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Gulf currencies would prosper if decoupled from the US dollar

Countries pegged to the dollar have to follow the Federal Reserve's lead on interest rates, even if it doesn't suit them. For the GCC, it might be time to break free

The Federal Reserve Board building on Constitution Avenue in Washington Reuters/Leah Millis
The Federal Reserve Board building on Constitution Avenue in Washington

Most central banks – particularly the US Federal Reserve – adopted aggressive monetary policies after the 2008 financial crisis, increasing bank reserves through quantitative easing. 

This was coupled with interest rates at historic lows of 0 percent and even some negative interest rates. 

Quantitative easing does not in itself cause inflation, but it leads to it in an indirect way. Central banks create new money they use to buy assets from financial institutions. This increases the money supply in the system by raising bank reserves, since it is mostly banks that are selling these assets. 

Having bigger reserves allow these banks to lend more. This fulfils the purpose of quantitative easing: to boost lending, which in turn accelerates economic activity. This ultimately increases demand for products and services, putting inflationary pressure on an economy.

Additionally, central banks increase quantitative easing whenever financial markets drop in value substantially because of financial or non-financial shocks, such as the coronavirus pandemic.

The Federal Reserve was able to do so with relatively limited systemic risk thanks to the US dollar, which is the reference currency of the world, as well as the fact that the country is an exporter of goods and services.

This has created a Pavlovian response among market players, whereby they are almost certain that central banks will intervene whenever markets drop and this creates a floor on the financial markets’ fall in prices. 

This policy of quantitative easing and extremely low interest rates favours debt ballooning, which we have seen mostly in the US and Europe. In the US, total debt to GDP now exceeds 100 percent by a significant amount. 

Company debt, both public and private, has also increased substantially. When companies can borrow at an extremely low cost, they are in effect incentivised to do so – and many have used this debt to buy back shares in order to boost their market value.

How this affects the Gulf

Almost all Gulf states have their currencies pegged to the US dollar. Kuwait is the exception – its dinar is pegged to a basket of currencies.

Countries that have their currencies pegged to the US dollar should generally follow American monetary policy on interest rates, to avoid arbitrage and imbalances.

This is despite the fact that these countries do not need to adopt such an aggressive monetary policy from a fundamental economic perspective. The GCC countries are net exporters of oil and oil derivatives. Other than that, they are not major exporters of most goods and services. 

What’s more, the GCC states and particularly the UAE have strong economic balance sheets. Tying local currencies to the US dollar keeps these currencies artificially undervalued when compared with what their value would be if they were not pegged.

Given the increasing difference in macroeconomic strength between the GCC countries and the US, it could be worthwhile for the region’s monetary policymakers to consider decoupling from the dollar. 

In the US, monetary policymakers cannot increase interest rates above certain levels because of the adverse effects on debt servicing. This is not a problem for the GCC countries and the divergence is widening every day.

Decoupling would not affect the competitiveness of Gulf oil exports, thanks to the dollar pricing of oil. Plus, stronger local currencies would improve purchasing power for GCC consumers, whether they’re buying imported goods and services or travelling abroad. 

Dr Ryan Lemand is a non-executive director at FundRock

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