The GCC’s COMMON CURRENCY: PREPAREDNESS

AND CHOICE OF EXCHANGE RATE REGIME

By
Mohamed Mustafa
Student Number: 070014252
Investment and Financial Risk Management

Supervised By: Elena Kalotychou

April 2010
 Acknowledgements

(In the Name of Allah the most Gracious the most Merciful)

I thank Allah for his guidance and help throughout this dissertation, for he
deserves all praise. I would also like to thank my parents for their continuous love and
support throughout my life. I am also very grateful to my supervisor Elena
Kalotychou for her encouragement and guidance.
 Table of Contents
LITERATURE REVIEW:...........................................................................................................................4
INTRODUCTION.........................................................................................................................................5
SECTION ONE .............................................................................................................................................5
OPTIMUM CURRENCY AREA:......................................................................................................................5
Mundell’s Criterion: .............................................................................................................................5
McKinnon’s Criterion:..........................................................................................................................5
Kenen’s Criterion: ................................................................................................................................6
Other Factors: .......................................................................................................................................6
GCC PREPAREDNESS:.................................................................................................................................6
PROS AND CONS OF CREATING A MONETARY UNION: ..............................................................................9
SECTION TWO ..........................................................................................................................................10
CHOICE OF EXCHANGE RATE REGIME: ....................................................................................................10
The Dollar Peg:...................................................................................................................................11
Floating: ..............................................................................................................................................12
Basket peg:...........................................................................................................................................14
THE DOLLAR VS. EURO ............................................................................................................................15
CONCLUSION ............................................................................................................................................18
BIBLIOGRAPHY .......................................................................................................................................20

Table of Figures

TABLE 1 GDP CORRELATION 2004-2008.................................................................... 6

TABLE 2 INFLATION RATE CORRELATION 2004-2008.................................................. 7
TABLE 3 TRADE TO GDP RATIO................................................................................. 7
TABLE 4 SHARE OF GCC IMPORTS AND EXPORTS BY ORIGIN ........................................ 8
TABLE 5 PERCENTAGE OF OIL EXPORTS FROM TOTAL EXPORTS .................................. 8
GRAPH 1 EUROZONE IMPORTS VS. US IMPORTS ........................................................ 15
GRAPH 2 NORMAL DISTRIBUTION (T=13, 5% SIGNIFICANCE LEVEL)......................... 16
TABLE 6 REGRESSION RESULTS FOR OIL EXPORTS..................................................... 17
TABLE 7 REGRESSION RESULTS FOR NON-OIL EXPORTS ............................................ 17
TABLE 8 REGRESSION RESULTS FOR IMPORTS............................................................ 18
LITERATURE REVIEW:
The gulf cooperation council was established in May 19811, it consists of six
countries: Saudi Arabia, Kuwait, Bahrain, UAE, Oman and Qatar. The main purpose
of the council was to promote unity between the neighboring countries due to the
similarities in the countries’ cultures, language, production, and political systems
based on Islamic belief. A few months after the creation of the council, the GCC Free
trade Area was created as a start; to encourage economic integration between the
countries. One of the main goals of the council is to create an economic and monetary
union, which includes constructing a unified currency and a central bank.

Many steps have been undertaken to achieve this goal; in fact, a timetable was set to
achieve the requirements of the union with the deadline being in 2010. Due to the
global financial crisis and some political issues mentioned later in this paper, the
deadline is unlikely to be met, however, there has been a huge progress in
accomplishing its requirements. The Customs Union and the Common Market where
launched during the early years of the new millennium, which removed the barriers
between the countries, promoting intraregional mobility of goods, capital, and labor.
Also, the members have taken necessary procedures to harmonize economic,
monetary policies, and banking legislation. These steps include unifying the
regulation on adequacy of capital, asset risks, and credit concentrations2. Furthermore,
the countries constructed a fixed exchange rate policy between member states, which
stabilized the prices of intraregional imports and exports traded between the countries
and simplified the financial and accounting transactions. More importantly, in 2003,
the countries officially pegged their currencies to the dollar, with Kuwait being an
exception, as it pegged its currency to a basket of currencies.

The GCC Monetary union has faced some major setbacks; the main delay was
because of the withdrawal of the UAE in 2009 after the announcement that the central
bank would be held in Saudi Arabia. Moreover, the member states have failed to meet
the convergence criteria which was set to create a unified currency, which includes
the countries’ budget deficit to be lower than 3% and an inflation rate not more than 2
%3, these are clearly some of the consequences of the global financial crisis. There
has been a lot of debate on whether the time was right for the GCC to set up a
common currency, using problems faced by the European Monetary Union as an
illustrative example. In addition, due to the weakening of the US Dollar and the
inflation problem, there has been a lot of speculation that the GCC common currency
could follow another exchange rate regime rather than being fully pegged to the US
Dollar.

