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Samson » April 16th, 2022

Pegging Gulf currencies to the dollar… How to survive wars and oil shocks?

14th April, 2022

Bloomberg” agency explained the secret of the Gulf’s peg to the dollar not being affected by wars and oil shocks, warning that the dollar’s status as an international reserve currency will be eroded from its foundation if the Gulf Cooperation Council countries loosen their peg to the dollar

Gulf  states have pegged their currencies to the US dollar for decades. The reason is that this step reduces the foreign exchange rate risks of the countries of the region because a large part of their revenues come from oil, the price of which is determined in the global market in the US currency.

These mechanisms are tested periodically, as happened in 2020, when the price war caused oil to plummet below $20 a barrel.

With the oil price returning to about $100 in 2022, these countries seem to be in a good position, despite the questions revolving around the dollar’s role in the global economy.

1. Which countries have pegged their currencies to the dollar? And why?

The six member states of the Gulf Cooperation Council, Bahrain, Kuwait, Oman, Qatar, Saudi Arabia and the UAE, have pegged their currencies, or managed foreign exchange rates, since the 1970s and 1980s.

The Kuwaiti dinar tracks a basket of currencies believed to be dominated by the dollar, while other currencies are linked to the dollar alone.  This peg helped insulate the region’s economies from the vagaries of energy markets, and allowed central banks to all the reserves in good times.

In turn, these reserves are used, along with foreign assets held by the sovereign wealth funds of countries in the region, to defend the level of the currency peg. 

2. What are the factors that may put pressure on the currency peg?

Asia’s fixed exchange-rate regimes collapsed completely during the financial crisis of the late 1990s, when speculators forced countries such as Thailand and South Korea to abandon their pegs to the US dollar.

The adoption of these systems is currently generally limited to the major oil-producing countries in the Middle East, in addition to Hong Kong, whose dollar has been pegged to the US currency since 1983.

The Gulf’s currency link to local central banks often informs the monetary policy of the US Federal Reserve, raising the risk of policy disruption when business cycles are inappropriate. 

Today, the Gulf countries are facing the problem of high inflation and the prospects of increasing interest rates globally, led by the US Federal Reserve.

There is a state of grumbling about the global dominance of the dollar and the willingness of the United States to use it as a weapon in the sanctions directed against Russia because of its invasion of Ukraine.

3. What can the Gulf countries do next?

Not a single government in the region has indicated that it might abandon its currency peg and leave it to the markets to determine the value of the currency.

However, Saudi Arabia, the region’s largest economy, is said to be considering accepting the yuan to pay for its oil exports to China. And if it takes this step, the “petrodollar” system will be tested, especially if its neighbors follow suit, given that China represents more than 20% of the oil exports of the GCC countries.

Currency strategists say that Saudi Arabia appears to be sending a political message to the United States by talking about the yuan, amid tense relations with Washington, and they underestimate any immediate move in this regard.

4. What pressures have occurred in the past?

This system has weathered severe tests, including successive years of low oil prices in the 1990s, a period of weakness in the dollar before the 2008 financial crisis and the 2014 oil price crisis.

Speculators intervened in that period in an unsuccessful attempt to resist the peg of the Saudi currency to the dollar, raising the price of the 12-month futures contracts that investors used to bet on the depegging of the two currencies or to hedge if that happened.

 5. How did Saudi Arabia react?

Instead of opting to devalue the riyal, the kingdom cut spending and subsidies and turned to the debt markets to finance the budget deficit. Its neighbors are adopting similar strategies.

Saudi futures prices jumped again in 2020 amid the double whammy of low crude prices and the spread of the Corona pandemic. The Omani riyal contracts recorded a record high in that year before turning to a decline.

6. What happens to the economies of the Gulf countries if the United States raises interest rates?

The problem is that, in order to maintain their pegs, the region’s governments are forced to follow the Federal Reserve with a series of interest rate increases that end up hurting their economies.

If it does, it will still have a way to avoid falling into an economic recession, as oil prices continue to rise, which generates abundant liquidity that it can use to increase spending and support growth rates.

7. Which linkages appear to be more susceptible to speculative risks?

For a long time, the weakest economies in the region were Oman and Bahrain, and the latter was the only country in the region that needed an oil price increase above $100 a barrel to balance its public budget, according to the International Monetary Fund.

Recently, the two countries have performed better, and Standard & Poor’s Global Ratings upgraded Oman’s rating in April.

The rise in oil prices eased concerns about the Sultanate’s ability to maintain the riyal’s peg to the dollar, which encouraged traders to reduce their bets on devaluing the currency.

Saudi Arabia, the UAE, Kuwait and Qatar always have enough ammunition in the form of massive cash reserves to defend the level of their currency pegs.

8. What would happen if the countries of the region abandoned the peg of their currencies to the dollar?

While the currency peg limits the freedom of the region’s governments to pursue monetary policy objectives such as reviving economic growth rates or creating jobs, it provides greater predictability of the currency’s value to foreign investors and residents.

The dollar’s status as an international reserve currency will be completely eroded if the Gulf Cooperation Council countries loosen their peg to the dollar.

The reserves of Middle Eastern countries represent between 10% and 15% of the total international reserves of foreign exchange outside China, according to estimates by “Goldman Sachs”. Saudi Arabia alone constitutes about 5% of this total.

If Saudi Arabia accepts payment for the oil in Chinese yuan, it will accumulate large reserves of yuan, which it must then allocate, Goldman Sachs noted in a research note last March.  This will be a challenge in itself given the size of the Chinese bond market.   LINK

Source: Dinar Recaps

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