Middle East Economic Survey

VOL. XLIX

No 14

2-Apr-2007

REGIONAL/GCC

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

This report is the second of two on GCC monetary union by Calyon’s Africa and Middle East Economist Koceila Maames. It deals with timing. The first, published last week (MEES, 26 March), examined relevance and feasibility.  

Compared to the situation in the EU countries when they launched their economic and monetary integration process, the GCC countries appear well placed to see the project through. From the point of view of economic theory, the Gulf states form a currency zone considerably more optimal than the Eurozone countries did, or even do now after more than 50 years of integration.

An ‘Almost’ Optimal Currency Zone

The theory of optimal currency zones emerged from the debate between fixed and flexible exchange rates. It was presented for the first time in 1961, in an article by Robert Mundell. An optimal currency zone is defined as a geographical zone (a group of countries or regions) where the introduction of fixed parities between the existing currencies helps improve the economic efficiency of agents. First, Prof Mundell highlighted the fact that even certain states, as defined by their political frontiers, do not constitute optimal currency zones justifying the circulation of a single currency. As a result, if there is an economic or political shock, two regions of a single country, with different structural characteristics, economic activity, sensitivity to oil prices and/or level of unemployment) are affected asymmetrically. This then requires the adoption of different solutions, incompatible with the objective of single currency circulation.

Second, the studies by Prof Mundell, backed up by those of McKinnon (1963) and Fleming (1971), explained that to be an optimal currency zone, a geographical zone must meet certain criteria. GCC countries satisfy the majority of them:

• Convergence of the productive structures. With economies dominated by the hydrocarbons sector, Gulf countries have limited exposure to the asymmetrical effects of macro-economic shocks.
   

• The degree of international exposure.

The more open an economy, the more devaluation becomes a source of imported inflation, reducing the advantages related to an adjustment via the currency. All GCC countries have very high degrees of international exposure ((imports + exports) / GDP). The figure varies between 76% for Saudi Arabia and more than 130% for Bahrain and the UAE. Based on this criterion, they are to a great extent eligible to constitute an optimal currency zone.

• Labor market flexibility.

Countries participating in a monetary union must individually, as each Eurozone country has done, give up its monetary policy instrument (exchange rate and interest rates). In the event of shock, labor market flexibility (flexibility in wages and mobility of workers) helps offset the impossibility of undertaking an adjustment via the currency. In the Gulf, foreign labor accounts for between an estimated 55% of total employment in Bahrain and more than 80% in the UAE, Kuwait and Qatar, and is flexible. For nationals (85% of them employed in the public sector), wage rigidity could be offset by greater inter-state mobility (common language religion and culture).

• The cyclical criteria.

Interest rates in the Gulf countries are relatively close, nullifying the effect of exchange-rate movements. Among other things, such movements are intended to offset interest rate differentials. Inflation rates are also more or less converging (see below), contributing to stability in purchasing power parities and limiting the need to resort to an adjustment via the currency.

Financial Convergence

Economic theory and the experience of the Eurozone suggest that achieving monetary union and preserving its viability over time require a strong economic and financial convergence among its members (comparable inflation, interest rates, fiscal performance etc). Economic and financial convergence as well as the “constraints” it sometimes implies are needed mainly to limit the risks of asymmetric shocks, encourage cooperative attitudes and avoid making the most virtuous members of the monetary union pay for less virtuous ones. Accordingly, the six Gulf states in December 2005 approved a set of economic and financial convergence criteria mainly in the form of monetary and fiscal targets to be achieved before the launch of the single currency – widely based on those adopted at Maastricht in 1992 to qualify the European countries for the euro.

The main difference between these two sets of criteria is the absence of an exchange rate target, which is no surprise, given the implementation of largely comparable exchange rate regimes within the GCC. Pegging the Gulf currencies to the same benchmark currency (US dollar) for the past 20 years or so has implicitly helped achieve a strong degree of monetary convergence. With the exception of Qatar, all the GCC countries have met the inflation criterion since 2000 – even in 2006, amid a significant revival in price pressures (combined impact of the US dollar weakness, rapidly growing domestic liquidity, real estate ‘bubble,’ etc).

Compared Inflation Rates                                                     Compared Lending Rates

Sources: Regional central banks, Fed and Calyon Research.  