1
Gulf Corporation Council Info, http://www.globalsecurity.org/military/world/gulf/gcc.htm
2
Tony Maalouli, Harmonization of Banking regulations http://www.uaeahead.com/knowledge/conferences/harmon.pdf
3
http://www.thefreelibrary.com/Box+2:+Dimming+Prospects+for+a+GCC+Monetary+Union+in+2010.-a0205827122
INTRODUCTION
This paper aims to address two topics; firstly, we intend to test the preparedness of the
GCC countries on launching a unified currency using the Optimum Currency Area
theory as our benchmark. Also, we plan to discuss the advantages and disadvantages
of creating a unified currency with regards to the GCC. The second topic is going to
discuss the choice of exchange regime for the new GCC currency, analyzing three
options available to GCC countries: The Dollar Peg, Managed Floating, and The
basket Peg. The basket peg is going to be discussed in more detail using the
regression model created by George T. Abed, S. Nuri Erbas, and Behrouz Guerami
(2003).

SECTION ONE
Optimum Currency Area:

In order for a region to be an Optimal Currency Area, an employment of a single

currency in this region would maximize economic efficiency4. Mundell, Mckinnon
and Kenen have developed several factors for determining whether a region fits an
Optimal Currency Area. These factors are:

Mundell’s Criterion:

The group of countries’ responsiveness to shocks should be symmetric. The reason

can be explained using the following example. Consider two countries: Country A
and Country B. A decrease in the demand of the goods produced by countries A and
B would lead to a decrease in the output level and therefore an increase in
unemployment in the two countries. If the countries were engaged in a currency
union, this problem can be fixed by reducing the price of the common currency
against the rest of the world, which would lead to an increase in the demand of their
goods and would offset this negative shock. However, if the effect of the shock was
affecting only one country (asymmetric), altering the common currencies exchange
rate is not a valid solution. In spite of this, Mundell argues that the latter scenario can
be solved if the countries had a high degree of freedom in the mobility of labour and
capital. Suppose that the decrease in demand was only on the goods produced by
country A whereas country B was entirely unaffected. The rise in unemployment in
country A could be solved if the unemployed workers are able to move to country B
freely to find jobs.

McKinnon’s Criterion:

Countries that are highly dependant on international trade are eligible to form an
optimum currency area. The reason being is that small open-economies are price
takers and can’t rely on exchange rates as a means of improving competitiveness.

4
http://encyclopedia.stateuniversity.com/pages/16384/optimum-currency-area.html
 Another condition is that the countries should be highly involved in trading with each
other, because this also diminishes the need for exchange rate adjustment.

Kenen’s Criterion:

Kenen argues that countries with diversified economies and similarities in production
should create a common currency. Since countries engaged in the production of
similar products are exposed to the same supply and demand shocks. Additionally,
having highly diversified economies provides insulation against shocks.

Other Factors:

In order for a currency union to succeed the countries that are involved should be
willing to cooperate with one another in creating similar policies to achieve this goal.
They should also be prepared to compensate one another in the case of shocks and
recessions.

GCC Preparedness:
The huge similarities between the GCC countries in terms of economic structure,
exchange rate and monetary policies have made these countries’ business cycles
extremely synchronized. As a means of proving symmetry, we have created
correlation matrixes for the following economic indicators: GDP and Inflation Rate.
Table one and two clearly show the huge positive correlations between GCC
members, using the economic indicators mentioned above for the period 2004 to
2008. This confirms the synchronization of GCC countries’ business cycles when
responding to different oil price changes.

TABLE 1 GDP CORRELATION 2004-2008

Bahrain Saudi Arabia UAE Kuwait Oman Qatar

Bahrain 1
Saudi
Arabia 0.94827756 1
UAE 0.975691291 0.987648533 1
Kuwait 0.964546232 0.997739533 0.992378987 1
Oman 0.927927346 0.990841736 0.986643451 0.986218986 1
Qatar 0.927251611 0.982002141 0.986544525 0.978379091 0.997923655 1
Source: Author’s calculation
based on data from Bank
Scope’s Database
 TABLE 2 INFLATION RATE CORRELATIONS 2004-2008

Bahrain Saudi Arabia UAE kUWAIT Oman Qatar

Bahrain 1
Saudi
Arabia 0.960446792 1
UAE 0.82991719 0.895848244 1
kUWAIT 0.965283421 0.953648998 0.935743211 1
Oman 0.959456163 0.997567739 0.904751283 0.962712437 1
Qatar 0.615990242 0.793494469 0.763120536 0.681136905 0.808446601 1
Source: Author’s calculation
based on data from Bank
Scope’s Database

The Common Market and The Unified Economic Agreement were launched to
promote free movement of labour and capital between GCC countries. Yet,
intraregional labour and investment between GCC countries has been very limited.
This is because of the increase of foreign labour in the GCC, which has reached to
13.9 million in 2007. Due to the cheap cost of foreign labour and its enhanced
qualifications, the private sectors rely on foreigners for employment rather than GCC
nationals. This contradicts with the requirements that have been set by Mundell.

