The Gulf Cooperation Council (GCC) countries are expected to maintain their fixed exchange rate regime for the next few years, even as their currencies are “now clearly misaligned with their fundamentals,” according to International Institute of Finance (IIF).
“In our view, the GCC’s relatively low public debt ratios, large financial buffers, and the sizeable fiscal consolidation being planned, combined with a modest recovery in global oil prices, should put the fiscal position on a more sustainable footing and allow the pegs to be preserved, at least for the next few years,” Washington-based IIF said yesterday.
While public foreign assets will continue to decline, albeit from very high levels, import cover will remain well above 20 months through 2020, it said in the report “GCC: Dollar Pegs Will be Maintained”.
The GCC countries’ dollar pegs are backed by large stocks of international assets and low debt ratios such that large deficits in the coming few years can be managed. However, pegs will only be feasible over the medium term if fiscal policy adjusts sufficiently to ensure sustainable trajectories even with prolonged low oil prices, it said.
“But if we get into 2018 with international public assets substantially depleted, and it is clear that the oil price is going to remain around $40/bbl and that fiscal deficits will remain at high levels, then a significant devaluation may be the only option, particularly in Oman, Bahrain and perhaps Saudi Arabia,” it said.
The medium-term choices for the GCC countries could be a move towards a managed float, which has the advantage of allowing them use monetary policy to smooth business cycles, or peg to a basket that includes oil price, which does not require autonomous monetary policy and would ensure that the GCC currencies generally move with the global price of oil while dampening the volatility associated with a pure oil peg.
The GCC authorities’ continued commitment to defending their pegs reflects limited benefits from flexible exchange rates, it said, adding import and export volume elasticity with respect to real exchange changes are very low, given the limited domestic manufacturing and non-oil tradable goods sectors in the region.
There would be some benefit in the form of boosting oil revenue in local currency, but the adjustment would also raise local currency costs of imported materials, it said.
Finding that for almost three decades, the GCC countries have pegged their currencies to the US dollar; IIF said supported by the flexibility of the labour market, their currencies’ pegs have provided monetary policy credibility and have helped deliver low inflation and inflation volatility.
But the sharp fall in oil prices and the appreciation of the dollar in the past two years have raised doubts about the sustainability of the GCC’s pegs, it said.
Terming that “GCC currencies are now clearly misaligned with their fundamentals”; it said the equilibrium real effective exchange rates (ERER) have depreciated significantly in the past two years, given the large terms-of-trade losses (as a result of the slump in oil prices), but the actual real effective exchange rate (REER) has appreciated because of the appreciation of the dollar.
Finding that the observed REER was 12% above its estimated equilibrium level in 2015; the report said however, “the depreciation of the ERER should reverse in the coming years” in response to the authorities’ fiscal consolidation efforts (mainly through real spending declines) and the projected small improvement in terms of trade with gradual recovery in oil prices.