The creation of a monetary union has been an overriding objective of the regional economic integration process among Gulf Cooperation Council (GCC) members since the early 1980s. (Khan 2009) Since then, the GCC member countries have come a long way on the road to economic integration. When established, the GCC monetary union would be the second most important supranational monetary union in the world in GDP terms, second only to the European Monetary Union (EMU). The experience of monetary unions elsewhere in the world can provide useful insights into the challenges that the planned GCC monetary union faces. Presently there are five monetary unions in the world. Three of these unions are in Africa, one in the Caribbean, and one in Europe.
In all of them, a new common currency was created, except in the Southern African Common Monetary Area (CMA), in which the South African rand is the common currency in circulation. The GCC countries are probably the most homogeneous among the unions, sharing a common history, language, and culture. (Buiter 2008) They are mainly oil exporters (with the exception of Bahrain), are very open to trade and imported labor, have very flexible labor markets in which even nominal wages can adjust, and have complete factor mobility within the group. Further, they all have full convertibility. One could argue that the GCC countries have already fulfilled many of the preconditions for a currency union. Overall the GCC meets the generally accepted criteria for a single currency among its members, namely proximity, size, fluctuations of output, trade structure, and inflation performance (Buiter 2008).
Much progress has been made toward achieving the goal of a full-fledged GCC monetary union. GCC countries have achieved virtually unrestricted intraregional mobility of goods, national labor, and capital, and prudential regulations and supervision of the banking sector are being gradually harmonized. All members except Kuwait have pegged their currencies to the US dollar since 2003, and a common external tariff was introduced in 2003. Although the GCC currencies have been de facto pegged to the US dollar for decades, single GCC currency is expected to encourage trade and financial integration, facilitate foreign direct investment, and foster the development of the GCC into an “optimum currency area” ex post even if, as has been argued by some, the GCC grouping may not constitute one ex ante (O’Sullivan 2008).
A common external tariff was introduced in 2003, and on January 1, 2008, the GCC launched the common market. The common market provides GCC citizens equal treatment in all economic activities, especially freedom of movement and residence; work in private and government jobs; pension and social security; engagement in all professions and crafts as well as all economic, investment, and service activities; real estate ownership; capital movements; tax treatment; stock ownership and formation of corporations; and education, health, and social services. The common market is expected to result in increased production efficiencies and an improved negotiating position in international economic fora.
Full implementation of the common market will require the adoption of national laws and regulations, a process that is underway at the GCC Secretariat based in Riyadh, Saudi Arabia. So far, the GCC Secretariat has developed dispute resolution mechanisms, including a common market committee, a ministerial level committee, and an arbitration center in Bahrain, and plans are underway to create a supranational court. The European Central Bank (ECB) has provided the GCC with a draft Monetary Union Agreement (MUA) and statutes on the Gulf Monetary Council (GMC) and the Gulf Central Bank (GCB). It is expected that a monetary council will be established by the end of 2009 to serve as a transition body in preparation for the single currency and the GCC Central Bank.
A set of five convergence criteria (on inflation, interest rates, reserves, fiscal balance, and public debt), similar to those used in the run-up to the European Monetary Union, has been agreed in principle (Buiter 2008). Although they are not preconditions for entry, by the end of 2006 the GCC countries had met almost all of the convergence criteria and exhibited a high degree of convergence on many macroeconomic indicators. With inflation across the GCC (except in Bahrain) rising to similar rates, inflation convergence (which has been lagging) is being achieved, although at a level that is obviously too high from the standpoint of macroeconomic stability. But there have also been some unanticipated setbacks to achieving the monetary union.
In October 2006 Oman announced that it would not join the union by 2010, and in May 2007 Kuwait declared that it was moving from the dollar peg to an undisclosed currency basket, although it reaffirmed its commitment to join the union. (Khan 2009) There have also been delays in establishing harmonized systems and in institution building. In terms of preparedness for the common currency and the creation of a common, independent central bank, the monetary policy frameworks, payment and settlement systems, regulatory and supervisory structures, macroeconomic statistics, and other specific central bank functions have yet to be fully harmonized.
The management of reserves and nonreserve assets has also not yet been agreed. In addition, on the fiscal side, setting up a common accounting framework and adequate budgetary procedures are a high priority in the period leading up to the introduction of a common currency. As a result, the 2010 deadline for the single GCC currency appears increasingly unachievable, a fact that is now acknowledged by several of the countries as well as by the GCC Secretariat. Looking ahead, one very important decision in the formation of a monetary union is the choice of an appropriate exchange rate regime. The countries’ choice of a US dollar peg as the external anchor for monetary policy has obviously been credible and has served them well so far.
In fact, one can argue that the generally low inflation rate in the GCC until recently has been due to the pegging of their currencies to the US dollar. (O’Sullivan 2008)
At the same time, rising inflationary pressures in the last couple of years, increasing integration with global markets, and differing economic cycles and policy needs from that of the anchor country, the United States, have raised questions about whether the peg to the dollar remains appropriate. The choice of the exchange rate regime has to be seen in the context of the structural characteristics of the GCC economies, in particular the importance of the oil sector in GDP, exports, and government revenue, as well as the emerging economic challenges for these countries in the near future. The primary challenge for them is to further develop the non-oil private sector in order to create employment opportunities for the rapidly growing national labor force.
A strong case can be made for the monetary union to continue pegging to the dollar. Macroeconomic conditions in the GCC countries have been stable for the last two decades even during periods of dollar fluctuations, and over the long run cyclical synchronicity between the GCC and the United States has been increasing despite some recent divergence (O’Sullivan 2008). The peg to the US dollar has helped the region avoid nominal shocks from geopolitical risks feeding into the economy. These risks are likely to continue, placing a premium on a credible US dollar peg. Furthermore, from a historical perspective, the recent fluctuations in the US dollar are not fundamentally different from previous fluctuations. The dollar peg provides a credible and easily understood anchor for monetary policy (Buiter 2008).
