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Towards aCommon GCCCurrencyGCCs Best Exchange Rate Regime
This paper focuses on the best exchange rate system to peg the newGCC common currency to it, whether it is the US Dollar, or the basket ofcurrencies or to more flexible regime which is the floating regime andthen examine the empirical evidence on the delineation of regimes andtheir macro performance.
2010
Aisha Al-OmranAmerican University f Kuwait
25-May-10
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Index
1. Introduction 3
2. Literary Review..... 4
3. Methodology . 5
4. Data........ 5
What is an OCA? .. 5
Brief History of a Common GCC Currency.. 6
Exchange rate regime of the Khaleeji.. 7
The Optimal Exchange rate regime. 8
5. Results and Discussion. . 12
6. Conclusion. 13
7. References. 15
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Introduction
Kuwaits last ruler has come up with the idea of establishing a Cooperation
Council for the Arab States of the Gulf in the early eighties of the previous century.
Kuwait, Saudi Arabia, United Arab Emirates, Qatar, Bahrain and Oman were
members of this council (GCC countries hereafter). GCC leaders came up with an
Economic Agreement to establish a complete economic integration. The economic
agreement was meant to be a first block in the monetary and economic union.
Arab Gulf Countries or the GCC countries are known to be of the worlds
highest GDPs; So that, a monetary union within these countries could be one of the
most important monetary unions around the world second after the European Union.
As this Union is very important the exchange rate regime that would be used
within the region would affect the worlds economy as the region is one of the most
opened region to the world in terms of trade.
Leaders of GCC countries agreed to adopt a common exchange rate regime to
help them maintaining the parity between the GCC member countries as a first step
towards the monetary union. This meeting has been held in Bahrain in year 2000.
However, they have agreed on that the start date of pegging against the common
currency is on 2003 and the common peg to be against the US Dollar.
Starting from 2003, all the GCC currencies were fully pegged to the US
Dollar. However, on the 2007 while the global crisis was taking place, the US dollar
was depreciating dramatically against the major currencies of the world; So that,
Kuwait depegged its currency from the US Dollar and pegged the Kuwaiti Dinar to a
basket of currencies that was dominated by the US Dollar. Through all these doubts,
this contributed to the delay of issuing the common currency plus the demurred of
Oman and the UAE out of the convention for economic and political reasons
respectively.US Dollar has a very strong relationship with currencies of the GCC currencies, since
most of their currencies are pegged with the US Dollar except for Kuwait which has
an exchange rate regime of a basket of currencies that is dominated by the US Dollar.
As for the recent changes, GCC countries unofficially considered many
options other than pegging the new common currency to the US Dollar, such as the
basket of currencies and the more flexible regime which is the floating. This study
tries to examine the optimal choice of the exchange rate system for the GCCMonetary Union.
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Literary Review
The research concentrated on two main articles, the first one is the paper
written by Eisa A. Aleisa and Shawkat Hammoudeh which is A Common Currency
Peg in the GCC Area: The Optimal Choice of Exchange Rate Regime. The paper
discussed the best choice of exchange rate system that should be adopted for the
region of GCC. The paper tested the exogenous factors that are based on exterior
shocks on the region. The paper assumes that GCC region is a single bloc and fully
integrated. The research results prove that the regions output is mostly affected by
domestic impacts in the short and long run. In addition, it is not affected by the Euro
or the US Dollar fluctuations as well. This would lead us to conclude that the basket
peg would be more preferable as long as there is no huge effect from US Dollar and
the Euro on the output movement in the region. In other words, if the output
movement is more effected by the terms of trade other than other international
currencies the region should adopt more flexible regime. The paper was wrapped up
by the conclusion of that the optimal exchange rate regime is the adoption of a basket
that is highly dominated by the U.S. dollar and the Euro. It also, recommends the
basket peg as a more flexible regime that would lead a more flexible regime in the
future.
Another article is The choice of exchange rate regime: An empirical analysis
for transition economies that was written by Jrgen, Hagen and Jizhong Zhou. The
article explored the alternative exchange rate systems within Europe. The sample is
constructed using the data of the 25 transition economies in that area after 1990. The
empirical results prove that the traditional OCA literature presents applicable methods
to help choosing the optimal exchange rate regime within the choices in these
countries. Furthermore, these choices depend on many measurements, such as,
inflation rates, cumulative inflation differentials, and the availability of internationalreserves. This means that economic performance and many other factors play a very
important role on choosing the optimal exchange rate regime for the OCA region.