As far as openness is concerned, GCC countries are considered to have one of the
most open economies in the world. Table Three demonstrates the openness of GCC
economies between 2004 and 2006; this is calculated by adding the total imports and
exports of each country and dividing it by the countries’ GDP. As it can be seen from
Table three, the GCC countries have an extremely high trade to GDP ratio, with ratios
up to 3.60 with regards to the UAE. This high ratio represents the dependency of
GCC countries on oil exports for government revenues. Also, the high amount of
imports shows their reliance on foreign imports for consumptions purposes rather than
domestic production. As mentioned earlier, the reliance of GCC countries on foreign
products labels them as price takers, which makes their individual exchange rates
ineffective.

TABLE 3 TRADE TO GDP RATIO

2005 2004 2003 2002

Bahrain 1.33521704 1.246348022 1.26073678 1.272756579
Kuwait 1.897946311 1.871024634 1.666057842 1.69019135
UAE 3.644584689 3.345392794 3.133700661 2.847755551
Saudi Arabia 0.76119938 0.692554542 0.606599323 0.555575653
Qatar 0.8336678 0.770638594 0.768674984 0.755448017
Oman 0.071807706 0.966480701 1.043242893 0.867500781
Source: Author’s calculations based on data from Bloomberg
(World economic statistics).
However, when testing for intraregional trade, GCC countries have performed very
badly in this factor. Table Four shows the percentage of intra GCC trade from total
imports and exports during the last 20 years. The average percentage has been less
than 7%, which is extremely low. In spite of that, it has been proven that when
countries engage in currency unions, intraregional trade gets boosted by 300%5
TABLE 4 SHARE OF GCC IMPORTS AND EXPORTS BY ORIGIN

Source: Emilie J. Rutledge (2009), her calculations are based on IMF Data.

With regards to Kenan’s criterion, GCC countries are famous for being oil exporters.
GCC’S percentage of oil exports from total exports exceeds 70% during the period
2004 to 2006 (Table Five), which proves the obvious similarities in the members’
productions structure. On the other hand, this also proves that their economies are not
diversified, which breaches Kenan’s diversification criterion. In the case of a huge
symmetric shock, the lack of diversification can be really harmful to the region.

TABLE 5 PERCENTAGE OF OIL EXPORTS FROM TOTAL EXPORTS

2006 2005 2004
GCC % OF OIL EXPORTS FROM TOTAL
EXPORTS 0.805572921 0.784459565 0.81068526
Source: Author’s calculations based on data from Bloomberg (World Economic Statistics)

As mentioned in the introduction, since the creation of the GCC, the members have
clearly shown their willingness of enhancing economic integration. Throughout the
years many steps have been undertaken to achieve this. As a start, the countries
pegged their currencies fully to the dollar. In 2001, a technical committee was created
to analyze the requirements of the GCC to enter a currency union. During the
Manama summit, the GCC members agreed on a working agenda to meet the
convergence criteria, which was set in order to accomplish the monetary union. It is

5
Rose (2000)
important to mention that the royal families in the GCC are very closely related to
each other; this clearly increases their eagerness on helping each other out. A very
recent example is Abu Dhabi bailing Dubai out when their recent real estate crises
occurred. In fact, many of the neighboring countries helped bailing Dubai out of its
crisis. Political will is considered to be the most important factor in making a currency
union succeed.

Pros and Cons of Creating a Monetary union:

Forming a Currency Union has its advantages and disadvantages. The main advantage
is the removal of the transaction costs faced by firms and individuals because of
multiple exchange rates. These costs include monitoring exchange rate fluctuations,
cost of currency conversion, and the cost and time of intraregional cross-border
payments. Removing these costs would increase economic efficiency by encouraging
intraregional trade and investment between the neighboring countries. It is important
to mention that intraregional trade between the Gulf countries is mainly in the non-oil
sector. Therefore, encouraging intraregional trade would boost the non-oil industry in
the Gulf; this will decrease the countries’ dependency on oil revenues and make it
more competitive in other industries. The European union experience proves this
point. Since the creation of the European monetary union, intraregional trade has
increased considerably.

