Currency Union and Exchange Rate Issues: Lessons for the Gulf States

Currency Union and Exchange Rate Issues

NEW HORIZONS IN MONEY AND FINANCE Series Editor: Mervyn K. Lewis, University of South Australia This important series is designed to make a significant contribution to the shaping and development of thinking in finance. The series will provide an invaluable forum for the publication of high quality works of scholarship on a breadth of topics ranging from financial markets and financial systems to monetary policy and banking reform, and will show the diversity of theory, issues and practices. The focus of the series is on the development and application of new original ideas in finance. Rigorous and often path-breaking in its approach, it will pay particular attention to the international and comparative dimension of finance and will include innovative theoretical and empirical work from both wellestablished authors and the new generation of scholars. Titles in the series include: Banking Reforms in South-East Europe Edited by Zeljko Sevic Russian Banking Evolution, Problems and Prospects Edited by David Lane Currency Crises A Theoretical and Empirical Perspective André Fourçans and Raphaël Franck East Asia’s Monetary Future Integration in the Global Economy Suthiphand Chirathivat, Emil-Maria Claassen and Jürgen Schroeder Reforming China’s State-Owned Enterprises and Banks Becky Chiu and Mervyn K. Lewis Financial Innovation in Retail and Corporate Banking Edited by Luisa Anderloni, David T. Llewellyn and Reinhard H. Schmidt An Islamic Perspective on Governance Zafar Iqbal and Mervyn K. Lewis Currency Union and Exchange Rate Issues Lessons for the Gulf States Edited by Ronald MacDonald and Abdulrazak Al Faris

Currency Union and Exchange Rate Issues Lessons for the Gulf States

Edited by

Ronald MacDonald Adam Smith Professor of Political Economy, University of Glasgow, UK

Abdulrazak Al Faris Chief Economist and CEO of Research, Dubai Economic Council

NEW HORIZONS IN MONEY AND FINANCE

Edward Elgar Cheltenham, UK • Northampton, MA, USA

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ISBN 978 1 84844 857 5

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Printed and bound by MPG Books Group, UK

Contents List of contributors

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Introduction Ronald MacDonald and Abdulrazak Al Faris

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Currency union in the GCC countries: history, prerequisites and implications Abdulrazak Al Faris

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Economic, political and institutional prerequisites for monetary union among the members of the Gulf Cooperation Council Willem H. Buiter The euro experience and lessons for the GCC currency union Paul De Grauwe

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The GCC monetary union: choice of exchange rate regime Mohsin S. Khan

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International experiences in operating exchange rate regimes: drawing lessons from the United Arab Emirates Ronald MacDonald

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Operational implications of changing to alternative exchange rate regimes Warren Coats

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The United Arab Emirates: exchange rate regime options Zubair Iqbal

Index

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Contributors Abdulrazak Al Faris, Chief Economist and CEO of Research, Dubai Economic Council Willem H. Buiter, Professor of European Political Economy, European Institute, London School of Economics and Political Science, UK Warren Coats, Director, Cayman Islands Monetary Authority Paul De Grauwe, Professor of International Economics, University of Leuven, Belgium Zubair Iqbal, Scholar, Middle East Institute, Washington, DC, USA Mohsin S. Khan, Senior Fellow, Peterson Institute for International Economics, Washington, DC, USA Ronald MacDonald, Adam Smith Professor of Political Economy, University of Glasgow, UK

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Introduction Ronald MacDonald and Abdulrazak Al Faris

ABOUT THIS BOOK The Gulf Cooperation Council (GCC) – the United Arab Emirates, the State of Bahrain, the Kingdom of Saudi Arabia, the Sultanate of Oman, the State of Qatar and the State of Kuwait – has as an objective the formation of a monetary union in 2010. This proposed monetary union raises clear issues in terms of the appropriateness of such a regime for these countries and whether, for example, the necessary institutional mechanisms are in place in the run up to the proposed union. Furthermore, in the run up to the monetary union most of the GCC countries have pegged their currencies rigidly to the US dollar, but the relatively dramatic movements in the US dollar in the recent past, and also in the early 1990s, have called this practice into question for a group of countries that predominantly rely on hydrocarbons as their primary export. This book brings together a selection of papers that focus on these important issues for the United Arab Emirates and other Gulf State countries. Specifically, the papers by Warren Coats, Zubair Iqbal, Mohsin Khan and Ronald MacDonald focus on exchange rate regime issues for either the UAE dirham or for the proposed GCC currency, while the primary focus of the papers by Abdulrazak Al Faris, Willem Buiter and Paul De Grauwe is on monetary union issues for the Gulf States. Abdulrazak Al Faris provides in Chapter 2 a historical perspective of the main developments in the GCC integration process that led to the decision to adopt the single currency. The literature on the subject is reviewed, and the costs and benefits of a monetary union are critically evaluated before moving on to an analysis of the criteria required for a successful integration, followed by an investigation into the implications of such a union on the political and economic landscape of the region. Al Faris reviews the steps taken thus far in the process of achieving a currency union within the framework of wider regional integration. Moving on, the author then provides a critical analysis of the fundamental criteria necessary for successful integration, particularly their relevance, consistency and compatibility

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with the Gulf region. The author stresses that convergence criteria should reflect ‘the particular circumstances of the region, level of development and the degree of sophistication the members have in terms of fiscal and monetary management’. Moreover, since reliable and timely statistics on key macroeconomic indicators are absent from most of these countries, the emphasis should be put now on transparency, a mandatory deadline for the provision of data and an independent international and regional surveillance on the observance of standards and codes and convergence criteria. Using both technical economic arguments and political economy considerations, Willem Buiter in Chapter 3 reviews the arguments for and against monetary union among the six members of the Gulf Cooperation Council. He concludes that although there is an economic case for GCC monetary union, that case is not overwhelming. This follows from the lack of economic integration (displayed in the lack of free movement of goods, services, capital and persons) among the GCC members, which Buiter finds striking. Given this lack of economic integration, the case for monetary union is mainly based on the small size of all GCC member countries, other than Saudi Arabia, and their high degree of openness. Buiter argues that even without the creation of a monetary union, there could be significant advantages to all GCC members, from both an economic and a security perspective, from greater economic integration, through the creation of a true common market for goods, services, capital and labor and from deeper political integration. Furthermore, Buiter argues that the political arguments against a GCC monetary union appear overwhelming: the absence of effective supranational political institutions encompassing the six GCC members means that there could be no effective political accountability of the GCC central bank and the surrender of political sovereignty inherent in joining a monetary union would therefore not be perceived as legitimate by an increasingly politically sophisticated citizenry. He argues that monetary union among the GCC members will occur only as part of a broad and broadly-based movement towards far-reaching political integration and there is little evidence of that as yet. Paul De Grauwe uses the historical experience of the European countries’ move to full monetary union (EMU) to draw lessons for the Gulf States and their planned monetary union. He argues that the overriding lesson from the European experience is that a monetary union is not created in a political and institutional desert and that monetary union was made possible in Europe because of at least 40 years of preparatory work in terms of institution building. For example, the creation of the European Central Bank was made possible by the pre-existence of numerous European institutions (the European Commission, the Council,

Introduction

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the European Parliament, the European Court of Justice) to which the member states of the EU gradually transferred part of their national sovereignty. Once the process of institutional building started, an endogenous dynamic took over, whereby limited first steps called for other steps towards further institutional cooperation. Second, Paul De Grauwe’s discussion of the EMU convergence criteria leads him to conclude that these criteria can in fact be dispensed with and the candidate countries of the GCC currency union have nothing useful to learn from them. He argues that these convergence criteria are either useless and harmless, in terms of the interest rate convergence criterion, or useless and harmful, in terms of the fixed exchange rate requirement. He argues that the latter can be seen as a rite of passage in which countries show to the others that they are capable of sustaining pain and the inflation convergence requirement has the same quality of a rite of passage, whereby high-inflation countries show to the low-inflation countries how serious they are in keeping a low inflation rate. Finally, De Grauwe notes that the numerical precision, as given in the Maastricht Treaty, appears to be unhelpful in imposing budgetary discipline. Exchange rate policy in the UAE, and other Gulf States, has been driven by the need to ensure external stability, market credibility and – in conjunction with fiscal and structural policies – to facilitate development of the non-oil sector in order to reduce excessive dependence on oil exports. For this purpose, the UAE and other Gulf State authorities have adopted an exchange rate regime that pegs their currency to the US dollar. As Zubair Iqbal, Mohsin Khan and Ronald MacDonald point out in their chapters, such regimes have a number of advantages, such as providing a credible nominal anchor for private expectations about the behavior of the exchange rate and the appropriate supporting monetary policy; it is a relatively straightforward system and avoids many of the complexities and institutional requirements for establishing an alternative anchor, such as an inflation target; pegged exchange rates would seem to be suitable for small open economies with a dominant trading partner that maintains a reasonably stable monetary policy, thus obviating the need for managing an independent and perhaps costly monetary policy. Finally, a fixed exchange rate is thought to better insulate a country against monetary shocks, regardless of the degree of capital mobility. However, and as recent history shows, fixity can have a number of disadvantages. Crucially, failure to provide adjustment to changing economic conditions affecting the underlying equilibrium real exchange rate, including temporary real shocks (such as temporary oil price shocks), means adjustment has to be made by other means, particularly changes in the level of domestic prices and costs, which in turn lead to changes in

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the level of economic activity – growth – and employment. In particular, adjustment to negative real shocks will have to be effected through a contractionary fiscal policy since a fixed rate implies monetary policy is assigned primarily to maintenance of the exchange rate, which could make it more difficult to simultaneously achieve internal and external objectives. Moreover, greater terms-of-trade volatility implies higher costs associated with a pegged exchange rate. Also, if the pegged regime is adopted when conditions are favorable, but without adequate policy commitment and institutional foundations to withstand the potential strains on the peg, it can entail a costly crisis when conditions turn unfavorable, particularly in an environment of capital mobility. The most recent IMF Article IV statements for the Gulf States that have chosen to peg to the US dollar, make clear that pegging to the US dollar has served these countries well, allowing them to ‘import’ US monetary policy credibility and relatively low inflation, and until 2004/05 inflation remained relatively low and broadly aligned to that in the US. However, in the post-2004 period, up until the financial crises of 2008, the rapid increase in private sector demand, particularly in the non-tradable sector, increase in the cost of imports from non-dollar areas and the emerging supply constraints have intensified inflationary pressures in these countries and for many brought into question the suitability of the pegged exchange rate regime. The alternative regimes to pegging to the dollar are set out in some detail in the chapters by Zubair Iqbal, Mohsin Khan and Ronald MacDonald and range from a rigid peg against the US dollar, a managed float against the dollar, pegs with wider bands, currency basket pegs, crawling peg against a basket of currencies, pegging exchange rate to the price of oil to a freely floating regime. Mohsin Khan in Chapter 5, considers the exchange rate regime issues facing the unified GCC currency and although he has a preference for pegging to the US dollar recognizes that the decision for a particular exchange rate regime depends ultimately on the policy objectives and common preferences of the authorities involved. He also notes that the choice of an exchange rate regime under the monetary union is not necessarily a permanent one. For example, the GCC countries could initially peg the single currency to the US dollar and then move to a more flexible regime, such as a dollar-euro peg, as circumstances dictate. This would allow for a smoother transition for the monetary union to a new exchange rate system. Khan also emphasizes that in a fast-changing environment, a forward-looking monitoring framework will be essential for the monetary union and that the exchange rate regime is only one element of the overall policy framework and, as such, should not be assessed in isolation. Hence, it must be compatible with the other elements of the framework, such as

Introduction

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monetary, fiscal and structural policies (that is, policies related to price formation in labor and product markets), and the broader institutional development of the GCC region. In Chapter 6 Ronald MacDonald examines exchange rate regime issues for the UAE, although his discussion has wider applicability for other hydrocarbon-based economies and therefore his proposals would also apply for the proposed unified GCC currency. MacDonald argues that although pegging to the US dollar has served the UAE, and many of the other Gulf States well, recent events and especially the asymmetric nature of the US and UAE economies has to be recognized in the design of an appropriate exchange rate regime for the UAE (this asymmetry shows up in two ways: the UAE is predominantly a hydrocarbon exporter while the US is predominantly a hydrocarbon importer; the monetary policy needs of the two countries are often very different). MacDonald argues that this would involve moving away from the current regime of pegging to the US dollar to one in which the dirham is pegged to an appropriate basket of currencies, thereby providing the non-hydrocarbon sector with the stability and credibility it needs to flourish while at the same time allowing the price of oil to influence the external value of the currency. He envisages the latter being achieved by either including the price of oil directly into the basket of currencies or by adjusting the basket – along the lines of a crawling peg, as the price of oil changes. As the title of Chapter 7 indicates, Warren Oates’ chapter nicely complements those concerning alternative exchange rate regimes in that it looks at the operational implications of moving to the alternative regimes. As he points out, one of the key aspects in moving from fixed to flexible exchange rates, for a country with no prior experience of flexibility, is the necessity of developing an interbank market in foreign exchange trade. Oates then examines the operational issues surrounding exchange rate targeting, monetary aggregate targeting and inflation targeting. For exchange rate targeting, the key operational aspects are: data analysis of factors effecting equilibrium balance of payments used to determine the exchange rate target; a clear explanation to the market of the factors guiding the choice of exchange rate targets and what would lead to a change in target; and contingency plans for how to deal with a speculative attack on the exchange rate. For monetary aggregate targeting the key elements are, inter alia: the determination of which monetary aggregate has the most predictable relationship with inflation; a target for the growth of this aggregate must be chosen, periodically reviewed and adjusted as necessary in light of the behavior of the real economy and the desired inflation; central bank instruments need to be developed for controlling the size of its balance sheet, in particular its monetary liabilities and the central bank

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must estimate and forecast the relationship between its monetary liabilities (the monetary base) and its chosen monetary aggregate. For inflation targeting the key aspects are, inter alia: the central bank and government must credibly commit to an inflation target, preferably in legislation; a suitable price index to target must be chosen, along with the horizon over which the target is to be achieved; and a forecasting team must be established to develop inflation forecasting models and to maintain and update them. Zubair Iqbal in Chapter 8 recommends moving to much more exchange rate flexibility for the UAE dirham, but that the move to such flexibility should be ‘a gradual step-by-step approach’, which initially involves a shift to a currency basket peg to allow flexibility, widening of margins to permit a greater role of the market in the determination of the rate, followed by the introduction of nominal exchange rate targeting as a nominal anchor. Iqbal demonstrates using a simulation analysis for the past ten years or so that a relatively small currency basket would have been characterized by moderate exchange rate volatility while allowing an appropriate movement in the Dh/USD rate. Furthermore, during the initial phase of rate flexibility, steps could be taken to establish the needed institutional infrastructure for managing a more flexible exchange rate system. These include a deep and liquid foreign exchange market, central bank intervention policy, establishment of mechanisms to ensure effective management of exchange risk and strengthened regulation.

2.

Currency union in the GCC countries: history, prerequisites and implications Abdulrazak Al Faris

INTRODUCTION From a global perspective, the GCC countries do not exhibit extraordinary qualities from several standpoints: they have the geographical size of the eurozone, albeit with a combined GDP equivalent to a medium-size European country like the Netherlands. The region’s total population amounts to less than 0.6 percent of the total world population, and its export represents 1.5 percent of global exports. However, looking beyond the surface the GCC’s significance is demonstrated in a variety of other factors: its members control more than 40 percent of world-proven oil reserves, around 23 percent of global gas reserves and nearly 38 percent of global official financial reserves. Moreover, the region’s impressive development in infrastructure, financial services and communications allowed it to benefit from the process of globalization, be better integrated in international markets and take a leading role in several development spheres in the Middle East and North Africa (MENA) region. The Gulf States, due to massive investment in education, health, housing and other social services, rank high in many international indicators such as Human Development Index (HDI), competitiveness, economic freedom and transparency. Given all this, if realized, the Gulf single currency would be the second largest common currency after the euro, and its constituent, the Gulf Monetary Union, would be the second most important supranational monetary union in terms of GDP after the euro area. This chapter provides a broad survey of the main issues in the GCC currency union experience. It starts with a background on the start of the initiative, the main achievements so far and the process to achieve single currency within the framework of wider regional integration. Next, the chapter surveys the growing literature on the subject, summarizes their main hypotheses and findings and highlights the relevant lessons from 7

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other currency union experiences. The remainder of the chapter critically reviews convergence criteria; their relevance, consistency and compatibility with the Gulf region, before moving on to some concluding remarks.

BACKGROUND Economic integration among the six member states of the Gulf Cooperation Council (GCC) goes back to December 1981, when a unified Economic Agreement was ratified. The agreement set the stage for the GCC Free Trade Area (FTA) and closer regional economic cooperation. In the first two decades after its inception the Council was preoccupied with rising regional tensions, the escalating war between its neighbors Iraq and Iran and the invasion of Kuwait by Iraq in 1990. Despite that, several practical steps toward economic integration were taken: in March 1983 a decision was adopted to exempt all GCC national products from custom duties, and the first services sectors were opened to GCC citizens by early 1986. In the 1990s, the GCC efforts shifted toward achieving custom union, and an agreement was reached in 1999 to establish the custom union no later than March 2005, then brought forward to January 2003. Immediately after the events of 9/11 (2001), the integration process among the GCC members gained momentum, where in the December 2001 summit in Muscat (Oman) a substantially revised Economic Agreement was agreed upon to expedite the completion of the common market, and begin the process of economic and monetary union that will lead to a single currency by 2010. The Agreement contains revised and new provisions addressing the custom union, common market and the monetary union. According to this revision, the Free Trade Area was brought forward to January 2003 from its initial plan for January 2005, an external common custom tariff (ECT) was set at 5 percent on all foreign imports with some exceptions, while all goods produced in any GCC member states are accorded national treatment and will be allowed to move freely within the region. The GCC adopted a two-tier ECT that is based on a unified common tariff of 5 percent on most imported products; a 0 percent rate on imports of some of 53 tariff lines at the HS 6-digit level, mainly ‘essential’ goods, and a 5 percent ECT that applies to ‘other’ goods. Additionally, the role of a single entry point where common customs duties are collected was put in force, along with the Single Customs Declaration (SCD) for the purposes of importation, exportation and re-exportation. At Muscat’s summit, the Supreme Council also agreed on the following: the establishment of implementation guidelines, including convergence criteria for the monetary union by 2005, the completion of the common

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market by 2007, and the adoption of the single currency by 2010 (see GCC, 2004). Article 3 in the new Economic Agreement specifies several areas where complete equality must be achieved in order to implement the single market. These areas are: residence and movement of GCC nationals and granting them equal treatment in the entire GCC member states and work in private and government sectors. After some delay, the GCC common market was launched in January 2008, which gives, in principle, equal treatment to all GCC citizens, including unrestricted employment opportunity in private and public sectors and equal coverage of pension and social security. Significant progress toward regional integration has been achieved since then through elimination of barriers to free movement of goods, services, capital and national labor and a common external tariff, and many measures have been taken to harmonize their standards, codes and regulations, and align their monetary, fiscal and economic policies. The financial committee (ministerial) agreed, in preparation for the currency union, to peg all the Gulf States’ currencies to the US dollar. All the GCC members, with the exception of Kuwait, had already chosen the dollar as the nominal anchor well before the planned monetary union, and this has become an official policy since 2003. Kuwait, after pegging its currency to the US dollar in 2003, switched back to the system of a basket of currencies in the middle of 2007 to deal with declining dollar and high inflation rate. However, it is widely believed that the dollar still retains a decisive weight in this basket.

LITERATURE REVIEW There has been an ever-growing literature on the monetary union in the GCC region. This literature has concentrated on three main themes, namely: the costs and benefits of a single currency in the short and long term; the degree of macroeconomic policy coordination and the extent to which the Gulf States meet the theoretical criteria of an optimal monetary union; and finally the best exchange rate regime for the single currency. Jadresic (2002) and Badr-El-Din (2004) discussed in detail the pros and cons of monetary union, highlighting the main challenges by taking into consideration the long-term perspective. For Jadresic, the benefits of the program are overwhelming and include: enhancing regional economic efficiency, deepening economic and political integration and promoting structural diversification away from the oil sector. To reap the full benefits, the monetary union should be part of a wider integration process that entails the removal of all intra-regional barriers, and harmonization

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of macroeconomic policies. Badr-El-Din (2004) presented a cost–benefit analysis for the potential GCC monetary union. By looking at the criteria of convergence – flexibility, investment, financial services and growth, stability and unemployment – the author determined that fiscal policies are the least coordinated. He goes on further to assert that the benefits to the countries of the GCC from a monetary union may not necessarily outweigh the costs. A large body of the literature addresses the issue of the GCC countries’ compatibility to form a currency union. This includes papers by Dar and Presley (2001), Laabas and Limam (2002), Darrat and Al-Shamsi (2005), Kamar and Bakardzhieva (2006), Kamar and Ben Naceur (2007), AbuQarn and Abu-Bader (2008), Coury and Dave (2008) and Al-Hassan (2009). The main questions raised by these papers are the extent to which the GCC represents an optimum (or optimal) currency area (OCA), the degree of monetary and fiscal coordination among the Gulf members and whether these countries are subject to symmetric external shocks and similar supply and demand disturbances. Abu-Qarn and Abu-Bader (2008, p. 629) examined the readiness of the GCC members to form a currency union by employing three methods: the structural VAR (vector autoregression) procedure to identify demand and supply disturbances, the Johansen cointegration test to verify the existence of long-term relationships of real GDP among all countries and finally a test for common business cycles. Their main conclusion is that ‘the requirements for a successful union are not yet met . . . and significant efforts are needed to align the fiscal, financial and political systems’. Dar and Presley (2001) argued that the GCC countries, despite great advances in areas such as communications and infrastructure networks, remain quite far from a successful monetary union. Citing the domination of one economy (Saudi Arabia) over all others, heavy dependence on oil and oil-related products, as well as heavy dependence upon trade, the authors argued that the GCC countries will remain on a slow path toward a monetary union. The authors further assert that the GCC should strive for heavier intraregional integration through encouraging the private sector and foreign direct investment, which together would allow for the successful formation of a monetary union. Laabas and Limam (2002) attempted to evaluate the degree to which the GCC countries represent the criteria essential for becoming an optimum currency area. Using a generalized purchasing power parity test as well as other tests based on OCA literature the authors then concluded that GCC countries remain unable to fulfil all prerequisites for the successful establishment of an OCA. This is true given issues such as the dominance of most GCC economies by the oil sector, a lack of synchronized

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macroeconomic fundamentals, as well as limited internal trade. The authors, however, assert that one of the most fundamentally favorable conditions for the successful establishment of the GCC monetary union lies in the strong commitment to economic and political integration exhibited by all countries. Particularly emphasizing policy prerequisites for monetary integration, Kamar and Bakardzhieva (2006) investigated the degree of monetary policy coordination among the countries concerned. Despite identifying extensive cooperation among the countries of the GCC the authors did not observe the degree of policy coordination that is required for successful monetary integration, though indicators suggest that the prerequisites for policy coordination already exist. Coury and Dave (2008) evaluated several criteria they deemed essential for successful monetary integration, namely the co-movement of business cycles among the countries of the union, co-movement of business cycles of the countries of the GCC and the US and co-movement of inflation between the GCC countries and the US. Analyzing inflation data and business cycle components of aggregate output for the GCC countries, the authors concluded that there exists little business cycle synchronization among the member countries as well as with the US. The authors assert that successfully moving toward a monetary union requires structural adjustments and institutional design of a common central bank as a way to deal with economic asymmetries. Iqbal and Erbas (1997), Abed et al. (2003) and Aleisa and Hammoudeh (2004) dealt with the issue of the optimal exchange rate regime for the single currency; single currency peg, managed floating, basket peg, or pegging to the export of oil. A full account of these options is contained in the papers by MacDonald, Khan and Iqbal, all of which are published in this volume.

PROS AND CONS OF THE CURRENCY UNION Economics literature drawing on the experiences of other currency unions provides a survey of different benefits and costs to the member countries in a currency union area. On the positive side, to begin with, the adoption of a unified currency allows for increased efficiency in terms of the allocation of resources and access to markets such as labor and financial markets, among many others. This increased efficiency has proven to have a positive impact on GDP growth where it has been found that member countries of currency unions tend to enjoy higher per capita GDP growth in comparison to other countries. This positive effect has also been shown to

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be applicable to inflation where countries of a currency union have lower inflation rates than comparable countries with sovereign currency. Moreover, the formation of a currency union has been shown to have a significant impact on enhancing trade, the magnitude of which remains the subject of ongoing research. Some researchers not only found a 100 percent increase in bilateral trade but also determined that the formation of a currency union in itself is ‘equally beneficial to bilateral trade in large countries as well as in small ones’ (Berengaut and Elborgh-Wyotek, 2006, p. 5). Moreover, other studies find that the formation of a currency union enhanced trade by a factor of over 3, though in the case of the European Monetary Union the increase in trade was much lower, between 12 to 19 percent (see Berengaut and Elborgh-Wyotek, 2006). Additionally, from a microeconomic perspective, the adoption of a single currency allows for the elimination of foreign exchange costs associated with inter-regional transactions as economic players (mainly households and firms) no longer have to pay foreign exchange commission or incur losses associated with having to deal with multiple exchange rates. Similar benefits apply in the case of firms that may operate in more than one country, which, with the formation of a currency union, would reduce accounting costs, time and cost related to intra-regional cross-border payments. This is in addition to the fact that a currency union allows for the emergence of economies of scale as it not only allows for a more efficient use of resources (ones that may have otherwise remained unused) but also ‘enhances the role of money as a unit of account and a means of payment’ while reducing the ‘ability of speculators to affect prices and disrupt the conduct of monetary policy’ (Laabas and Limam, 2002, p. 4). However, in spite of the aforementioned benefits, the formation of a currency union does not come without costs. Perhaps one of the most significant of these is the fact that the countries of the union would no longer be able to unilaterally change the value of the currency they use, a feature that could be essential in scenarios where a country requires a sizable change in its nominal exchange rate. Similarly, under a currency union each country’s central bank will be stripped of the ability to independently undertake monetary policy measures. While some would argue that under a currency peg central banks are already unable to do so, the magnitude of this is radically different than when under a currency union. In cases of a crisis in the financial sector central banks are able to ‘always ponder financing their lender-of-last-resort activities by printing money’, a sovereign decision that would not be possible under a currency union (Jadresic, 2002, p. 11). Also, a loss of sovereign decision-making in turn implies a loss over the control of inflation rates. The formation of a currency union also involves a ‘spillover cost’

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whereby some countries suffer from ‘negative monetary spillovers from the macroeconomic imbalances in other countries in the region’ (Jadresic, 2002, p. 6). This implies that even in the case where a country does not need any changes in its monetary policies it would be forced to adopt them should another country (or group) require it to deal with its own financial difficulties. A more serious consequence is that shaky financial conditions in one country (or group) could potentially cause a ‘general loss of credibility in the regional currency peg, with attendant adverse consequences on interest rates and liquidity in all the countries in the region, regardless of their particular circumstances’ (Jadresic, 2002, p. 12). Another cost associated with the adoption of a single currency is the one related to policy measures where it can be both costly and challenging to coordinate policies among the member countries, which could in turn affect the very fabric of the union, particularly in areas where sociopolitical differences could have a significant role.

