The United States Federal Reserve’s interest rate cut on September 18, 2007, has sparked concerns over the possibility that Gulf Cooperation Council (GCC) states – which include Kuwait, Saudi Arabia, Bahrain, Oman, Qatar and the United Arab Emirates (UAE) – would follow Kuwait’s lead and drop the peg between their individual currencies and the dollar. Kuwait previously dropped the dollar standard in May 2007 due to fears of inflation.
Of note, following the recent US Federal Reserve rate cut, Kuwait also cut its interest rates by half a percentage point and the UAE lowered its rates by .15 of a point. The other four GCC members kept their rates on hold.
However, since oil is still priced in US dollars, GCC members are not overly concerned as the price of oil is still rising, providing healthy profit margins.
• Although the GCC’s economies face certain challenges as a result of a weaker US dollar, we believe it is highly unlikely that other oil rich Persian Gulf countries will unpeg their currencies from the American dollar in the foreseeable future.
Scattered Response of the GCC
As the GCC aims to strengthen economic cooperation within its member states, it has set an ambitious goal to create a common currency by 2010. Previously, the GCC had agreed to keep pegs to the lowering US dollar in place until the region created its single currency, however, Kuwait abandoned its peg on May 20, 2007, saying the US currency’s weakness was fuelling inflation by making imports more expensive.
Though no other GCC state has abandoned its fix to the US dollar, two out of the six states have cut interest rates along with the US. The decision by the UAE and Kuwait, the second and third-largest Arab economies after Saudi Arabia, to cut rates may increase pressure on Gulf states to end the policy of pegging their currencies to the US standard as inflationary risks rise.
As an incentive to drop the dollar standard, the value of the Kuwaiti dinar rose against most GCC and main currencies since its disengagement from the US dollar. Currently the dinar is pegged to the international currency basket, which heavily relies on the US dollar.
Soaring Inflation and Oil Pricing
High oil prices have spurred an investment boom and led inflation to near record highs among the Gulf’s sheikdoms. Inflation in the UAE is projected to reach 8 percent in 2007, according to the International Monetary Fund.
The dollar’s decline has partly undermined the benefit of record oil prices in the region that is expected to accrue a budget surplus in excess of $500 billion this year. Crude traded in New York at near intraday records above $82 per barrel this week after the Organization of Petroleum Exporting Countries agreed to boost output by 500,000 barrels per day beginning November 1, 2007 (Previous Report).
Outlook
Saudi Arabia, Oman, Bahrain, and Qatar are not planning on decreasing interest rates any time soon for fear of soaring inflation and high oil prices. Saudi Arabia, however, may come under pressure to reduce borrowing costs or revalue the riyal if the US Federal Reserve cuts rates again this year, as this will severely increase inflation in the Kingdom.
Nevertheless, as long as the petrodollar remains the standard for pricing oil, it is highly unlikely that the GCC will eliminate the dollar peg for their currencies. Doing so would result in delaying their 2010 goal for a common currency indefinitely.
