GCC currency pegs and a new crude oil order

The GCC currency pegs to the US dollar have been prominent in international finance in place since the early 1980’s, in times of war and revolution, in times of economic boom and bust, in times of crude oil price surges and crashes. Yet the oil crash of 2014-16 was an inflection point in the economic history of the Arabian Gulf. Crude oil prices were $115 a barrel in June 2014, the month ISIS terrorists seized the Iraqi city of Mosul. Yet Brent crude had plunged to $28 by February 2016 and inflicted the longest period of cumulative foreign exchange losses for the six GCC oil exporting monarchies. The financial impact of the oil price crash was seismic for the GCC - $350 billion in fiscal deficits, $270 billion in foreign exchange losses and $250 billion in sovereign net worth declines in 2015 - 17.

For the UAE, the most globalized, networked and diversified economy of the GCC, the negative impact of the oil crash was amplified by the 30% rise in the US Dollar Index in 2013-18, an unsettled period in world history that witnessed the Russian invasion of the Crimea, the Brexit referendum, the ECB’s quantitative easing civil wars in Libya, Syria, Iraq and Yemen, the Qatar embargo, a military coup in Egypt, a US-China trade war and India’s rupee demonetization. The surge in the US dollar and geopolitical risk led to a protracted fall in tourism revenues, FDI, property prices, cross-border capital flows and stock exchange values in the UAE. The GCC currency pegs import inflation when the US dollar declines, as in 2002 -07. Yet the GCC currency pegs import deflation when the US dollar rises, as in the early 1980’s, late 1990’s and 2014-18.

The significance of the 2014-18 oil shock was not just in the magnitude of financial losses it inflicted on the GCC but also the fact that it stemmed from a structural shift in the international oil market – the emergence of US shale oil and gas output as a key component of the global energy equation. The US produced just under 12 million barrels of oil in 2018 and could well add one million barrel of extra oil every year for the next five years. While a Saudi-Russian pact to cut output has raised Brent crude to $60 in early 2019, the GCC will face a succession of oil shocks in the next decade, a decade which will see the Permian Basin in West Texas replace the Arabian desert as the epicenter of the kingdom of black oil. Chinese economic growth and petroleum demand will slow and electric cars slash the need for transport fossil fuels. These future oil shocks will force fundamental economic change in even the most affluent GCC societies as well as a rethinking of their US dollar currency peg.

There have been sporadic currency crises in the past but the GCC has maintained a consistent political commitment to fixed exchange rates regimes and the US dollar peg. In 2006-07, expectations of a revaluation of the UAE dirham led to a tsunami of capital inflows that inflated the local stock and property markets. More recently, volatile spot markets and forward premium spikes have led to requests from Bahrain and Oman for GCC central bank swap lines to defend the Bahraini Dinar and Omani Riyal. Even the Saudi Arabian Monetary Agency (SAMA) imposed punitive regulations to deter speculation in the Saudi Riyal forward exchange market.

The GCC economies vary dramatically in size, central bank reserves, sovereign wealth assets and vulnerability of individual currencies to cross-market contagion. There is no real prospect of a common GCC currency (the Khaliji) as the six countries could not even agree on the location of a GCC central bank, let alone the alignment of fiscal and monetary policies. The Qatar crisis has made a pan GCC response to liquidity shocks and currency crises impossible, though UAE, Saudi Arabia and Kuwait have often extended financial support to Oman and Bahrain.

Though they exacerbate the boom-burst cycles in local asset markets, the GCC currency pegs have anchored inflation expectations and provided low transaction costs/balance sheet risks for the business sector. Yet when the economic cycles of the US and GCC diverge, the need to shadow Federal Reserve rate hikes becomes painful for the region. After all, there have been nine Fed rate hikes since December 2015 and GCC central banks were forced to embrace tight money even during the 2014-16 oil price crash.

The huge numbers of low wage expat labour, the absence of Dutch disease syndrome and relatively underdeveloped capital markets make US dollar pegs an optimal foreign exchange regime for the GCC. After all, the GCC outperformed most emerging market peers in GDP growth and monetary stability since the 1980’s. As long as oil is traded in US dollars, the GCC hard dollar pegs will endure, backed by the petrodollar sovereign reserves of Saudi Arabia, UAE and Kuwait.