "We have done research which looks at three criteria as to what anchor currency you would pick," he told The Middle East. "We've looked at inflation, we've looked at output disturbances, and at trade disturbances. Each one of those criteria is important in choosing a currency with which to anchor.

"If your inflation rates are very close to each other, then it makes sense to adopt a currency anchor that has an inflation rate that is very close to yours," Saidi explains.

The same reasoning applies to output disturbances, or trade disturbances. "When you do the analysis for the GCC, the optimal currency basket is one where you have [US] dollars, euros and Japanese yen," he adds. "It was only a question of time before the desirability of the dollar as the dominant global reserve currency would be questioned," observes David Woo, head of foreign exchange strategy at Barclays Capital in London. "Over the past decade, the US has failed to fulfil its basic obligation as the issuer of the global reserve currency: maintaining the dollar's value." After peaking in 2002, Woo said the dollar in trade-weighted terms had "depreciated almost ever since".

Part 2:

Although the financial crisis had given the dollar a lift owing to its haven status, "the consensus is that this rebound will be short-lived", he maintained. "The US's aggressive policy response to the crisis--an extraordinary loosening of fiscal policy and large-scale asset purchases by the Federal Reserve--is raising serious concerns about the US's longterm inflation outlook." The fact that over the past 10 years consumer price inflation in the US has averaged 2.7%, versus 2.1% in the eurozone and just 1.8% in the UK, "does not bolster confidence in the dollar, especially at a time when some of the structural disinflationary forces of the past decade may be in retreat", Woo adds.

His words came shortly after China had called for the creation of a new international reserve currency based on the International Monetary Fund's Special Drawing Rights (SDRs). These Rights represent a basket of four currencies in which the euro has 34%, the yen and pound sterling 11% each and the dollar 44%. Under the proposal, central banks would be allowed to swap their dollar reserves for SDRs held by the IMF in a separate substitition account. The proposal is said to have received unofficial support from some GCC countries, as well as Egypt and Russia.

"Swaps with the IMF for SDRs would provide central banks with a convenient way to diversify their portfolios without depressing the market for US dollars," explains Robert Pozen, chairman of MFS Investment Management and the author of a forthcoming book on the financial crisis, Too Big to Fail. "However," he adds, "these swaps would have to be of limited volume because they effectively transfer the risk of dollar depreciation from central banks to the IMF."

His observations reflect the growing concern in many world capitals as well as in the GCC that the risk is growing of a substantial dollar depreciation on the back of a sustained rise in inflation, both in the US and elsewhere. The US budget deficit this year is likely to be close to $2 trillion, while the total federal debt is threatening to break the $12.1 trillion limit set by the US Congress, economists have noted. Public debt could rise from 44% of GDP in 2008 to 87% by 2020, according to the Congressional Budget Office and other analysts.

"The nightmare scenario is that mounting fears over US creditworthiness push up longterm interest rates, thereby choking off nascent recovery," says Niall Ferguson, a professor at Harvard and the author of the bestseller, The Ascent of Money. In addition to recent falls in private consumption and a rise in the number of prime borrowers behind on their mortgage payments, as well as in the business default rate, Ferguson says things could get even worse in the US next year, not least because "the contribution of the [federal fiscal] stimulus to growth has now passed its peak and by January 2010 will be zero."

Some of these criticisms were addressed directly by US Treasury Secretary Timothy Geithner during his visit to the GCC in July. The US realised that it had "a special responsibility" to protect the value of the dollar, he stated shortly before holding private talks with King Abdullah of Saudi Arabia; the UAE's minister of foreign trade, Sheikha Lubna Al Qasimi; and central bank governor, Sultan bin Nasser Al Suwaidi, as well as other financial and investment officials in Riyadh and Abu Dhabi.

The Obama administration, he insisted, was determined to rebuild its economy and to tackle its deficits. "We need to make sure that as we rebuild, we build a stronger and more productive economy, less prone to crisis, with the gains of growth more broadly shared," Geithner said. The country "was on an unsustainable fiscal path before this crisis, and we will not succeed in establishing sustainable recovery without a credible commitment to address our long-term deficits".

His words were followed by a commitment from Suwaidi that the dirham would remain pegged to the dollar. In addition to benefiting from the dollar's appreciation regarding its own vast holdings in the US currency, the UAE stands to gain credibility from the monetary tools it can, in effect, import from the US Federal Reserve, explained one analyst in London. Others in the Gulf note that the decision also ensures a stable exchange rate between the currencies of the GCC countries at a time of global economic uncertainty.

However, the most ringing endorsement of the dollar peg so far came from OAPEC in its report, published in August. "We hear from time to time calls for abandoning the US dollar as the world's main currency reserve and [as] a unit of price for oil sales," officials wrote. "These calls are neither pragmatic nor based on understanding the real role of the US currency."