Yet, Government debit has an uncertain role in this scenario; it works both sides;
whether moving towards the more flexible regime or towards a more fixed regime.
So, the effect of such an indicator was not clear or hard to follow.
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Methodology
This study of the optimal choice of the exchange rate policy for the GCC
Common Currency is expressed by an expressive analytical model throughout
collecting data, study the implications of these data in order to reach the best
conclusion which is the optimal exchange rate regime that should be taken within the
GCC monetary union to contribute in improvement and development in the region of
the GCC. The findings of this study were presented by the quantities and qualities
methods. Data of the study were collected from many different resources, such as,
books, recent researches, statistics, IMF reports, regulations and laws, and some
newspapers. I also have worked within the process of the Monetary Union in the
region. The research includes some details from the meeting minutes of the GCC
meetings regarding this issue. So, I have also interviewed many people who are in
power within the ministry.
Data
What is an OCA?
OCA is the short term of the economics term of Optimal Currency Union.
This means the area or the region that uses the same currency. For a monetary union
we need a common currency, thus a common central bank to create single monetary
policies. The availability of such a union needs some work. Political integration is one
of the most important factors in the region; also economics relationships among
countries of the OCA should show a high correlation with the same shock
expectations among the region (Aleisa et al. 2007).
The monetary union reduces transaction costs within the region of the OCA
and the exchange rate insecurity. In an OCA economies of scale can be achieved by
release unoccupied reserves. An OCA may lessen the capability of speculators toaffect prices and disrupt the accomplishment of monetary policy. It can also make use
of reserves in a productive manner in case of a problem in offsetting payments. In
inflation affected countries an OCA can also discipline and make the monetary policy
credible. Also, there are countries that adopt a common currency and peg it to a
credible currency in order to get the trust (Chabrier, 2002).
An OCA does not allow a country to follow independent and exchange rate
policies. Exchange rates are compulsorily fixed, interest rates are tied to foreign
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interest rates, and any increase in money stock will result in balance of payment
deficits (Aleisa et al. 2007).
The main benefits of CU are from the expansion of bilateral trade among the
countries of the Union (Rose, 2000) found that trade among the countries of a CU
could rise three-fold once the union started. However this may too optimistic due to
some inherent upward bias in the estimation due to the common decision to join a CU
(Tenreyro, 2001).
Brief History of a Common GCC Currency
A European Central Bank delegation visited the secretariat of the Gulf
Cooperation Council in the first week of June 2002. They were invited in order to
discuss the main themes of the workshop which will be held in cooperation with
European Central Bank in Riyadh on October. (Ministry of Finance, 2010)
The technical committee which was setup agreed to determine a timetable that
is divided into three phases to achieve the main goal, which is the GCC common
currency. The first stage was the adoption of a common currency to peg their
currencies with it, and they agreed on the US Dollar to be the currency other that the
basket of currencies. This step was planned to be achieved by the end of the year
2002. The next step was the configuration of a monetary union. This point includes
the specification of the economic performance criteria that are related to financial,
monetary, and ratio stability. This was to be agreed before the end of 2005. The third
and the final phase scheduled is the physical issuing of the GCC common currency
with the deadline of January 2010. This was the plan, however, we are now in 2010,
and the deadline has been further postponed due to many things, such as, the delay in
the customs union, the withdrawal of Oman and the UAE out of the monetary union,
in 2007 and 2009 respectively, and the depreciation of US Dollar (Ministry ofFinance, 2010).
This monetary union in the GCC countries is expected to raise the efficiency
of the financial institutions, reduce the cost of financial and commercial transactions
in the region, better use of the available resources, and to create a new economic
force. Furthermore, there is a significant economic convergence between GCC
countries. On the other hand, there is a considerable variation between GCC countries
in number of criteria, such as, budget deficit, public debt, unemployment rates, depth
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of financial markets, degree of transparency of data, and type, timing and
comprehensiveness of economic statistics (Ministry of Finance, 2010).