Furthermore, introducing a common currency would eliminate any risk stemming

from uncertainty about bilateral exchange rates. Even though some may argue that the
exchange rates between the member states are already fixed due to the peg to the US
Dollar, the possibility of a country changing the value of its exchange rate remains
plausible in the event of a large macroeconomic imbalance. However, the possibility
of a macroeconomic shock occurring to one GCC country only is unlikely, due to the
similarities in the GCC countries’ production, which specializes in oil and gas.

Moreover, if intraregional trade and non-oil output increases, producers will be able
to gain economies of scale if the barriers are removed. This will reduce the chances of
any form of monopoly occurring, thus increasing competition between producers and
bring up benefits to costumers as low prices are observed under competition. This
increase in competition will also be witnessed in the financial and banking services
sector, hence the quality of financial services in the GCC would be improved and the
sophistication of GCC financial markets would increase.

In addition, a currency union would require having one central bank, this would
coordinate banking policies between the members and increase price transparency6.
This will unify the way financial markets in the region operate, increasing the trade of
bonds and equity and stabilizing the business environment.

Under a common currency, private firms will be allowed to pay for regional imports
using the new common currency. This will remove some of the difficulties faced by

6
http://www.ccsenet.org/journal/index.php/ijbm/article/viewFile/1673/1586
national central banks, as they are required to set some foreign exchange reserves
aside to settle intraregional transactions.

The main cost a country has to accept when joining a currency union is the loss of
independence in controlling monetary and exchange rate policies. Each country will
be forced to follow the monetary and exchange rate policies decided by the union.
This will require each country to give up the possibility of altering its exchange rate in
the event of macroeconomic shocks. In the case of the GCC, the countries have
already pegged their currencies to the US Dollar, which makes this so called
“independence” very limited. Countries mainly attach their currencies to an anchor
currency in order to secure economic stability. This is achieved by following the
anchor’s monetary policy. This has been beneficial to the GCC so far, since inflation
rates have been relatively stable in the last decade.

Another issue that should be kept in mind is that the policies determined by the union
are for the benefit of the whole region and not for individual countries only. For
example, if a subgroup of countries in the region face an economic recession,
monetary and exchange rate policies have to be changed even though other countries
may find it beneficial if the policies stay the same way they are. However, as
mentioned above, the similarities in the countries’ production structures makes their
responsiveness to economic shocks symmetric, which makes the possibility of a
shock occurring to one country only very doubtful.

Lastly, tying a countries’ interest rate to foreign interest rates could result in balance
of payment deficits if any increase in money stock occurs. The loss of controlling
monetary policies as economic stabilizers in this case could result in employment and
output losses. In spite of that, the large amount of foreign assets owned by GCC
countries eliminates the need to resort to money printing during financial difficulties.

SECTION TWO

Choice of Exchange Rate Regime:

Another important issue GCC countries must consider when engaging in a
currency union is their choice of exchange rate policy. As stated above, the countries
have officially pegged their currencies to the US Dollar in 2003 with Kuwait being an
exception. Even though their currencies were effectively pegged to the US dollar
during the last 20 years. However, the members of the council have stated that they
are willing to consider any alternative policies after the common currency is launched.
Historically speaking, the peg to the Dollar has served the GCC currencies well
during the last 20 years. It has helped the countries maintain a low inflation rate and
has insured macroeconomic stability. In addition, it has simplified the financial and
accounting transactions undertaken by the private and public sectors, given that the
countries are mainly engaged on oil exports, with oil prices being dominated in US
Dollars. Moreover, it has stabilized the volatility of revenues generated from oil
exports.

Nevertheless, many have argued that it may be the time for GCC countries to drop
their Dollar peg and consider alternative exchange rate regimes. This is because of the
increase in oil prices, which results in large account surpluses held by the GCC
countries. Some argue that the latter should have resulted in an appreciation of the
GCC’s real exchange rate, which makes the current exchange rate undervalued. Also,
the depreciation of the US dollar against international currencies and the rising
inflationary pressure has made the peg to the Dollar unattractive. In addition, the
increase in global integration in the world today has exposed the GCC to new
exchange rate risks that have to be maintained. All these issues have raised
speculation on the suitability of the Dollar peg in the future.

In the next section, this paper aims to analyze the following exchange rate
alternatives: The Dollar peg, Managed Floating, and The Basket Peg. The main
criterion that will be used is insuring macroeconomic and financial stability in the
event of economic shocks.