Again in terms of monetary convergence, all the GCC countries meet the interest rate criterion. Regional central banks tend to track the US Federal Reserve movements, given the exchange rate peg to the dollar. Admittedly, a few divergences occurred in 2006, mainly attributable to some reluctance to totally follow the Fed’s tightening, amid severe corrections in GCC equity markets. But Gulf interest rates have continued to exhibit a significant degree of convergence.

Concerning the fiscal performance, and after the past years’ exceptional rise in oil prices (oil and gas revenue make up to 90% of government revenue), all Gulf states comfortably satisfy the budget deficit and public debt restrictions. During the past few years, paying off debt has been a key priority for GCC countries, which have used part of their windfall petrodollars to cut their public debt stocks (down to less than 30% of GDP in Saudi Arabia from 102% in 1998). Lastly, in terms of foreign exchange reserves, all Gulf states’ central banks (with the exception of Bahrain) exhibit a level of foreign exchange holdings that cover more than four months of goods imports (the agreed criteria). This has been the case since 2000, in spite of the tripling of imports over that same period and the fact that regional central banks detain only a small portion of Gulf states’ foreign assets (major role played by the national investment authorities).

Gulf Economies’ Differences

Gulf states have asked the European Central Bank to provide support for their proposed monetary union. Moreover, GCC countries have rightly adopted almost the same convergence criteria as the Eurozone, not only because this is the only historical experience of a monetary union (being conducted before a political one) but also because it has been successful and was achieved within set time frames. However, bearing in mind differences in economic structure between the Middle East hydrocarbon-based economies and Europe, we must ask ourselves whether these criteria are relevant for the GCC countries.

Generally, these Maastricht-style convergence rules could prove costly in terms of growth and employment, a risk that “euro-skeptics” and sovereignists in Europe have cited when opposing the introduction of the euro. Indeed, the fiscal and monetary discipline imposed on countries wishing to join the single currency may limit the ability of the authorities in those countries to adjust policy to boost or support economic activity. In the case of the GCC, the fiscal convergence criteria are by far the most controversial. The earnings of the Gulf states are marked by significant volatility because of their sensitivity to fluctuations in oil prices. Therefore, in a year when crude oil prices are strong budgets appear healthy, with the majority of the countries meeting their set deficit criterion. But when prices decline sharply few of the Gulf states qualify. In 1998, when oil prices averaged $12/B, all GCC countries recorded budget deficits of more than 3% of GDP. In 1999, despite recovering oil prices (close to $18/B), Oman alone in the GCC recorded a near balanced budget. Furthermore, after the past years’ continued rises in government spending and imports of goods (amid continued dollar weakness), increasingly higher oil prices are required to balance both the budget and external accounts.

Again on these specific fiscal convergence criteria (budget deficit and public debt levels) the Maastricht-style limits are far from being optimal for oil-and-gas-based economies. At the same time, the viability of Gulf monetary union would be widely questioned in the event of no fiscal performance targets being set. The setting of more tailored fiscal criteria may be achieved through the implementation of three non-exclusive guidelines:

• Make compulsory the establishment of fiscal income stabilization funds. As is the case in some Gulf countries (Oman, Kuwait etc), these would be made up from privatization receipts and surplus earnings, generated during periods of sharply rising oil prices. When oil prices fall, the authorities would offset the earnings decline by accessing these funds.
   

• Introduce (on top of quantitative budget targets) qualitative convergence criteria (reducing the overwhelming share of hydrocarbon receipts in government revenue, improving tax collection and/or a better arbitrage between current and investment expenditure).
   

• Consider the non-oil budget performance (rather than the overall one). Both the primary and the overall non-oil balances are relevant, with different pros and cons (see ECB Occasional Paper No 31, June 2005, pages 56-62).

Besides the need for more adapted fiscal convergence rules, Gulf countries are also faced with the challenge of further specifying all of their five convergence criteria (what reference period?, composition of price indexes, what interest rate? etc). A bigger challenge is to ensure the availability and the comparability of statistical data among the monetary union members. Gulf states already exhibit a strong economic and financial convergence that should allow them (at least from the strict macroeconomic point of view) to be qualified to be part of the proposed monetary union. Looking ahead, at the cost of some additional efforts (relevant convergence rules, wiser budget policies), GCC states would most likely ensure the viability of their union.