CONVERGENCE CRITERIA To ensure the success of a monetary union, the constituent members have to achieve a certain degree of economic convergence, the ultimate objective of which is to attain price and fiscal stability. Existing currency unions in the world have been unanimous in terms of criteria they set as a prerequisite to establishing the union or to admitting new members. Convergence criteria, while maintaining the minimum requirements to establish a single currency, should reflect, at the same time, the particular circumstances of the region, level of development and the degree of sophistication the members have in terms of fiscal and monetary management. In the GCC, and at the request of the 2000 summit, the financial committee (finance ministries and governors of central banks) presented to the Muscat summit in 2001 a timetable for establishing the monetary union, and set 2010 as the target to launch the GCC single currency. According to this timetable, all state members should formally peg their currencies to the US dollar no later than January 2003. Moreover, a high-level committee consisting of experts from ministries of finance and central banks was formed in 2002 to postulate convergence criteria and assess the process leading toward the objective. At a later stage, the GCC members agreed in 2007 to five European Union-style convergence criteria to achieve a common currency. These criteria include on the monetary side: the inflation rate shall not exceed the weighted average inflation rate of the member countries (weighted by GDP) by more than 2 percent; the interest rate shall not exceed the average of the least three rates (three

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Currency union and exchange rate issues

months’ interbank rates) by more than 2 percent; and the foreign reserves of the member country shall be sufficient to cover at least four months of imports. On the fiscal front the public budget deficit to GDP ratio shall not exceed 3 percent on the condition that average oil price is equal to or above 25 USD. If the average oil price is below 25 USD, the ratio should be equal to the following formula: 3% + 3 * [|(OPt – 25)/25|] where, the OP is the average oil price represented by the OPEC Reference Basket. The criteria simply states that in the event that oil prices go below 25 USD, the budget deficit to GDP ratio should be no more than 3 percent plus triple the absolute percentage change in average oil price relative to the baseline price of 25 USD. Fiscal criteria also include a provision that public debt to GDP ratio shall not exceed 60 percent for the general/ federal government and 70 percent for the central government. In the coming sections this chapter will address three issues of relevance to the GCC convergence criteria; to assess whether the criteria are methodologically sound and practically applicable to the GCC situation, to ascertain their comparability cross-country in terms of definition and method of calculation, and finally to test how state members meet generally accepted criteria. The Relevance of Criteria All GCC members, except Kuwait, have for a long time followed a monetary policy based on an ad hoc peg to the US dollar, which meant in practice, that the GCC members cannot diverge their monetary policy from US policy for too long or by too much, given the presence of capital mobility. The dollar peg, despite all the advantages it renders, comes at the cost of monetary policy independence, and the neutralization of most non-fiscal instruments. Any country with its currency pegged to the dollar has to keep its benchmark interest rates in tandem with the US Federal Reserve’s. Divergence in the business cycles between the US and any Gulf State will put extra pressure on the peg, and tend to accentuate the pro-cyclicality of monetary policy in the pegged country, as past recent experience has shown. Being an emerging market, Gulf economies tend to grow at a higher rate than a mature economy like the US during the peak cycle and slow at a lower pace during an economic downturn. This means the GCC monetary policy will remain out of step with that of the US, which needs to maintain interest rates at a lower level for a much longer period. On the other hand, if the US dollar were to rally significantly as

Currency union in the GCC countries

15

a consequence of tighter monetary policy in the US, then the region’s non-oil sector competitiveness would suffer and with it a deterioration in the diversification efforts. The US Federal Reserve focuses on the US economy when setting interest rates and the GCC central banks are forced to mimic US monetary policy, or risk speculative pressure on their currencies. In the recent past, the Fed’s adoption of loosening monetary policy, necessitated by the continuing credit crunch and the looming recessionary fears, has consistently posed the GCC policy-makers with a real dilemma. Against this backdrop the interest rates set by the GCC are perceived to be neither appropriate nor a legitimate convergence criterion for the monetary union. Moreover, lower interest rates with high inflation means negative real interest rates, which may have a profound effect on saving. Negative real interest rates weaken the attractiveness of domestic bank deposits and encourage capital flight to assets (property and stocks), and eventually may force domestic banks to contract excessive foreign debt in order to meet their funding needs. In addition, all Gulf States have built considerable financial reserves, boosted by the recent strong oil prices. Only a small fraction of those reserves is kept at the central banks, while the rest is managed either in Sovereign Wealth Funds, Next Generation Funds, or Oil Stabilization Funds. All in all, the Gulf States’ reserves can well cover much more than the four-month floor recommended by the convergence criteria. That said, this criterion is, also, considered to be irrelevant. Out of the three monetary convergence criteria, then, only inflation rate seems to be an appropriate one. Fiscal Criteria Because of the currency peg, none of the GCC countries have used monetary policy as an instrument to navigate their economies through business cycles. Fiscal policy therefore, has been, and will continue to be the major tool to spur economic growth and maintain macroeconomic stability. The Gulf States face, on this front, two major challenges. The first is that fiscal stance in all the GCC countries is highly vulnerable to oil price shocks, while oil revenues constitute more than 75 percent of total revenues. Moreover, as a recent IMF study (Medas and Zakharova, 2009) on the debt sustainability has shown, GCC countries follow a pro-cyclical fiscal policy with respect to both oil prices and growth. Accordingly, the cyclicality of debt/surplus situations adds to the vulnerability of these economies to long-term fiscal imbalances. Second, unlike the situation in the European Community where a policy of low economic growth was designed against a backdrop of diminishing population growth and aging

16

Currency union and exchange rate issues

population, the GCC area, on the contrary, is characterized by a young population structure, an increase in the number of UAE nationals entering the education system and the labor market. These countries, therefore, are required to maintain high economic growth rates to create more job opportunities, and this can only be achieved by large investments in infrastructure and social services. Against this backdrop, setting as a convergence criterion a budget deficit at 3 percent of GDP is considered to be unrealistic, too restrictive and unsustainable in the long term, a point of view maintained by many experts, and shared at least by one GCC member, Oman. A further question could be asked about the rationale and connection between the 3 percent budget deficit and 60 percent of public debt. When these criteria were introduced in the euro area, they were based on the prevailing circumstance at that time, where the average public debt for the state members was around 60 percent and the nominal growth rate of the GDP was 5 percent. Maintaining a growth rate of 5 percent with an inflation rate of 2 percent will produce a real growth rate of 3 percent ‘The link between 3% and 60% becomes more obvious. In mathematical terms, 3% is actually 5% of 60%; in economic terms, in a country with a budget deficit of 3% of GDP and a 5% nominal growth, public debt will, in the long-run, stabilize at the level of 60% of GDP’ (see Faulend et al., 2005, p. 10). Definitional and Data Problems Maintaining a currency union requires good-quality statistics to facilitate timely monitoring and rigorous supervision, and the absence of essential statistics and/or variation in the definitions of comparable data could hamper the entire integration process. A meaningful test of adherence to convergence criteria requires a proper definition of these macroeconomic indicators to ensure their cross-country comparability. The GCC countries are therefore required to pay close attention to definitions, calculation methodology and data collection. For instance, the criterion of inflation in a monetary union is usually set to ensure that state members maintain a price performance that is sustainable. The underlying reason is that maintaining low and stable inflation spurs economic activity, and creates an environment conducive to growth, equity and competitiveness. Despite the fact that the GCC has introduced the inflation rate as a convergence criterion, it never spelled out attaining price stability as a targeted objective. To the contrary, achieving high economic growth rates has been the driving force in the GCC efforts in recent years with no due attention to development in the price level. Attaining and preserving a low and stable inflation rate was set aside,

Currency union in the GCC countries

17

which led to unprecedented high GDP growth rates associated with high inflation rates. Average inflation rate in the GCC countries increased from 0.9 percent 2002 to 3.1 percent in 2005 and then to a record of 10.7 percent in 2008. The spike in inflation was brought about by abundant liquidity, expansionary macroeconomic policies and the dollar’s weakness, which led to a sustained depreciation of the real effective exchange rates and an increase in imported inflation. Moreover, disparities in inflation rates have undermined the convergence of the Gulf economies and threaten to delay monetary union. In the eurozone monetary union, the achievement of a high degree of price stability was set as the main objective of the inflation rate criterion. While the criterion stipulates that a member state’s inflation rate should not exceed by more than 1.5 percentage points that of, at most, the three best performing member states, it carries on to indicate that ‘the reference value is applied by using the unweighted arithmetic average of the rate of inflation in the three countries with the lowest inflation rates, given that these rates are compatible with price stability’ (European Central Bank1). In addition, the calculation and collection of CPI data, to measure the inflation rate, has been surrounded by controversies in many GCC countries. In some GCC countries, the CPI is based on a basket of goods and services first used in the middle of the 1990s. The consumer’s basket has not been updated to reflect changes in family structure, new consumption patterns and improvements in the quality of goods and services. A further question could arise regarding whether the criteria on inflation should include countries with a negative rate of inflation. While deflation is not a desired result on its own, and it may be indicative of a prolonged economic slowdown, negative inflation rate was a feature of some Gulf States during the 1980s and part of the 1990s (notably Bahrain and Saudi Arabia). Also, moving to a single currency requires that an aggregate index of consumer prices of the Gulf States should be constructed to be the key indicator of price stability for the Gulf Central Bank. As far as the interest rate criterion is concerned, the three-month interest rate on interbank loans is not a good indicator of long-term interest rate in the market. This is contrary to the criterion set in the eurozone, which defines the interest rate on a long-term bond, and states that the bond is ‘issued by the central government and traded on the secondary market, with a residual maturity of about 10 years’.2 Interbank loans, because they are uninsured and often uncollateralized, may bear different interest rates depending on the bank position, balance sheets and so on. In real life, there is no single rate that applies to all borrowers and there is always the risk that a borrower, albeit a bank, might not repay its loans. At times of crises, or high uncertainty, the holders of liquidity may demand

18

Currency union and exchange rate issues

higher rates of return. Not all the GCC members have long-term government bonds, and the alternative could be the yield on some other longterm financial instruments that would be comparable. Acknowledging that the interest rate is an ineffective instrument, and an inappropriate criterion, the GCC should redirect its efforts to harmonize other monetary instruments it uses within the banking regulatory framework. These include: entry restrictions, liquidity requirements, loan classification and provisioning and ownership requirement and restriction. Disparities in these fields have hampered the integration of the region’s financial and capital markets. Data and information on fiscal policies and procedures are the most worrying part of the GCC economic integration. Most GCC countries lack fiscal transparency, very few publish their data in the IMF’s Government Finance Statistics (GFS) and a common code of fiscal conduct for the group is absent, including a common accounting framework for government accounts, and adequate transparent budgetary procedures. Other issues of importance to fiscal policy that should be clearly dealt with are: non-oil fiscal deficit, the treatment of revenue from investment income, extra-budgetary government funds and pension funds. As a report by the IMF has stated ‘the harmonization of fiscal concepts and data quality based on internationally accepted standards and methods should be given high priority before monetary union takes place’ (Fasano-Filho and Schaechter, 2003, p. 3).

COUNTRIES’ PERFORMANCE WITH REGARD TO KEY CRITERIA Notwithstanding the above critique regarding the suitability of some aspects of the criteria, this section presents empirical evidence on the progress and prospects of the GCC integration process, by measuring the level and rate of convergence of the agreed monetary and fiscal targets such as inflation, interest rate, financial reserves, budget deficit and public debt. The exercise will cover the period 1980–2008 whenever the data allows, with an eye to assessing the contribution of criteria to enhance these economies to achieve low inflation rates, low interest rates, low budget deficits and low public debt in an environment of high growth rates. Inflation An inflation target of no more than 2 percent above the region’s average has been one of the most contentious criteria agreed by the Gulf States.

Currency union in the GCC countries

Table 2.1

1980–90 Mean Median St. Dev. Kurtosis J-Ba 1990–2000 Mean Median St. Dev. Kurtosis J-B 2000–08 Mean Median St. Dev. Kurtosis J-B Note: Source: issues.

a.

19

Inflation criterion Bahrain

Kuwait

Oman

Qatar

Saudi Arabia

UAE

2.12 0.90 4.47 2.87 1.74

4.15 3.30 3.30 1.68 1.14

1.22 1.60 4.48 2.45 0.47

3.78 3.00 2.31 2.68 1.51

0.09 –0.60 2.25 1.97 0.48

3.66 2.90 2.62 1.78 0.94

0.55 0.90 1.24 2.23 0.51

3.02 2.50 3.44 3.00 2.35

0.35 0.30 1.65 5.08 6.38

2.57 3.00 1.55 3.38 0.72

1.02 0.50 2.14 2.69 1.79

3.65 3.40 1.84 2.32 0.23

1.76 2.30 2.15 1.91 0.45

3.17 1.80 2.85 3.64 2.75

2.01 0.70 3.30 2.62 1.41

6.83 6.80 5.67 1.43 0.98

1.81 0.60 1.57 4.48 4.52

6.22 5.00 3.76 1.56 1.18

Jarque-Bera Probability. Arab Monetary Fund (AMF); Arab Countries: Economic Indicators, various

The GCC countries moved from relatively high inflation economies in the 1980s to a very low inflation in the 1990s and back again to moderate inflation in the early 2000s and very high inflation in the period 2006–08. The degree of variation, as measured by standard deviation indicates that higher inflation rates in the 2000s have also been associated with a large dispersion from the mean, an indication of wider fluctuations in the rates (Table 2.1 and Figure 2.1). Inflation rates in the GCC countries appear to be positively correlated with petroleum prices. Higher oil prices bring with them increased public spending, higher liquidity and robust domestic demand, and these feed through to higher inflation. In the last three years, inflation rates in two GCC members (Qatar and the UAE) reached double digits, rendering these countries as violators of the convergence criteria. Although there are some similarities in the causes of inflation in the Gulf States’ economies, there are also some differences. High population growth rates, bottlenecks in the non-tradable sector (mainly housing market) are the main driving

20

Currency union and exchange rate issues 12 10 8

Percentage

6 4 2 0 –2 –4 –6

Bahrain

Kuwait

Oman

Qatar

SA

UAE

2008

2006

2004

2002

2000

1998

1996

1994

1992

1990

1988

1986

1984

1982

1980

–8

Inflation criterion

Source: Author’s own calculations.

Figure 2.1

Inflation criterion

forces of inflation in Qatar and the UAE. Common factors among all the states are the weaker US dollar, higher international food prices, abundant liquidity and a surge in government expenditure. Divergence in the inflation rate with the pegged exchange rate, and the lack of effective tools to tackle rising price levels, mean that inflation will be a continuous problem for the GCC members. Interest Rate As Table 2.2 and Figure 2.2 depict, during the decade 1980–90, there were large variations in the interest rates within the GCC countries, with the lowest mean in Saudi Arabia (2.88 percentage points) and the highest in Kuwait (8.34 percentage points). Interest rates, also, tend to fluctuate widely as captured by the standard deviation, ranging from 1.27 percent in Bahrain to 4.25 percent in Oman. These variations reflect, among others, the degree of sophistication of financial institutions, access to international capital markets and the size of domestic liquidity. Similar trends continue to prevail in the following decade (1990–2000) with less variation and a tendency to co-move in four countries at least (Bahrain, Oman, Qatar and Saudi Arabia). During the 2000–08 period, interest rates in all the GCC countries co-moved, generally following the US interest rate and the state members’ determination to adhere to convergence criteria. The spread between the highest and lowest interest rates

Currency union in the GCC countries

Table 2.2

Interest rate criterion

1980–90 Mean Median St. Dev. Kurtosis J-Ba 1990–2000 Mean Median St. Dev. Kurtosis J-B 2000–08 Mean Median St. Dev. Kurtosis J-B Note:

a.

Source: issues.

21

Bahrain

Kuwait

Oman

Qatar

Saudi Arabia

UAE

7.01 7.00 1.27 2.10 0.41

8.34 8.70 1.67 1.78 0.69

5.33 7.60 4.25 1.33 1.78

6.00 6.00 0.00 N/A N/A

2.88 0.00 4.03 1.44 1.81

N/A N/A N/A N/A N/A

5.47 5.40 1.41 2.37 0.25

7.31 7.10 0.98 1.83 1.03

5.77 6.10 1.36 2.66 0.05

5.23 5.40 0.86 3.03 1.10

5.69 5.80 1.27 2.87 0.12

3.66 5.20 2.53 1.74 1.49

3.36 3.40 1.77 2.03 0.43

3.71 3.30 1.55 2.10 0.74

3.14 3.10 1.71 2.22 0.32

3.26 3.30 1.81 1.93 0.65

3.63 3.80 1.77 1.97 0.63

3.36 3.50 1.84 1.86 0.69

Jarque-Bera Probability. Arab Monetary Fund (AMF); Arab Countries: Economic Indicators, various

12

Percentage

10 8 6 4 2

Bahrain Qatar Interest rate criterion

Source:

Author’s own calculations.

Figure 2.2

Interest rate criterion

Kuwait SA

Oman UAE

2008

2006

2004

2002

2000

1998

1996

1994

1992

1990

1988

1986

1984

1982

1980

0

22

Currency union and exchange rate issues

Table 2.3

1980–90 Mean Median St. Dev. Kurtosis J-Ba 1990–2000 Mean Median St. Dev. Kurtosis J-B 2000–08 Mean Median St. Dev. Kurtosis J-B Note: Source: issues.

a.

Financial reserves Bahrain

Kuwait

Oman

Qatar

Saudi Arabia

UAE

6.64 5.10 4.61 3.65 4.75

8.00 8.00 2.52 2.69 0.27

5.35 4.10 1.89 2.41 1.51

4.23 4.50 1.33 2.10 0.50

10.10 9.50 2.20 2.51 0.18

4.80 4.80 1.65 2.00 0.58

4.19 4.30 0.41 2.03 0.54

7.26 6.30 2.34 4.80 5.76

4.85 4.50 1.83 1.71 0.95

4.49 4.50 1.13 2.77 0.34

4.56 5.80 2.03 2.07 0.46

4.17 4.10 0.65 2.78 0.06

3.86 3.80 0.80 1.72 0.62

10.69 9.70 3.21 2.36 0.92

7.04 6.50 1.76 2.65 1.63

5.77 5.70 1.22 2.17 0.92

6.77 7.40 1.54 1.24 1.21

4.46 4.20 0.87 1.61 0.80

Jarque-Bera Probability. Arab Monetary Fund (AMF); Money and Credit in Arab Countries, various

is small, and the standard deviation is almost identical in all countries except Kuwait for the obvious reason of its decision to de-peg its currency from the dollar to a basket of currencies. Financial Reserves Reserve adequacy is the level of reserves that ensures smooth balance of payments and macroeconomic adjustment in an uncertain environment. As Table 2.3 and Figure 2.3 show, reserves in most of the GCC countries cover more than four months of imports of goods and services, and from the viewpoint of this criterion, the level of reserves in most of the Gulf States is quite adequate. The exceptions to this are the UAE and to a lesser extent Bahrain, which tend to violate this rule, and maintain reserves insufficient to cover the benchmark of four months of imports. The main drawback of the traditional reserve adequacy ratio with respect to imports, according to these two countries, is that a sizeable proportion

Currency union in the GCC countries

23

20 18 16

Months

14 12 10 8 6 4 2

Bahrain

Kuwait

Oman

SA

UAE

CC

2008

2006

2004

2002

2000

1998

1996

1994

1992

1990

1988

1986

1984

1982

1980

0

Qatar

Note: The straight horizontal line (= 4) is for the minimum financial reserves to cover four months of import. CC = convergence criteria. Source:

Author’s own calculations.

Figure 2.3

Financial reserves

of their imports is for re-export and not for internal consumption, a factor that is not reflected in this criterion. In addition, and as mentioned earlier, financial reserves kept in the central bank constitute a fraction of total reserves owned by these countries, since they tend to keep more and more of their foreign reserves in different formats such as Sovereign Wealth Funds because the reserves kept with the central banks earn a relatively lower rate of return than foreign financial assets. Budget Deficit The pro-cyclical fiscal policy adopted by the Gulf States is reflected in a strong correlation between oil prices and fiscal balance. Despite that, government expenditure, which tends to increase with the rise in oil price, does not adjust immediately to oil price correction, a phenomenon that leads to a widening budget deficit during periods of weak oil prices. Fiscal balance in the GCC countries during the 1980s as shown in Table 2.4 and Figure 2.4 tended to diverge widely and by a big margin, ranging from a mean surplus of 1.06 percent of GDP in Bahrain to a deficit of –8.29 percent of GDP in Saudi Arabia. Variation in the budget deficit,

24

Currency union and exchange rate issues

Table 2.4

1980–90 Mean Median St. Dev. Kurtosis J-Ba 1990–2000 Mean Median St. Dev. Kurtosis J-B 2000–08 Mean Median St. Dev. Kurtosis J-B Note: Source: issues.

a.

Budget deficit criterion Bahrain

Kuwait

Oman

Qatar

Saudi Arabia

UAE

1.06 –2.30 6.47 2.22 1.75

–3.90 –7.20 12.15 4.17 4.07

–7.96 –8.60 6.76 2.99 0.45

–2.32 1.40 16.99 2.46 0.14

–8.29 –12.80 15.12 2.67 1.69

–4.45 –5.90 7.87 4.47 4.34

–2.59 –2.50 2.37 2.07 0.60

–5.12 –4.10 13.65 1.95 0.50

–6.66 –6.90 3.87 2.13 0.62

–4.42 –4.60 5.37 3.15 1.65

–6.36 –6.80 5.55 2.80 0.02

–8.93 –7.00 5.89 1.75 0.77

1.50 1.40 1.62 3.69 2.22

16.50 15.10 8.12 2.32 0.80

5.87 5.30 6.84 1.99 0.72

9.73 9.00 4.73 1.72 0.65

11.21 11.40 12.28 2.25 0.47

1.92 –0.40 10.47 1.70 0.67

Jarque-Bera Probability. Arab Monetary Fund (AMF); Arab Countries: Economic Indicators, various

as depicted by standard deviation, was also pervasive, ranging from 6.47 percent in Bahrain to 16.99 percent in Qatar. Fiscal balance in the period 2000–08, however, shifted to surplus in all countries, benefitting mainly from positive development in the oil market. The actual level of budget surplus has been dissimilar among the countries, reflecting differences in petroleum endowment, the availability of other non-oil revenues and the degree of restraint on public spending. This is portrayed in the variance in fiscal positions in 2008, which ranged from a projected surplus of 2.1 percent of GDP in Bahrain to a surplus of 33.6 percent of GDP in Saudi Arabia. The Gulf States, further, and because of their strong reliance on oil revenues, must address two important issues in their fiscal policies in the medium and long term. The first is the large divergence in proven oil reserves that may require flexible fiscal rules to accommodate the future financial needs of petroleum-scarce members such as Oman and Bahrain. Oman’s main objection to the monetary union concentrates on

Currency union in the GCC countries

25

40

Percentage of GDP

30 20 3% rule

10 0 –10 –20 –30

Bahrain

Source:

Kuwait

Oman

Qatar

Saudi Arabia

2008

2006

2004

2002

2000

1998

1996

1994

1992

1990

1988

1986

1984

1982

1980

–40

UAE

Author’s own calculations.

Figure 2.4

Budget deficit criterion

the criterion to cap budget deficit at 3 percent of GDP. It asserts that such criteria would constrain Oman’s ability to finance its development projects and impede its drive to diversify its economy away from dwindling oil revenue. The second is how to broaden their tax base and increase nonoil revenue without compromising their competitiveness stance, and the attractiveness of their economies to FDI. Public Debt Table 2.5 shows the ratio of public debt to GDP to be very noticeable in the GCC countries. In 2002 Saudi Arabia had the highest debt to GDP ratio, followed by Bahrain and then by the UAE. During the following six years, Saudi Arabia, thanks to high oil revenues, managed to reduce its public debt ratio to 4.6 percent while Bahrain maintains roughly the same level. UAE more than doubled its public debt accumulated by non-oil local emirates’ governments. Kuwait and Qatar, on the other hand, do not record any public debt.

