Gulf Arabs increasingly expected to ditch dollar pegs

By Peter Garnham
Financial Times, London
Thursday, November 15, 2007

http://www.ft.com/cms/s/0/14499d74-93b0-11dc-acd0-0000779fd2ac.html

Speculation heightened on Thursday that Gulf Arab states were preparing to ditch their currencies' pegs against the dollar as the United Arab Emirates expressed concerns over the policy for the second time this week.

Sultan Nasser al-Suwaidi, governor of the UAE central bank, said on Tuesday that the dollar's slide had pushed the country to a "crossroads" over the UAE dirham's peg.

On Thursday, Mr al-Suwaidi followed up those comments, saying there were strong social and economic pressures to drop the dollar peg, suggesting the UAE could move to track a basket of currencies instead, which would predominantly, but not entirely, consist of dollars.

The statement sent the dirham, which has been fixed at Dh3.6725 against the dollar since 1997, sharply higher in the forward currency market, with one-year forward rates predicting a 2.7 per cent appreciation in the currency.

Kuwait switched from a dollar peg to a currency basket in May, but other members of the Gulf Co-operation Council -- Saudi Arabia, the UAE, Oman, Bahrain, and Qatar -- have held steadfastly to their dollar pegs, in spite of the US currency slumping to record lows.

The UAE said it would drop its dollar peg only in concert with other GCC members. Saudi Arabia, the GCC's most influential member, has so far showed strong determination to fight speculation that it would revalue the Saudi riyal, intervening aggressively last week in the forward foreign exchange market to defend the riyal's peg.

However, analysts say the UAE's comments could undermine the credibility of any verbal or market intervention from Saudi Arabia.

The problem for the Gulf states is that, as the Federal Reserve cuts US interest rates, a weakening dollar adds to inflationary pressures in the region.

Gerard Lyons, head of global research at Standard Chartered, says problems develop when there is a disconnect between the policies needed in one region and those needed elsewhere. This is something the UK found to its cost when it was tied to the Deutsche mark in Europe's exchange rate mechanism in the early nineties -- something which eventually forced the UK out of the ERM.

"A similar episode, albeit different in scale, is now being seen in the Gulf," says Dr Lyons. "While the US is cutting interest rates in response to a slowing economy, the Gulf needs a tighter monetary policy to curb inflation."

Hedge funds could benefit from any appreciation in Gulf currencies as, according to dealers in London, they started building up bets on a revaluation by the Gulf states as soon as the problems in the US mortgage market became evident in July.

However, Hans Redeker of BNP Paribas, says the prospect of an appreciation in GCC currencies is no longer just a trade for expert hedge funds. "This has become a widespread trade that family offices, private banks, and most proprietary desks have on," he says.

Russell Jones of RBC Capital says it is in the interest of the region's rulers to act to quell inflation. Rising inflation could prompt civil unrest from the region's predominantly young population, he says. "The longer they delay abandoning their pegs, the more painful it will be."

However, there is a wider context to the debate, given the strains being felt in Europe from the strong euro and a widespread feeling that some Asian currencies, including China’s renminbi, need to strengthen further.

Mervyn King, governor of the Bank of England, said this week that countries, such as China, that link their currencies to the dollar were causing increasing tensions and the matter needed to be addressed at this weekend's G20 meeting of finance ministers and central banks in Cape Town.

When asked about GCC currency pegs, Mr King said he was concerned that states such as Saudi Arabia and the UAE might de-peg their currencies, indicating that he would prefer Asian currency appreciation to an early de-pegging from the GCC.

Mr Redeker says: "Western central banks fear that a GCC de-peg will increase commercial and financial demand for floating non-dollar currencies, such as the euro and sterling, which in current market conditions would send them sharply higher."

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