the effects of establishing a monetary union on the integration of financial markets

8/8/2019 The Effects of Establishing a Monetary Union on the Integration of Financial Markets

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Preparing for CurrencyPreparing for CurrencyUnification in the GCCUnification in the GCCPreparing for CurrencyPreparing for CurrencyUnification in the GCCUnification in the GCC

Dr. Said AlDr. Said Al--ShaikhShaikhChief EconomistChief Economist

The National Commercial BankThe National Commercial Bank

April 2006


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OutlineOutline

History of Monetary Interdependence in the Gulf

Mundells Optimal Currency Area Theory

GCC and the optimality criteria Economic Benefits and cost of Currency Union to GCC

countries

GCC Preparations toward a successful Currency Union

The Future of GCC single currency


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History of Monetary InterdependenceHistory of Monetary InterdependenceIn the GulfIn the Gulf

1950s & 1960s, some Gulf States Shared a single currency (Indian Rupee)

After independence, Qatar and Dubai shared a common currency

The Riyal (1966- 1973)

In 1981, Unified Economic Agreement was approved

In 1983, a GCC Free Trade Area was established; Tariffs on goods ofnational origin were eliminated

In 2001, a decision was taken to adopt a fixed peg to the US dollar in

preparation for a monetary union by 2010

With the exception of Kuwait, other GCC states effectively pegged their

currencies to US dollar.

Kuwait dinar had been pegged to a trade weighted basket of currencies

In 2003, all GCC states officially pegged their currencies to US dollar

In 2003, GCC members implemented a Custom Union; 5% tariff on

imported foreign goods


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The Rationale to Peg to US DollarThe Rationale to Peg to US Dollar

The US dollar has been a de facto anchor in the past for all GCC

members except Kuwait, whose currency fluctuated marginally against

the dollar

Oil & gas exports are priced in US currency as fluctuations of thedollar against other currencies will be mirrored by that of GCC

currencies.

The peg to dollar also establishes a stabilizing influence for

government budgets as oil and gas are major sources of revenues.

US dollar would most likely be the anchor of the new Gulf currency

when it is established in 2010.


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GCC and the Optimality CriteriaGCC and the Optimality CriteriaDoes GCC economies meet the currency area optimality criteria

GCC states are among most open economies in Arab region;

(average Trade/GDP varies 70% to 150%)

GCC impose restrictions on ownership by GCC nationals and

Labor market regulations are not similar. GCC countries remain heavily dependent on oil; ( GCC adopt a

policy not to use ER for adjustment in case of oil shocks)

GCC have same production structure with a dominant oil

sector; this entails symmetric shocks Prices and wages dont adjust systematically to oil shocks;

government expenditures are used as a stabilizer and not ER


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GCC and the Optimality CriteriaGCC and the Optimality Criteria

Inflation rates not correlated among GCC and inflation differentials reflect

a difference in microeconomic determinants

GCC countries continue to reinforce commonalities and coordinate

economic policies; especially in the context of CU

Favorable Unfavorable

Openness *

Factor Mobility *

Degree of Diversification *

Economic Structures *Price & Wage Flexibility *

Inflation Rate Similarity *

Policy Coordination *


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Economic Benefits of Currency UnionEconomic Benefits of Currency Unionto GCC Economiesto GCC Economies

Elimination of currency transaction costs.

Elimination of exchange risk encourages intra-gulf trade & investment.

Help GCC states diversify their economic base away from hydrocarbon.

Greater transparency in pricing & improved business competitiveness.

Fiscal discipline by GCC states contribute towards low inflation &

interest rate environment within the GCC.

The new Gulf currency encourages more efficient cash management

and reduces the cost of hedging against exchange rate volatility.

For the size of GCC, monetary union would offer new trading &

investment opportunities, attracting more foreign investment. Increasing regional and international investment into GCCs capital

market


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Economic Costs of CurrencyEconomic Costs of CurrencyUnion to GCC EconomiesUnion to GCC Economies

y Loss of national sovereignty due to relinquishing of

independence control over domestic monetary, fiscal and

exchange rate policies.

y

Possible net loss in income due to lack of ability to pursueexpansionary monetary and fiscal policy during periods of

falling oil prices.

y The GCC Currency Union involves rather arbitrary

restrictions on national budgetary policies with regards to

individual taxation and spending programs.