CONCLUSION Progress by the GCC countries in areas of cooperation and integration has been impressive by regional standards (MENA at large). The unified

26

Table 2.5

Currency union and exchange rate issues

Public debt/GDP in GCC countries 2002–08

Year

Bahrain

Kuwait

Qatar

2002 2003 2004 2005 2006 2007 2008

23.5 31.7 33.3 29.8 26.0 23.5 22.9

0.0 0.0 0.0 0.0 0.0 0.0 0.0

0.0 0.0 0.0 0.0 0.0 0.0 0.0

Saudi

UAE

24.5 21.5 17.7 11.8 8.6 7.5 4.6

6.1 7.0 8.3 8.7 13.8 17.7 15.5

Source: GCC Secretariat: Member States’ Performance with Convergence Criteria, periodic publication (2008).

Economic Agreement helped these states to converge their economies, accelerate their integration into the global economy, observe international standards and codes and be better prepared for any external shocks. The main advantages of integration blocks, as the experiences of other regions have shown, are to set benchmarks and create incentives for macroeconomic policy coordination. On that front, the GCC members are making tremendous efforts toward achieving sound macroeconomic policy, and convergence in several areas. Among others, the GCC countries have done well in curtailing budget deficit and reducing public debt, but performed poorly in the area of inflation. High economic growth in the past few years has been associated with high inflation rates that affected the competitiveness of these economies, delayed their diversification programs and reduced their ability to retain a skilled and talented workforce. Looking forward, these countries need to enhance their integration process in, at least, two areas. First, there is an urgent need to streamline the convergence criteria to ensure their practicality and compatibility with other monetary and macroeconomic objectives, and make certain their long-term viability and sustainability. Some criteria, as discussed in the chapter, are either irrelevant (interest rate and reserve adequacy ratio) or extremely restrictive (budget deficits). Proper review of criteria may also bring back countries (Oman) that distance themselves from the single currency to the union again. Second, the GCC countries still lack transparency, timely provision of data and statistics, especially in fiscal areas, and adequate reporting of decisions related to economic and political matters. Gulf States provide incomplete data with some delay to International Financial Statistics (IFS), and few members subscribe to reliable international finance reports such as GFS, both published by the IMF. Fewer still publish or accept the

Currency union in the GCC countries

27

publication of an independent and reliable assessment of their economies such as the annual Article IV Consultation Reports prepared by the IMF (only Kuwait, Qatar and the UAE publish this report). Before moving to a single currency, these countries need a strong commitment to transparency and independent evaluation of the health of their economies by an impartial international body. Moreover, and as a first step, they need to agree to be part of the General Data Dissemination System (GDDS) and Special Data Dissemination Standard (SDDS) and provide quarterly data on major financial and macroeconomic indicators, especially on fiscal stance.

NOTES 1. Available at: http://www.ecb.int/ecb/orga/escb/html/convergence-criteria.en.html (accessed 16 November 2009). 2. Available at: http://www.ecb.europa.eu/ecb/orga/escb/html/convergence-criteria.en.html (accessed 9 December, 2009).

BIBLIOGRAPHY Abed, T. George, S. Nuri Erbas and Behrouz Guerami (2003), ‘The GCC monetary union: some consideration for the exchange rate regimes’, Working Paper No. WP/03/66, Washington DC: IMF. Abu-Qarn, Aamer S. and Suleiman Abu-Bader (2008), ‘On the optimality of a GCC monetary union: structural VAR, common trends, and common cycles evidence’, The World Economy, 31(5), 612–30. Aleisa, Eisa and Shawkat Hammoudeh (2004), ‘A common currency peg in the GCC area: the optimal choice of exchange rate regime’, MEEA Proceedings, 9. Al-Hassan, Abdullah (2009), ‘A coincident indicator of the Gulf Cooperation Council (GCC) business cycle’, Working Paper No. WP/09/73, Washington DC: IMF. Badr-El-Din, Ibrahim (2004), ‘Do the AGCC economies need a single currency? Some potential costs and benefits of a monetary union for the member states of the Arab Gulf Cooperation Council (AGCC)’, Economic Research Forum, Conference Proceedings No. 112004. Berengaut, Julian and Katrim Elborgh-Wyotek (2006), ‘Beauty queens and wallflowers – currency maps in the Middle East and Central Asia’, Working Paper No. WP/06/226, Washington DC: IMF. Buiter, Willem H. (2008), ‘Economic, political, and institutional prerequisites for monetary union: the case of the GCC’, DEC Working Paper Series No. WP 03-08. Coury, Tarek and Chetan Dave (2008), ‘Monetary union in the GCC: a preliminary analysis’, Dubai School of Government, Working Paper Series No. 08-10. Dar, Humayon A. and John R. Presley (2001), ‘The Gulf Cooperation Council: a slow path to integration?’, The World Economy, 24(9), 1161–78.

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Darrat, Ali F. and Fatima S. Al-Shamsi (2005), ‘On the path of integration in the Gulf region’, Applied Economics, 37(9), 1055–62. Fasano-Filho, Ugo and Andrea Schaechter (2003), ‘Monetary union among member countries of the Gulf Cooperation Council’, Occasional Paper No. 223, IMF. Faulend, M., D. Loncarek, I. Curavic and A. Sabic (2005), EU Criteria with Special Emphasis on the Economic Convergence Criteria – Where is Croatia?, Croatian National Bank Survey S-13. GCC (2004), New Economic Agreement, available at: http://library.gcc-sg.org/ English/Books/econagree2004.htm (accessed 9 December 2009). Iqbal, Zubair and S. Nuri Erbas (1997), ‘External stability under alternative nominal exchange rate anchors: an application to the GCC countries’, Working Paper No. WP/97/8, Washington DC: IMF. Jadresic, E. (2002), ‘On a common currency for the AGCC countries’, IMF Policy Discussion Paper No. 02/12, Washington DC: IMF. Kamar, Bassem and Damyana Bakardzhieva (2006), ‘The appropriate monetary policy coordination for the GCC monetary union’, Working Paper, Massachusetts: The Middle East Economic Association. Kamar, Bassem and Samy Ben Naceur (2007), ‘GCC monetary union and the degree of macroeconomic policy coordination’, IMF Working Paper No. WP/07/249. Laabas, Belkacem and Imed Limam (2002), ‘Are GCC countries ready for currency union?’, API-Working Paper Series No. 0203, Kuwait: Arab Planning Institute, Information Center. Louis, Rosmy, Faruk Balli and Mohammad Osman (2008), ‘Monetary union among Arab Gulf Cooperation Council (AGCC) countries: does the symmetry of shocks extend to the non-oil sector?’, MPRA Paper No. 11610, University Library of Munich. Medas, Paulo and Daria Zakharova (2009), ‘A primer on fiscal analysis in oilproducing countries’, IMF Working Paper No. WP/09/56. Sturm, Michael and Nikolaus Siegfried (2005), ‘Regional monetary integration in the member states of the Gulf Cooperation Council’, Occasional Paper Series No. 31, European Central Bank.

3.

Economic, political and institutional prerequisites for monetary union among the members of the Gulf Cooperation Council1 Willem H. Buiter2

INTRODUCTION This chapter considers the viability and desirability of alternative exchange rate regimes for the six members of the Gulf Cooperation Council (GCC) – the United Arab Emirates, the Kingdom of Bahrain, the Kingdom of Saudi Arabia, the Sultanate of Oman, the State of Qatar and the State of Kuwait. There are two key dimensions of the currency regimes of the GCC countries: the internal exchange rate regime and the external exchange rate regime. The internal currency regime choice concerns the exchange rate regime of each of the GCC members with regard to the other members. The external exchange rate regime concerns the exchange rate regime of the GCC as a whole vis-à-vis the rest of the world. The two cannot, in general, be specified independently. If every GCC member has a well-defined regime for its national currency regarding some external currency or basket of currencies, this would fully determine the ‘internal’ relationships among the external values of the six GCC national currencies. However, the opposite does not hold. Even if the six GCC countries were to adopt a common currency, this would leave completely open the issue of how the external value of this common currency is to be managed or determined. I will not focus on the optimal external exchange rate regime of a GCC monetary union, other than noting that it is unlikely to involve a currency peg with regard to the US dollar, as this is the regime whose shortcomings are currently creating pressures for the individual GCC members to abandon their bilateral pegs with the US dollar. As regards the internal exchange rate regime, I will focus on the economic and political feasibility and desirability of monetary union, or a

29

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Currency union and exchange rate issues

common currency, a long-standing ambition of the GCC. The establishment of a common currency, which I term the ‘khaleeji’, by 2010, was declared an official objective of the GCC in the Economic Agreement of 2001 between the GCC states. However, Oman announced in 2006 that it would not be able to meet the target date. It proposed that the other GCC members move ahead with monetary union, with Oman joining at a later date. In addition, the common practice of pegging to the US dollar that had been adopted by all six GCC members before May 2007, and which was viewed by many as a good platform from which to launch a common currency, was abandoned by Kuwait in May 2007 when, in a bid to reduce inflationary pressures, it pegged its dinar to a basket of international currencies after more than four years of linking the local currency to the US dollar. The dinar had been pegged to the US dollar in January 2003 in preparation for the move towards the single currency. In November 2007, the governor of the UAE Central Bank announced that the UAE would consider switching from a US dollar peg to a currency basket if the US dollar were to weaken further. Anticipating and summarizing the argument that follows, I consider the establishment of a common currency for all six GCC members by the target date to be practically impossible; the Omani decision to delay, the Kuwaiti abandonment of the US dollar peg and the prospect of the UAE also moving to a currency basket peg play only a small part in reaching that conclusion. The non-feasibility of monetary union by 2010 should come as no surprise, nor should it be taken as evidence that the objectives will not be achieved in due course (which need not mean ‘in the fullness of time’). Economic and monetary union is a difficult and lengthy process. In the GCC, even the customs union, set up in 2003 is not yet completely implemented. The establishment of a common market that was to be achieved by 2007 is still a long way off. The proponents of economic and monetary union for the GCC should consider the fact that the EU was founded (as the European Economic Community) 50 years ago, and that even in the EU there is still no single market in services, which accounts for 70 per cent of EU GDP. Monetary union in the EU includes only 15 of the 27 member states and two EU members, the UK and Denmark, have opt-outs from monetary union that are, in principle, open-ended. I will consider some of the key issues facing countries considering joining together in a monetary union. The issues are not just technical and economic in nature. Some are deeply political. A historical and political economy perspective is therefore just as essential as a mastery of technical monetary, financial and economic matters. The unique structural economic characteristics of the GCC as a region dominated by oil and natural gas production but with a strong drive towards diversification into

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tradable services, make for a number of unique challenges for fiscal, financial, monetary and exchange rate management. The exchange rate regime must be capable of accommodating both cross-sectional heterogeneity and profound structural change over time. The political and economic prerequisites for the sustainability of a currency union for the GCC are demanding. Currency union can be a rewarding option if these preconditions are met. But it is by no means the easy option. The political and economic consequences of a failed currency union could be serious. This chapter will also cover the transitional arrangements, the preconditions for membership, including nominal, financial and real convergence, that would maximize the chances of a successful currency union.

MICROECONOMIC EFFICIENCY AND FINANCIAL STABILITY ASPECTS OF A COMMON CURRENCY The Microeconomics of a Common Currency The transactions-costs-saving advantages of a common currency are familiar. A medium of exchange or transactions medium is subject to a network externality (European Commission, 1990; Dowd and Greenaway, 1993). The usefulness of a medium of exchange is increasing in the number of economic agents likely to accept it as a medium of exchange. By eliminating the need for the exchange of one currency for another, real resource costs are saved. From a microeconomic efficiency point of view, if one were to design the world from scratch, a single currency would be adopted. If the status quo is a situation in which there are multiple national currencies, as it is for the GCC, the permanent flow of transaction cost savings from having a common currency have to be balanced against the one-off, up-front switchover costs of moving to a common currency. Little can be said about the magnitude of the resource savings involved. Estimating them from the spreads in the foreign exchange markets will understate the true cost because it ignores the ‘in-house’ costs incurred by the non-bank parties in the foreign exchange transactions. It overestimates the true costs to the extent that there are monopoly profits or X-inefficiency in the foreign exchange markets. In its report ‘One market, one money’ (European Commission, 1990), the Commission of the European Communities estimated the permanent flow of exchange transaction costs savings at about 0.5 per cent of GDP for the Community as a whole. Of course, this exercise involved the abolition of 14 national currencies and their replacement by a single currency. With

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Currency union and exchange rate issues

only six currencies involved, the resource savings for the GCC members would be smaller. The foreign exchange transactions costs savings should also be augmented by the transactions costs saved in transactions between instruments denominated in national currencies that would be redundant if a common currency were adopted. For example, switching from Qatari riyal-denominated securities into otherwise identical UAE dirhamdenominated securities would involve the sale of the Qatari securities, a purchase of dirham and the purchase of the UAE securities. There would be three transactions, and three sets of transaction costs. Foreign exchange market transaction costs are just one of the three. The magnitude of the switching costs for the GCC are even harder to estimate. I am assuming here that the new common currency for the GCC would be a physically new currency, the ‘khaleeji’, rather than the existing currency with the largest circulation. Using an existing currency (in the case of the GCC this could only be the Saudi riyal) would be cheaper, but would pose political problems and detract from the symbolism of creating de novo a new currency. In the case of EMU, competing estimates differed by one and sometimes two orders of magnitude. The switching costs do not just involve the administrative and hardware costs of re-denominating all contracts, changing vending machines and so on, but also the psychological/mental costs of having to compute prices with a new numeraire. A final microeconomic benefit from a common currency is the greater price transparency it creates. Price discrimination and market segmentation are discouraged when buyers can more easily engage in comparison shopping. Again, this argument relies on bounded rationality, and the magnitude of these benefits is anyone’s guess. Seigniorage and the Inflation Tax I assume the GCC monetary union would be a formally symmetric monetary union, in which each member state has a voice in the monetary policy decision-making process, each member state has recourse to the lender-of-last-resort facilities of the central bank and the seigniorage of the central bank is shared fairly among the members, based on some key like population, GDP or national seigniorage prior to monetary union. There are several ways of measuring the resources appropriated by the state through the issuance of non-interest-bearing monetary liabilities. Currency is, of course, non-interest-bearing. The other main liquid liability of the central bank, commercial bank reserves with the central bank, can be either remunerated (bearing interest or its Sharia-compliant analogue) or unremunerated.

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One straightforward measure of revenue from the activities of the central bank is simply the change in the monetary base. To get a sense of magnitude, it is helpful to express this as a fraction of nominal GDP. Letting Mt denote the nominal stock of base money at the beginning of period t, Pt the price level and Yt real GDP in period t, I define seigniorage, s, as follows:3 st 5

DMt11 PtYt

(3.1)

An alternative measure considers the interest bill foregone by having non-interest-bearing rather than interest-bearing liabilities. I denote this w. Let it be the short risk-free nominal interest rate between periods t21 and t, then: wt 5 it

Mt PtYt

(3.2)

A related measure of the monetary revenue of the state is the inflation tax, the reduction in the purchasing value of the outstanding stock of base money. I will refer to this as the anticipated inflation tax, denoted t. Let πt be the rate of inflation between periods t21 and t, then: tt 5 pt

Mt P tY t

(3.3)

The three measures are related (see Buiter, 2007a). For my purposes here, the most important relationship is that between seigniorage and the inflation tax. Let mt = Mt/PtYt be the base-money–GDP ratio and g the growth rate of real GDP, then: DMt11 5 pt11mt11 1 gt11 (1 1 pt11) mt11 1 Dmt11 PtYt or

(3.4) st 5 tt 11 1 gt 11 (1 1 pt 11) mt11 1 Dmt 11

That is, seigniorage as a share of GDP equals the inflation tax, plus the real growth bonus (the increase in the demand for real base money associated with higher real GDP growth) plus the change in the stock of real money balances as a share of GDP. Of course, attempts to raise seigniorage as a share of GDP by increasing the growth rate of the nominal stock of base money will cause inflation and higher nominal interest rates. This will lower the demand for real money balances. Ultimately, for empirically relevant money demand functions like the log-linear and the linear ones, the demand for real money balances becomes more than unit elastic

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Currency union and exchange rate issues

(in absolute value) with respect to the (expected) rate of inflation as the (expected) rate of inflation rises, and real seigniorage and seigniorage as a share of GDP decline as inflation rises beyond that point. Neoclassical optimal public finance arguments suggest that, if the fiscal authorities do not have sufficient non-distortionary taxes at their disposal, the distortionary inflation tax will be used, together with all other distortionary taxes, in such a way as to minimize the inevitable distortions and efficiency losses, now and in the future, associated with the financing of any given public spending programme. If the GCC countries differ in the effectiveness of their tax administrations, different national inflation rates may be optimal. This would be an argument against monetary union. Even in the rarified world of these neoclassical public finance models, this argument is by no means robust, however. Money is an asset, as well as a medium of exchange (indeed, to be a medium of exchange it has to maintain some value over some period, however short, so it has to be a store of value), and there is a considerable literature suggesting that, at least in steady state, assets should not be taxed (see Chamley, 1986). Money can also be thought of as an intermediate input in the process transforming primary inputs into goods and services available for household consumption. There is another body of literature suggesting that taxing intermediate inputs is undesirable. The intuition is that a tax on an intermediate input creates two separate distortions. It creates an allocative inefficiency in final demand (consumption) as users substitute away from goods and services using the taxed intermediate input more intensively towards goods and services that use it less intensively. A tax on an intermediate input also creates a productive inefficiency by distorting the input mix used to produce the final good or service. The first inefficiency is unavoidable. The second inefficiency can be avoided by taxing the final good or service rather than the intermediate input (Diamond and Mirrlees, 1971; Dasgupta and Stiglitz, 1972). This is, of course, not the final word on the issue, as with more than one distortion, for example, distortionary taxes and imperfect competition, the ‘curse of the second-best’ strikes, and unambiguously welfare-improving policy interventions become hard to find (Stiglitz and Dasgupta, 1971). Whatever the merits of this literature, the data make it clear that modern states with well-developed financial systems do not make use of the inflation tax to any significant extent. In addition, the GCC member states have, for the foreseeable future, access to ample oil revenues, which have many of the properties of lump-sum tax revenues. I would therefore recommend the GCC member countries not to see the inflation tax as a desirable source of government revenue, regardless of whether they build a monetary union together. As long as each member state in the GCC monetary union gets a fair

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share of the seigniorage revenue of the single central bank, there should be no revenue losses associated with a move to monetary union. If anything, there would be a benefit from increased international seigniorage. In a monetary union national foreign exchange reserves are pooled, but the demand for international reserves by the single central bank is likely to be less than the sum of the demands of the national central banks prior to monetary union. In addition, with continued sound macroeconomic management and robust economic growth, the new khaleeji could become an attractive reserve currency for other countries, initially mainly other states in the region, but ultimately also at the global level, alongside the US dollar and the euro. The currency could also be held abroad by private individuals and businesses who trust its value more than that of their national currencies. Centralized Decision-making, Decentralized Issuance, Possible Decentralized Implementation It is worth stating explicitly, although it should be redundant, that there can be but one central bank and but one monetary authority with the power to set interest rates, to decide on monetary issuance, to manage the common external exchange rate and so on. There have been historical examples of monetary unions with multiple independent centres of monetary issuance. This occurred, for instance, following the collapse of the Soviet Union in 1991, when there was an attempt to maintain the rouble zone among a number of CIS countries. Not surprisingly, the experiment ended in hyperinflation, with each independent centre of monetary issuance trying to free-ride on the rouble-zone-wide demand for roubles issued in any of the centres of issuance. It is possible, as the example of the Eurosystem and the Federal Reserve System show, to have operational decentralization of certain aspects of the implementation of the single monetary policy, such as open market operations and discount window operations. But in substance, the national central banks in the euro area have become branches of the European Central Bank (ECB).4 They have no independent authority and policy role. The same holds true, of course, for the regional reserve banks of the Federal Reserve System. It would be the same for the GCC. Unrestricted Capital Mobility Within the Monetary Union While it is technically conceivable to maintain capital controls within a monetary union, it would make the transmission of the common monetary policy awkward. It would also greatly undermine the attractiveness of the new currency as a store of value, domestically and internationally,

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Currency union and exchange rate issues

as a reserve currency and as a vehicle currency. The GCC would be well advised to have completely unrestricted internal mobility of financial capital in the monetary union. The external capital mobility regime for the union as a whole is, in principle, a matter of choice. However, given the ambitions of Dubai and Qatar to become regional and even global financial centres, it is difficult to envisage any external capital mobility regime for a GCC monetary union other than that of completely unrestricted mobility of financial capital. A Single Regulator for the Banking System and the Financial Sector It is possible to have multiple independent regulators and supervisors for the banking system, other financial institutions and financial markets in a monetary union. The example of the Eurosystem, where regulation and supervision continue at the national level makes that clear. The need for coordination and cooperation would, however, be paramount in such a decentralized system of supervision and regulation. Again, the example of the Eurosystem during the financial crisis of 2007 provides an example of what happens when the need for coordination exceeds the institutional capacity for delivering it. The logic of a single currency dictates the most rapid possible convergence of supervisory and regulatory standards and practices, and preferably the creation of a single GCC-wide regulator for a given set of financial institutions, markets, exchanges or instruments. Whether this should take the form of a single regulator, like the FSA in the UK, for virtually all financial markets, exchanges, instruments and institutions (other than pension funds) or instead separate regulators for different subsectors of the financial services industry, such as insurance, commercial banking, brokerage and so on, remains an open issue. Synergies and economies of scale and scope are exhausted at some point and turn into lack of focus and problems posed by an excessive span of control. At what scale and range of activities this happens we don’t know. It also remains an open issue as to whether the central bank (the monetary authority of the GCC) should have a regulatory and supervisory role with regard to the banking sector, or should be restricted to a narrow set of tasks strictly related to monetary policy – a minimalist monetary authority in Buiter’s sense (Buiter, 2006b). Operational independence for the central bank as regards the conduct of monetary policy cohabits uncomfortably with the deeply political nature of banking supervision and regulation. On the other hand, the financial crisis of 2007 has provided a brutal reminder of what happens to central banks that are assigned the lender-of-lastresort (LOLR) function (discussed in the next section below), but that do not have adequate information on the liquidity positions of the individual

Economic, political and institutional prerequisites

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banks that constitute their potential LOLR clientele. The mismanagement by the Bank of England and FSA of the Northern Rock crisis is not surprising when the institution that should have the individual bank-specific information (the FSA) does not have the resources to act as LOLR and the institution with the resources (the Bank of England) does not have the necessary individual bank-specific information (see Buiter, 2007b). Financial Stability: the Lender of Last Resort The state has a unique responsibility for dealing with systemic financial instability. The reason is that the state has deeper pockets than any private domestic agent. The state has the monopoly of the legitimate use of coercion and force. This is expressed through its power to tax, to declare certain of its liabilities to be legal tender and to regulate – to prescribe and to proscribe behaviour. The central bank is the state agency with the short-term deep pockets, derived from its ability to issue legal tender. If a financial crisis is not a short-lived phenomenon (a liquidity or rollover crisis), but becomes a long-term solvency crisis for a substantial part of the financial sector, the short-term deep pockets of the central bank must be supplemented with the long-term deep pockets of the ministry of finance. A central bank that attempts to recapitalize a sizeable chunk of a bankrupt private financial sector’s balance sheet would undermine its own solvency. Since the central bank does not itself have the power to tax, central bank solvency could be safeguarded only by continued monetary issuance, which would be inflationary. Non-inflationary recapitalization of a bankrupt financial system requires the resources of the state agency with the long-term deep pockets: the ministry of finance with its power to tax. I assume that monetary union in the GCC would follow the lead of the EU, where there is no serious supranational fiscal power. The European Commission budget is about 1 per cent of EU GDP, and it has no borrowing authority. The ECB is therefore backed, financially, by the national Treasuries of, in the first instance, the EMU member states, and ultimately, the resources of the Treasuries of all EU member states. After all, all EU national central banks are ECB shareholders, and the NCBs are backed by their respective national fiscal authorities. At the EU level, the distribution of the fiscal cost of recapitalizing private banks, should the need arise, is still an open issue. The GCC will face the same issues. With five (possibly six) national Treasuries involved in a full GCC monetary union, there would have to be clarity about the distribution of the fiscal burden associated with LOLR and other liquidity and solvency support operations conducted by the GCC central bank.

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Currency union and exchange rate issues 20 15 Bahrain Kuwait Oman Qatar Saudi Arabia UAE

%

10 5

19 80 19 82 19 84 19 86 19 88 19 90 19 92 19 94 19 96 19 98 20 00 20 02 20 04 20 06

0 –5

–10

Figure 3.1

Inflation in the GCC member countries (average consumer prices, annual percentage prices)

To a minor extent, the lender-of-last-resort function can be ‘privatized’, through deposit insurance, the arranging of contingent credit lines and so on. For truly systemic financial crises this is inadequate. In a monetary union, there is a single lender of last resort – the unionwide central bank. The operational implementation of the lender-of-lastresort function can, however, be decentralized, as it continues to be in the Federal Reserve System and in the Eurosystem. The GCC central bank would, however, have the right to veto any financial support operations by the GCC NCBs that would, in the opinion of the GCC central bank, undermine the GCC’s central mandate, which I take to be price stability, that is, a low and stable rate of inflation in the medium and long term.