The Dollar Peg:

Some say that the GCC’s new currency should remain pegged to the US Dollar. As
mentioned above, oil and gas contributes to almost 70% of GCC exports. These
commodities and a huge proportion of external assets held by GCC countries are
Dollar dominated. Remaining pegged to the Dollar would stabilize the income
generated from GCC exports and would secure their financial wealth from fluctuating
in value. Even though the fluctuation of the Dollar against major currencies could
increase the volatility of income from non-oil exports, realistically speaking, the small
amount of non-oil products produced by the GCC minimizes the risk of exchange rate
fluctuations.

The most important advantage of pegging to the Dollar is that it allows emerging
economies – unsophisticated ones in particular – to import the policies created by the
US to ensure monetary stability. Because the peg is easily administered and it saves
the time and cost these countries would have to incur to build institutions for
implementing independent monetary policies. These institutions need to time to be
credible and effective. The benefit of pegging has been clearly evident in the case of
the GCC, with inflation rates being relatively low during the last 20 years. How ever,
during the last two years the inflation rates have risen considerably due to the
depreciation of the US Dollar.

Setser (2007) argues that oil exporters should not follow the macroeconomic policies
implemented by oil importing economies, which the makes the Dollar peg in the
GCC’s case self-contradictory. He presents this argument using an illustrative
example. Consider a supply shock occurring, if this happens oil exporting and oil
importing economies should have different policy responses. An oil importing
economy would want to loosen it’s monetary policy to increase the demand of it’s
good and services, whereas an oil exporting economy would want to tighten it’s
monetary policy to offset the expansionary effects of oil price rises. Sester (2007)
argues that such a thing cannot be achieved under a peg to a single currency.

In spite of that, when we look into history, Dollar fluctuations have occurred and
macroeconomic stability in the GCC has still been achieved. In fact, Dollar
depreciations similar to the ones that are happening now have occurred in the past.
Even then, the US and GCC economies have been well synchronized with no
problems.

Another advantage is that the Dollar peg has prevented any nominal shocks being
faced by GCC countries from geopolitical risks. Being in the Middle East, GCC
countries are clearly exposed to these shocks, and these shocks could cause instability
from investment returns and a lack of confidence. So the cost of pegging to the Dollar
peg could be considered as a premium payment, because judging from the political
situation in the Middle East today, these risks are likely to continue.

Moreover, pegging to the US Dollar provides insulation against a Dutch disease

occurring. A Dutch disease occurs when the oil-exporting sector expands to the extent
that it has a negative effect on the non-oil sector leading to a contraction in the
economy as a whole. Pegging to the Dollar would prevent GCC currencies to
appreciate when the price of oil appreciates, eliminating any Dutch disease risk.

It is also important to mention that the Dollar peg simplifies the financial and
accounting transactions recorded by firms and investors. It also helps in immunizing
any exchange rate risk faced by the countries. Even though forward markets are not
available in the GCC, the countries find it easy to work through US forward markets;
this makes exchange risk hedging very easy. Also, the peg makes the cross-rates
between GCC members constant; this eliminates any uncertainty faced by investors
when engaging in intraregional transactions, thereby promoting intraregional trade
between GCC members.

Finally, GCC countries have effectively pegged their currencies to the Dollar for more
than 20 years. GCC authorities and economic agents have grown familiar to this
exchange rate regime and the consensus among GCC members is to remain pegged to
the Dollar.

Floating:

An alternative to pegging a currency to a single currency is to let the currency float

against the market. Under this strategy, the exchange rate is determined through the
demand and supply of the market. A floating exchange rate is considered to be “self
correcting”. Consider the following example, if the demand for a particular currency
decreases its price would decrease. This decrease in price would make the value of the
currency depreciate against other currencies, causing imported goods to be more
expensive, thus the demand for domestic goods will increase. This increase in demand
will increase the amount of jobs available in the market, creating an “auto correction”
of the market.

The main advantage of a floating exchange rate is that it enables an economy to

control its monetary policy independently in response to economic shocks. This will
allow the country to use monetary instruments such as interest rates to stabilize
inflation and to encourage the growth of the non-oil economy. Oil and gas are scarce
resources and GCC countries have to diversify their economic structures and reduce
their dependence on oil to maintain economic growth. As economies become more
diversified, the increased participation of nationals in the non-oil sector would
decrease the flexibility of capital and labor in that region. If an economic shock
occurs diversified economies should adjust exchange rates rather than depend on the
mobility of capital and labor as shock stabilizers. Another argument is that if the GCC
members engage in a currency union their economies would be too large to stay
pegged to a single currency and should rather let the common currency float.