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Preparation Toward a SuccessfulPreparation Toward a SuccessfulCurrency UnionCurrency Union

Deadline has been set for 2007

Free trade in banking and finance will require greater coordination;

monitoring and regulating

Free movement of capital will require establishing links between stock

markets; allowing for cross-listing

Allowing for free mobility of labor, including expatriate labor

1 Creating GCC Common Market

2 Creating a GCC Central Bank

Recently announced that a GCC Central Bank will be established

Exact model has yet to be decided; Merging existing ones versus onestyled on the European Central Bank (ECB)

GCC States need to agree on each states Capital Contribution

Structure and Mandate of Central Bank must be agreed upon soon enough


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3 Setting Convergence Criteria

GCC States opted for similar criteria to those of Maastricht

Acceptable levels of Public Debt ----------- 60% to GDP

Acceptable level of budget deficit ----------- 3% to GDPInflation Rate (capped at) ----------- Weighted average + 2%

Interest Rate (not to exceed) ----------- Average of lowest threecountries + 2%

Foreign Reserve (not final) ----------- 4 Months of total imports

Potential problems are likely to occur,

- especially in government deficit, usually correlate with low oil prices

- wide difference in inflation rates among GCC States

Yet, GCC need to comply by 2007 before Union achieved in 2010

Preparation Toward a SuccessfulPreparation Toward a SuccessfulCurrency UnionCurrency Union


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How GCC countries measure up to ConvergenceHow GCC countries measure up to ConvergenceCriteria based onCriteria based on 20042004 datadata

Budget surplus

of GDP %

Public Debt

of GDP %

FX reserves

Months of important cover

Bahrain *0.7 *34.3 3.8

Kuwait 19.1 21.1 8.5

Oman *4.8 *13.1 5.5

Qatar *8.6 *34.6 6.6

Saudi Arabia *10.4 *65.3 8.0

UAE 18.3 8.4 4.1

Central Government *

Source: IMF/IIF estimates, SCB Global Research calculations


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GCC Inflation Rates divergence areGCC Inflation Rates divergence areexpected to continueexpected to continue

Inflation Interest rate (%)

Bahrain 5.3 1.6

Kuwait 1.8 2.0

Oman 0.4 2.3

Qatar 6.8 1.5

Saudi Arabia 0.3 1.7

UAE 4.6 1.6

Threshold 5.2 3.6

Source: IMF/IIF estimates, SCB Global Research calculations


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Can GCC sustainably meet Budget DeficitCriteria given Medium Term Outlook for oil

Kuwait Qatar OmanSaudi

ArabiaUAE GCC

Balance 10.0 19.0 17.0 28.0 23.0 21.6

3% deficit 7.0 11.4 13.0 24.0 21.0 20.5

Source: SCB Global Research


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4 Agreement on bilateral exchange rate

In case of euro, bi-lateral exchange rates were locked in at their central

rates and were announced 7 months before its launch

The Collective peg to US dollar provides a stable bilateral rate that could

be fixed in currency union may desire to renegotiate their values againstUS dollar

5 Economic Policies Coordination

Several states interested in parallel industries; may result in some painful

adjustment

Increased cooperation will minimize damage caused by establishing

competing activities

Intra-industry activities should be developed on a regional basis whenever

possible

Preparation Toward a SuccessfulPreparation Toward a Successful

Currency UnionCurrency Union


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6 Transparency and data standardization

7 Public Awareness

The need for clear economic data will become more important to asses

convergence criteria

Reliable and timely data is important to improve investor confidence in

the region

Provide guidance to business on how to prepare for introduction of the

new currency

GCC business must be made aware of the need to ensure that their

information technology, accounting, marketing, pricing and payrollsystems have been adopted to new currency

Regulation on conversion of price will need to be published; involving

rounding to nearest unit of new currency

Preparation Toward a SuccessfulPreparation Toward a Successful

Currency UnionCurrency Union


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The Future of the Unified CurrencyThe Future of the Unified Currency

1 - Choosing an alternative peg arrangement

Trade with Eurozone and Asia account for over 60%; a trade weighted

basket of currencies maintains stability of trade revenues

Recent decline in dollar has weakened GCC currencies and has increased

the relative price of imports.

Real wealth has been lost due to holding of reserves in dollar denominated

assets

Pegging to dollar, means GCC interest rates are determined by Federal

Reserve, monetary policy is based on US economic conditions

High oil prices are generally associated with low interest rate in US, thusexacerbating pro-cyclical tendencies


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Pricing Oil in the Unified CurrencyPricing Oil in the Unified Currency

Increased exchange rate autonomy (floating the single currency) Provides GCCStates with feasibility in setting interest rates and making future economic

policy decision

2 Pricing Oil in the new currency

If GCC chose an independent exchange rate, there would be compellingincentive to price oil in the new currency

This would create demand for it as central banks in other countrieswould hold reserves in the new currency to cover their oil purchases

Increased overseas demand on the new currency would strengthen thenew currency


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