MACROECONOMIC STABILIZATION ASPECTS OF A COMMON CURRENCY: THE THEORY OF OPTIMAL CURRENCY AREAS REVISITED My first maintained hypothesis in what follows is that national monetary autonomy is capable of delivering, on average and in a sustained manner, a rate of inflation compatible with most reasonable definitions of price stability. In the case of the GCC countries, the pursuit of price stability does require abandoning the US dollar peg and moving to an exchange rate regime that permits the currency to appreciate with regard to the US dollar as the US dollar weakens. When oil-wealth-driven demand is booming, a currency peg with a currency that is weakening steadily against most other currencies (and in terms of its effective or trade-weighted exchange rate) is incompatible with price stability or low inflation.5 Figures 3.1 and 3.2 show that periods of

Economic, political and institutional prerequisites

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Bahrain Exchange Rates 120.0

0.50

100.0

0.45

80.0

0.40

60.0

0.35

40.0

0.30 Nominal effective rate (2000 = 100) Real effective rate (2000 = 100) US $ Exchange rate, average (BD:$)

20.0

0.25

0.20

19

9 19 0 9 19 1 9 19 2 9 19 3 9 19 4 9 19 5 9 19 6 9 19 7 9 19 8 9 20 9 0 20 0 0 20 1 0 20 2 0 20 3 0 20 4 0 20 5 0 20 6 07 f

0.0

Kuwait Exchange Rates 120.0

0.50

100.0

0.45

80.0

0.40

60.0

0.35

40.0

0.30

20.0

Nominal effective rate (2000 = 100) Real effective rate (2000 = 100) US $ Exchange rate, average (KD:$)

0.20

19 9 19 0 9 19 1 9 19 2 9 19 3 9 19 4 9 19 5 9 19 6 9 19 7 9 19 8 9 20 9 00 20 0 20 1 0 20 2 03 20 0 20 4 0 20 5 0 20 6 07 f

0.0

0.25

Figure 3.2

Exchange rates for the six GCC countries

US dollar weakness (interpreted here as periods when the bilateral exchange rate of the GCC currencies vis-à-vis the US dollar remained constant while the effective nominal exchange rates of the GCC currencies weakened), have tended to be periods of high GCC inflation and that periods of US dollar strength have tended to be periods of low GCC inflation. The past three years are no exception to this rule, although the increase in inflation rates differs significantly among the individual GCC members.

40

Currency union and exchange rate issues Oman Exchange Rates 140.0

0.50

120.0

0.45

100.0 0.40 80.0 0.35 60.0 0.30 40.0 Nominal effective rate (2000 = 100) Real effective rate (2000 = 100) US $ Exchange rate, average (RO:$)

20.0 0.0

0.25

19

9 19 0 9 19 1 9 19 2 9 19 3 9 19 4 9 19 5 9 19 6 9 19 7 9 19 8 99 20 0 20 0 01 20 0 20 2 03 20 0 20 4 0 20 5 0 20 6 07 f

0.20

Qatar Exchange Rates 140.0

5.00

120.0

4.50

100.0 4.00 80.0 3.50 60.0 3.00 40.0 Nominal effective rate (2000 = 100) Real effective rate (2000 = 100) US $ Exchange rate, average (QR:$)

20.0

2.50

2.00

19

9 19 0 9 19 1 92 19 9 19 3 9 19 4 95 19 9 19 6 97 19 9 19 8 9 20 9 00 20 0 20 1 02 20 0 20 3 0 20 4 0 20 5 06 20 07 f

0.0

Figure 3.2

(continued)

It is striking that, whatever the official designation of the exchange rate regimes of the GCC countries may have been (see Box 3.1), all but Kuwait have operated an effectively fixed nominal exchange rate with regard to the US dollar for the 17-year period shown in Figure 3.2. And even for Kuwait, the changes in the bilateral exchange rate of the Kuwaiti dinar and the US dollar have been small. These common nominal bilateral exchange rates vis-à-vis the US dollar have been compatible with movements in opposite

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Saudi Arabia Exchange Rates 120.0

5.00

100.0

4.50

80.0

4.00

60.0

3.50

40.0

3.00 Nominal effective rate (2000 = 100) Real effective rate (2000 = 100) US $ Exchange rate, average (SR:$)

20.0

0.0

2.50

19

9 19 0 9 19 1 9 19 2 9 19 3 9 19 4 9 19 5 96 19 9 19 7 9 19 8 9 20 9 0 20 0 0 20 1 0 20 2 0 20 3 0 20 4 0 20 5 0 20 6 07 f

2.00

UAE Exchange Rates 5.00

140.0 120.0

4.50

100.0 4.00 80.0 3.50 60.0 3.00 40.0 Nominal effective rate (2000 = 100) Real effective rate (2000 = 100) US $ Exchange rate, average (Dh:$)

20.0

2.50

2.00 19

9 19 0 9 19 1 92 19 9 19 3 9 19 4 95 19 9 19 6 97 19 9 19 8 99 20 0 20 0 01 20 0 20 2 03 20 0 20 4 05 20 0 20 6 07 f

0.0

Figure 3.2

(continued)

directions of nominal and real effective (trade-weighted) exchange rates and significant divergences in inflation rates, with both Qatar and the UAE approaching 15 per cent inflation rates during 2007, with Saudi Arabia’s inflation rate at no more than 5 per cent. This experience is rather like that of the Baltic States in the EMU during 2006 and 2007 (taking the roles of Qatar and the UAE), compared with that of Germany and France (playing the part of Saudi Arabia).

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Currency union and exchange rate issues

BOX 3.1

THE CURRENT EXCHANGE RATE REGIMES OF THE GCC COUNTRIES

United Arab Emirates: In January 1978 the UAE dirham was officially pegged to the IMF’s SDR. In practice it is pegged to the US dollar for most of the time. Since November 1997, the dirham peg to the US dollar has not changed. Bahrain: In 1980 the Bahraini dinar was pegged to the IMF’s SDR. In practice it is pegged to the US dollar. Saudi Arabia: In June 1986, the Saudi riyal was officially pegged to the IMF’s SDR. In practice, it is pegged to the US dollar. Oman: Since 1973 the Omani rial has been pegged to the US dollar, with a single devaluation of the rial in 1986. Qatar: In March 1975, the riyal was officially pegged to the IMF’s SDR. In practice, it has been pegged to the US dollar with a fixed exchange rate since 1980. Kuwait: From March 1975 to January 2003, the Kuwaiti dinar was pegged to a weighted currency basket. From January 2003 till May 2007, the dinar was pegged to the US dollar with margins of ±3.5 per cent. Since May 2007, the Kuwaiti dinar has been pegged to a basket of currencies. The exact composition of this basket has not been made public. According to the Central Bank of Kuwait, ‘the determination of the exchange rate of the Kuwaiti dinar (KD) against the US dollar became based on a basket of major world currencies reflecting the foreign trade and financial relations of the State of Kuwait, and in a similar way to the policy applied before the 5th of January 2003’.6 Granted then that, given a change in the external exchange rate regime, both national monetary autonomy and monetary union can deliver a reasonable degree of price stability in the medium and long term, the macroeconomic stability issue can be narrowed down to the question as to which regime is more likely to stabilize the real economy, that is, which regime is more likely to avoid or minimize deviations of actual from capacity output.

Economic, political and institutional prerequisites

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My second maintained hypothesis is that the choice of exchange rate regime will have no significant impact on the path of capacity output or on the natural rate of unemployment. I therefore rule out both a long-run non-vertical Phillips curve and hysteresis in the natural rate of unemployment. Temporary real shocks only have temporary real effects. Nominal shocks, whether temporary or permanent, are like temporary real shocks. I recognize that monetary shocks, to the extent that they affect investment decisions of any kind (or through such features as overlapping, staggered nominal contracts), can have real effects that may last longer than the duration of even the longest nominal contract. I do, however, maintain the assumption that money is neutral in the long run. For practical purposes, we can take the long run to be between two and three years. How useful a stabilization instrument is monetary policy, working through domestic short nominal interest rates and a floating nominal exchange rate? What does a nation give up, in terms of the ability to pursue macroeconomic stabilization policy, by surrendering monetary sovereignty and joining a monetary union and, if there is a material loss a stabilization potential, how can it compensate for the loss of the monetary instrument? These are the central questions that motivated the theory of optimal (or optimum) currency areas (OCA). The theory of optimal currency areas (Mundell, 1961; McKinnon, 1963; Ingram, 1969; Masson and Taylor, 1992) is almost entirely useless as a guide to the choice of currency regime in modern economies. It has two key failures. The first is a chronic confusion between transitory nominal rigidities and permanent real rigidities. The theory, not surprisingly given its date of birth, is highly ‘old-Keynesian’. The result is a greatly overblown account of the power of monetary policy to affect real economic performance. The second key shortcoming from the perspective of relevance to contemporary macroeconomic stabilization policy is that the conventional OCA literature was designed for a world without endogenous capital mobility. Exchange rate movements are driven by the trade balance, by exogenous capital movements and by goods markets. Exchange rate movements are stabilizing and dampen the excess demand for or excess supply of output and labour. It ignores the modern reality that exchange rates are proximately set in financial asset markets, and that far from acting as buffers and stabilizing elements for the real economy, they can amplify shocks and disturbances and destabilize the real economy. The foreign exchange market can be a source of shocks, excess volatility, instability and persistent misalignment. The optimal currency area literature asks which of a set of national (or regional) economies, each of which has its own national (regional)

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Currency union and exchange rate issues

currency, would benefit from having irrevocably fixed exchange rates with one or more of the other currencies. The following characteristics of either the individual national economies or the multi-country system as a whole, have been argued to favour retention of the national currency, and the associated scope for nominal exchange rate flexibility (for an empirical analysis of some of these criteria for the six GCC countries, see Pattanaik, 2007): 1. 2. 3.

a high degree of nominal rigidity in domestic prices and/or costs; a high degree of openness to trade in real goods and services; a high incidence of asymmetric (nation-specific) shocks rather than symmetric or common shocks and/or dissimilarities in national economic structures or transmission mechanisms that cause even symmetric shocks to have asymmetric consequences; 4. a less diversified structure of production and demand; 5. a low degree of real factor mobility (especially labour mobility) across national boundaries; 6. absence of significant international (and supranational) fiscal taxtransfer mechanisms. How Important are Nominal Cost and Price Rigidities in the GCC? If there are no significant nominal cost and price rigidities, the exchange rate regime is a matter of supreme macroeconomic insignificance. From the perspective of economics, only the microeconomic transactions and switchover costs matter. A country mired in real rigidities will no doubt have a miserable real economic performance. Unless these real rigidities can be addressed effectively through changes in the nominal exchange rate, which is exceedingly unlikely, the country’s performance will be equally miserable with a common currency, an independent national currency and a floating exchange rate, or with a system of universal bilateral barter. The severity and persistence of nominal rigidities therefore becomes a key empirical and policy issue. Unfortunately, the available empirical evidence is extremely opaque and very hard to interpret. Information drawn from micro data sets for the GCC countries, or even systematic studies of the macroeconomic regularities in nominal wage and price setting for the GCC countries, are few and far between. In addition, a straightforward causal interpretation of summary statistics on the duration of nominal wage and price contracts and on the extent to which they are synchronized or staggered is subject to an obvious application of the Lucas critique. These contracting practices are not invariant laws of nature, but the

Economic, political and institutional prerequisites

45

outcomes of purposeful choices. Changes in the economic environment conditioning these choices will change the practices. The application to optimal currency area theory and empirics of the Lucas critique has become known as the ‘endogeneity of the OCA criteria literature’ (see Frankel and Rose, 1997, 1998). In this particular application, the endogeneity of the OCA criteria would suggest that the degree of nominal rigidity and persistence could itself be a function of the exchange rate regime, and could change as a result of the adoption of a common currency. Testing price and wage data for persistence is equally unlikely to be enlightening. The pattern of serial correlation in the data reflects both ‘true’ structural lags, invariant under changes in the economic environment, and expectational dynamics that will not be invariant when the rules of the game are changed. There is no deep theory of nominal rigidities worth the name. Menu cost theory assumes that there are real costs associated with changing the prices of goods and services in terms of some numeraire. It does not explain why the numeraire should be money (the means of payment and medium of exchange) or what the consequences would be of a change in the numeraire. Economics has a hard enough time motivating the use of a transactions medium. It has nothing to say about why the numeraire matters. A theory of the numeraire would swiftly land us in the domain of bounded rationality, an area where conventional economists are loath to tread. This leaves the economics profession in an uncomfortable position. We believe the numeraire matters, although we cannot explain why (using conventional economic tools). We believe that nominal wage and price rigidities are common and that they matter for real economic performance, but we do not know how to measure these rigidities, nor how stable they are likely to be under the kind of policy regime changes that are under discussion. Are the GCC Countries Individually too Small and/or too Open to be OCAs and thus to Benefit from Exchange Rate Flexibility? A common theme in most optimal currency area approaches is that an economy that is more open to trade in goods and services will lose less when it gives up its national currency. It should be obvious that this proposition cannot be correct as stated. An economy that is completely closed to trade in goods and services neither gains nor loses from a macroeconomic stabilization point of view when it adopts a common currency. If there is a relationship between degree of openness and the cost of giving up exchange rate flexibility, the relationship cannot be monotone.

46

Table 3.1

Currency union and exchange rate issues

Population and GDP in the GCC countries, 2006

UAE Bahrain Saudi Arabia Oman Quatar Kuwait Total

2006 GDP (US$bn)

Share of 2006 GCC Countries GDP (%)

2006 Population

Share of 2006 GCC Countries’ Population (%)

168 178 450 36 42 90 964

17.4 18.5 46.7 3.7 4.4 9.3

4 000 000 715 000 25 000 000 3 200 000 850 000 3 200 000 37 065 000

10.9 1.9 67.5 8.7 2.3 8.7

A small open economy cannot use variations in its nominal exchange rate to affect its international terms of trade. If all final goods and services as well as all intermediate goods and services and raw materials are traded internationally, and if the country is small (a price-taker in the global markets), changes in the nominal exchange rate also will not affect the relative price of traded and non-traded goods (the ‘real exchange rate’). However, labour services are unlikely to be internationally traded on a scale sufficient to have the domestic price determined as the product of the exogenous world price of labour and the nominal exchange rate. With labour non-traded, nominal wage rigidities are sufficient to give the nominal exchange rate a (temporary) handle on the real economy, through its ability to influence relative labour costs and profitability. Even the largest of the GCC member states, Saudi Arabia, with its $450 billion GDP in 2006 and its 25 million population is a small open economy, that is, a price-taker in the international financial markets and, with the exception of oil, where it has some monopoly power, also in the markets for real goods and services (see Table 3.1). With almost half of the GCC GDP and two-thirds of its population, it is more dominant, economically and politically in the GCC than Germany is in the European Union, and in the EMU. All the GCC economies are also very open to trade, and increasingly to international financial flows. Figure 3.3, taken from Kamar and Ben Naceur (2007), shows that openness (measured here as the share of imports to GDP, to avoid some of the distortions that occur for oil- and gas-exporting countries when the more conventional sum of imports and exports as a share of GDP is used as an openness indicator) is high but not rising (except for Saudi Arabia). Interestingly, while all six GCC countries are highly open to international

Economic, political and institutional prerequisites Bahrain

Kuwait

Oman

Qatar

47

Sudia

UAE

Source:

2005

2004

2003

2002

2001

2000

1999

1998

1997

1996

1995

1994

1993

1992

1991

3.0 2.0 1.5 1.0 0.5 0

Kamar and Ben Naceur (2007).

Figure 3.3

Imports as a share of GDP for the GCC countries (ratio)

trade (even allowing for the small size of most of them), the amount of intra-trade, that is, trade among GCC members is low indeed, as Table 3.2 makes clear (see Akarli, 2007 for a discussion of trade performance and prospects in the GCC). Not only is intra-trade low, it also does not appear to be rising significantly. As expected the GCC share of exports is lower than the GCC share of imports, but except for Bahrain, even the GCC import share is very low. The Bahraini import share figure is likely to be overstated by the fact that other GCC countries are likely to be transshipment countries for this island economy. Although the GCC countries collectively (and Saudi Arabia individually) have some influence over their external terms of trade (through their influence on the price of oil), this is unlikely to be an effective macroeconomic stabilization instrument. But the relative price of traded to non-trade goods (as proxied, for instance, by the real consumption wage) certainly can be influenced by domestic monetary and fiscal policy and the presence of some immobile labour and nominal wage rigidity mean that policy can also influence relative unit labour costs. Potentially therefore, the nominal exchange rate is a stabilization instrument. However, there can be little doubt that even the largest of the individual GCC countries is too small and too open to be an OCA. The same can even be argued for the GCC as a whole. Even a monetary union of all GCC members would remain a small open economy, one too small to constitute an OCA. While this is correct, it is also not practically relevant. GCC monetary union is the only monetary union game in town. Nothing else is on offer. I view the situation of the region rather like that of Australia and New Zealand. From an economic point of view, monetary union between Australia and New Zealand would make sense. It certainly

48

1970 1971 1972 1973 1974 1975 1976 1977 1978 1979 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990

N/A N/A N/A N/A 17.0 20.9 32.3 37.3 N/A 29.7 24.5 28.2 26.9 24.3 23.6 23.6 23.6 23.6 9.4 9.4 5.8

N/A N/A N/A 40.3 61.8 54.1 44.1 46.6 45.4 51.9 58.2 61.2 49.5 44.4 48.5 48.5 43.9 49.4 45.0 45.2 53.1

Imports

Bahrain

N/A N/A N/A 3.2 1.3 2.9 5.4 5.9 5.0 3.3 4.7 5.1 8.0 5.5 4.0 3.8 1.7 1.4 1.9 1.7 1.6

Exports 0.4 0.3 0.5 0.5 0.5 0.4 0.3 0.1 0.5 1.2 1.3 0.8 1.0 1.4 2.2 1.9 3.5 5.7 7.5 7.4 0.0

Imports

Kuwait

0.5 0.4 0.2 0.4 0.1 0.2 0.2 0.2 0.4 0.3 0.3 0.0 0.0 0.0 0.0 0.0 49.2 53.7 55.3 62.5 56.8

Exports 12.8 17.8 20.8 25.0 22.9 20.3 22.1 17.9 18.7 17.9 22.2 24.5 21.6 17.9 18.7 22.8 19.0 21.9 23.0 27.7 26.5

Imports

Oman

N/A N/A 3.4 2.3 N/A N/A 0.0 N/A 0.0 3.2 2.8 2.2 2.2 2.2 2.2 2.2 7.1 6.9 9.0 8.6 5.5

Exports 8.2 5.9 7.8 9.2 8.7 8.0 10.2 7.9 2.9 3.0 5.1 4.0 3.2 3.0 3.3 3.2 3.6 6.2 7.1 8.7 8.6

Imports

Qatar

GCC share of exports and imports for individual GCC countries (%)

Exports

Table 3.2

4.9 3.9 2.9 2.4 2.3 2.3 2.0 2.3 2.5 2.3 2.1 2.6 3.0 3.4 4.2 5.2 6.5 7.0 6.5 7.8 6.7

Exports 3.7 4.7 5.1 5.8 7.5 6.9 12.0 6.7 1.0 1.4 1.1 1.4 1.4 1.3 1.3 2.1 2.0 1.8 2.1 2.4 1.8

Imports

Saudi Arabia

N/A N/A N/A N/A N/A N/A 2.5 2.0 2.3 2.5 2.4 2.6 3.6 3.6 3.6 3.6 5.2 4.6 5.7 5.0 3.7

Exports

4.4 4.3 6.1 4.9 5.1 4.0 5.2 4.9 3.1 8.4 5.8 10.1 6.9 6.4 7.6 7.0 6.0 5.6 4.6 5.6 6.3

Imports

UAE

49

International Monetary Fund.

1.8 1.7 1.5 1.6 1.8 1.3 1.3 2.0 1.9 1.2 1.6 1.6 1.8 1.8 1.6 1.6

Source:

41.9 40.2 35.8 39.3 44.3 46.6 46.8 27.9 28.0 33.9 35.5 34.4 34.8 37.9 42.5 43.7

12.0 12.5 14.4 10.7 10.2 9.5 6.1 6.9 6.3 5.2 5.1 5.8 6.4 7.5 8.1 8.0

1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006

0.0 0.0 6.7 9.1 9.7 9.6 10.4 9.4 10.4 14.0 13.0 11.1 9.6 10.3 11.3 12.5

1.5 9.5 10.8 11.7 12.1 10.0 11.6 16.7 12.5 10.1 10.0 11.6 10.6 9.4 9.3 8.2

29.0 31.0 32.3 32.3 28.6 27.8 29.0 28.9 32.7 33.2 33.2 33.2 27.8 27.7 29.2 29.3

5.6 5.7 6.1 6.7 6.6 5.1 3.9 4.7 3.7 5.7 4.0 6.4 4.8 5.1 4.3 4.0

10.0 10.6 14.4 14.0 14.4 10.2 12.5 15.4 17.6 14.9 12.0 15.4 14.9 18.2 13.9 11.1

6.7 6.0 6.5 6.7 7.2 7.2 7.5 8.6 6.8 4.2 4.8 5.4 4.9 4.9 4.7 4.8

1.4 1.7 2.2 2.8 2.8 3.2 3.1 3.4 3.9 2.9 2.9 2.6 2.5 4.9 4.6 4.7

4.4 5.9 7.0 7.6 6.7 6.2 6.1 8.7 7.9 6.1 6.5 6.8 5.2 5.1 4.9 4.9

4.5 3.7 4.1 4.1 5.1 4.7 4.7 4.9 5.8 4.8 4.7 4.8 5.1 3.7 3.7 3.9

50

Currency union and exchange rate issues

would bring significantly greater stability to New Zealand. Even an Anzac monetary union would, however, still be a small open economy, really too small to be an OCA. But since no other monetary union is feasible now or in the foreseeable future, monetary union, even a suboptimal monetary union, will be better than continued national monetary autarky. Are the GCC Countries Subject to Asymmetric Shocks that Make Monetary Union Among them Costly? There are three distinct issues here. First, how frequent and severe are asymmetric shocks now (without a common currency)? Second, how frequent and severe would common shocks be after the countries move to adopt a common currency? Third, are exchange rate flexibility, and monetary autonomy in general, an effective instrument for dealing with asymmetric shocks? The ‘one-size fits all’ monetary policy corset inflicted on all members of a monetary union is most costly to a member state if it is subject to especially severe asymmetric shocks or if its structure is such as to cause even symmetric or common shocks to have seriously asymmetric impacts on output and employment. The proposition that a monetary union is more attractive when the structure of production and demand is well-diversified should be seen as a statement about the conditions under which asymmetric shocks are less likely. It is true that adopting a common currency would deprive individual GCC members of a mechanism for responding to asymmetric shocks. While nominal exchange rate flexibility does not reduce the long-term pain of changing relative costs or prices, it can, if used properly, reduce the transitional costs of achieving the real adjustment that is required. How serious this loss is depends on how well, in practice, this mechanism has been used and can be used. Asymmetric shocks are certainly possible. While all GCC members are oil and/or gas producers and exporters, there are significant differences among their production structures. The service sectors, including financial services and tourism are expanding rapidly everywhere, but are much more important in Oman and Qatar than, for instance, in Saudi Arabia. The manufacturing sectors, although small for countries at the level of per capita income and development, are growing and of differing importance across the GCC members. At the seminar where this paper was first presented, there was some consensus that even though the direct role of oil and gas (and thus of oil and gas prices) as a driver of supply-side shocks and shocks to wealth and disposable income now differed significantly between the six GCC members,

Economic, political and institutional prerequisites

51

the total effect of oil and gas prices, operating also through national and regional consumer and investment demand, was much less differentiated and remained the main driver of economic activity at cyclical and lower frequencies. This consensus is not strongly supported by the available systematic statistical and econometric evidence (see, for example, Erbas et al., 2003; Fasano-Filho and Schaechter, 2003; Sturm and Siegfried, 2005; Abu-Bader and Abu-Qarn, 2006; Al-Raisi et al., 2007; Kamar and Ben Naceur, 2007). The empirical evidence on asymmetric shocks and asymmetric transmission for the GCC area is, at best, inconclusive. The most thorough of the empirical studies, by Abu-Bader and Abu-Qarn (2006), finds that while the transitory demand shocks are typically symmetric, the permanent supply shocks are asymmetric. They also do not find synchronous long-run and short-run movements in output. Note that the theoretical underpinnings as well as the identifying assumption used to make causal interpretations of empirical correlations are dubious at best. It is a straightforward implication of the openeconomy version of Poole’s (1970) model of optimal monetary policy, that under unrestricted capital mobility, a fixed exchange rate provides the optimal adjustment to demand shocks coming from the money demand or money supply side of the economy (‘LM shocks’). Most of the empirical work does not distinguish between LM and IS (investment saving) shocks. Furthermore, a common identifying restriction is that demand shocks have no permanent real effects. That is a property of standard macromodels for some monetary shocks (an unexpected, immediate and permanent equiproportional increase in the nominal money stock now and in the future) but not for others (changes in the growth rate of the nominal money stock or changes in short-term nominal interest rates, unless there is superneutrality of money as well). It almost never holds for IS shocks such as fiscal policy shocks or changes in private time preference rates. The endogeneity of the OCA criteria is potentially important here also. There are two conflicting theories about the link between economic integration and business cycle synchronization (or the likelihood of asymmetric shocks). One view, called the ‘the European Commission View’ by De Grauwe (1997), holds that closer integration leads to less frequent asymmetric shocks and to more synchronized business cycles between countries (see European Commission, 1990). If monetary union promotes further integration, this would imply that monetary union reduces the likelihood and severity of asymmetric shocks. The other view, called ‘the Krugman View’ by De Grauwe holds that closer integration implies higher specialization and, thus, higher risks of idiosyncratic shocks. The empirical evidence for the transition countries of Central and Eastern Europe provides rather more support for the Commission View, although I tend

52

Currency union and exchange rate issues

to support the view of Kenen (2001) that the impact of trade integration on shock asymmetry depends on the type of shock. The belief that national monetary policy, including exchange rate management can be used effectively to minimize, let alone eliminate, cyclical fluctuations in economic activity is an example of the ‘fine-tuning fallacy’. The lags in the effects of monetary policy are long, variable and uncertain; the impacts, at the random lags, are also uncertain. Policy-makers can be neither confident about the timing, nor about the magnitude, nor about the persistence of these effects. It is wise not to be overly impressed with the efficiency of financial markets in general, and with the efficiency of the foreign exchange market in particular. Most of the time, the foreign exchange market is technically efficient, in the sense that large transactions can be made almost instantaneously, at very low transactions costs and with a minimal impact on the exchange rate. Even if the foreign exchange market is technically efficient (in the weak, semi-strong or even the strong sense) and no risk-adjusted pure profits can be made, the price established in this technically efficient market may not convey the right social scarcity valuation. Rational speculative bubbles can cause an asset price like the exchange rate to differ from its fundamental valuation. Departures from technical efficiency are also common. Herding instinct, bandwagon effects and other irrational behaviour, noise traders, panic traders and traders caught in a liquidity squeeze in other financial markets make for excessive volatility and sometimes quite persistent misalignments in the foreign exchange markets. The foreign exchange market and the exchange rate can therefore be a source of extraneous shocks as well as a mechanism for adjusting to fundamental shocks. One cannot have the one without the other. The potential advantages of nominal exchange rate flexibility as an effective adjustment mechanism are bundled with the undoubted disadvantages of excessive noise and unwarranted movements in the exchange rate, inflicting unnecessary real adjustments on the rest of the economy. It is by no means clear that the advantages of nominal exchange rate flexibility when faced with fundamental asymmetric shocks dominate its disadvantages as a source of extraneous asymmetric shocks. Is Limited Real Factor Mobility an Obstacle to GCC Monetary Union? It is clear that a high degree of real factor mobility can be an effective substitute for nominal exchange rate adjustments in the face of asymmetric shocks. Indeed, factor mobility permits long-term, even permanent real adjustments to asymmetric real shocks, something nominal exchange flexibility cannot deliver.

