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Bank urges care with currency reform

The GCC countries should resist US, G7 and International Monetary Fund pressure for sweeping currency reform, and instead adopt a policy of gradual reform, according to a new report.

The GCC countries should resist US, G7 and International Monetary Fund pressure for sweeping currency reform, and instead adopt a policy of gradual reform, according to a new report.

Standard Chartered Bank’s research, entitled “The Guide to Middle East FX Markets 2006”, studies recent developments and analyses trends in the region’s foreign exchange (FX) hedging and investing marketplaces.

The bank supports the GCC’s move towards a single currency, claiming that the change “represents a great opportunity to move to a flexible exchange rate system”. However, it emphasizes that the shift must be towards a floating single currency. The floating currency, it argues, would increase the incentive for oil producers to use different currencies when pricing their export goods and services.

“Currently, the authorities match any net inflows on the current account with flows on the capital account by buying overseas assets (or vice-versa),” reads the report. “This stops the local currency appreciating (or depreciating) against the USD. We suggest something similar going forward, but instead of the currency being referenced against the USD, we believe it should be marked against a trade-weighted basket instead. This can be as transparent as the authorities want to make it.”

Such measures, the report argues, would guard against ‘Dutch disease’ - when huge current account surpluses resulting from large commodity exports put an upward pressure on the local currency, and thus crowd out other economic activities due to the loss of competition – and allow the central bank to respond better to changes in the economic climate.

“The issue [of ‘Dutch disease’] is particularly pertinent for the region, which has a very youthful population and thus needs to create a lot of jobs,” reads the report.

“Oil and gas and downstream activities are largely capital-intensive rather than labour-intensive. Therefore, while they create a significant amount of value to the economy, they do not employ a lot of people,” it continues.

The bank warns, however, that there needs to be a concerted effort to educate monetary policy managers in the region before currency pegs to the US$ are abandoned. It suggests that Central Bank officials are “seconded to the major central banks around the world to observe alternative working models, and to see which is best suited to the local economy.”

In addition, the report argues that whilst “the economic size of the region is substantial at just under US$600 billion, some of the countries are very small in size and therefore may find it difficult to manage their own currencies against the vagaries of international speculators.”

The report also slams the pegging of many of the region’s currencies to the US$, and argues that as a result, the US Federal Reserve often exerts an “inappropriate” influence over the economic conditions of the Gulf states.

“The main reason for advocating currency reform is purely domestic in nature, it is not because the US or the G7 or the IMF is calling for it,” Steve Brice, Standard Chartered’s Regional Head of Research for the Middle East, Pakistan and South Asia, told Arabian Business.

“It’s basically saying: why would economies in the region rely on the US Federal Reserve to determine monetary policy in the region when it doesn’t know, or doesn’t care, what is actually happening in the region?” he continued. “It makes much more sense for somebody who has a better idea of what’s good for the local economy, and obviously cares about the local economy, to set those parameters.”

“It is very difficult to argue that currency pegs have helped monetary policy or indeed that monetary policy has worked well,” claims the report. “At a time when local economies needed low interest rates they have often had high interest rates – such as the early 1980s – and when they needed high interest rates, rates have been low or negative in real terms – such as the current state of affairs. Naturally, there have been times when monetary policy is appropriate. However, to us this looks very much like the phenomenon of the stopped clock being right twice a day.

“Due to the US$ currency pegs, domestic interest rates are effectively determined by the Federal Reserve,” the report continues. “However, the outlook for GCC economies is not part of the Fed’s mandate when setting interest rates. It only cares about the US economy.

"Therefore, it is hardly surprising that the interest rates set by the Fed may be inappropriate for the economic conditions of the Gulf countries.”

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