Commentators and the public needed to understand the difference between the dollar as a unit of price and as a reserve currency, OAPEC maintained. Setting the price of crude oil in another currency could "create havoc" given the constant change in foreign exchange rates worldwide, it argued.

As for the dollar's role as a reserve currency, OAPEC insisted that: "Given the gigantic size of the US economy and the depth of the US market, we do not believe there will be an alternative to the dollar for the time being as the world's main currency, and as a reserve currency that is endorsed by many countries with financial reserves."

While critics focused on the size of the US trade deficit, in OAPEC's view this ignored the fact that it was offset by the massive inflows of capital into the US and by the contribution which the US made to global growth by acting as a much bigger market for products imported from other countries than it provided to them as exports.

There was no problem, the report concluded, if the dollar remained the main international currency or the unit for pricing oil globally as long as the US economy was open to all and US economic output remained high. These two factors, OAPEC maintained, would serve to "boost assets invested" in the US. And, by implication, the Gulf and other Arab producers would benefit by having a bigger global market for their energy exports, as well as benefiting from the appreciation of their massive dollar holdings.

Not surprisingly, the debate continues. Although Geithner sought to reassure the Gulf's private investors, as well as GCC governments, that the Obama administration remains committed to a strong dollar, sceptics are not convinced. It is not much more than "rhetoric", given America's huge "debt binge", argues Eckart Woertz, programme manager for economics at the Gulf Research Centre in Dubai. In his view, it was "reminiscent of a notorious drinker promising to give up the bottle tomorrow". There are serious "structural issues" with the US dollar, with US monetary policy and with the policies of central banks worldwide, Woertz went on to say, "that will lead, inevitably, to some kind of currency devaluation".

Tarik Yousef, dean of the Harvard-affiliated Dubai School of Government, was less critical, but also wary of taking Geithner's promises too seriously. The Treasury Secretary's visit was "really to re-emphasise US leadership and US pre-eminence in the world economy even in the midst of this global downturn", he feels. "The last thing the US wants is for people to lose confidence in its policies and its currency."

So what is to be done? Woertz says that the Gulf states should do three things. First, they should buy real assets and build up their own strategic industries, as the Chinese have done with commodities and overseas companies, rather than buying financial paper like US Treasuries. Secondly, they should carefully diversify their curency holdings, using gold as "the ultimate dollar hedge". And thirdly, they should seek agreement on reforming the international financial system and try to obtain more influence in a reformed IMF.

"The US dollar is the undisputed reserve currency and will remain so for as far as one can see," maintains Ala'a Al Yousuf, chief economist at the Gulf Finance House in London. Nevertheless, he adds, "the question is, is it losing some of its market share to the euro?". Those economies with surplus earnings, such as the Gulf states and China, he says, have an interest in diversifying "their reserves and portfolios to protect their values".

The euro has established itself as a credible alternative [to the dollar], agrees Woo at Barclays Capital. "But," he cautions, "the willingness of eurozone governments to run up large current account deficits should not be taken for granted." It is also unlikely that there is much scope for "the already over valued euro" to appreciate substantially against the dollar.

"Gold remains the world's primary financial asset that is no one's liability," observes Terrence Keeley, global head for sovereign client services at the Swiss-based UBS Investment Bank. China has been raising its official gold holdings substantially in recent months, he notes, and "where it goes, others take heed".

"The clear alternative to the dollar in 2009 is not other currencies, but that ancient form of money--gold," agrees David Hale of David Hale Global Economics in the US. "Precious metals could emerge as a hedge for investors suspicious of central banks and fearful that inflation will be the simplest solution to the challenge of global deleveraging."

Saidi at the DIFC is concerned, like Woertz, about the international financial system and maintains that more should be done to include the Gulf states as part of the necessary sweeping reforms. "The Gulf countries have a big stake in the financial stability of the US," he agrees. "They're a big creditor. The earlier you bring the Gulf and the Middle East onto the agenda, the better."

The GCC can also do much more to help itself, suggests Saidi. Although both the UAE and Oman have rejected calls for the formation of a common Gulf currency by early next year, Saidi remains hopeful that it could eventually form the basis for pricing crude oil in a basket of currencies.

The "khaliji"--as the unified Gulf unit has been called informally--could even become a strong global currency on a par with other major world currencies given the region's enormous fiscal and oil reserves, he feels. "Since the GCC countries control more than 45% of the world's proven oil reserves, it would be more than natural to price our main exports in our own currency. I think this is a sensible and realistic approach."

While it is clear that at a time of continued uncertainty about the state of the world's financial system and the prospects for a sustained global economic recovery, Gulf governments and Arab oil exporters will be hesitant to disrupt confidence in the leading international reserve currency, the dollar, it is also clear that questions about supplementing it in the future with the euro, the yen, sterling or the khaliji will not go away soon. Political and economic power is shifting eastward and Washington, as Geithner realises, will face yet more calls for a sharing of global wealth, and of the enormous privileges that come from operating the world's reserve currency.