Economic, political and institutional prerequisites

53

The real factors whose mobility matters are labour and real capital. Real capital mobility is limited, even when financial capital mobility is perfect. Once real capital (plant, machinery and other equipment, infrastructure and so on) is installed, it becomes hard to shift geographically. There are some examples of ‘flying capital’, such as Jumbo jets and of mobile real capital (such as fishing vessels), and there have been examples of whole factories being moved over great distances by rail and ship, but as a first approximation, real capital cannot be relocated. New gross investment can, of course, be redirected across national boundaries, and financial capital mobility can facilitate this process, by permitting the decoupling of national saving and gross domestic capital formation. This is not a process that is likely to be very significant at cyclical frequencies, however. Moving the real capital stock between Kuwait and Saudi Arabia through variations in gross investment is therefore unlikely to be an effective cyclical stabilization instrument. A similar point can be made about international labour mobility. Even without legal and administrative obstacles to labour mobility, cross-border labour mobility tends to be limited, especially at cyclical frequencies, because of personal preferences, cultural barriers and housing markets that make it hard for outsiders to find accommodation. All migration is costly, within as well as between nations. Workers are only likely to move if the fixed, up-front cost of moving is compensated for by a long period of higher earnings in the country of destination. Permanent (or at least persistent) real shocks will trigger labour mobility. Nominal exchange rate flexibility only affects the real economy for a short transition period. To mimic the effect of nominal exchange rate flexibility, net cross-border migration flows would have to be reversible and significant at cyclical frequencies. The GCC countries have in the past managed to use net migration flows from outside the region as a cyclical stabilizer for their domestic economies and residents. It is hard to see that continuing in a world where unskilled and even skilled manual labour are no longer effectively in infinitely elastic supply, as was the case for several decades for the oil-rich Gulf states. The labour markets of the GCC countries are highly unusual. Foreign labour accounts for around 55 per cent of total employment in Bahrain and for more than 80 per cent in the UAE, Kuwait and Qatar. This labour force has been both flexible and internationally mobile, although not directly mobile between the individual GCC members. The employment of nationals/natives is overwhelmingly (85 per cent for the GCC area as a whole) in the public sector. It is characterized by wage rigidity and other human-made obstacles to mobility and flexibility, although a common language, religion and culture could, should these human-made obstacles

54

Currency union and exchange rate issues

be swept away, support a much higher degree of inter-state mobility than has been observed historically. For the GCC countries, labour mobility thus far has meant movement into and out of each of the GCC countries individually by expatriates from outside the GCC region. There has been very little mobility between workers, native or expatriate, between GCC countries. The expatriate labour force comes from the Indian subcontinent, from other Asian countries like the Philippines and Indonesia, from other Middle Eastern and Arab-speaking nations and from Europe and the US. As long as the GCC countries can attract and expel labour freely from outside the region, this form of labour mobility can be a substitute for the removal of legal and administrative obstacles to cross-border labour mobility by resident workers, native and expatriate, which would be the standard way to use labour mobility as a substitute for exchange rate flexibility. It is unclear how long the current migration paradigm of the GCC countries can survive. At some point the ‘guest workers’ will demand greater rights and will no longer be willing to accept passively to act as the residual in the GCC labour markets. That moment will come sooner if economic development in the ‘source countries’ continues as it has this past decade. When the GCC countries encounter increasing difficulties and higher costs of attracting temporary labour from outside the region, and when the temporary, expatriate workers acquire more economic and political rights, the efficient use of the GCC-wide stock of labour, native and expatriate, will take on much greater significance. To maintain labour mobility, whether within the GCC members or bilaterally with the world outside the GCC, it will also be increasingly important to take measures to increase the efficiency of the housing market, including the market for rental accommodation. The treatment of the mobility rights within the GCC area of guest workers and other temporary workers will to a growing extent determine to what degree labour mobility can act as an effective stabilization device in a GCC monetary union. I conclude that cross-border mobility of real capital and of labour among GCC members will have some stabilization potential, but that its contribution will remain limited unless intra-GCC labour mobility rights are also extended to the large number of guest workers in the region. Note also, that even within existing currency unions (like the US or Euroland), net interregional migration flows are not highly quantitatively important at cyclical frequencies. This means one of two things. Either, these existing currency unions are not optimal currency areas or an optimal currency area does not require a high degree of labour mobility at cyclical frequencies.

Economic, political and institutional prerequisites

55

Is a Strong Supranational Federal Fiscal Authority Necessary to Compensate for the Loss of the Exchange Rate Instrument? The brief answer is ‘no’ if the macroeconomic stabilization potential of fiscal policy is concerned. Fiscal stabilization policy works if and to the extent that postponing taxes, and borrowing to finance the resulting revenue shortfall, boosts aggregate demand. This will be the case either if there is myopia among consumers, who fail to realize that the present value of current and future taxes need not be affected by the timing of taxes, or if postponing taxes redistributes resources from households with lower marginal propensities to consume out of current disposable income to households with higher marginal propensities to consume. In overlapping generations models without an operative intergenerational gift motive, postponing taxes redistributes resources from the young to the old and from generations yet to be born to generations already alive. This will boost aggregate consumption in the short run. Intra-cohort heterogeneity (say through the coexistence of life-cycle consumers and currentdisposable-income-constrained consumers) can reinforce these effects. Unless the supranational federal fiscal authority in a currency union has access to the financial markets on terms that are superior to those enjoyed by the national fiscal authorities, there is nothing the federal authorities can achieve by way of fiscal stabilization that cannot be achieved equally well by national or by even lower-tier fiscal authorities. National government financial deficits and surpluses, probably mirrored to some extent in national current account imbalances, are a perfect substitute for supranational fiscal stabilization. There have been a number of recent studies trying to determine the redistributive and insurance properties of federal tax-transfer systems. A study by Bayoumi and Masson (1995), building on earlier work by Salai-Martin and Sachs (1992), analyses regional flows of federal taxes and transfers within the US and Canada. They try to distinguish between longterm fiscal flows (the redistributive element) and short-term responses to regional business cycles, which they identify with the stabilization element. They find that in the US, long-run flows amount to 22 cents in the dollar while the stabilization element is 31 cents in the dollar. For Canada, the corresponding figures are 39 cents and 17 cents respectively. While interesting, these studies tell us nothing of relevance to the issue of whether fiscal policy in a North American monetary union could compensate for the loss of the exchange rate instrument from the point of view of macroeconomic stabilization. The fiscal-federal structure in the US and Canada compensates a state or province for a decline in its income not only when this decline is temporary, for example, cyclical, but also

56

Currency union and exchange rate issues

when it is permanent. It is an instrument of redistribution that happens to have cyclical stabilization properties to the extent that those who suffer a cyclical decline in their income are likely to be liquidity-constrained. To compensate for the loss of the monetary stabilization instrument, a tool capable of permanent redistribution is not required, because the nominal exchange rate is not an instrument for long-term redistribution or insurance against long-term loss. The stabilization properties of the combined supranational, national and subnational fiscal system in a monetary union do matter, but the necessary stabilization can be provided at the supranational, national or subnational level. In the EU, the European Commission has only a tiny budget amounting to about 1 per cent of EU GDP, yet this is no obstacle to effective fiscal stabilization policy in the EU, provided the national fiscal authorities (1) are willing and able to use their national fiscal instruments to stabilize their national economies, that is, they are not subject to binding fiscal financial constraints like those of the Stability and Growth Pact, and (2) are capable of coordinating their budgetary actions to ensure that the combined fiscal stance of the monetary union makes sense for the union as a whole, and in relation to the monetary policy pursued by the monetary union’s monetary authority. It is true that, to the extent that monetary union is part of a wider process of political integration, the political pressures may grow for longterm redistribution among the nations that constitute the monetary union. What the redistribution figures in the studies of Bayoumi and Masson and of Sala-i-Martin and Sachs tell us, is the degree to which the US and Canada are societies and communities, rather than just economies, and the extent to which notions of national solidarity are translated into crossborder redistributive measures at the level of the monetary union through the tax-transfer mechanism.

MEMBERSHIP CONDITIONS FOR MONETARY UNION: THE IRRELEVANCE OF PRIOR NOMINAL AND REAL CONVERGENCE I have written elsewhere at length on the nature of the ‘membership conditions’, such as nominal and real convergence criteria, that should be imposed on countries contemplating joining a monetary union (see, for example, Buiter, 1997, 1999, 2005, 2006a and Buiter and Sibert, 2006a, b). I will only state my main conclusions here. From a purely economic point of view, the creation of a monetary union by the GCC countries at the earliest possible date makes very good

Economic, political and institutional prerequisites

57

sense. As regards economic stability and financial deepening, it would be in the national interest of each of the five member states. Even the largest among them (Saudi Arabia) is too small, too open and too financially vulnerable to constitute an optimal currency area. The unavoidable vulnerability associated with unrestricted international capital mobility makes a national currency a costly and dangerous luxury. The full benefits from international financial integration (superior risk-sharing through international portfolio diversification, deep and liquid financial markets, a more competitive and efficient financial services sector) can only be reaped by joining a larger currency area. Membership in the EMU, which is often viewed as a role model or benchmark for other attempts at monetary union, is subject to a number of nominal convergence criteria. There are four Maastricht criteria for full membership in EMU. The first is a pair of fiscal conditions that constrain gross general government debt to be less than 60 per cent of (annual) GDP. The second is an interest rate criterion: long-term (tenyear) nominal interest rates on central government debt are to be within 2 per cent of the average in the three EU member countries with the best (lowest) inflation record. The third is an inflation criterion that specifies that the annual inflation rate cannot exceed the average of the three best-performing EU member countries in terms of price stability by more than 1.5 percentage points during the year prior to the formal assessment of whether a candidate has met the EMU membership criteria. Finally, there is an exchange rate criterion: the exchange rate has to remain within the normal fluctuation margins provided for by the Exchange Rate Mechanism (ERM) of the European Monetary System without severe tensions for at least the last two years before the formal assessment. In particular, the candidate must not devalue its currency on its own initiative during the period. The ‘normal fluctuation margins’ have been interpreted by the ECB and the European Commission to be plus or minus 15 per cent around a fixed central parity against the euro. In addition, there is a requirement that the central bank of the candidate country must be independent. It is my view that, except for the requirement that the central bank be operationally independent, none of these criteria make any economic sense. Unfortunately, the GCC has adopted five nominal convergence criteria that closely mimic the unfortunate model of the EMU. They are: 1. Short-term interest rates for each successful applicant will be no higher than 2 percentage points above the average short-term interest rate of the three GCC member countries with the lowest short-term interest rates.

58

2.

3.

4. 5.

Currency union and exchange rate issues

Inflation for any successful applicant will be no higher than 2 percentage points above the weighted average inflation rate for all six GCC countries. The general government fiscal deficit will be no higher than 3 per cent of GDP; and no more than 5 per cent of GDP when oil prices are weak. General government gross financial debt will not exceed 60 per cent of GDP. Foreign exchange reserve import coverage will be at least four months.

There is no exchange rate criterion, presumably because the GCC members assumed they would enter currency union from a fixed US dollar peg. With Kuwait no longer pegged to the US dollar and with a number of other GCC members contemplating dropping their US dollar pegs, that assumption is no longer correct. The minimum foreign exchange reserve criterion (5) makes little or no sense in a world with unrestricted financial capital mobility, but it is unlikely to do any harm. The inflation and (nominal) interest rate criteria (which together imply a short-term real interest rate criterion), should be scrapped. Monetary union is an effective mechanism for achieving inflation convergence. Requiring prior inflation convergence is putting the cart before the horse. It most likely reflects a form of unnecessary paternalism – a desire to prevent a would-be monetary union member from putting itself at a competitive disadvantage by joining the monetary union with a rate of inflation well above the average of the existing union members. Achieving fiscal sustainability prior to joining a monetary union is highly desirable, perhaps even essential, from the perspective of the national interest of each candidate country. Whether it is necessary to impose it ‘externally’ as a precondition of membership, rather than allowing a country to join a monetary union even though its fiscal house is not in order, and letting that country live with the consequences of its fiscal non-sustainability, is something on which I continue to be in two minds. Fiscal sustainability is not, however, synonymous with the achievement of the two Maastricht fiscal criteria. They are neither necessary nor sufficient for fiscal sustainability (or for macroeconomic stability) for the EU. They are ludicrously inappropriate for the oil-rich GCC members. For the oil-and-gas-rich GCC members, the fiscal sustainability concerns that prompted the Maastricht debt and deficit criteria are quite irrelevant. First, typically the state is a massive gross and net financial creditor. Adding to this the present discounted value of future oil and gas revenues net of extraction costs (the value of oil and gas wealth held underground)

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makes gross general government debt an irrelevant portfolio entry. The general government (central, state/provincial and municipal) government, which excludes the central bank, is a spectacularly inappropriate unit to consider for fiscal sustainability analysis. It is absolutely essential to specify fiscal-financial norms and criteria, and to collect data, on all assets and liabilities, outright and contingent, of the state – the sovereign. This means that we need to consolidate the balance sheet and flow-of-funds-accounts of the conventional general government sector, both with the accounts of the central bank (which often hold massive external assets and foreign exchange reserves) and with the accounts of the entire panoply of publicly owned and controlled financial entities, including sovereign wealth funds, other state-owned investment funds and all other institutions that hold assets owned or controlled by the state or are, de jure or de facto, subject to a state guarantee. Any fiscal sustainability criteria that do not fully allow for the assets held by all the publicly owned and publicly controlled wealth funds/investment funds, regardless of whether they have a cyclical stabilization mandate, a longterm development mandate or an intergenerational mandate, are bound to be useless at best, positively misleading at worst. There are further complications associated with fiscal sustainability analysis in the GCC countries because the line between public or state wealth and the wealth owned and controlled by the ruling families is frequently rather fuzzy, but that is no reason for adopting criteria like the ones currently proposed, which are uninformative under any conceivable set of circumstances. Achieving durable fiscal sustainability is the only truly necessary financial-economic condition for joining a monetary union. It should also be a sufficient condition for membership. When a country joins a monetary union, a decision I take to be irrevocable, it gives up its discretionary access to seigniorage and its ability to impose both the anticipated inflation tax and the unanticipated inflation tax.7 Such a reduction in the national crisis management arsenal should only be contemplated if there is confidence that politically mandated expenditure levels will be financeable with the available taxes and other regular sources of revenue, now and in the future. Nominal convergence, interpreted as convergence of a monetary union candidate nation’s inflation rate, prior to membership, to its post-joining monetary union membership equilibrium inflation rate, would be helpful for the country considering joining, but not essential. The monetary union equilibrium inflation rate is the union-wide target inflation rate (assuming there is one) plus any country-specific Balassa-Samuelson real exchange rate appreciation premium (see Buiter, 2005; Buiter and Sibert, 2006a, b). It is somewhat problematic, from the point of view of achieving price

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stability rather than just achieving monetary union with a common underlying inflation rate, that the GCC has not adopted a numerical inflation target for the monetary union as a whole. Admittedly, the EMU when it started also did not have an absolute inflation anchor, since it only required that during the year preceding the examination for membership, a candidate country’s inflation rate could not exceed by more than 1.5 percentage points the unweighted arithmetic average of the inflation rates of the three best-performing EU member states in terms of price stability. However, the GCC does not have among its members the monetary equivalent of the Bundesbank and its allies in the Netherlands and Austria, which provided a de facto low inflation anchor for the EMU, even before the ECB Governing Council adopted its formal inflation target. No monetary authority should ever be asked to pursue more than one nominal target. The simultaneous pursuit of three nominal targets (the case for the EMU) greatly enhances the likelihood that a major financial accident will happen before a country can get all three of its ducks in a row. The two nominal targets/ceilings for the GCC monetary union (inflation and the short-term nominal interest rate) and the minimum threshold for foreign exchange reserves are somewhat less onerous than their EMU counterparts, but are still an unnecessary distraction. As soon as fiscal sustainability (and preferably also inflation convergence (properly defined) is achieved, a date (for starting the GCC monetary union) and a set of six rates (the irrevocable conversion rate of the six national currencies and the khaleeji) should be announced. This will give the markets the focal points they require to achieve an orderly convergence of the market exchange rates to the required conversion rates at the right time. Candidates should be allowed to have any exchange rate regime, from a fixed rate with the US dollar to a free floating exchange rate, between the time the ‘date and rate’ are announced and the time their currencies are locked irrevocably to the ‘khaleeji’. If they opt to float after the announcement date, they could be required to pursue continued convergence to their post-monetary union joining date equilibrium inflation rates. If on the announcement date they choose to peg the exchange rate immediately at the level of the eventual conversion rate, they should not be given any additional nominal target. An exchange rate criterion in the spirit of ERM II would be a distraction at best, and an invitation to unnecessary instability at worst. Finally, even though the Maastricht criteria does not contain any real or structural convergence criteria for monetary union, the ECB and the European Commission constantly press the need for prior real convergence. They are wrong. Real convergence, defined as convergence of productivity levels, real per capita income, structures of production and

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employment, financial markets and institutions, quality of regulatory and supervisory institutions, is not necessary prior to khaleeji adoption. Indeed, the weaker the domestic monetary and financial institutions and markets, the stronger the case for early adoption of the common currency.

POLITICAL AND CONSTITUTIONAL ASPECTS OF MONETARY UNION Monetary union is not just a technical economic, financial or monetary issue. It represents a very significant constitutional and political change (see Eichengreen, 1996; Buiter et al., 1998; Tietmeyer, 1998; Fidrmuc and Horváth, 1999; Kenen, 2001; Gilbert, 2004; and Kenen and Meade, 2008). Monetary union raises two distinct but related political and constitutional issues: first the legitimacy of the surrender of national sovereignty involved in joining a monetary union, and second the accountability of the monetary policy-makers to the legitimate political authorities in the monetary union and its constituent member states. National Sovereignty Monetary union represents a surrender of national sovereignty to a supranational entity. This is true even for the full, formally symmetric monetary union. A central bank is a key agent of the state. The ability to issue legal tender is an expression of the power of the state to use physical force, to coerce, to prescribe and proscribe behaviour. The common use of the term ‘seigniorage’ to refer to the revenues accruing to the state through its monopoly of legal tender is a reminder of the fact that the power to issue legal tender is a manifestation of the state’s sovereign power – its ability to tax. A nation that joins a monetary union surrenders its national sovereignty in the monetary domain and becomes subject to a supranational form of sovereignty. The nation state is weakened by this surrender of monetary sovereignty. I am not expressing a view here on whether this would be a good thing or a bad thing for the GCC member states. I am merely stating a fact. The sober reality of this partial surrender of national sovereignty is complicated by the strong symbolic significance often attached to the national currency. The irreducible minimal list of symbols that define a nation as a nation state include a national currency, along with an anthem, a flag and a football team. The emotions that are kindled when the abolition of the national currency is under discussion go beyond what can be rationalized in terms of concerns about the loss of national discretion in the use of

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seigniorage, the inability to levy the anticipated and unanticipated inflation taxes, or the loss of the national monetary stabilization instrument (see, for example, Gilbert, 2004). These constitutional issues have been clear in the case of EMU. Economic and Monetary Union in Europe is part of an ongoing process of economic and political integration in Europe, and not an isolated, ‘technical’, monetary arrangement. In this it differs from arrangements like the classical gold standard, which flourished between 1880 and 1914, the heyday of European imperialism and nationalism. EMU is foremost a major step on the road to ‘ever closer union’ in Europe. It represents the opening of a new chapter in the European federalist agenda, a significant transfer of national sovereignty to a supranational institution. Like EMU, monetary union among the GCC member states would involve a transfer of national sovereignty to the central or federal level. Unless this transfer of power is perceived as legitimate by the citizens of the GCC countries, this transfer of authority to the supranational GCC central bank will be challenged by those who perceive themselves to be adversely affected by it, or by political opportunists prepared to use it as a means of leveraging popular misgivings in the pursuit of possibly quite unrelated objectives. In the past, political processes leading to the creation of a common currency, including a supranational central banking system with centralized authority, have survived only when, at the time of their creation, a stronger and more legitimate federal government structure was in place than is currently the case in the EMU area. A fortiori, past political processes resulting in the creation of a common currency have been supported by a level of political integration that goes far beyond the level of effective political integration (and indeed economic integration) that currently exists among the GCC member states. The EU has, at present, only a very weak, proto-federal set up, but it does have a Parliament, a Court of Justice, precedence of EU law over national law in the EU’s areas of competence, a proto-executive, made up of the Commission and the Council of Ministers, and a small but effective supranational bureaucracy, headed by the European Commission, with important regulatory powers. It does not amount to a supranational federal government structure, but it is also far more than a set of intergovernmental arrangements. So far, the relations between the member states of the GCC appear to be more in the tradition of intergovernmentalism than of supranationalism. The GCC central bank would not be supported by robust supranational political legitimizing structures. For that reason alone, I very much doubt it would survive. Creating a monetary union only to watch it collapse again would be costly and highly disruptive.

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The track record of past monetary unions is instructive. For instance, monetary union in the US was not complete until long after political unification. While one can make allowances for the war period (1776–83) and for the Confederation period (1783–89), even the US monetary union created with the signing of the Constitution in 1789, was far from complete. While the Constitution gave the Congress the monopoly of coinage and of the regulation of its value, the states continued to be able to charter commercial banks and to regulate their note issuance. Until the creation of the Federal Reserve System in 1914, the US did not have a central bank, although the First Bank of the US (1791–1811) and the Second Bank of the US (1816–36) can perhaps be characterized as proto-central banks. A monetary union with a centralized authority really did not exist in the US until the Banking Act of 1935. Italian monetary unification occurred in 1862, with the introduction of a new unified coinage system, based on the Sardinian lira, after political unification had been completed in 1861. Centralization of note and coin issuance and of other central bank functions did not occur until 1893. The history of German monetary and political union in the 19th century is open to two very different interpretations. The political establishment of the German Reich in 1871, following the Franco-Prussian War, preceded the coinage acts of 1871 and 1873, which unified coinage throughout the Reich and introduced the mark and the unit of account. In 1875, the new Reichsbank (a relabelling of the Prussian bank) became the de facto central bank of the Reich. In practice, it monopolized the issuance of notes. In 1875 Germany went on the gold standard (Germany used the Franco-Prussian War indemnity of 1870 to finance the creation of a gold standard – an early example of the use of Regional Funds to facilitate monetary integration perhaps). This sequence of events suggests that political unification in Germany preceded monetary union. Against that, the customs union (Zollverein) of 1834 was followed by the Munich Coin Treaty of 1837 and the Dresden Coinage Convention of 1838, which created a double currency standard among all members of the Zollverein, most of which were members of the Deutscher Bund. In 1857, the Vienna Coinage Treaty joined Austria to the Dresden arrangement. On this reading, most of the key steps towards German monetary unification were taken before political unification. It should, however, be noted, that Austria left the Vienna arrangement in 1867 following defeat in its war with Prussia. It did not join the German Reich in 1871. German political reunification in 1990 coincided with monetary union between the former West and East Germanies (GEMU). This is not an event with any clear implications for EMU, since GEMU was little more

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than a takeover by West Germany of a near financially bankrupt and utterly politically and morally bankrupt East Germany. There have been exceptions to the rule that political unification precedes monetary union. Even if one ignores the ambiguous German 19thcentury experience, the seven provinces that formed the Dutch Republic established a monetary union at the end of the 16th century, with only the weakest (con)federal political institutions and with almost completely decentralized fiscal authority. It lasted for two centuries, until the conquest of the Republic by Napoleon (Dormans, 1991). Belgium and Luxembourg were in a monetary union from 1922 until they were both absorbed into Euroland in 1999. While this association is more akin to a union between an elephant and a mouse (and belongs in the France-Andorra, France-Monaco, Italy-Vatican City, Italy-San Marino, Switzerland-San Marino category), it is interesting that monetary union did not lead to far-reaching political integration between Belgium and Luxembourg. Slightly different in nature are the currency unions adopted by contiguous former colonies following independence. The CFA Franc Zone, set up in 1959 by 13 former French colonies in West and Central Africa, survives till this day, although the CFA franc was devalued by 50 per cent in 1994. The survival of the arrangement appears to owe much to the continued involvement of (and budgetary transfers from) France. The East Caribbean Currency Area, consisting of seven former British colonies, has survived since 1966, unlike the East African Currency Area between Kenya, Uganda and Tanzania, which lasted only from 1966 until 1977. Monetary unions that occurred without prior political unification and that did not subsequently lead to political unification, have not survived. Examples include the following: ●

●

●

The Latin Monetary Union among France, Belgium, Switzerland and Italy, which lasted (with some temporary suspensions of convertibility by individual members) from 1865 until, de facto, World War I. The official time of death was 1927. The Scandinavian monetary union among Sweden, Denmark and Norway, which lasted from 1873 till, de facto, World War I, although the arrangements was not officially put out of its misery until 1924. Attempts by ‘successor states’ to maintain monetary union following the break-up of a larger political entity, have been short-lived, with the possible exception of the ‘monetary union’ between the UK and Ireland (a currency board arrangement for Ireland, rather than a ‘symmetric’ monetary union), which lasted from 1922 till 1979.