The dollar peg has clearly anchored inflationary expectations at low levels and provided certainty about future exchange rates. For example, the recent uptick in inflation notwithstanding, forward markets continue to reflect confidence in the dollar peg. The peg is easy to administer and does not require the institutions necessary for implementing an independent monetary policy. Such institutions would need to be built, become effective, and establish credibility. Since the monetary transmission mechanism is weak, given the absence of domestic capital markets, the shallow size of credit markets, and the limited role of interest rates, a peg rather than a float is a realistic option for the first few years of a GCC monetary union. The exchange rate peg simplifies trade and financial transactions, accounting and business planning, as well as monetary coordination among the member countries.
Exchange rate risk can be easily hedged, even in the absence of a well-developed domestic private market in forward exchange, as it is possible to work through US dollar markets. With cross-rates constant, intra-GCC transactions benefit,as traders and investors do not have to take on any exchange rate risk, thereby encouraging further integration of the members. Absent developed financial markets, and particularly forward markets in which to hedge, the central banks would probably have to take on the task of providing forward cover. (Khan 2009) Labor market flexibility can support international competitiveness under a fixed exchange rate regime.
At present GCC countries face a relatively elastic supply of labor (mostly unskilled) coming from low-income countries in the Middle East and South Asia. GCC countries have also been applying their policy of nationalization of the labor force in a very flexible manner so as to avoid labor shortages and minimize output disruptions. Pegged exchange rate regimes are preferred by major oil exporters. Of the 26 countries whose oil exports account for over 50 percent of total exports, 18 have conventional fixed pegs, including the GCC countries and members of the Central African Economic and Monetary Community (CEMAC). (Khan 2009) Other countries with a peg include Brunei (a currency board) and Ecuador (a dollarized economy). Algeria, Kazakhstan, and Russia have managed floats, but the volatility of their exchange rates has been contained within a tight band. (Khan 2009)
This points to the commonality of features among the large, oil-exporting economies. In particular, with foreign exchange receipts provided predominantly by the dominant export commodity and subject to significant price volatility, it is relatively more difficult to operate a free foreign exchange market, particularly if the institutions needed to support it are not well developed. The familiarity of GCC authorities and private economic agents with the US dollar peg as well as the similar preferences the GCC countries have shown for a fixed exchange rate both speak in favor of maintaining the current arrangement after the implementation of the planned monetary union. In fact, in 2003 GCC member countries opted to fix their bilateral parities and to peg their currencies to the dollar in the run-up to the GCC monetary union in 2010 to benefit from greater certainty about the parities at which they would enter the monetary union. (O’Sullivan 2008)
Keeping the single GCC currency peg to the dollar would leave the public and policymakers on already familiar ground. The dollar peg does have a number of disadvantages. First, it imports monetary policy from the United States, which at times may not be appropriate for local needs (O’Sullivan 2008). With an open capital account, the dollar peg requires the GCC countries to follow US interest rate policy, which has the potential to result in policies unsuited to the needs of the GCC countries’ business cycles. When the divergences between the business cycles are likely to be temporary, policy tools other than interest rates or exchange rates would have to be used to influence domestic activity. In particular, fiscal policy and, to a lesser extent, quantitative credit restrictions and tighter prudential regulations would need to be used to curb aggregate demand and credit expansion.
The peg also means that GCC countries cannot defend against imported inflation, although in the long run, higher inflation in trading partners would tend to be offset by depreciation of their currencies against the US dollar. Further, the peg forces any adjustment of the real exchange rate to a new equilibrium to take place through inflation rather than through adjustment in the nominal exchange rate. Adjustment through inflation is slower than that through the exchange rate and may trigger price-wage spirals, generate low real interest rates, and increase the risk of asset bubbles as investors switch into real estate and equity assets. It also reduces the real value of financial savings. (Buiter 2008)
If individual exchange rate parities, however, were considered out of line with fundamentals at the time of the GCC monetary union’s establishment, which would be signaled by continued high domestic inflation, the GCC could retain the dollar peg but effect a one-off coordinated adjustment of the current parities at the establishment of the common currency. A revaluation could allow a temporary dampening of imported inflation and help bring real exchange rates closer to equilibrium. However, a revaluation would impose significant and immediate valuation losses on the large official foreign assets of the GCC countries16and would reduce international competitiveness for those countries that have embarked on economic diversification.
If large, a revaluation could generate sharply lower fiscal revenues in domestic currency and entail a significant adverse impact on the balance sheets of both the government and private sectors, including banks. There is also a risk that as soon as the signal is given that the exchange rate is a policy instrument available to tackle inflation, this could increase market expectations of further revaluations and encourage speculation, even if fundamentals are unchanged. (O’Sullivan 2008) In fact, this was observed when Kuwait moved to a basket peg and again in late 2007 when investors reacted to statements of GCC officials by transferring substantial deposits into the region, betting on an imminent currency revaluation. Further, it would be important to estimate the needed adjustment accurately.
Debate continues on how to determine the equilibrium real exchange rate and hence the appropriate level of the nominal exchange rate for oil exporters. This is an extremely difficult exercise that yields a wide range of results. Ideally, the exchange rate should be set at a level that would be consistent with sustaining the current account at some desired equilibrium level (or “norm”). But the equilibrium real exchange rate will depend on both the level and volatility of oil prices over the medium term. In fact, any change in current or future oil prices will alter the equilibrium exchange rate and the current account norm. While evidence suggests some undervaluation for the GCC countries, the available estimates are typically prone to large errors, and quantification of the degree of undervaluation is difficult.