The six members of the Gulf Cooperation Council — Bahrain, Kuwait, Oman, Qatar, Saudi Arabia and the United Arab Emirates – – have been running currency pegs to the USD or managing their foreign exchange for around 50 years now.
All six of these countries rely, to a varying extent, on the export of oil and gas which are priced in dollars therefore pegging one’s currency to the USD helped remove volatility from their major revenue generator. Alongside which, it has allowed these countries to build up significant currency reserves which allow them to protect the peg should market conditions become aggressive.
No longer a barrel of laughs
As well as the impact of the Covid-19 crisis, financial markets have had to deal with a substantial amount of volatility in oil markets thanks to a price war between Saudi Arabia and Russia. The declines in the price of oil meant lower revenues for these Gulf states with central banks feeling the need to sell some of their foreign currency reserves; the Saudi Arabian Monetary Authority – the country’s central bank – sold more than $27bn in March to free up cash.
We have seen big moves in oil and dollar markets before with one or both volatile through events such as both Gulf Wars, 9/11 and the Global Financial Crisis so stresses on the pegs are not new however, investors are always willing to test whether something will eventually give way.
Of course, a country’s vulnerability depends on how long it can defend itself against poor oil prices. Saudi Arabia, Kuwait, Qatar and the UAE have such huge levels of reserves that we would likely need to see months, if not years, of oil prices below their individual break-even prices before a lack of currency reserves became an issue. Bahrain and Qatar are different however, given their breakeven prices on a barrel of exported crude oil are around $90 and they are the two poorest nations of the six.
Are the pegs good policy?
GCC countries are obviously huge exporters of hydrocarbons but are incredibly reliant on imports of most other necessities such as food and medicine. When currency pegs are stable and FX reserves are large and increasing the costs of those imports are easily taken care of. When export revenues dip however then those reserves begin to diminish, and pressure is put on the currency peg.
However, these countries are keen to move away from their reliance on oil and diversify their economies. Creation of new sectors are typically helped by a weak currency as it allows for investment and encourages companies to employ local labour as opposed to seeking migrant workers.
But a change in a peg will mean a devaluation; an economic effect that is incredibly expensive and difficult to control. But a change is likely needed to uncouple these economies from oil.
The Kuwaiti example
As noted above, Kuwait pegs its currency to a basket of currencies not just the USD diversifying its currency exposure across the US dollar but also the EUR, GBP and CNY. This allows for more flexibility and also means that Kuwait is better prepared for a shift in global trade given the retrenching of the US from the international stage and, the increasing dominance of China and its ‘Belt and Road’ scheme.
Unless oil markets collapse again there is little chance that these GCC pegs break anytime soon although changes could be made to make a managed foreign exchange regime less vulnerable in the future. A movement in one country’s peg would increase speculation that all will move so as soon as pressure on one of the weaker countries increases we would expect to see richer GCC countries offer support to maintain their pegged level.
For now, the pegs are safe. Changes will come though and it is crucial that the GCC make these decisions before having it forced upon them.