Economic, political and institutional prerequisites ●

●

65

Examples of spectacular failures to maintain a common currency following a political break-up include the successor states of the Austro-Hungarian Empire following the defeat of the Habsbourg empire in World War I; the ill-fated rouble zone among 11 CIS members between 1991 and mid-1993, following the dissolution of the Soviet Union; and the collapse of the monetary union among the successor states to the Federal Republic of Yugoslavia, which dissolved in 1991. All three political break-ups lead to hyperinflations. Czechoslovakia broke up as a political union on 1 January 1993; the Czech-Slovak monetary union collapsed on 8 February 1993 (Fidrmuc and Horváth, 1999). Here the political and monetary break-up was not accompanied by hyperinflation.

I have considerable sympathy for the long-standing German position that, in the context of European Economic and Monetary Union, further political integration should have accompanied (or even preceded) monetary union. On the other hand, the whole European integration experiment, from the Coal and Steel Community on, has been a political wolf dressed in economic sheep’s clothing. It has been successful so far, and it may well continue to be so. Accountability of the GCC Monetary Authority Following Monetary Union Monetary policy today is made by operationally independent central banks run by experts, not by politicians. The targets or objectives of the central bank should, of course, be politically determined. Once set, they should be very hard to change, lest the opportunistic political manipulation of the objectives of the central bank ends in recreating the same problems that exist when the monetary policy instrument is under the direct control of opportunistic politicians. In any society where the rulers are accountable to the citizens, the delegation of policy-making powers to unelected officials, especially if the majority of these officials are likely to be foreign nationals, will only be accepted as legitimate by the citizens, if the independent central bank is accountable to a body viewed as representative and legitimate. Accountability requires openness and transparency. The objective or objectives of the central bank must be clear and unambiguous. This is essential if the public and the legitimate political authorities are to be able to judge the performance of the central bank. The need for openness and transparency also applies to the procedures of the central bank, if only to ensure better informed financial markets.

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Individual voting records of the members of the central bank’s decisionmaking Council should be in the public domain. So should the minutes of its meetings. More elaborate and in-depth analyses of the policy-making Council’s thinking (like the Bank of England’s quarterly Inflation Report and inflation forecast) should be published regularly. An independent body (like the Non-Executive Directors of the Court of the Bank of England) should vet the procedures of the central bank and its policymaking Council on a regular basis, and should have the power to make binding recommendations. At the core of effective accountability is the need for the Council members, collectively and individually, to justify themselves before a duly constituted representative and legitimate committee that speaks for the entire GCC membership. In the US, the Governor of the Fed appears periodically before the Congress. In Euroland, the Subcommittee on Monetary Affairs of the European Parliament is charged with the political supervision of the ECB. In the UK, committees of both the House of Commons and the House of Lords call Monetary Policy Committee members to appear on a regular basis to explain their actions.

CONCLUSION I conclude that there is an economic case for GCC monetary union, but that it is not overwhelming. The lack of economic integration among the GCC members is striking. Without anything approaching the free movement of goods, services, capital and persons among the six GCC member countries, the case for monetary union is mainly based on the small size of all GCC members other than Saudi Arabia, and their high degree of openness. Indeed, even without the creation of a monetary union, there could be significant advantages to all GCC members, from both an economic and a security perspective, from greater economic integration, through the creation of a true common market for goods, services, capital and labour and from deeper political integration. The political arguments against monetary union at this juncture appear overwhelming, however. The absence of effective supranational political institutions means that there could be no effective political accountability of the GCC central bank. The surrender of political sovereignty inherent in joining a monetary union would therefore not be perceived as legitimate by an increasingly politically sophisticated citizenry. I believe that monetary union among the GCC members will occur only as part of a broad and broadly-based movement towards far-reaching political integration. And there is little evidence of that as yet.

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NOTES 1. Paper presented at the Seminar ‘Preparing for GCC Currency Union: Institutional Framework and Policy Options’, 20–21 November 2007 in Dubai. I would like to thank Robert Mundell, Mohsin Khan, Ahmet Akarli, Abdulrazak Al Faris, Emilie Rutledge, Carole Chartouni, Marios Maratheftis and other participants at the Seminar for helpful comments on an earlier version of this paper. 2. © Willem H. Buiter 2007, 2008. 3. When the monetary base pays a nominal interest rate iM t11 on a unit of the monetary base held between periods t and t + 1, the equation becomes: st = Mt + 1 – (1 + itM) Mt/PtYt (see Buiter, 2007a). 4. This emasculation of the national central banks (NCBs) has occurred despite the fact that the NCBs are the shareholders of the ECB. The only role in monetary policy formulation and design of the NCBs comes from the fact that each of them provides its governor as a member of the rate-setting body of the ECB, the Governing Council. With Malta and Cyprus joining the EMU on 1 January 2008, there are now 15 EU member states. Fifteen is the maximum number of NCB governors that can vote at ECB Governing Council meetings. Now the number of EMU member states exceeds 15, the NCB governors will begin to rotate as regards voting rights, even though all governors continue to have the right to participate in Governing Council meetings. 5. As a currency basket, the SDR would appear to be a much better choice for the GCC countries than the US dollar. The current composition of the SDR basket of currencies is as follows: 44 per cent US dollar, 34 per cent euro, 11 per cent yen and 11 per cent sterling. 6. Available at: http://www.cbk.gov.kw/cbkweb/servlet/cbkNewsMain?Action=newsdisp& id=1225 (accessed 20 November 2009). 7. The anticipated inflation tax, discussed earlier, is the ability to reduce the real value of the stock of base money through inflation. The unanticipated inflation tax is the de facto capital levy the monetary authorities can impose on holders of nominally denominated fixed rate government debt, through an unanticipated increase in the rate of inflation and the associated increase in long-term market nominal interest rates.

REFERENCES Abu-Bader, Suleiman and Aamer Abu-Qarn (2006), ‘On the optimality of a GCC monetary union: structural VAR, common trends and common cycles evidence’, Ben-Gurion University of the Negev, Department of Economics Working Papers Series No. 225. Akarli, Ahmet O. (2007), ‘The GCC dream: between the BRICs and the developed world’, Goldman Sachs Global Economics Paper No. 155, April, available at: http://www2.goldmansachs.com/ideas/brics/book/BRICs-Chapter14.pdf (accessed 18 November 2009). Al-Raisi, Ali Hamdan, Sitikantha Pattanaik and Amal Yousuf Al-Raisi (2007), ‘Transmission mechanism of monetary policy under the fixed exchange regime of Oman’, Central Bank of Oman Occasional Paper No. 2007-1. Bayoumi, Tamim and Paul R. Masson (1995), ‘Fiscal flows in the US and Canada: lessons for monetary union in Europe’, European Economic Review, 39(2), 253–74. Buiter, Willem H. (1997), ‘The economic case for monetary union in the European Union’, in Christophe Deissenberg, Robert F. Owen and David Ulph (eds),

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European Economic Integration, supplement to the Review of International Economics, 5(4), 10–35. Buiter, Willem H. (1999), ‘Alice in Euroland’, Journal of Common Market Studies, 37(2), 181–209. Buiter, Willem H. (2005), ‘To purgatory and beyond; when and how should the accession countries from Central and Eastern Europe become full members of the EMU?’, in Fritz Breuss and Eduard Hochreiter (eds), Challenges for Central Banks in an Enlarged EMU, Springer: Wien, New York, pp. 145–86. Buiter, Willem (2006a), ‘The “sense and nonsense of Maastricht” revisited: what have we learnt about stabilization in EMU?’, Journal of Common Market Studies, 44(4), 687–710. Buiter, Willem H. (2006b), ‘Rethinking inflation targeting and central bank independence’, Background Paper for an Inaugural Lecture for the Chair of European Political Economy in the European Institute at the London School of Economics and Political Science, given on Thursday, 26 October 2006, at London School of Economics and Political Science. Buiter, Willem H. (2007a), ‘Seigniorage’, Economics – The Open-Access, OpenAssessment E-Journal, available at: http://www.economics-ejournal.org/ economics/journalarticles/2007-10 (accessed 17 November 2009). Buiter, Willem H. (2007b), ‘Lessons from the 2007 financial crisis’, paper submitted in evidence to the UK Treasury Select Committee in connection with my appearance before the Committee on Tuesday, 13 November 2007; abstract available at http://www.voxeu.org/index.php?q=node/830 (accessed 17 November 2009); published as CEPR Policy Insight No. 18, December 2007. Buiter, Willem H. and Anne C. Sibert (2006a), ‘Eurozone entry of new EU member states from Central Europe: should they? could they?’, in Development & Transition, UNDP-LSE Newsletter, 4, 16–19. Buiter, Willem H. and Anne C. Sibert (2006b), ‘When should the new Central European members join the eurozone?’, Bankni vestnik – The Journal for Money and Banking of the Bank Association of Slovenia, Special Issue, Small Economies in the Euro Area: Issues, Challenges and Opportunities, November, 5–11. Buiter, Willem H, Giancarlo Corsetti and Paolo Pesenti (1998), Financial Markets and European Monetary Cooperation: the Lessons of the 92–93 ERM Crisis, Cambridge: Cambridge University Press. Chamley, C. (1986), ‘Optimal taxation of capital income in general equilibrium with infinite lives’, Econometrica, 54(3), 607–22. Dasgupta, P. and J. Stiglitz (1972), ‘On optimal taxation and public production’, Review of Economic Studies, 39(1), 87–103. De Grauwe, Paul (1997), The Economics of Monetary Integration, Oxford: Oxford University Press. Diamond, P. and J. Mirrlees (1971), ‘Optimal taxation and public production I: production efficiency’, American Economic Review, 61(1), 8–27. Dormans, E.H.M. (1991), Het tekort. Staatsschuld in de tijd van de Republiek, Amsterdam: NEHA. Dowd, Kevin and David Greenaway (1993), ‘Currency competition, network externalities and switching costs: towards an alternative view of optimum currency areas’, Economic Journal, 102(420), 1180–89. Eichengreen, Barry (1996), ‘On the links between monetary and political integration’, mimeo, CIDER Working Paper No. C96-077, University of California at Berkeley.

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Erbas, S. Nuri, Behrouz Guerami and George T. Abed (2003), ‘The GCC monetary union: some considerations for the exchange rate regime’, IMF Working Papers No. 03/66, International Monetary Fund. European Commission (1990), ‘One market, one money’, European Economy, 44, October. Fasano-Filho, Ugo and Andrea Schaechter (2003), ‘Monetary union among member countries of the Gulf Cooperation Council’, IMF Occasional Papers No. 223, International Monetary Fund. Fidrmuc, Jan and Julius Horváth (1999), ‘Stability of monetary unions: lessons from the break-up of Czechoslovakia’, Journal of Comparative Economics, 27(4), 753–81. Frankel, Jeffrey A. and Andrew K. Rose (1997), ‘Is EMU more justifiable ex post than ex ante?’, European Economic Review, 41(3–5), 753–60. Frankel, J.A. and A.K. Rose (1998), ‘The endogeneity of the optimum currency area criteria’, Economic Journal, 108(449), 1009–25. Gilbert, Emily (2004), ‘What is at stake in the NAMU debates? A review of the arguments for and against North American monetary union’, International Journal of Canadian Studies/Revue internationale d’études canadiennes, 30, 161–84. Ingram, James (1969), ‘The currency area problem’, in R.A. Mundell and A.K. Svoboda (eds), Monetary Problems of the International Economy, Chicago IL: Chicago University Press. Kamar, Bassem and Samy Ben Naceur (2007), ‘GCC monetary union and the degree of macroeconomic policy coordination’, IMF Working Paper No. WP/07/249. Kenen, Peter B. (2001), ‘Currency areas, policy domains, and the institutionalization of fixed exchange rates’, CEP Discussion Paper No. dp0467. Kenen, Peter B. and Ellen E. Meade (2008), Regional Monetary Integration, Cambridge, UK: Cambridge University Press. McKinnon, Ronald I. (1963), ‘Optimum currency areas’, American Economic Review, 53(4), 717–25. Masson, Paul R. and Mark P. Taylor (1992), ‘Currency unions: a survey of the issues’, in Paul R. Masson and Mark P. Taylor (eds), Policy Issues in the Operation of Currency Unions, pp. 3–53, Cambridge, UK: Cambridge University Press. Mundell, Robert A. (1961), ‘A theory of optimum currency areas’, American Economic Review, 51(4), 657–75. Pattanaik, Sitikantha (2007), ‘How closely the GCC approximates an optimum currency area?’, Journal of Economic Integration, 22(3), 573–97. Poole, William (1970), ‘Optimal choice of monetary policy instruments in a simple stochastic macromodel’, Quarterly Journal of Economics, 84(2), 197–216. Sala-i-Martin, Xavier and Jeffrey Sachs (1992), ‘Fiscal federalism and optimum currency areas: evidence for Europe from the US’, in M.B. Canzoneri, V. Grilli and P.R. Masson (eds), Establishing a Central Bank: Issues in Europe and Lessons from the U.S., Cambridge, UK: Cambridge University Press. Stiglitz, J. and P. Dasgupta (1971), ‘Differential taxation, public goods and economic efficiency’, Review of Economic Studies, 38, 151–74. Sturm, Michael and Nikolaus Siegfried (2005), ‘Regional monetary integration in the member states of the Gulf Cooperation Council’, Occasional Paper Series No. 31, European Central Bank. Tietmeyer, Hans (1998), ‘Political consequences of monetary union’, speech given at the Social Congress of the Commission of Bishop’s Conferences of the European Community, 20 February.

4.

The euro experience and lessons for the GCC currency union1 Paul De Grauwe

INTRODUCTION In 1999 one of the great monetary experiments in history was launched. Eleven member countries of the European Union (EU) created a new common currency, the euro, managed by a new institution, the European Central Bank.2 In so doing, these member countries transferred their monetary sovereignty to this supranational institution. The launch of the euro was a great success. It leads to the questions of how this success was made possible and how the euro experience can be used by other countries to steer towards monetary union. In this chapter I will analyze two ingredients of the successful launch of the euro. The first one has to do with the political and institutional integration that preceded the monetary unification, and the second one will focus on the convergence criteria that were used as a prerequisite to joining the monetary union. While the former will be shown to be essential to a successful monetary unification, the latter will be shown to be dispensable. The destruction of World War II led to a desire for political unification in Europe and a build up of institutions like the European Commission, the European Court of Justice and the European Parliament that all embody some transfer of national sovereignty. I will argue that in order to move into a monetary union the existence of these institutions was necessary. The pre-existence of a supranational institutional structure made it possible to create a new supranational institution, the European Central Bank. I will also show that the pre-existing supranational institutions often forced member countries to make steps towards monetary unification. Only recently economists have started to stress the institutional problems that arise when moving to a different economic regime. Economists long thought that when one moves to a monetary union, all one has to do is to parachute in a common central bank. It appears that this is not how it works in reality. Institutional reform is a slow process. The ECB was not just parachuted into an institutional desert. It was the ultimate step in 70

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a long process of institution-building in Europe. I now elaborate on this theme.

A BRIEF HISTORY OF MONETARY UNIFICATION IN EUROPE Monetary cooperation started in Europe with the European Payments Union (EPU) in 1950. This was an arrangement among the 18 members of the Organisation for European Economic Co-operation (OEEC), the precursor of the OECD. The dollar shortage and the absence of convertibility within the OEEC had created the problem that each country would have to balance its payments against each of its trading partners. The EPU solved this problem by setting up a multilateral clearing system. This made it possible for European countries to accumulate deficits against some countries matched by surpluses against others. This greatly facilitated trade. The EPU became superfluous when the participating countries made their currencies convertible in 1959. Apart from facilitating trade, the EPU was also useful as the first postwar training ground for monetary cooperation in Europe. During the 1960s, the Bretton Woods system reigned. Monetary relations were centered on the dollar and the commitments of the European countries to maintain a peg with the dollar. This commitment collapsed in the early 1970s. The collapse of the Bretton Woods system started a series of attempts in Europe to set up fixed exchange rate systems among the members of the European Union (the European Community at that time). The first such attempt, which had already been announced in the Werner Plan of 1970, was an agreement among the EU countries to peg their bilateral exchange rates. This agreement was seen as a first step towards full monetary union in 1980. It failed miserably under the onslaughts of the turbulences in the foreign exchange markets involving the dollar and the main currencies. Very soon, the UK, Italy and France withdrew. Exchange rate turbulences within the EU prevailed throughout the 1970s. The second attempt aimed at fixing exchange rates was made in 1979 with the institution of the European Monetary System (EMS). One feature of this system was an exchange rate mechanism (the ERM) keeping the bilateral exchange rates within a band of +2.25 percent and –2.25 percent around the parities.3 The mechanism was maintained throughout the 1980s, although with many realignments. It ultimately collapsed in 1992–93 when the UK withdrew (1992) and the bands of fluctuation were enlarged to +15 percent and –15 percent, transforming it into a system close to floating (for more institutional detail see Box 4.1).

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BOX 4.1

THE EUROPEAN MONETARY SYSTEM: SOME INSTITUTIONAL FEATURES

The European Monetary System was instituted in 1979. It was a reaction to the large exchange rate variability of Community currencies during the 1970s, which was seen as endangering the integration process in Europe.4 The EMS consisted of two elements: the ’Exchange Rate Mechanism’ (ERM) and the ECU (European Currency Unit). Like the Bretton Woods system, the ERM was an ’adjustable peg’ system. That is, countries participating in the ERM determined an official exchange rate (central rate) for all their currencies, and a band around these central rates within which the exchange rates could fluctuate freely. This band was set at 2.25 percent and –2.25 percent around the central rate for most member countries (Belgium, Denmark, France, Germany, Ireland and the Netherlands). Italy was allowed to use a larger band of fluctuation (6 percent and –6 percent) until 1990 when it decided to use the narrower band. The three newcomers to the system, Spain (1989), the UK (1990) and Portugal (1992), used the wider band of fluctuation. The UK dropped out of the system in September 1992. In August 1993, the band of fluctuation was raised to 15 percent and –15 percent. On 1 January 1999 the EMS ceased to exist. When the limits of the band (the margins) were reached, the central banks of the currencies involved were committed to intervening so as to maintain the exchange rate within the band. (This intervention was called ‘marginal’ intervention, that is, intervention at the margins of the band.) The commitment to intervene at the margins, however, was not absolute. Countries could (after consultation with the other members of the system) decide to change the parity rates of their currency (a realignment). These realignments were very frequent during the first half of the 1980s, when more than ten took place. They became much less frequent after the middle of the 1980s. During the years 1987–92 no realignment took place. In 1992–93 major crises erupted that led to several realignments. In August 1993, the nature of the ERM was changed drastically by the increase of the band of fluctuations to 15 percent and –15 percent.

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The second feature of the EMS was the existence of the ECU. The ECU was defined as a basket of currencies of the countries that are members of the EMS. (This was a larger group of countries than the ERM members. It included all the EU countries except Austria, Finland and Sweden.) The value of the ECU in terms of currency i (the ECU rate of currency i) was defined as follows: ECUi = Sj aj Sji

(4.1)

where aj is the amount of currency j in the basket; Sji is the price of currency j in units of currency i (the bilateral exchange rate). Since the ajs were fixed this definition of the ECU implies that an appreciating currency will see its percentage share in the ECU increase, while a depreciating currency will see its percentage share decline. This feature was deemed unacceptable for political reasons. As a result, every five years the amounts (the aj’s) in the basket were adjusted, that is, they were increased for the depreciating currencies and reduced for the appreciating currencies. This feature may have solved a political problem; it created another problem, that is, the poor attractiveness of the ECU as a currency to be used in market transactions. On 1 January 1999, the ECU was transformed into the euro at the rate of 1 ECU = 1 euro. When the euro became a currency in its own right, the basket definition ceased to exist. The inability of the EU countries to maintain fixed exchange rates forced them to make a choice between flexibility of the exchange rate or irrevocably fixing within a monetary union. It was increasingly realized in Europe and elsewhere that in a world of capital mobility, fixed exchange rates could not be maintained except by abandoning monetary sovereignty. In 1993, many EU countries were willing to abandon monetary sovereignty in order to achieve exchange rate stability within the European Union. This willingness led to the next step, which was the organization of a monetary union. The rest of the 1990s would be dominated by the transition process towards monetary union. The latter was successfully launched on 1 January 1999. From this brief historical overview two conclusions can be drawn. First, the overriding immediate objective of monetary cooperation in the EU was to maintain exchange rate stability. We will come back to this feature and ask the question of why exchange rate stability figured so prominently

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in the early stages of monetary cooperation. Second, exchange rate pegging was most often seen as a preliminary step towards full monetary union. Although it can be said that all these attempts at pegging the exchange rates failed, it is also true that they were ultimately successful in guiding the European countries into a monetary union. The reason is that these attempts created new institutions and led to an intensified use of pre-existing supranational institutions. Thus, the success of these fixed exchange rate arrangements must be sought in the fact that they were institution-building devices. Even if it can be said that the attempt to peg the exchange rates failed, it succeeded in creating the embryonic institutional framework that could be used for the future monetary union. Let us go into more detail and describe how these institutions became the breeding ground for monetary union.

EXCHANGE RATE PEGGING AS A DEVICE OF INSTITUTION-BUILDING A multilateral fixed exchange rate system faces the problem of how to set the system-wide level of the money stock and the interest rate. This issue essentially arises from the so-called n – 1 problem. In a system of n countries, there are only n – 1 independent exchange rates.5 Therefore n – 1 monetary authorities will be forced to adjust their monetary policy instrument so as to maintain a fixed exchange rate. There will be one monetary authority that is free to set its monetary policy independently. Thus, the system has one degree of freedom. This leads to the problem of how this degree of freedom will be used. Will this degree of freedom be given to one central bank, which is then left free to set its monetary policies independently? This was the solution embedded in the Bretton Woods system, in which the US took up this role. Or will this degree of freedom be shared by all member countries? This can be achieved by intense cooperation whereby the participating countries decide jointly about the level of the interest rate in the system. There can be no doubt that the intention of the designers of the EMS was to move to such a cooperative system. It did not work out this way, though, as very quickly the German Bundesbank took up the role of using the degree of freedom. As a result, the EMS evolved into an asymmetric arrangement, very much like the Bretton Woods system, in which the Bundesbank decided the interest rate in Germany, forcing the other central banks to follow the German lead. Thus, the attempt at designing a cooperative system failed. Yet in another sense it was quite successful as an institution-building device, in two ways. First, by putting the Bundesbank

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at the center of the action, it made it easier at a later stage to create a European Central Bank that would be a close copy (some would say a clone) of the Bundesbank. This was very much helped by the success of that institution in maintaining price stability. The secret formula embedded in the statutes of the Bundesbank was political independence and the primacy of price stability as an objective of monetary policies. Given the central position of the Bundesbank in the EMS it became easy to copy these institutional features into the design of the European Central Bank. There was another sense in which the EMS was successful as an institutionbuilding device. Despite the dominance of Germany in the system, there was a need for intense consultation among participating central banks. The management of the exchange rate led to the institutionalization of cooperation through the Committee of Central Bank Governors, the Monetary Committee and other ad hoc groups. Although these committees were at the time wholly inadequate to sustain the fixed exchange rate arrangement, they created a culture of cooperation that would prove useful later (see Gros and Thygesen, 1998 for a detailed analysis of these institutions). Other, pre-existing institutions, in particular ECOFIN (the council of EU-finance ministers), obtained added stature thanks to the EMS. As part of the executive branch of the European Union, ECOFIN could take decisions with a qualified majority. It was instrumental in organizing several realignments within ERM in an orderly fashion, and in so doing it helped to create a culture of cooperation within the EU. Thus, the exchange rate management within the EMS led to an intensified use of pre-existing European institutions and created new ones. All this contributed to building an infrastructure of institutions without which monetary union would not have been possible. As was pointed out earlier, the monetary cooperation process in Europe was focused on maintaining fixed exchange rates. One can ask why this objective took such a prominent role. The answer must be that this had a lot to do with the degree of integration achieved in other areas. Trade integration became increasingly intense during the 1960s and the 1970s, creating the possibility of large trade disruptions when exchange rates were changed. Even more important was the existence of the Common Agricultural Policy (CAP). Agriculture had evolved into a truly unified market. In addition, a unified price support system had been instituted in which the European authorities (the council of ministers of agriculture) set prices for the main agricultural products. These prices were expressed in the European Unit of Account (EUA), which was later to become the ECU. As long as exchange rates were fixed, this system did not create any problem as the national prices could be obtained by converting the EUA into the national currency at the fixed price. When in the 1970s

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the bilateral exchange rates within the EU became volatile, this system was very much disrupted. Countries that saw their currency depreciate (for example, France and Italy) experienced strong and immediate price increases of agricultural products, while countries with appreciating currencies (for example, Germany) experienced price declines. These movements were very much resisted by both France and Germany. A ‘corrective’ mechanism was instituted to eliminate the impact of exchange rate changes on the domestic agricultural prices. This mechanism, however, required the use of tariffs and subsidies on imports of agricultural products. It also threatened to destroy the market integration achieved in the agricultural sector. As a result, the pressure to go back to fixed exchange rates remained an underlying drive of monetary cooperation. What are the lessons from the European experience for the GCC currency union? The overriding lesson is that a monetary union is not created in a political and institutional desert. Monetary union was made possible in Europe because of at least 40 years of preparatory work. This preparatory work took the form of institution-building. Once the process started, an endogenous dynamics took over, whereby limited first steps called for other steps towards further institutional cooperation. This mechanism is akin to the well-known theory of the endogeneity of the economic criteria of a monetary union. This theory runs as follows. If you start a monetary union, the very fact that you do this will make the economic criteria for optimality of the union more favorable, thereby justifying the very decision to start with a monetary union (Frankel and Rose, 1998; De Grauwe and Mongelli, 2005). A similar mechanism applies with institutional integration. The decision to set up institutions for monetary cooperation creates a political dynamics in which further institutional integration will occur. So, even if the political conditions do not seem to be in place to move forward into a monetary union, limited steps in creating institutions for monetary cooperation makes the next steps easier, leading into a dynamics of further institutional integration. This mechanism has been very forceful in the European Union. Of course, such a strategy can only work if the economics is right, that is, if the economic conditions for an optimal currency area are satisfied. The question of whether these economic conditions are satisfied in the GCC currency union is outside the scope of this chapter.