Timing Of Monetary Union – 2007 A Critical Year

The achievement of monetary union, and more specifically the launch of a single currency, is far from being restricted to a ‘simple’ matter of economics. As with the Eurozone experience, the final achievement of such an ambitious project will also require the setting up of credible and competent supranational institutions to operate the currency.

Almost 26 years after the creation of the GCC, the six states clearly stand at a crucial stage of institutional reform, which requires major sovereignty sharing, based on a strong political will and commitment. We forecast that 2007 will be a critical year for the achievement of monetary union (at least within the 2010 schedule). After the launch of a customs union (started in 2003), a common market (free movement of capital and labor) is planned by end-2007. More importantly, a decision should be made on the location and the nature of the future supranational institutions (including the GCC Central Bank), a highly sensitive and political issue.

The setting up of a common market in less than 12 months from now will prove particularly challenging. At the same time as promoting the free circulation of goods, the Gulf countries will also need to guarantee free movement of capital. Also, as was carried out through the Schengen agreement in Europe, they will need to organize the free movement of people. This will involve GCC countries undertaking a long process of harmonizing their national legal frameworks.

The establishment of the political and monetary institutions responsible for the launch and operation of the new single currency will be the final step in achieving the objective of economic and monetary union. Because of the political questions involved, this stage will probably present the most difficulties. The future regional central bank will have the six GCC central banks under its authority. As for the political institutions, the Gulf will probably follow the European example. Supranational councils consisting of the heads-of-state or finance ministers will be set up. They will be required to define common economic and financial policies. Whether the two main steps scheduled for 2007 (common market and location of the regional central bank) will be taken on time (in less than 12 months from now) is highly questionable.

The Puzzle Of Sovereignty Transfer

Before making their single currency project a reality, the GCC countries will need to concede a significant transfer of sovereignty. In addition to the disappearance of their currencies and the important symbols of regal power, the political and monetary institutions of the six will have to give up many national prerogatives (monetary creation, monetary policy, definition of budget policy). The reluctance of a significant section of European opinion to accept such concessions has led (among other factors) the UK, Denmark and Sweden to reject the euro.

In the case of the Gulf countries, this transfer of sovereignty will be especially difficult because the “political” existence of these states is of relatively recent standing (1932 for Saudi Arabia, 1961 for Kuwait and 1971 for the UAE, Bahrain and Qatar). These reigning dynasties, only in their first generations, are still consolidating power. In some cases, questions concerning the succession and the role of the national political institutions have yet to be fully resolved. Challenged by globalization and the need to adapt their political structures, the pace at which the Gulf monarchies are implementing political reforms and opening up their countries varies greatly.

The GCC countries seem to be resigned to conceding transfer of sovereignty. However, they must also face up to the question of who will lead the new economic and monetary union. For the EU, there are several countries (France, Italy, the UK and Germany) with comparable demographic and economic strength. However, in the GCC, the question will be complicated by the very great disparity there. Saudi Arabia accounts for more than 70% of the population of the proposed monetary union. The kingdom generates more than 50% of the total GDP of the GCC, and accounts for 58% of its oil production and almost half of total exports. On these grounds, Saudi Arabia is bound to exert considerable influence within the future supranational political and monetary institutions. The other states may find it difficult to accept this, or at least the issue could further complicate the puzzle of sovereignty transfer.

Gulf States Share Of Population, GDP, Exports, Oil Production

(%)

Source: Calyon.

At the end of 2006, several Gulf states questioned the feasibility of monetary union under its schedule (less then three years from now). Oman has opted not to join the single currency if the 2010 deadline is maintained. While reiterating their full commitment to monetary union, Saudi officials finally admitted that the 2010 target was “very ambitious,” leaving the door open for a rescheduling.

It our view, the launch of the single currency will be delayed, but certainly not cancelled given: (i) the good sense of this project; (ii) the undeniable and often reiterated commitment of GCC rulers to it; and (iii) the undisputed feasibility of this plan, at least from the strict economic point of view. Depending on time and difficulties over sovereignty sharing, the launch of a “common” currency as a first step to a single one is not to be ruled out. This could be an example of the “simpler form of a monetary union that includes only the basics,” mentioned last December by the UAE’s Central Bank Governor.