How ever, the effectiveness of using monetary and exchange rate policies in the GCC
to achieve economic stability is debatable. One important argument is that the amount
of investment and consumption in the GCC is insensitive to changes in interest rates.
Evidence shows that these two increase with the increase of government spending,
this limits the role of interest rates (monetary policy) to stabilize the economy
whereas fiscal policy is used instead. Also, the non-availability of domestic goods and
the GCC’s huge reliance on foreign goods makes the demand for imported goods
inelastic to price fluctuations.

If the GCC members decide to let their currencies float there are some risks and costs
they should be willing to endure. Firstly, the instability of oil prices could lead to
large fluctuations in the common currencies’ exchange rate, causing a disruption in
non-oil output and inflationary problems. In addition, letting the currency float would
introduce a new type of exchange rate risk and uncertainty. Investors would no longer
be able to use US forward markets to hedge exchange rate risks and the unavailability
of hedging instruments in the GCC makes exchange rate risks uncontrollable. This
will increase uncertainty among foreign investors and would reduce their confidence,
which would shrink the size of foreign investments in the Gulf.

Another issue is the nominal anchor GCC countries would choose under a float. Some
say that GCC countries should either implement inflation targeting or monetary
targeting as an alternative anchor. The former requires sophisticated monetary
operations, an independent central bank, and would require time for it to be credible
and effective. Due to the 20-year reliance on US imported policies these technical
requirements aren’t available in the GCC. Monetary targeting seems to be a more
feasible solution for stabilizing prices. Even though this would require GCC countries
to develop liquidity management instruments, which are not available at the moment
but are easier to obtain than the requirements of inflation targeting.
Basket peg:

Pegging the currency to a basket that consists of more than one currency could be a
good start towards gradual exchange rate flexibility. A basket peg would give GCC
countries the opportunity to import foreign monetary policy and at the same time it
would give them some freedom in responding to economic shocks that effect their
exchange rates. The nominal GCC currency would be less volatile under a basket peg;
this would improve the economies’ competitiveness in terms of trade and would
achieve balance sheet stability.

The main advantage of a basket peg is that it will prepare GCC countries gradually to
live with a more flexible exchange rate regime. Investors and economic agents will
have to learn how to adapt against exchange rate risk. Even though one can argue that
the lack of hedging instruments such as forward and derivative markets make it
difficult for GCC investors to immunize risk, under a basket peg the time would be
available for the GCC to progressively create these financial instruments. Also,
because the basket contains more than one major currency, this will provide GCC
investors access to different foreign forward markets. Furthermore, it will give GCC
countries sufficient time to create sophisticated monetary policies, financial
institutions, and the technical and institutional requirements for converting their
common currency to a floating one.

Pegging the GCC currency to a basket that contains the price of oil would act as a
perfect substitute to pegging the currency to the price of oil only. As mentioned
above, if the currency was only pegged to the price of oil, the dramatic volatility of oil
prices would lead to horrific exchange rate fluctuations in the economy. On the other
hand, when pegged to a basket that contains the price of oil, the price of the currency
would appreciate with an increase in oil price but in a balanced way due to the
attachment to other currencies that are involved in the basket.

How ever, pegging the currency to a basket makes price comparisons and economic
transactions more difficult due to the different proportions of international currencies
that are attached to the peg. The lack of transparency makes it difficult for
governments to explain the basket peg to the public, thus some people will have book
keeping difficulties in the event of exchange rate fluctuations.

A good solution to the problems that might be faced by the GCC is to peg their
currency to a basket that consists of the US dollar and the Euro currency only. This
will make it easier for governments to explain the peg, and financial and book
keeping transactions would be easier. Also, it will provide GCC investors access to
Euro hedging instruments, which are considered to be the best in the world in terms of
depth.
The Dollar vs. Euro

The Euro is the currency unit of the European Monetary Union. Since the
establishment of the Euro, it has proved as a powerful international currency because
of the size and depth of its market and its exceptional stability. Also, it has proven to
compete against the US Dollar clearly as the Dollar continues to depreciate in value
against it. In addition, it is capturing a large share of international trade and is
fulfilling the function of an international reserve.

In terms of imports, the goods imported by the GCC aren’t Dollar dominated, this
exposes the region to an exchange risk, especially with the depreciation of the Dollar;
which devalues the price of the GCC currency against other currencies. More
importantly, the total imported goods from the Euro zone are larger than the imports
from the Unites States (Graph One). Also, non-oil products exported to the United
States are low, whereas the proportion exported Europe and the rest of the world is
relatively higher. Furthermore, the Free Trade Arrangement with European union that
is set to take place proves that the GCC and the Euro zone are planning to be more
integrated. This emphasizes the GCC’s need to develop a new way to ensure external
stability and maintain competitiveness.