THE CONVERGENCE CRITERIA The strategy for the transition process towards monetary union in the EU was spelled out in the Maastricht Treaty. The strategy was based on two

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principles.6 First, the transition towards monetary union in Europe was seen as a gradual one, extending over a period of many years. Second, entry into the union was made conditional on satisfying convergence criteria. In this section I analyze the Maastricht strategy, and I ask how useful it is as a blueprint for the transition into the GCC currency union. It is important to be aware that the Maastricht strategy was not the only one available. In fact, throughout history monetary unification has quite often been organized in a very different way. Take as an example the German monetary unification, which happened on 1 July 1990. The characteristic feature of the German monetary union was its speed and the absence of any convergence requirement. The decision to go ahead with monetary union was taken at the end of 1989, and six months later German monetary union was a reality. This monetary union was made possible by the fact that the whole of the West German political, legal and social institutions were transplanted into East Germany. Monetary union became possible very quickly because it coincided with a complete political unification. In addition, East Germany was allowed into the West German monetary area without any conditions attached. Surely, had Maastrichttype convergence requirements been imposed on East Germany, German monetary union would not have occurred. All this shows that a monetary union can be established quickly and without prior conditions. It does not show, of course, that this was the desirable way to organize the transition into the monetary union in Europe. The main characteristic of this transition process was the requirement that candidate countries had to go through a process of convergence of their economies. This necessary convergence process was described in detail in the Treaty. The Treaty stipulated that the transition to the final stage of monetary union was conditional on a number of ‘convergence criteria’. A country can join the union only if: 1.

its inflation rate is not more than 1.5 percent higher than the average of the three lowest inflation rates among the EU member states; 2. its long-term interest rate is not more than 2 percent higher than the average observed in these three low-inflation countries; 3. it has joined the exchange rate mechanism of the EMS and has not experienced a devaluation during the two years preceding the entrance into the union; 4. its government budget deficit is not higher than 3 percent of its GDP (if it is, it should be declining continuously and substantially and come close to the 3 percent norm, or alternatively, the deviation from the reference value (3 percent) ‘should be exceptional and temporary and remain close to the reference value’ (Article 104c(a));

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its government debt should not exceed 60 percent of GDP (if it does it should ‘diminish sufficiently and approach the reference value [60 percent] at a satisfactory pace’, Article 104c(b)).

Why convergence requirements? We noted earlier that monetary unions can and have been organized in a different way than in the Maastricht Treaty. What is more, the theory of optimum currency areas, which identifies the economic conditions of optimality of a currency union, is silent about Maastricht-type convergence criteria. Instead the optimum currency area (OCA) theory stresses the need to have labor market flexibility and labor mobility as important requirements for a successful monetary union (see Mundell, 1961).7 Why then did the designers of the Treaty stress so much macroeconomic convergence (inflation, interest rates, budgetary policies) prior to the start of EMU while the theory stresses microeconomic conditions for a successful monetary union? Let’s discuss the different convergence criteria and analyze possible economic reasons for their necessity. Why Inflation Convergence? The answer had to do with the fear of some of the future member countries, most prominently Germany, that the future monetary union would have an inflationary bias. Therefore, before the union started, the candidate member countries were asked to provide evidence that they cared about a low inflation rate in the same way as Germany did. This they did, by bringing down their inflation rate to the German level. During this disinflationary process, a temporary increase in the unemployment rate was inevitable (a movement along the short-term Phillips curve). This self-imposed suffering was added evidence for Germany that countries like Italy were serious about fighting inflation. Once the proof was given, these countries could be let in safely. Thus, the inflation convergence came into being as a result of a fundamental distrust by the low inflation countries, mainly Germany, in the willingness of the high inflation countries to follow low inflation policies. The inflation convergence criteria became a ‘rite of passage’ in which the candidate member countries had to show their toughness in combating inflation. Budgetary Convergence There can be no doubt that sustainable budgetary policies should be pursued. The issue is whether the membership in a monetary union

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necessitates extra conditions on budgetary policies that would not apply to countries that do not belong to a monetary union. Economists have analyzed this question in great detail. My conclusion is that the theoretical case for special treatment of member countries of a monetary union has not been firmly established (see De Grauwe, 2007 for more detail). What is certain, however, is that the numerical detail of the Maastricht budgetary conditions (the 3 percent budgetary rule and the 60 percent debt rule) are ill-conceived. There is no theoretical argument for these numbers. This has led many economists to criticize the 3 percent and 60 percent norms as arbitrary, or worse, as some form of voodoo economics.8 The paradox of these budgetary convergence criteria is that more than half of the present euro-member countries did not satisfy these convergence criteria, in particular the debt convergence criterion. In the end, despite the rhetoric about their importance, policy-makers were willing to turn a blind eye to the fact that these criteria were not satisfied and continued their political project of starting the monetary union. Exchange Rate Convergence (No Devaluation Requirement) The main motivation for requiring countries not to have devalued during the two years prior to their entry into the EMU is straightforward. It prevents countries from manipulating their exchange rates so as to force entry at a more favorable exchange rate (a depreciated one, which would increase their competitive position). While one can sympathize with the idea that countries should not seek to enter the union with an undervalued currency, the question arises whether forcing countries into the straightjacket of a fixed exchange rate arrangement prior to entry is a sensible idea. The most common argument advanced for doing so is the discipline argument. This runs as follows. Countries should show their capacity to impose discipline so that markets will be satisfied and not attack the exchange rate. The history of the monetary unification process, however, amply demonstrates that this is very difficult. As argued earlier, the fixed exchange rate arrangements of the past have most often failed. Countries quite often fail to keep the exchange rate fixed even if their policies are disciplined, because exchange markets can be caught by a speculative dynamics unrelated to fundamentals. The fixed exchange rate condition appears to be unreasonable when one considers that once in the union, keeping the exchange rate fixed is achieved without the least difficulty because the intra-union exchange rates do not exist anymore. Thus, it does not seem to be reasonable to require countries to show their capacity of keeping their exchange rate

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within a certain band (which is very difficult), while they will not need to do so once they are in the union. My interpretation is that the fixed exchange rate requirement (like the inflation convergence requirement) has to be interpreted as a ‘rite of passage’; a test that countries should pass to show to the others that they take their membership seriously and that they are willing to inflict selfimposed pain. Like most of the rites of passage, the tests have nothing to do with what will happen later following entry to the club. Interest Rate Convergence The justification of this rule is that excessively large differences in the interest rates prior to entry could lead to large capital gains and losses at the moment of entry into EMU. The peculiarity of this rule is its self-fulfilling nature. The rule says that the long-term government bond rate of a prospective member should not exceed the interest rate level (+2 percent) in the eurozone.9 Consider the UK and suppose (quite unlikely) that it is expected to join in, say, 2012. It can easily be seen that the UK long-term bond rate will start converging to the euro rate prior to entry. As a result, the capital gains and losses (which are inevitable) will be borne before the entry into the union. At the start of the union, these capital gains and losses will be very small. The upshot of all this is that the interest rate convergence criterion is redundant. As soon as countries are expected to satisfy the other criteria, arbitrage forces make sure that the interest rates quickly converge. This also happened prior to the start of EMU. Once countries were expected to join EMU, long-term interest rates converged automatically. For countries like Spain, Ireland, Portugal, and Italy where interest rates used to be very high, this led to strong declines in the longterm interest rates prior to the start of EMU. This also contributed to the strong economic booms in these countries at the beginning of EMU.

CONCLUSION The experience of monetary unification in Europe has a number of interesting lessons for the GCC currency union. First, it shows that monetary union among sovereign nations comes about after a relatively long process of political unification that includes the building of common institutions. The creation of a European Central Bank was made possible by the preexistence of numerous European institutions (the European Commission, the Council, the European Parliament, the European Court of Justice) to which the member states of the EU gradually transferred part of their

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national sovereignty. These institutions facilitated monetary cooperation and contributed to the creation of new institutions. The European Central Bank was not dropped from the sky in an institutional desert. We also learned that there is an endogenous component in institutional building. Once the process starts, the existing institutions push for more integration and for the creation of new institutions to make further integration possible. The nice part of this process is that if one wants to integrate, the decision to start the process facilitates further integration. Seen from this perspective, it does not help to wait. Second, our discussion of the convergence criteria leads us to conclude that these criteria can be dispensed of. The candidate countries of the GCC currency union have nothing useful to learn from them. These convergence criteria are either useless or harmless (the interest rate convergence) or useless and harmful (fixed exchange rate requirement). The latter can be seen as a rite of passage in which countries show to the others that they are capable of sustaining pain. The inflation convergence requirement has the same quality of a rite of passage whereby high inflation countries show to the low inflation countries how serious they are in keeping a low inflation (without any guarantee that they will continue to show this preference once in the union). Finally, the numerical precision budgetary discipline has received in the Maastricht Treaty appears to be unhelpful in imposing budgetary discipline. It was disregarded at the moment of the start of the union. Its further embodiment in the Stability Pact has led to large-scale bookkeeping ingenuity to hide the true nature of the budgetary figures, and if these did not work anymore, to abandoning the numerical conditions, as was done in 2003 when France and Germany decided to set aside the rules.

NOTES 1. Paper presented at the High Level Seminar ‘Preparing for GCC currency union: institutional framework and policy options’, 20–21 November 2007, Dubai Council for Economic Affairs. 2. In 2002 Greece joined and in 2007 Slovenia became the 13th member. 3. There was also a larger brand of fluctuations of +/–6 percent that was used by the Italian lira. 4. For a fascinating account of the discussions that led to the establishment of the EMS, see Ludlow (1982). For a more detailed description of some institutional features of the system see Van Ypersele (1985). 5. There are more exchange rates (actually the number is n(n – 1)/2). Arbitrage, however, ensures that only n – 1 are independent. 6. In this the Treaty was very much influenced by the Delores Committee Report, which was issued in 1989. See Committee on the Study of Economic and Monetary Union (1989).

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7. See the other classical papers by McKinnon (1963) and Kenen (1969) for analyses of additional conditions for forming an optimal currency area. 8. See Buiter and Kletzer (1990), Buiter et al. (1993) and Wickens (1993) among others. 9. Note that prior to the start of EMU the requirement was that the interest rate of the prospective members had to be at most 2 percent above the interest rate of the three EMS countries with the lowest rates of inflation.

REFERENCES Buiter, W. and K. Kletzer (1990), ‘Reflections on the fiscal implications of a common currency’, CEPR Discussion Paper No. 418. Buiter, W., G. Corsetti and N. Roubini (1993), ‘Sense and nonsense in the Treaty of Maastricht’, Economic Policy, 16. Committee on the Study of Economic and Monetary Union (the Delors Committee) (1989), Report on Economic and Monetary Union in the European Community (Delors Report) (with Collection of Papers), Luxembourg: Office for Official Publications of the European Communities. De Grauwe, P. (2007), The Economics of Monetary Union, Oxford: Oxford University Press. De Grauwe, P. and F. Mongelli (2005), ‘Endogeneities of optimum currency areas. What brings countries sharing a single currency closer together?’, Working Paper No. 468, European Central Bank. Frankel, Jeffrey A. and Andrew K. Rose (1998), ‘The endogeneity of the optimum currency area criteria’, Economic Journal, 108, 1009–25. Gros, D. and N. Thygesen (1998), European Monetary Integration, 2nd edition, Essex: Longman. Kenen, Peter B. (1969), ‘The theory of optimum currency areas: an eclectic view’, in R.A. Mundell and A.K. Swoboda (eds), Monetary Problems of the International Economy, Chicago: University Press. Ludlow, R. (1982), The Making of the European Monetary System, London: Butterworths. Maastricht Treaty (Treaty on European Union) (1992) CONF-UP-UEM 2002/92, Brussels, 1 February. McKinnon, Ronald I. (1963), ‘Optimum currency areas’, American Economic Review, 53(4), 717–25. Mundell, Robert A. (1961), ‘A theory of optimum currency areas’, American Economic Review, 51(4), 657–65. Van Ypersele (1985), The European Monetary System, Cambridge: Woodhead. Wickens, M. (1993), ‘The sustainability of fiscal policy and the Maastricht conditions’, London Business School Discussion Paper No. 10–93.

5.

The GCC monetary union: choice of exchange rate regime1 Mohsin S. Khan

INTRODUCTION The creation of a monetary union has been an overriding objective of the regional economic integration process among Gulf Cooperation Council (GCC) members since the early1980s.2 Since then, the GCC member countries have come a long way on the road to economic integration. When established, the GCC monetary union would be the second most important supranational monetary union in the world in GDP terms, second only to the European Monetary Union.3 The experience of monetary unions elsewhere in the world can provide useful insights into the challenges that the planned GCC monetary union faces. Currently, there are five monetary unions in the world. Three of these unions are in Africa, one in the Caribbean and one in Europe. In all of them, a new common currency was created, except in the Southern African Common Monetary Area (CMA), in which the South African rand is the common currency in circulation. The GCC countries are probably the most homogeneous among the unions, sharing a common history, language and culture.4 They are mainly oil exporters (with the exception of Bahrain), are very open to trade and imported labor, have very flexible labor markets in which even nominal wages can adjust and have complete factor mobility within the group. Further, they all have full convertibility. One could argue that the GCC countries have already fulfilled many of the preconditions for a currency union. Overall, the GCC meets the generally accepted criteria for a single currency among its members, namely proximity, size, fluctuations of output, trade structure and inflation performance (Berengaut and Elborgh-Woytek, 2006). Much progress has been made toward achieving the goal of a full-fledged GCC monetary union. GCC countries have achieved virtually unrestricted intraregional mobility of goods, national labor, and capital. In addition, prudential regulations and supervision of the banking sector are being gradually harmonized. All members except Kuwait have pegged their currencies to the US dollar 83

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Table 5.1

GCC countries: compliance with the convergence criteria, end2006

Country

Bahrain Kuwait Oman Qatar Saudi Arabia UAE

Budget Deficit Lower than 3% of GDP, or 5% when Oil Prices are Weak

Public Debt to GDP Ratio Lower than 60%

Foreign Exchange Reserves in Excess of Four Months’ Imports

Interest Rates Not Higher than 2% Points Above the Average of the Lowest Three Countries’ Rates

Inflation Not Higher than 2% Above the Average Rate of the Six Statesa

u u u u u u

u u u u u u

– u u u u u

u u u u u u

u u u – u –

Note: a. A weighted average based on US dollar nominal GDP of the six states; u = criterion has been met; – = criterion has not been met. Source:

Country authorities and IMF.

since 2003, a common external tariff was introduced in 2003 and the GCC common market was launched on 1 January 2008. Although the GCC currencies have been de facto pegged to the US dollar for decades,5 a single GCC currency is expected to encourage trade and financial integration, and facilitate foreign direct investment, although there are questions as to whether the GCC can be considered an ‘optimum currency area’ (Frankel and Rose, 1998, 2000; Rose, 2000; Buiter, 2008). The European Central Bank (ECB) has provided the GCC with a draft Monetary Union Agreement (MUA) and statutes on the Gulf Monetary Council (GMC) and the Gulf Central Bank (GCB). GCC member states decided to establish a monetary council at the end of 2009 to serve as a transition body in preparation for the single currency and the GCB. A set of five convergence criteria (on inflation, interest rates, reserves, fiscal balance and public debt), similar to those used in the run up to the European Monetary Union, has been agreed in principle (Table 5.1). Although they are not preconditions for entry, by the end of 2008 the GCC countries had met almost all of the convergence criteria. The exception is inflation, reflecting the recent higher inflation rates in Qatar and

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the UAE. But even in these countries, inflation is not expected to persist. In fact, the high inflation in these two fast-growing economies is due to supply constraints arising from the rapid pace of implementing large investment and construction projects, and these pressures are expected to ease soon. However, there have also been some unanticipated setbacks to achieving the monetary union. In October 2006 Oman announced that it would not join by 2010, and in May 2009 the UAE also opted out. In addition, in May 2007 Kuwait declared that it was moving from the dollar peg to an undisclosed currency basket, although it reaffirmed its commitment to join the union as planned. There have also been delays in establishing harmonized systems and in institution-building. In terms of preparedness for the common currency and the creation of a common independent central bank, the monetary policy frameworks, payment and settlement systems, regulatory and supervisory structures, macroeconomic statistics and other specific central bank functions have yet to be fully harmonized. The management of international reserves and non-reserve foreign assets has also not yet been agreed. In addition, on the fiscal side, setting up a common accounting framework and adequate budgetary procedures are a high priority in the period leading up to the introduction of a common currency. Finally, the countries facing high inflation rates need to reduce them to the GCC average. The remaining agenda is certainly challenging, and as a result, the 2010 deadline for the single GCC currency appears increasingly unachievable, a fact that is now acknowledged by the member countries as well as by the GCC Secretariat. Looking ahead, one very important decision in the formation of a monetary union is the choice of an appropriate exchange rate regime. The countries’ choice of a US dollar peg as the external anchor for monetary policy has obviously been credible and has served them well so far. In fact, one can argue that the generally low inflation rate in the GCC until recently has been due to the pegging of their currencies to the US dollar. At the same time, rising inflationary pressures in the last couple of years, increasing integration with global markets and differing economic cycles and policy needs from that of the anchor country, the United States, have raised questions about whether the peg to the dollar remains appropriate. The choice of the exchange rate regime has to be seen in the context of the structural characteristics of the GCC economies, in particular the importance of the oil sector in GDP, exports and government revenue. At present, oil and gas production contributes about half of GDP and threequarters of exports and government revenues. The primary challenge for them is to diversify their economies and further develop the non-oil private sector in order to create employment opportunities for the rapidly

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growing national labor force. The issue then is which exchange rate regime would be most suitable in achieving this goal. The objective of this chapter is to outline the main alternative exchange rate regimes for the unified GCC currency and to discuss their respective advantages and disadvantages. To start with, this chapter will discuss general considerations in determining exchange rate regimes. It will then consider GCC-specific issues.

GENERAL CONSIDERATIONS IN DETERMINING THE EXCHANGE RATE REGIME The most common criterion suggested by the theoretical literature for determining the optimal exchange rate regime is macroeconomic and financial stability in the face of transitory real or nominal shocks. The conventional view on the choice of exchange rate regime has been that exchange rate flexibility allows for macroeconomic and financial stability in the face of real domestic shocks or foreign nominal shocks. Fixed exchange rates are more effective in achieving macroeconomic and financial stability in reaction to domestic monetary shocks. However, the insulating properties of alternative exchange rate regimes are strongly affected by the structural characteristics of the economy, such as openness to international trade, capital mobility and labor market flexibility. In practice, it is difficult to evaluate the effect of these characteristics on the functioning of the exchange rate regime because they may have ambiguous effects, and domestic and external shocks can occur simultaneously. Therefore, in choosing the exchange rate arrangement, one has to look to a number of criteria. Ideally, the exchange rate regime chosen should yield external stability, internal stability (low inflation), balance sheet stability, international competitiveness, credibility of monetary policy, and low transaction costs (Husain, 2006). External stability is defined as a balance of payments position that is not likely to give rise to disruptive adjustments in exchange rates. A balance of payments position consistent with external stability is one in which both the underlying current account is broadly in line with its equilibrium level, and the capital and financial account position does not create risks of abrupt shifts in capital flows.6 Balance sheet stability deals with the impact of exchange rate volatility on the net open positions of the financial and public sectors. International competitiveness of the non-oil tradable goods sector is related to how well the real exchange rate supports external trade, and changes (actual and expected) in the nominal exchange rate can be an important indicator of the credibility of the domestic monetary policy

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stance. Similarly, exchange rate volatility can raise transaction costs in international trade and finance by increasing uncertainty and information needs. In applying these criteria, trade-offs are usually necessary and political economy considerations in the choice of regime may become relevant. Also, policy management considerations may dictate keeping an existing regime if no substantial gain is to be achieved by switching from one arrangement to another, and if the change would involve significant political or adjustment costs. GCC member countries officially pegged their national currencies to the US dollar on 1 January 2003 as an explicit step toward monetary integration. Although at that time the countries (except Kuwait) were already pegged to the US dollar, the decision was based on the expectation that the dollar peg would maintain stability and strengthen confidence in the economies, and therefore the countries would go into the monetary union at those parities. As such, GCC countries have pursued economic policies consistent with exchange rate pegs. For instance, they have implemented appropriate fiscal policies and have maintained flexible labor and product markets.7 GCC members have also accumulated significant foreign exchange reserves, underpinning the credibility of the peg and discouraging speculation against their currencies. All in all, from the standpoint of macroeconomic stability, the dollar peg has worked well in these countries, keeping inflation relatively low and strengthening confidence in the currencies and in the economies more generally. GCC governments (other than Kuwait) have stated that there would be no change in the current pegged regime until the monetary union, but that they remain open to the choice of the exchange rate arrangement under the planned GCC currency union. Ultimately, the choice of a specific exchange rate regime will depend on the preferences of the GCC member countries and will presumably be based on both economic and political considerations. The next section examines the arguments for and against the following alternative exchange rate regimes: a single currency (US dollar) peg, managed floating, pegging to a basket of currencies, and pegging to the export price of oil.