The central banks of GCC states agreed on the monetary union. As a result
Bahrain, Kuwait, Qatar, and Saudi Arabia have stopped lending money to the public
sector entities in a step towards the establishment of Khaleeji, because it is a part of
the agreement that the four countries have agreed on. In addition, they need to sell the
loan portfolios of the public sectors, after which, countries can establish a common
central bank that will not lend to public sectors like the European model (Ministry of
Finance, 2010).
Exchange rate regime of the Khaleeji
There are differences in opinion of the kind of policy which needs to be
adopted. Should it be a dollar or basket pegged exchange rate regime or a free floating
exchange rate system?
The issue of depegging the GCC common currency to the US Dollar came up
when the US Dollar value was decreasing and oil prices were highly affected. In the
past, GCC countries adopted fixed exchange rate systems to stabilize the currency and
the economy as a whole. But now, a single currency like the US Dollar may affect the
economy hardly by importing inflation overseas. Economies which depend on human
capital and trade need to adopt more flexible exchange rate regime so that they could
be better off (Aleisa et al. 2007).
In addition, Kuwait's foreign minister, Sheikh Mohammed Al-Sabah, said that
the GCC's common currency might be linked to basket of currencies other than one
currency. He said that to the Kuwaiti Parliament showing that there is a possibility
that the new currency might not be pegged to the US Dollar. On the other hand,
Youssef Kamal, the Finance Minister of Qatar said that Qatar is satisfied with thevalue of its riyal currency and sees no need to change its peg to the dollar (Reuters,
2007). He was wondering about the reason of pegging his currency to a basket of
currency when he have 100% of his exports are sold for US Dollars in Washington,
quoted Qatari daily Gulf Times, 2007. He also said that he has a comparative
advantage over products that are not pegged to the US Dollar. An economist was
talking to Sheikh Hamad Al-Thani the Ruler of Qatar, he was discussing the issue of
major oil producers, and he said that they should be more willing to discuss theviability of linking their currencies to the US Dollar. Going forward, if you have a
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structurally weak US Dollar, policymakers will have to look at different options, said
Monika Malek (Reuters, 2007). According to MENAFN, the GCC common currency
might be pegged to the US Dollar in the first place then they might consider ditching
the dollar peg to a basket of currencies that is dominated by the US Dollar
(MENAFN, 2009).
However, a note that was published by The Dubai International Financial
Centre stated that the new currency of the GCC should be pegged to a basket of
currencies from the beginning. The study argues that pegging the new currency to a
basket of currencies will allow the Gulf Central Bank to have more flexibility in
monetary policies. The note suggested that the basket should be compromised of four
major currencies and the weight of each currency in the basket should be based on the
trade, the output, and inflation inter-linkages. So, the US Dollar might weight 45% of
the basket, 30% Euro, 20% Japanese yen, and 5% of the British pound (The exchange
rate regime of the GCC monetary union, 2008).
The Optimal Exchange rate regime
Since the IMF is leading economies towards more flexible regimes which is
floating the currency to supply and demand forces in the international market; so that,
as it is seen in table 2 and table 3, countries are moving towards a more flexible
exchange rate regime.
According to IMFs, instead of the fact that a fixed exchange rate regime
provides some credibility instead of the flexibility that would be assured by the
flexible exchange rate regime, the IMF research department assured that the tradeoff
between credibility and flexibility depends on the general orientation of the country or
the monetary union as well. The IMF recommends that a flexible exchange rate
regime would be more beneficial for a country when the political costs of exchangerate adjustments exceed the benefit (Caramazza et al, 1998).
If the GCCs exchange rate system of the unified Gulf currency was left to be
determined through market forces or let the exchange rate proposed in accordance
with the forces of supply and demand this would expose the region to shocks affecting
the monetary stability of the GCC countries and increase the likelihood of speculative
attacks, which could result in the worst threat to Union project. Especially for a region
that is affected violently by external attacks. It would be more prefer not to be floating
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the new unified Gulf currency, or at least in the early stages of the production process
so as not to exposing the region to stability shocks.
On the other hand, Alan Greenspan, former Chairman of the Board of
Governors of Federal Reserve in the ninth session of Jeddah Economic Conference,
said that adopting the most flexible exchange rate regime would extensively relieve
the inflation rates within the region in the short term and erase it entirely in the long
term (Abdelaziz, 2008).
Yet, IMF argues that the free-floating system or the exchange rate system
against the crude-oil price would be inappropriate because of its negative effect on the
other sectors of the economy; although, the positive advantages of a hedge against
shocks of foreign trade (Ministry of Finance, 2010).
