Middle East Economic Survey

VOL. XLIX

No 13

26-Mar-2007

GCC Monetary Union: Relevance Feasibility And Timing (1/2)

This report is the first of a two part series on the Gulf Cooperation Council (GCC) monetary union by Calyon’s Africa and Middle East Economist Koceila Maames. It deals with the relevance and feasibility. The second, to be published next week, will examine timing.

The six Gulf States (Bahrain, Kuwait, Oman, Qatar, Saudi Arabia and the UAE) plan to introduce a single currency by 2010 and several reform steps have already been taken accordingly. However, the past few weeks have been marked by the casting of the first doubts over this project, calling into question the initially scheduled deadline.

Forming the Gulf monetary union has several associated benefits: being better prepared for globalization challenges, lowering of transaction costs, boosting cross-border trade and financial transactions, sustaining diversification, improving risk perception and bolstering foreign investment. Monetary union is perfectly feasible. The Gulf countries could constitute a currency zone considerably more optimal than the Eurozone countries did, or even do today, after more than half a century of integration. The reasons being: convergent productive structures, a comparable degree of external trade openness, linguistic and cultural homogeneity favoring labor market flexibility.

The Gulf States already exhibit a strong economic and financial convergence after more than 20 years anchored to the same benchmark currency (US dollar). At the cost of some additional but affordable efforts (relevant convergence rules, wiser budget policies), the Gulf countries will be in a position to achieve monetary union and to ensure its viability over time. Yet, monetary union is far from being “only” a matter of economics. As has been the case in the experience of the Eurozone, operating the proposed single currency also hangs on the ability to concede transfers of sovereignty and to set both credible and legitimate supranational institutions (a regional central bank etc).

Historical Background

The GCC was established on 25 May 1981, with six countries as members: Saudi Arabia, Bahrain, Kuwait, Oman, Qatar and the UAE. The initial driving forces behind this union were the common points of culture and language which link the populations of these countries.

Subsequently, the member kingdoms of this Council showed a growing desire for economic integration, with an ultimate objective of introducing a single currency by 2010. At which time, the national currencies of the countries of the Arabian Peninsula would disappear in favor of a new single currency that has sometimes been referred to as the Khaliji Dinar (the Gulf Dinar). The concept of a single currency is not entirely unknown in the Gulf countries. Up until the 1960s, the Indian rupee was still the currency used in most of the countries that are currently GCC members (cf an article in the Bahrain Dinar Digest – January 2002): “The Monetary History of the Gulf”).

The establishment of the EU and the launch of the euro represent one of the rare historical precedents for such a project. As has been the case in the European project initiated in 1951, economic and monetary union precedes political union.  Since 1 January 2002, 13 EU countries (out of 27) have abandoned their national currencies in favor of the euro, with Slovenia being the latest to join on January 2007. The similarities between the Eurozone experience and the GCC monetary union project (ex nihlo construction process in both cases, with the monetary union preceding the political one) offer many possibilities for comparison and more importantly to discuss the relevance, feasibility and foreseeable timing of the Gulf monetary union.

Gulf States, Main Indicators (2005 Data)

Sources: Gulf Central Banks, IIF, BP Amoco and Calyon Research.

Why Have An Economic And Monetary Union?

The long process of economic and monetary integration that began in Europe after the Second World War was driven by many factors. On the political front, the six founder countries (Germany, Belgium, France, Italy, Luxembourg and the Netherlands) saw it as a way to emphasize the commonality of their futures and avert the specter of another armed conflict. On the economic front, these countries were anxious to organize themselves in order to be better prepared for the coming of a new international economic environment. Indeed, since the end of the 1940s, the developed countries have been engaged in a cycle of liberalizing international trade, especially with the establishment in 1947 of the General Agreement on Tariffs and Trade (forerunner of the World Trade Organization – WTO). In the case of the six Gulf States, the political arguments in favor of introducing economic and monetary union have probably been less forceful (at least so far). Border disputes have been relatively rare between these recently established Gulf monarchies, none of which has suffered any trauma comparable to the two world wars. In contrast to the European nations, there is a great deal of common ground linking their populations: ethnic, linguistic, cultural and religious.

