(national currencies per USD, 1966-2004)
Source: IMF IFS. 0.25 0.30 0.35 0.40 0.45 0.50 1968 1972 1976 1980 1984 1988 1992 1996 2000 20043.0 3.2 3.4 3.6 3.8 4.0 4.2 4.4 4.6 4.8 5.0 Oman (left-hand scale)
Bahrain (left-hand scale) Saudi Arabia (right-hand scale) UAE (right-hand scale) Qatar (right-hand scale) Kuwait (left-hand scale)
only GCC country which also had a de jure US dollar peg. Thus the transition to a common US dollar peg in early 2003 meant only an adjustment of the de jure exchange rate regime to the long-standing de facto regime.
Kuwait’s exchange rate regime differed slightly from those of the other five GCC member states. Until the beginning of 2003 the Kuwaiti dinar was pegged to a basket of currencies of the country’s main trading and financial partners. The composition of the basket was not disclosed, but obviously the US dollar had a dominant weight, as only minor fluctuations occurred vis-à-vis the US dollar, and as a result, exchange rate fluctuations vis- à-vis the other five GCC currencies were also very limited. Nevertheless, the limited exchange rate flexibility enjoyed by Kuwait in the past explains the fact that under the present common US dollar peg, the Kuwaiti dinar is the only currency which is granted a narrow fluctuation band.
The last major adjustments of parities vis-à-vis the US dollar, and thus among the five GCC currencies pegged to the US dollar, took place in 1986 (in Oman and Saudi Arabia), while the parities of Bahrain, Qatar and the UAE have
remained largely unchanged since 1979.30
Accordingly, there has been almost complete exchange rate stability among five of the six GCC currencies over the last 18 years. In the last decade, the fluctuations of the Kuwaiti dinar did not exceed ± 3.5% vis-à-vis either the US dollar or the other five GCC currencies. With regard to real exchange rate developments, higher inflation rates have induced an appreciation of the real effective exchange rates of the Kuwaiti dinar, the Qatari riyal and the UAE dirham over the last decade. Interestingly, although the real appreciation is significant, in particular for the UAE dirham, this has not resulted in a loss of competitiveness or a rising current account deficit and, subsequently, in pressure on the nominal exchange rate, as standard economic theory would suggest. This may be explained
by stronger productivity growth in the UAE, which is more advanced in its degree of diversification (see Chapter 2). However, the dominance of oil in foreign trade may also be part of the explanation, as the price of and demand for oil is not influenced by domestic price developments.
Exchange rate stability among the GCC countries is all the more remarkable as it has evolved in an environment of relatively open capital accounts, and thus cannot be explained by foreign exchange restrictions. Moreover, this exchange rate stability has withstood various instances of severe economic and political turbulence, such as large oil price fluctuations, crises in various emerging market economies with a global impact, the 1990/1991 Gulf War following the Iraqi invasion of Kuwait, and most recently the military intervention in Iraq in 2003.
This stability can be explained by three main factors: (i) the similarity of economic structures of GCC member states, notably the role of oil in their economies, which reduces the potential for asymmetric shocks and thus the need to resort to exchange rate adjustments; (ii) economic policies in GCC member states, which have largely been consistent with the exchange rate pegs and have not undermined their credibility; and (iii) the accumulation of significant foreign exchange reserves by GCC member states, which have underpinned the credibility of the peg and deterred speculative attacks. Such attacks occasionally occur, mainly in the wake of low oil prices, and tend primarily to target the Saudi riyal, as it exhibits by far the most liquid foreign exchange market among GCC currencies. Past attacks have led to a temporary widening of interest rate spreads vis-à-vis the US and to interventions in the foreign exchange markets to defend the peg. No formal arrangement exists among GCC monetary agencies and central banks to support each others’ currencies when the exchange rate
30 A very small adjustment of the UAE dirham took place in 1997.
4 ECONOMIC CONVERGENCE OF GCC MEMBER STATES peg is under strain. However, it is widely
acknowledged that monetary agencies and central banks would be able to coordinate support informally on an ad hoc basis if deemed necessary.
The US dollar orientation of the GCC countries’ exchange rate policies is explained by the fact that oil revenues, which constitute their main income flow from exports, are priced in US dollars. The US dollar pegs thus serve the aim of stabilising export revenues, and, given the prominent role of oil revenues in GCC member states’ budgets, fiscal revenues as well. The repercussion of these US dollar pegs is that the GCC countries’ terms of trade are to a considerable extent exposed to fluctuations in the US dollar vis-à-vis other major currencies, given their foreign trade patterns (see Chapter 2).
4.2 FISCAL CONVERGENCE
Fiscal convergence is examined here on the basis of deficit-to-GDP ratios and debt-to-GDP ratios in order to provide a cursory overview of the fiscal situation.31
4.2.1 BUDGET DEFICITS
While GCC budget balance-to-GDP ratios tend to exhibit a considerable degree of co- movement, significant differences regarding the level of deficits/surpluses remain (see Chart 20).
Three major periods can be distinguished within the past three decades. In the 1970s, following the dramatic increases in oil prices, GCC budgets exhibited surpluses which were in some cases massive in relation to GDP. The early 1980s marked the transition to deficits, which remained the norm until the late 1990s. Most recently, fiscal revenues have significantly increased due to the pick-up in oil prices, and budget balances have moved into surplus again. However, the magnitude of the budget balance-to-GDP ratios differed between GCC member states, with Saudi Arabia exhibiting the highest annual average
deficit (-8.8% of GDP) in the period 1985- 2004, and Oman the lowest (-0.1% of GDP). Unsurprisingly, the budget balances are strongly influenced by oil price developments, and thus show a significant degree of co- movement (see Chart 21). However, country- specific developments leading to a divergence from the general trend can be identified, such as the high Kuwaiti deficit in the early 1990s due to the reconstruction effort following the Iraqi invasion.
The underlying components of the budget deficits – government revenue and expenditure – also exhibit a high degree of co-movement, although to a slightly different extent. Revenue growth tends to be highly correlated in all GCC member states, due to the high dependency of government budgets on oil as the major source of revenue. Thus revenue in all GCC countries increases sharply in times of high oil prices, and decreases when oil prices fall. Government expenditure growth tends to follow closely revenue growth and thus oil prices; accordingly, spending cycles of GCC member states are also correlated, although to a slightly smaller extent than revenues, with Kuwait in the early 1990s being the major outlier.
31 This does not imply that these would be appropriate f iscal convergence criteria in the GCC context in view of the role of oil in budget revenues (see Chapter 5, Section 5 on the issue of f iscal convergence criteria in the GCC).
Chart 20 Budget balances in GCC member