Table 1: Export Concentration Indices for GCC Countries
Table 2: Exchange Rate Arrangements as of December 31, 1997
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Flexibility Limited vis--vis a Single Currency or
Group of Currencies
More Flexible
Single currency1 Cooperative arrangements2 Other managed floating Independently floating
Bahrain5
Qatar5
Saudi Arabia5
United Arab Emirates
Austria
Belgium
Denmark
Finland
France
Germany
Ireland
Italy
Luxembourg
Netherlands
Portugal
Spain
Algeria
Belarus
Brazil4
Cambodia4
Chile4,7
China, Peoples Rep. of
Colombia9
Costa Rica
Croatia
Dominican Republic 4
Ecuador4,12
Egypt4
El Salvador
Georgia
Greece
Honduras4,12
Hungary15
Indonesia
Iran, Islamic Rep. of4
Israel14
Kazakhstan
Kyrgyz Republic
Lao P.D.R.
Macedonia, formerYugoslav Rep.of
Malaysia
Maldives
Mauritius
Nicaragua
Norway
Pakistan4
Poland14
Russian
Federation
Singapore
Slovenia
Sri Lanka
Sudan4
Suriname
Tunisia
Turkey
Turkmenistan4
Ukraine
Uruguay
Uzbekistan4
Venezuela8
Vietnam
Afghanistan, Islamic
State of4
Albania
Armenia
Australia
Azerbaijan
Bolivia
Bulgaria
Canada
Eritrea
Ethiopia
Gambia, The
Ghana
Guatemala
Guinea
Guyana
Haiti
India
Jamaica
Japan
Kenya Republic
Korea
Lebanon
LiberiaMadagascar
Malawi
Mauritania
Mexico
Moldova
Mongolia
Mozambique
New Zealand
Papua New Guinea
Paraguay
Peru
Philippines
Romania
Rwanda
So Tom and
Prncipe4
Sierra Leone
Somalia
South Africa
Sweden
Switzerland
Tajikistan, Rep. of4
Tanzania
Trinidad and Tobago
Uganda
United KingdomUnited States
Yemen, Rep. of
Zare4
Zambia4
Zimbabwe1In all countries listed in this column, the U.S. dollar was the currency against which exchange rates showed limited flexibility.
2This category consists of countries participating in the exchange rate mechanism (ERM) of the European Monetary System (EMS). In each case, the exchange rate
is maintained within a margin of 15 percent around the bilateral central rates against other participating currencies, with the exception of Germany and the
Netherlands, in which case the exchange rate i s maintained within a margin of 2.25 percent.
3The exchange rate is maintained within margins of 47 percent.
4Member maintained exchange arrangement involving more than one market. The arrangement shown is that maintained in the major market. For Zare, note that
the official name was changed to Democratic Republic of the Congo on May 17, 1997.
5Exchange rates are determined on the basis of a f ixed relationship to the SDR, within margins of up to 7.25 percent. However, because of the maintenance of a
relatively stable relationship with the U.S. dollar, these margins are not always observed.
6The exchange rate, which is pegged to the European currency unit (ECU), is maintained within margins of 2.25 percent.
7The exchange rate is maintained within margins of 12.5 percent on either side of a weighted composite of the currencies of the main trading areas. The exchange
arrangement involves more than one market.
8The exchange rate is maintained within margins of 7.5 percent.
9The exchange rate is maintained within margins of 7 percent.
10The exchange rate is maintained within margins of 6 percent.
11Country uses peg currency as legal tender.
12The exchange rate is maintained within margins of 5 percent.
13The exchange rate is maintained within margins of 3 percent.
14The exchange rate is maintained within margins of 7 percent with regard to the currency basket.
15The exchange rate is maintained within margins of 2.25 percent with regard to the currency basket.