Monetary Union Is Chiefly A Response To Globalization

Over the past few years, Gulf States have accelerated their integration into the global economy, as they have continuously liberalized their external trade. All the GCC states have joined the WTO, with Saudi Arabia the last to do so (December 2005). Some (Bahrain and Oman) are even signatories to a free trade agreement with the US, while the UAE is in the process of negotiation. Given the multiplication and the strengthening of regional trading blocs (Asia-Pacific Economic Cooperation, Association of South East Asian Nations, North American Free Trade Agreement, Eurozone etc), it has also become increasingly key that Gulf States work towards further economic and financial integration, at least for the purpose of increasing their negotiating power.

Their large reserves of oil and gas have enabled the Gulf countries to become first rank players in the international energy market. However, their contribution to global trade and their economic weight are still small. Saudi Arabia is the leading producer and exporter of oil in the world. Its economy is the most powerful of all the GCC countries and has seen both its nominal GDP and export of goods more than double since 2000. Nevertheless, it contributes no more than 0.8% to global GDP. Its exports represent barely 1.5% of global exports. Establishing an economic union between the six Gulf kingdoms would result in the new entity contributing almost 1.5% of global GDP. In parallel, the share of this economic union in global exports would come to more than 3%.

What is more, in establishing an economic union, as a preliminary stage to monetary union, the Gulf countries would probably be better placed to avoid deterioration in their terms of trade. On the domestic front, there would also be many advantages in a common market, within which free movement of goods, capital and people would be allowed and encouraged. Currently, the national populations of the GCC countries range from between less than 1mn for Bahrain and 25mn for Saudi Arabia, which is well ahead of second-placed UAE (4.2mn). The six Gulf kingdoms together would have a population of 36mn.

Compared to the Eurozone countries, with a total population of more than 300mn, this demographic mass would still be modest. However, with an economic union, the Gulf countries would have a single market significantly larger than each national market on its own. Such an increase would raise the number of outlets for every national economic sector. It would also promote economic diversification in a region dominated by the hydrocarbons sector.

Oil & Gas Dependency In The Gulf Countries              Main Destinations Of Exports

Sources: IIF, Arab Monetary Fund and Calyon Research.           Sources: Direction of Trade and Statistics.

Also, if properly launched and monitored, a monetary union would significantly increase the attractiveness of the countries involved from a foreign investor’s perspective. This would most likely facilitate the funding of the region’s considerable investment needs, amid still vibrant demographic pressure (more than $1,500bn already planned over the next years, mainly in public infrastructures).

Lastly, as has already been the case in the experience of the Eurozone, a monetary union would lower transaction costs and facilitate not only cross-border trade but also financial transactions. Such a benefit would come just in time to better capitalize on the past years’ tremendous development in regional banking sectors and financial markets. At best, fully integrated financial markets should improve liquidity conditions and lead to better regulation, likely preventing the repetition of the 2006 collapse in the regional equity market.

Safeguarding Currency Stability/Preserving ‘Common’ Interests

In the Eurozone countries, the need for a single currency gathered momentum in the 1970s, after exchange rate volatility was said to be detrimental to cross-border trade. Admittedly, the situation of the six Gulf States remains rather different: their productive structures are in many cases comparable, as they are all essentially dominated by the hydrocarbons sector.

Their currencies have been closely pegged to the US dollar for the past 20 years or so, and the resulting stability in their cross rates has (so far) made only a marginal contribution to the development of intra-regional trade. Trade between the six Gulf countries is marginal (barely 5% of total exports and 6% of imports).

Therefore, by contrast with Europe, the currency stability argument (cross rates) as a factor against disruption of trade carries less weight for Gulf monetary union. Nevertheless, there are many other reasons why establishing such a unions would be beneficial. A more detailed analysis of GCC country trade, especially with the rest of the world, demonstrates that the Gulf kingdoms have an interest in promoting convergence between their currencies. The six have similar structures of trade, both in the type of goods exported (between 75% and 95% hydrocarbons) and in the destination of exports/origin of imports (overwhelmingly Eurozone, US and Asia).

In this context, divergent currency movements would produce asymmetrical consequences in the event of exogenous shocks (fall in oil prices, high euro/dollar or dollar/yen volatility). The countries most affected would no longer be interested in pursuing strategies of corporation. Last but not least, without cooperative attitudes, an oil price stabilization mechanism, such as that established by OPEC in March 2000, with strong support from the GCC countries (all members, except for Oman and Bahrain), would probably not have emerged.