Every country has two major policy tools at hand to drive its economy – Fiscal and Monetary Policy to influence macro-economic variables like output, employment and consumer prices. Monetary policy in GCC countries is led by the primary objective to maintain the pegged exchange rate regime.
The approach is chosen to protect the oil economy against currency fluctuations. With exchange rates pegged to the U.S. dollar, the GCC central banks have limited scope for discretionary monetary policy. Nevertheless, even within the limits of a fixed exchange rate regime, the channels of monetary transmission play an important role.
Interest rate and bank lending channels are relatively effective in influencing non-hydrocarbon output and consumer prices, while the exchange rate channel does not appear to play an important role as a monetary transmission mechanism because of the pegged exchange rate regimes.
The empirical analysis suggests that policy measures and structural reforms—strengthening financial intermediation and facilitating the development of liquid domestic capital markets—would advance the effectiveness of monetary transmission mechanisms in the GCC countries. Over the years, GCC has moved toward closer economic and financial integration, aiming to form a monetary union.
In 2014, Bahrain, Kuwait, Qatar and Saudi Arabia took major steps to ensure the creation of a single currency. There is currently a degree to which a nominal GCC single currency already exists. Plans to introduce a single currency had been drawn up as far back as 2009, however due to the financial crisis and political differences, the UAE and Oman backed out.
The exchange rate graph plots the fixed currency rates for the GCC countries for 2015. They have been maintained at the same level for the last 5 years. Most GCC countries are pegged to the US dollar to avoid currency fluctuation and eliminate uncertainties in international transactions.
Since oil is the chief commodity in the GCC, and the oil price is fixed in dollars, any exchange rate fluctuation could drastically reduce revenue if the currencies were unpegged.
Saudi Riyal, in June 1986, was officially pegged to the IMF’s special drawing rights (SDRs). In practice, it is fixed at 1 U.S. dollar equal to 3.75 riyals. This rate was made official on January 1, 2003.
The current fall in oil prices has strained GCC currency policy, and increased the cost of carrying a US dollar peg. With the US economy expanding, the Federal Reserve has begun hiking interest rates gradually, and plans to achieve a target of 3 per cent by the end of 2018. While the US is expected to ride a growth wave over the next few years, the GCC economies, especially the oil exporters, are facing contraction because of low oil prices.
The oil price fall since mid-2014, has reduced the Saudi Arabia’s revenue, causing a deficit of $98bn in 2015 which is estimated to increase to $87bn in 2016. The Saudi government had funded this deficit by drawing down its central bank deposits, reducing its forex reserves to $602bn; a drop of $132bn, in the year to this January.
Saudi Arabia, with more than 73 per cent of government revenues come from the hydrocarbon sector, (IIF, Institute of International Finance) can either follow the monetary policy direction set by the US or deviate from it. If it opts for the former, the kingdom maintains the peg but sacrifices its growth, as it will tighten monetary conditions during a period of low growth.
According to the kingdom’s central bank, the Saudi Arabian Monetary Agency (SAMA), a 100 basis point increase in the Saudi Interbank Offered Rate (SIBOR) leads to a decline of 90 basis points in GDP in the subsequent quarter and 95 basis points in the quarter after that. If it deviates, then there will be a gap in interest rates between the US and Saudi Arabia, leading to arbitrage opportunities.
To counter this, SAMA will have to buy Saudi ¬riyals in the open market by selling US dollars from its reserves. And as the Fed increases the interest rate, SAMA has to keep depleting its forex reserves until it runs out of dollars.
Hence there is a cost involved with ¬either choice. According to Moody’s, the kingdom has large foreign currency reserves that provide ample room to maintain the pegged exchange rate regime for several years, even in an adverse oil price scenario.