Table 3: Exchange Rate Arrangements as of December 31, 1997
Source: Caramazza et al, 1998
Country/Region Bahrain Kuwait/1 Oman Qatar /1 Saudi Arabia UAE/1
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Share of GCC GDP (%) 2.5 10.2 3.3 6.7 56.6 20.7
Real GDPby Sectors
(%)
Non-oil 84.2 65.5 52.8 42.4 44.1 77.4
Oil 15.7 34.5 28.0 57.6 32.7 22.6
Government 0.1 n/a 19.2 n/a 23.2 n/a
% of Oil In Total Gov. Revenues 15.7 34.5 28.0 57.6 32.7 22.6
Exports/GDP (%) 79.1 60.5 71.6 63.8 51.2 n/a
Imports/GDP (%) 63.6 34.3 40.3 23.7 20.3 n/a
Notes:1/ Non-oil sector includes the government sector.2/ In % of total exports3/ In % of total imports within
Table 3: Exchange Selected Macroeconomic Indicators for the GCC countries (1998-2003)
Sources: IMF DOT, Monetary Agencies and central banks.
Table 4: Directions of GCC countries exports
Sources: IMF DOT, Monetary Agencies and central banks.
Table 5: Middle East and North Africa: Financial Development Ranking
Sources: (Creane et al., 2003)
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Table 6: Determinants of Exchange Rate Regime Choices
Source: (Jrgen et al., 2005)
Results and Discussion
It is shown in table 6 that is the determinants of exchange rate regime choices
that was took from the Jurgens paper The choice of exchange rate regime: An
empirical analysis for transition economies are seven. However, in this region, that is
the GCC countries most of these data are not available, so that, we would not be able
to apply the empirical analysis on the data of the GCC region. Yet, we would try to
analyze it using the available data.
First of all, OCA fundamentals measurements would be applied to the GCC
region as a single bloc. The higher the degree of Economic openness suggests the
fixed regime. As we all know the GCC region is considered to be a very open
economy, however, the output in this economy is not affected by the fluctuations of
other international currencies such as the US Dollar and the Euro as much as it is
affected by the terms-of-trade (Aleisa et al. 2007). So this wouldnt be as effective as
much. Another indicator is the geographical concentration of trade. The more
concentrated the trade, the more fixed exchange rate the economy should adopt. GCC
countries have some geographical concentration of trade as it is shown in table 4(IMF,
2008). So, fixed interest rate would be better in that case. In addition, the higher the
degree of the concentration of the commodities he more flexible exchange rate regime
recommended. As it is known that GCC region has a 66% commodity concentration,
so this would go for the flexible exchange rate regime (IMF, 2008). Furthermore,
large economic size goes with the flexible exchange rate regime, so as we deal with
the GCC as a single bloc, it would be considered a large sized economy. Also, the
higher the level of financial development the more flexible exchange rate regime
would be recommended, and as it is shown in table 5, all GCC countries considered to
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have high financial development (Creane et al., 2003) So that, flexible exchange rate
regime would be appreciated in that case. To know which exchange rate regime
would be more effective according to these measurements of OCA fundamentals we
would divide them into two sides and tick right on the more effective regime and then
compare contrast between the two regimes.
Determinant Flexible FixedHigh Degree of Economic Openness High Trade concentration : Commodities High Trade concentration : Geographical High Level of Economic Development Large Economic Size High Level of Financial Development
Table 7: Measuring the Determinants of exchanged rate regime of the GCC
According to table 7, the measurements would nominate the flexible exchange
rate regime to be applied on the GCC common currency as the GCC region as a bloc
is a very large, open economy that has to stand by its own and self-correct itself other
than pegging its currency to another currency that could affect it negatively and limits
its control on its currency.
Conclusion
It is yet to be determined when exactly the GCCs common currency will be
launched. At present it looks like the GCC could miss the initial 2010 deadline by at
least two years. The implications of the common currency for the US Dollar are
mixed. On one hand, if the GCC pegs the common currency to the Dollar, the
common currency could generate Dollar demand, and held to restore faith in the
Dollar. On the other hand, if the GCC moves away from the Dollar the implications
for the Dollar in the global marketplace will be much less than favorable.
Analysts are of the opinion that the new currency of the GCC should be
pegged to a basket of currencies from the beginning. By pegging the new currency to
a basket of currencies the Gulf Central Bank will have more flexibility in monetary
policies. The basket could comprise of major currencies and the weight of each
currency in the basket should be based on the trade, the output, and inflation inter-
linkages. However, depending on the experience of the EU, I see that floating could
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be a better solution from the begging as long as inflation is not very high in the region
and the IMF recommendations to most of the countries to float their currencies in
order to live the real economic situation and be more independent on themselves and
realize their own economic situation.
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