GRAPH 1 EUROZONE I MPORTS VS. US IMPORTS

Source: Chatham House (2009), Based on IMF Data

In this section, we plan to test if the GCC’s external stability would be improved if it
where pegged to a Basket that consists of the US Dollar and the Euro. We are going
present the model created by George T. Abed, S. Nuri Erbas, and Behrouz Guerami
(2003).

Firstly, it is important to clarify that George, Nuri, and Behrouz (GNB) used the
Dollar to UAE Dirham rate (.272) as an aggregation of the GCC Currency to US
Dollar exchange rate. The reason behind this is that the countries have effectively
pegged their currencies to the Dollar; which makes the cross-exchange rate between
GCC countries constant. Also the data that was used to build their regression model
was for the period 1987 to 2001.

The model they created was an estimation of external stability. As a means of

measuring external stability, they used elasticity estimates for GCC Imports and
Exports with respect to effective Dollar-GCC currency and Euro-GCC currency
exchange rates. So the Dependant variable in this model is either GCC Imports or
Exports, and the independent variables are the effective Dollar to GCC and Euro to
GCC exchange rates respectively. For simplicity purposes, we are going to refer to the
Euro to GCC exchange rate as (v), the Dollar to GCC exchange rate as (e), and the
exports and imports as (x) and (m) respectively.

So the Import and export equations are calculated as:

M = C0 + C1e+ C2v+ u
X = C0 + C1e+ C2v+ u

C1 and C2 are the elasticities of M or X (imports or exports) with respect to e and v,

C0 is the constant, and u is the random error term.

GNB have ran the regression on the following 6 equations: Oil Exports to the World,
Oil exports to the US, Total Exports to the World, Non-oil exports to the World,
Imports from the US, and Imports from the World.

Before analyzing the results obtained by GNB, some of the figures should be
interpreted. The coefficients C1 and C2 are the elasticities of imports and exports to
changes in the GCC Dollar and Euro exchange rate respectively. This measures the
extent of fluctuations in GCC imports and exports due to changes in the mentioned
exchange rates. The T-statistic measures the significance of each of the coefficient
results. In this case we have used a signifigance level of 5% and our Null hypothesis
is that the coefficients are equal to zero, therefore this is considered to be a two-tailed
test. Using the T distribution table (table), we found the rejection and non-rejection
regions of our two-tailed test using T-2 freedom. Because the data is for the period
1987 to 2001, the sample size is 13 (T = 15 years - 2) and the critical value we
obtained is 2.1604. The distribution can be illustrated as follows:

GRAPH 2 NORMAL D ISTRIBUTION (T=13, 5% SIGNIFICANCE LEVEL)

The blue areas are the rejection regions and the area between them is the non-
rejection region, so any amount that exceeds 2.1604 or deceeds -2.1604 is rejected. If
the T-statistic result lies in the rejection region, this means that we have to reject the
Null Hypothesis that the corresponding coefficient equals zero. This tells us that the
results are statistically significant, whereas if the figure lies in the non-rejection
region the result is considered to be statistically insignificant.

Thus, if the elasticity of X with respect to GD turned out to be significant statistically,

this tells us that the GD is a noteworthy source of volatility in GCC exports; therefore
pegging the GCC currency to the Dollar would stabilize this volatility and insure
steady income. How ever, if it turned out to be insignificant, this tells that GD
fluctuations don’t affect GCC exports and making the Dollar peg ineffective.

The first three regression results obtained by GNB where as follows:

TABLE 6 REGRESSION RESULTS FOR OIL EXPORTS

Oil Exports to The World
C0 C1 C2
Coefficients estimates -0.13 -8.36 0.92
T- statistic -1.3 -2.21 1

Exports to the United States

C0 C1 C2
Coefficients estimates -0.11 -8.53 0.19
T- statistic -0.81 -2.36 0.29

Exports to The World

C0 C1 C2
Coefficients estimates -0.08 -6.22 0.9
T- statistic -1.1 -2.25 1.33
Source: George T. Abed, S. Nuri Erbas, and Behrouz Guerami (2003)

The results show a clear biasness towards the Dollar peg, as the elasticities of X with
respect to GD appeared significant in all three equations as their figures lie in the non-
rejection region. The opposite occurred to the elasticities of X with respect to GE,
which proves that they are insignificant. These results clearly reflect the reliance of
the GCC on oil exports as their main source of income, and because the price of oil is
dollar-dominated, dramatic elasticity figures where resulted after performing the
regression reaching up to -8.53. This tells us that external stability is achieved under
the Dollar peg when analyzing GCC exports and Oil exports in particular,

How ever when the results of the fourth equation (Non-Oil exports to the world)
where obtained, the results where as follows:

TABLE 7 REGRESSION RESULTS FOR NON-OIL EXPORTS

Non-oil Exports to The World
C0 C1 C2
Coefficients estimates 0.08 0.28 0.32
T- statistic 2.34 0.22 1.04
Source: George T. Abed, S. Nuri Erbas, and Behrouz Guerami (2003)
In this equation both of the results estimated for the elasticities of X with respect to
GD and GE respectively turned out to be insignificant (not lying on the rejection
region). This tells us that competitiveness in non-oil exports can be achieved in an
exchange rate regime besides the Dollar peg. As the GCC countries’ economies
become more diversified, and as the population starts increasing, the proportion of
non-oil exports is going to increase. Especially with the fact that the public sector is
no longer considered to be the main employer of nationals, making individuals seek
jobs in the private sectors. In this case, pegging to a basket consisting of the Dollar
and the Euro would be a good way to increase the competitiveness of the non-oil
sector. Another important reason also is the scarceness of oil resources.

With regards to the Import equations, the following results where obtained:

TABLE 8 REGRESSION RESULTS FOR I MPORTS

Imports From the United
States
C0 C1 C2
Coefficients estimates -0.02 -1.09 -0.04
T- statistic -0.53 -0.61 -0.15

Imports From The World

C0 C1 C2
Coefficients estimates 0.04 -0.45 -0.1
T- statistic 1.23 -0.29 -0.43
Source: George T. Abed, S. Nuri Erbas, and Behrouz Guerami (2003)

As it can be seen, both of the elasticities are insignificant. This is due to the relatively
low imports from the United States and Europe. Nonetheless, as mentioned earlier,
the free trade agreement between the GCC and the European Monetary union
anticipates increases in trade between the two regions. Therefore pegging a proportion
of the GCC’s currency to the Euro could serve well as a stabilizer of European
imports. Also, being pegged to a basket that contains these two major currencies
would provide stability against international exchange rates.

CONCLUSION

To conclude, the success of the GCC currency union can be worthwhile if

implemented properly. In order for the GCC currency union to be successful,
intraregional trade between GCC countries should be encouraged; this can be
achieved by removing any barriers that discourage the movement of capital and
labour between the countries. In addition, the GCC countries have to take the
necessary steps to develop their non-oil sector; this will decrease their reliance on oil-
exports and will diversify their economies, making them immune to some economic
shocks. The political will to work together and to enhance policy coordination has
been clearly witnessed in the GCC’s case, this desire is considered to be the most
important factor in making a currency union succeed.

If the GCC’s currency union turned out to be successful, intra-regional trade is

expected to boom, with the experience of the European Union being clear evidence.
As intra-regional trade between GCC countries is mainly engaged in non-oil products,
the non-oil sector of the GCC will flourish, making the region more competitive
internationally in the non-oil sector.

However, when engaging in a currency union, each GCC country has to be willing to
give up its independent control of monetary policy, in addition, each country has to be
willing to accept the possibility of compensating another country in the event of an
asymmetric shock occurring. In spite of this, due to the similarities of the countries’
economic structures, asymmetric shocks seem to be unrealistic.

Judging from the advantages and advantages of joining a currency union, none of the
former and the latter seems significant in the GCC’s case. However, due to the
political will and the desire of GCC countries to succeed, the advantages outweigh the
disadvantages and make the currency union favorable.

With regards to the appropriate choice of exchange rate regime, the Dollar Peg
appears to be the best short-term option. Historically speaking, it has proven to be
considerably useful as it provided GCC countries economic stability during the last 20
years. Also, it has simplified the GCC’s accounting and trade transactions
domestically and internationally, and gave domestic investors access to the best
financial markets in the world. More importantly, since the bulk of the GCC’S trade is
in oil-exports; which is Dollar dominated, it has stabilized the revenues generated
from oil exports and eliminated any exchange rate risk exposed to the GCC.

Floating the currency seems to be an unpractical alternative to GCC currencies. Even

though it has the advantage of giving the countries the chance to control monetary
policy in response to external shocks, the unavailability of sophisticated financial
institutions and monetary policies in the GCC makes the floating alternative
hazardous.

The basket peg appears to be a good start towards loosening the exchange rate policy.
It gives the countries the facilities of imported monetary policy and in the same time
some independence in controlling monetary policy. Under the basket peg, the time
would be available to create credible financial institutions, hedging instruments, and
effective monetary policies. One of the key reasons to join a basket peg is that GCC
countries are anticipated to be more diversified, especially with oil being a scarce
resource. Joining a Basket peg would reduce exchange rate risk against major
currencies, making the region more competitive and stable economically.
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