ALTERNATIVE EXCHANGE RATE REGIMES FOR THE GCC MONETARY UNION Two main arguments have been offered by those who are in favor of alternative exchange rate regimes to the dollar peg for the GCC countries (for example, Setser, 2007). The first is that GCC countries could pursue domestic goals of inflation and output better if they had monetary policy

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independence. The second argument is that imported inflation, owing to a sustained depreciation of the US dollar, could be avoided by abandoning the peg. The question is whether these arguments have sufficient merit. For example, distortions in the monetary transmission mechanism would constrain the effectiveness and efficiency of an independent monetary policy. Further, imported inflation is limited by low pass-through effects and administrative price controls. Thus, despite a significant depreciation of the US dollar, inflation in most GCC countries has been subdued until recently. Exchange rate arrangements other than the dollar peg could be considered in light of emerging changes in trade and investment patterns, as well as in the economic structure across the GCC countries. One major factor is economic diversification. As countries diversify in the future, the differences in the economic structures of GCC countries will increase, leading to higher shares of manufacturing and service exports in total trade. This may increase intra-GCC trade, but will also highlight the importance of price flexibility in factor and product markets. In particular, the efforts at nationalizing the GCC countries’ labor force, by increasing the number of nationals in the private non-oil sector on the one hand, and raising the costs of employing expatriate workers on the other, will inevitably reduce the flexibility of the GCC countries’ labor markets. This will make it more difficult to ensure international competitiveness and adjust to terms-oftrade shocks while maintaining a currency peg. External financial assets, now mainly dollar-denominated, may also become progressively more diversified as a consequence of globalization, rapid growth in large emerging economies, and the rise of the euro as a reserve currency. With increased capital mobility, trade openness and foreign direct investment, the requirements for sustaining an exchange rate peg become more demanding. Indeed, maintaining a tight peg to the dollar forces the GCC countries to rely almost exclusively on fiscal policy to manage oil-related volatility, and a more flexible exchange rate regime could give these countries another tool for adjusting to oil shocks. Consequently, reasonable arguments can be made for adopting a more flexible exchange rate policy in the future after the monetary union is established. However, as argued later, there are equally important and valid arguments in favor of maintaining the current peg to the US dollar after the introduction of the single currency. Before examining the alternative options more closely, one may legitimately ask whether the current level of the exchange rate in each country is appropriate. An argument that is made often is that the equilibrium real exchange rate has appreciated in GCC countries because the oil price increases since 2003 have resulted in a permanent improvement in

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the terms of trade. In theory, this would mean that the current actual real exchange rate is undervalued and should appreciate either through nominal appreciation or inflation. If inflation is due to overheating or dollar depreciation vis-à-vis the euro, then a nominal appreciation would be preferable. But, the current spike in inflation has been predominantly a supply-side phenomenon, driven by capacity constraints and is expected to decrease as supply constraints ease, particularly in the area of housing. It is also the case that revaluation of the currency will only impact headline inflation in the short term, as it will have only a one-off effect on the domestic price level. Further, the associated costs of revaluation have to be balanced against the short-term beneficial effects that revaluation can have on inflation. In particular, a revaluation would impose significant valuation losses on the large official foreign assets of the GCC countries and reduce international competitiveness for those countries that have embarked on economic diversification by developing tourism and the nonoil export sectors. There is also a risk that as soon as the signal is given that the exchange rate is a policy instrument available to tackle inflation, this could increase market expectations of further revaluations and encourage speculation even if fundamentals are unchanged, as was seen in the case of Kuwait when it went off the dollar peg in 2007. For most countries it is extremely difficult in practice to determine the equilibrium real exchange rate and, hence, the appropriate level of the nominal exchange rate. It is even more problematic in the case of oil producers. Ideally, the exchange rate should be set at a level that would be consistent with sustaining the current account balance at some desired level (or ‘norm’). But the level of the equilibrium real exchange rate will depend on both the level and volatility of oil prices over the medium term. In fact, any change in current or future oil prices will change the equilibrium exchange rate and the current account norm, making the calculation of both extremely difficult as oil prices change substantially almost on a day-to-day basis. One particular argument that has been made is that because GCC countries are running large current account surpluses, their exchange rates must be undervalued. In that case, would the recommendation of a nominal (and therefore real) appreciation help to reduce the current account surpluses? The answer is not much. The problem here is that imports are highly inelastic in these countries, and the exchange rate changes that are generally advocated would have only a marginal, if any, effect on the current account. For example, empirical work in the IMF on the determinants of GCC countries’ current account positions shows that a 100 percent real appreciation would only reduce the current account surplus by about 4 percent of GDP. As a point of reference, the average

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current account surplus of the GCC countries in 2008 was 26 percent of GDP. A nominal appreciation may help somewhat on the inflation front, but inflation is expected to come down in these countries once supply bottlenecks and capacity constraints have eased. Current accounts in the GCC countries are mainly driven by the fiscal balance, so it will be the fiscal spending that is underway that will reduce current account surpluses over time.What then are the alternative exchange rate regime options for the monetary union? US Dollar Peg A good case can be made for the monetary union to continue pegging to the dollar. Although the share of GCC trade with the United States is comparatively low, almost all exports (that is, primarily oil and gas) and a very high proportion of the external assets are US dollar-denominated. A dollar peg ensures stability of income flows from abroad and stabilizes fluctuations in financial wealth. Although fluctuations in the value of the dollar against other reserve currencies could generate volatility in crossrates between these currencies and the GCC currencies, the share of GCC non-oil exports is still relatively small, minimizing the impact of such exchange rate changes on external trade. The peg to the US dollar has also helped the region avoid nominal shocks from geopolitical risks feeding into the economy. These risks are likely to continue, placing a premium on a credible US dollar peg. The dollar peg provides a strong and easily understood anchor for monetary policy (Abed et al., 2003). It is not possible to deviate too much from the US rate of inflation for an extended period of time. Yet, while inflation has been low in general, there have been significant differences between the GCC member states’ inflation rates, which have led to diverging developments in their real effective exchange rates. One can argue that in this circumstance, price stability has to be supported by fiscal policy and by giving priority to implementing projects aimed at improving the economy’s absorptive capacity. International competitiveness can be maintained under a fixed exchange rate in the GCC countries because of labor market flexibility. In addition, fiscal policy has been the main instrument for avoiding the transmission of oil sector volatility into the non-oil economy. Fiscal policy will obviously have to maintain its stabilizing role in the future, in particular as the GCC member countries agree on appropriate fiscal convergence criteria, diversify their revenue sources and cast their fiscal policies in medium-term budgetary frameworks. However, GCC countries will not be able to assure international competitiveness by retaining the currently high degree of

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labor market flexibility in the long run. The share of nationals in the labor force in the private non-oil sector is increasing, the result of a fast-growing national population and the fact that the public sector is no longer willing to act as employer of first and last resort. The exchange rate peg also simplifies trade and financial transactions, accounting and business planning, as well as monetary coordination among the member countries. Exchange rate risk can be easily hedged, even without a domestic forward market, since it is possible to work through US dollar markets. This has been particularly advantageous to importers and investors as they have relied on the more developed international capital markets to hedge themselves. Finally, the familiarity of GCC authorities and private economic agents with the US dollar peg, as well as the similar preferences the GCC countries have shown for a fixed exchange rate, speak in favor of maintaining the current arrangement after the implementation of the planned monetary union. Keeping the single currency peg to the dollar would leave the public and policy-makers on already familiar grounds and facilitate the acceptance of a common currency. Managed Floating Letting the single GCC currency float against other currencies would have the advantage of allowing the GCC countries to use monetary policy to stabilize inflation and non-oil output and to promote the growth of the private non-oil economy. A more flexible exchange rate regime would also allow the countries to absorb large adverse real shocks more easily than a fixed exchange rate regime. As the GCC economies, their exports and their international asset portfolios become more diversified, the flexibility of the labor market may decrease because of increased participation by nationals, and the exposure to shocks (including capital movements) may increase.Thus, greater flexibility of the exchange rate would become more desirable. In light of the current structural characteristics of the GCC economies, however, it is questionable whether active monetary and exchange rate policies would achieve external stability. This is because the interest rate channel of the monetary transmission mechanism is ineffective in an environment where economic agents’ decisions are highly insensitive to changes in the interest rate. Corporate-sector investment and spending decisions (investment and consumption) in the GCC countries depend to a large extent on actual and projected government spending, limiting the role of financial markets and interest rates. Thus, fiscal policy has to bear the burden of smoothing the effect of shocks on domestic activity. In

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addition, the exchange rate–current account channel is weak because of the insensitivity of exports and imports to changes in the exchange rate. A further issue relates to the choice of the nominal anchor under a float. The two main alternatives would be inflation targeting and monetary targeting. Inflation targeting must be based on a good understanding of the inflationary process and its determinants, in addition to institutional and technical requirements, such as sophisticated market-based monetary operations, central bank independence, and transparency of policy to build accountability and credibility. Monetary targeting would require a stable and predictable money demand function and the development of instruments and adequate forecasting ability to undertake efficient liquidity management. While none of these requirements is insurmountable, moving to an inflation targeting regime takes time, so monetary targeting would necessarily have to serve as the nominal anchor for price stability and would require the development of liquidity management instruments, which are currently lacking. There are also risks associated with floating exchange rates. For example, there is the danger that large swings in oil prices could lead to volatile exchange rates and in the end to larger fluctuations in non-oil output and higher and more volatile inflation (Cashin and McDermott, 2001). Especially given the thin foreign exchange markets that are dominated by a relatively small number of agents, it is likely that the central bank would have to intervene systematically to smooth the path of the exchange rate. Furthermore, letting the exchange rate of the GCC currency float would also introduce a new and different type of uncertainty and risk into international transactions, as well as complicate budgetary accounting and business planning. At the same time, underdeveloped and incomplete financial markets would make hedging against exchange rate risk costly and probably impossible in the near term. Basket Peg A basket peg could serve as a cautious strategy toward a more flexible exchange rate policy. With a basket peg, the main anchor properties of an exchange rate peg could be retained, while at the same time gaining some adaptability to the adverse effects of swings among the value of the major reserve currencies. The volatility of the nominal effective exchange rate would be reduced, benefiting external trade and balance sheet stability. For example, a peg to the SDR would result in lower volatility of oil export receipts relative to the dollar peg. Implementing a basket peg may be a useful way to introduce more

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flexibility of the exchange rate in a gradual manner, which would allow private market participants to learn to manage and live with foreign exchange risk. Compared with fixing to a single currency, pegging to a basket of currencies has the disadvantage that traders will have to bear the exchange rate risk. And in relatively underdeveloped financial markets hedging exchange rate risk would be difficult and costly. On the other hand, pegging to a single major currency allows market participants to take advantage of instruments available for that major currency. What probably matters most is the extent of the higher exchange rate risk versus the reduced cost from lower exchange rate volatility. One disadvantage of basket pegs is that they may reduce the microeconomic and informational benefits of maintaining constant at least one bilateral exchange rate relevant for price comparisons and economic transactions. Also, basket pegs tend to be less transparent and more difficult to explain to the public. The weights attached to the basket will have to be managed and lack of transparency could encourage speculative behavior, as the example of Kuwait shows. One simple approach would be to peg to a transparent basket consisting only of the US dollar and the euro.8 It would be simple to interpret, would reduce monetary dependence of the GCC on the US Federal Reserve, cover most transactions in goods, services and financial instruments (now in the US dollar and the euro area), and allow for the use of both dollar and euro hedging instruments to efficiently manage financial risks given the considerable depth in euro financial instruments. Pegging to the Export Price of Oil Pegging the domestic currency to the export price of the main export product (PEP) has sometimes been suggested for small open economies that are relatively specialized in the production and export of a particular mineral or agricultural commodity.9 The argument for PEP is that it simultaneously delivers automatic accommodation to terms-of-trade shocks, as floating exchange rates are supposed to do, while retaining the credibility-enhancing advantages of a nominal anchor, as dollar pegs are supposed to do (Frankel and Saiki, 2002). A peg to the price of oil would allow the real exchange rate to move in line with the real price of the main export commodity. Essentially, it would decouple oil exporters’ monetary policies from those of oil importers. But there are several important qualifications and drawbacks attached to this type of exchange rate policy. First, the GCC countries taken together account for a sizeable part of total world output and exports. Therefore, the small economy assumption is not applicable in the case of

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the GCC, as the price of oil cannot be regarded as exogenous. Indeed oil can be seen as a major international currency in itself, and pegging their national (fiat) currencies to their own (commodity) currency would not anchor the GCC countries’ currencies to something truly exogenous. Second, it is questionable whether an automatic adjustment to termsof-trade shocks would be effective under a PEP system. For example, an adverse terms-of-trade shock (a decline in oil prices) would, under the PEP, result in a real depreciation. However, with oil production in most GCC countries constrained by capacity and extraction limits, as well as by the OPEC quota system, all adjustment would have to come through expanding non-oil exports or cutting imports. However, in the GCC, nonoil exports depend on hydrocarbon production for inputs, and are therefore not independent from the level of oil and gas production. Third, pegging to the price of oil would make import prices highly variable, as well as create significant volatility for other sectors of the economy. For example, a consequence of high oil prices would be a real appreciation, which would raise the cost of other exports and dampen the diversification effort. In particular, the prices of non-pegged tradable goods would be destabilized in terms of domestic wages and non-traded goods, which could lead to adverse Dutch disease effects when oil prices rose. In the event of a decline in oil prices, it is unclear whether the oil peg would permit sufficient depreciation of the national currency to accommodate the adverse change in the terms of trade and stabilize export earnings. Further, it can be argued that a gradual adjustment in the real exchange rate may be preferable until the terms-of-trade shift appears permanent. In any event, with daily fixing of the exchange rate, PEP requires transparency and credibility that would take time to establish.

CONCLUSIONS In summary, the dollar peg seems to be the best option in the short run after the establishment of the monetary union and the single currency. The longstanding de facto peg of the GCC currencies to the US dollar has served the economies well so far. The dollar peg has provided a credible nominal anchor for monetary policy, ensuring external stability, and since most exports are denominated in dollars, it has assured external stability. It is easy to administer and has simplified trade and financial transactions and accounting. It has allowed for greater monetary coordination among the GCC member countries and established the parities at which the GCC member countries will go into the monetary union, much like the Exchange Rate Mechanism (ERM) did for European Monetary Union. High labor

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market flexibility in the private sector has also helped international competitiveness and quick adjustment to shocks under the pegged regime. During the run up to the monetary union, the main challenge would be to achieve the convergence criteria on inflation. Since rising inflation reflects mainly supply bottlenecks, the GCC countries should accelerate structural reforms to expand capacity and perhaps even rephase some of the large investment projects under implementation. The possibility of depreciation of the dollar against other major currencies can also make inflation management more difficult. The authorities need to be mindful that a commitment to the peg in the transition to the monetary union requires them to implement policies that are consistent with a pegged regime. Looking forward, the structural characteristics of the GCC economies will change and become more heterogeneous in the next couple of decades, as oil reserves will be depleted in some member countries, and the private non-oil sector will gain importance as the main source of new employment opportunities for the rapidly growing national labor force. GCC countries will be diversifying their economic structures, exports, and international assets. In these circumstances, a common monetary and exchange rate policy requires the setting of appropriate entry parities and compensating and/or incentive mechanisms (for example, a fiscal transfer system) to balance differences among the economies. The establishment of the monetary union would also require a harmonization of the financial market infrastructure – including regulatory and supervisory frameworks, clearing and settlement systems, standardization of financial contracts – as well as taxation and tariff agreements and labor policies. With increasing integration in international trade, services and asset markets, a higher degree of exchange rate flexibility may become more desirable in the prospective GCC monetary union to ensure external stability and international competitiveness. To conclude, there are good arguments in favor of retaining the current fixed exchange rate regime in the near future, but keeping open the option of introducing more exchange rate flexibility in the medium term. On balance, however, the dollar peg seems to be the best option, both leading up to and at least in the shortrun after the establishment of monetary union. A caveat to this position is that over the medium term, one does not expect to see a continuation of the depreciation of the dollar, or a diverging economic cycle relative to the United States. What is sure is that in a changing environment, a forward-looking monitoring framework will be essential for the monetary union. The decision for one or the other exchange rate regime depends ultimately on the policy objectives and common preferences of the authorities involved. It is important to also

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note that the choice of an exchange rate arrangement under the monetary union is not a permanent one. The GCC single currency could initially be pegged to the US dollar, but the exchange rate regime could be changed, say to a dollar-euro basket peg or even managed floating, in the future depending on how the economic and financial structures of the GCC economies evolve.

NOTES 1. An earlier version of this paper was presented at the Dubai Council of Economic Affairs seminar, ‘The GCC monetary union: institutional framework and policy options’, Dubai, United Arab Emirates, 21–22 November 2007, when the author was director of the Middle East and Central Asia department of the International Monetary Fund. He is grateful for comments by participants of the seminar and for the helpful inputs and suggestions of Ananthakrishnan Prasad, Klaus Enders, Maher Hasan, Gene Leon, Amor Tahari and Oral Williams. The views expressed in the paper are the sole responsibility of the author. 2. The GCC includes Bahrain, Kuwait, Oman, Qatar, Saudi Arabia and the United Arab Emirates (UAE). A useful description of the GCC is contained in a recent study by the European Central Bank; see Sturm et al. (2008). 3. In 2008, total GDP of the GCC was over $1 trillion, and the average per capita income was about $25 000. 4. Edmund O’Sullivan (2008) has a very interesting and detailed account of the history of the Gulf States. 5. During 1980–2002 Bahrain, Qatar, Saudi Arabia and the UAE were formally pegged to the IMF’s special drawing rights (SDR) basket but were effectively pegged to the US dollar. Oman was formally pegged to the US dollar and Kuwait to an undisclosed basket of currencies. 6. This concept is comprehensively discussed in IMF (2007). 7. Fiscal policy becomes the main instrument used to promote domestic and external stability under the pegged regime. 8. For a discussion of pegging to a dollar-euro basket, see Khan (2009). 9. A variant of this approach is pegging to a basket of commodities and currencies.

REFERENCES Abed, G., S. Nuri Erbas and B. Guerami (2003),‘The GCC monetary union: some considerations for the exchange rate regime’, IMF Working Paper No. 03/66, Washington DC: International Monetary Fund. Berengaut, J. and K. Elborgh-Woytek (2006),‘Beauty queens and wallflowers – currency maps in the Middle East and Central Asia’, IMF Working Paper No. 06/226, Washington DC: International Monetary Fund. Buiter, W.M. (2008), ‘Economic, political, and institutional prerequisites for monetary union among the members of the Gulf Cooperation Council’, CEPR Discussion Paper No. 6639, London: Centre for Economic Policy Research. Cashin, P. and J. McDermott (2001),‘The long-run behavior of commodity prices: small trends and big variability’, IMF Working Paper No. 01/68. Washington DC: International Monetary Fund.

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Frankel, J. and A. Rose (1998), ‘The endogeneity of the optimum currency area criterion’, Economic Journal, 108(449), 1009–25. Frankel, J. and A. Rose (2000), ‘An estimate of the effects of currency unions on trade and growth’, NBER Working Paper No. 7857. Frankel, J. and A. Saiki (2002), ‘A proposal to anchor monetary policy by the price of the export commodity’, Journal of Economic Integration, 17(3), 417–48. Husain, A. (2006), ‘To peg or not to peg: a template for assessing the nobler’, IMF Working Paper No. 06/54, Washington DC: International Monetary Fund. International Monetary Fund (IMF) (2007), Review of the 1997 Decision – Proposal for a New Decision, Washington DC: International Monetary Fund. Khan, M. (2009), ‘Middle East and oil exporters’, in Jean Pisani-Ferry and Adam S. Posen (eds), Euro at Ten: The Next Global Currency?, Washington and Brussels: Peterson Institute for International Economics and Bruegel. O’Sullivan, E. (2008), The New Gulf: How Modern Arabia is Changing the World for Good, United Arab Emirates: Motivate Publishing. Rose, A. (2000), ‘One money, one market? The effect of common currencies on international trade’, Economic Policy, 15(30), 7–45. Setser, B. (2007), ‘The case for exchange rate flexibility in oil-exporting economies’, Policy Brief No. 07-8, Washington DC: Peterson Institute for International Economics. Sturm, M., J. Strasky, P. Adolf and D. Peschel (2008), ‘The Gulf Cooperation Council countries: economic structures, recent developments, and role in the global economy’, European Central Bank Occasional Paper No. 92, Frankfurt: European Central Bank.

6.

International experiences in operating exchange rate regimes: drawing lessons from the United Arab Emirates Ronald MacDonald

INTRODUCTION In addressing the appropriate exchange rate regime for the United Arab Emirates (UAE) it is clearly important to recognize the unique nature of this federation of Emirates, particularly in terms of its external trade. Abu Dhabi accounts for approximately 95 per cent of the UAE’s oil and natural gas resources, while Dubai is a leading example of economic diversification away from the hydrocarbon sector as it has become an important and leading business hub in the world economy. The remaining Emirates – Sharjah, Ajman, Ras al-Khaimah, Umm al-Qaiwain and Fujairah – rely on a mix of trade and light manufacturing, and they depend on financial support from the federal government and Abu Dhabi and Dubai governments. Since the Emirates of Abu Dhabi and Dubai account for about 85 per cent of the country’s total GDP it is immediately clear that the exchange rate policy has to be predominantly focused on their needs. Yet this immediately raises a potential dilemma, since an exchange rate regime that is best suited to the hydrocarbon sector is unlikely to be well suited to the diversification attempts of the rest of the economy, or equally an exchange rate regime designed for the non-hydrocarbon sector is unlikely to be suitable for the hydrocarbon sector. The current exchange rate regime in the UAE consists of pegging the dirham to the US dollar, and as noted in the most recent IMF Article IV consultation (2007) this has served the country well and the UAE authorities have reiterated their commitment to the US dollar peg in the period leading up to the proposed GCC monetary union in 2010. The purpose of this chapter is to look at the dollar commitment in more detail in order to determine if this is indeed the most appropriate exchange rate/monetary

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regime choice for the UAE, given the experience of other countries with fixed exchange rates and other forms of exchange rate regime. A key aspect of fixing a currency to the US dollar involves the unique status of the dollar and this, combined with its floating exchange rate regime, can have important implications for countries that peg their currencies to the dollar, especially when US domestic (monetary policy) issues are paramount for the US authorities. This can be exacerbated if the country in question is a hydrocarbon producer facing volatility in hydrocarbon prices. This was amply illustrated in the late 1990s when the strong dollar contributed to the difficulties of many oil producing countries facing the combination of relatively modest oil prices coupled with deflationary pressures and high real interest rates as a result of the dollar peg. It has again been illustrated more recently when oil exporting countries faced the opposite scenario, of high oil prices and a free fall in the dollar as a result of the subprime crises. More generally, the deflation of the asset price bubble/boom in the US has produced a dramatic easing of monetary policy to stave off recessionary tendencies and this is likely to be ongoing for some time. For an oil exporting country pegging to the US dollar, the recent high volatility in the price of oil, combined with US monetary policy has had serious implications for the country’s domestic monetary policy and inflation. In the Emirates we note rapid growth in both the money supply and private sector credit in 2006, albeit at a somewhat slower pace than in 2005. Inflation rates are correspondingly high in the Gulf region with the GCC average of 4 per cent, and with individual countries running at much higher levels, such as in the UAE, which in the presence of low nominal interest rates, due to the fixity of the currency to the dollar combined with a high degree of capital mobility, creates very low negative real rates of interest indeed. Although there is some debate regarding the sources of inflation in the Gulf States (for example, cost push, coming from the housing sector, versus demand pull due to the monetary consequences of the peg) there can be little doubt that the kind of monetary regime in operation in the UAE and other Gulf States will only serve to underpin and facilitate any cost push pressures. Equally, as noted, the current regime will tend to easily transmit recessionary/deflationary impulses. In the most recent IMF Article IV report available at the time of writing (the 2007 report), the UAE authorities agreed that inflation was a major source of concern and if allowed to persist at the current rate, inflation could become entrenched, with the attendant risk of undermining competitiveness and long-term growth. Although the recent recovery of the US dollar has perhaps eased the pressure on the UAE and other countries in the Gulf, this respite is likely to be shortlived and indeed now – from

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a position of strength – would seem to be an ideal time to analyse and rethink the exchange rate regime. More specifically, what are the economic policy implications for the UAE of recent US macroeconomic policy and of its fixed peg? While the US is cutting interest rates for its domestic needs, the appropriate monetary action required in the UAE is at the time of writing a tightening of monetary policy, but this can clearly only occur if there is a shift away from the current dollar peg. With the peg to the US dollar combined with perfect capital mobility, the nominal interest rate in the UAE has tracked the US rate closely and this, along with the high inflation in the UAE, has resulted in the real rate of interest becoming increasingly negative, which generates a further stimulus to aggregate demand and helps to perpetuate a vicious inflationary circle. In other words the UAE faces the well-known trilemma of a fixed exchange rate, a high degree of capital mobility and a lack of an independent monetary policy. In a nutshell, the dilemma currently facing the UAE is that although the US dollar peg has served the country well by reducing trade and financial transaction costs, encouraging investment activities and providing a familiar and credible nominal anchor for the currency, its inability to tackle inflation, which must inevitably undermine the credibility of the peg, has put an increasing strain on the competitiveness of the non-oiltrading sector and the peg itself. The latter would seem to be a particularly important issue for the UAE given the explicit policy of diversification away from total reliance on trade in oil and gas, and shifts in the distribution of international financial assets may lessen the need for a continuing focus on the US dollar. The UAE, and indeed other dollar peggers, is currently at something of a crossroads with respect to its monetary regime and monetary policy. Should the UAE stick with its current regime, and continue to suffer the domestic inflationary pressures as the credit crunch continues to unravel in the US, or should it move to a different monetary regime? The current record high price of oil, and the volatility of oil prices, underscores the need for reform for a country that is predominantly a commodity producer. At its heart such reform should entail being part of a monetary regime in which when the price of oil rises, an appreciation of the real exchange rate is easily facilitated, and, conversely, when the price of oil falls the real exchange rate should depreciate. In this chapter we intend examining the appropriateness of the current monetary and exchange rate regime for the UAE. The following is the proposed outline. In the next section we examine the case of the choice between fixed and flexible exchange rates with a special reference to the position of the UAE. Next we look at alternative exchange rate regimes to the corner solutions of fixed and floating exchange rates and in the

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fourth section we look at what the so-called optimum currency literature has to say about the appropriate exchange rate regime for the UAE. Next we provide a general discussion of the empirical evidence on fixed versus floating exchange rate regimes. We then go on in to consider a comprehensive overview of the various alternative exchange rate regimes. A final section concludes.

FIXED VERSUS FLEXIBLE EXCHANGE RATES In this section we overview the respective cases for fixed and flexible exchange rates, with a special emphasis on the needs of the UAE. As we have noted, although the UAE hydrocarbon production is an important and key element of trade, the UAE is not like some other oil producers, who are essentially single commodity exporters, because it has an important traded sector particularly in financial services and tourism and an appropriate exchange rate policy must recognize this. The Advantages of a Fixed Exchange Rate There is a long tradition in the economics literature that recognizes that macroeconomic performance should be enhanced by having a fixed exchange rate. Perhaps the main perceived advantage of a fixed exchange rate, and the one that is emphasized most in the recent exchange rate literature, is that it prevents a country that would otherwise have a profligate monetary policy pursuing an independent monetary policy. In other words, it allows the country to buy into the monetary credibility of the country it is pegging to. Indeed, if a central bank puts a premium on fighting inflation it may find it advantageous to peg its exchange rate to a hard currency with a strong anti-inflationary reputation (for example, the Deutschemark was seen in this light for much of the post-Bretton Woods period) and so ‘import’ the credibility and low inflation environment. The idea being that in the presence of a credible peg, workers and managers will set wages and prices on the basis of an expected low inflation environment in the future (because the currency peg prevents the central bank from expanding the money supply, especially if it is an irrevocable peg), thereby allowing the country to attain a lower inflation rate for any given level of output (Giavazzi and Giovannini, 1989; Dornbusch, 2001). Edwards and Magendzo (2003) have argued that the harder the peg, the more effective it is in enhancing credibility). As the IMF makes clear in its recent Article IV document for the UAE, the issues of a credible peg, along with the familiarity argument, have been

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seen as one of the key arguments for sticking with a dollar peg in the UAE. However, pegging the exchange rate to a currency that is inappropriate, and one that pursues monetary policies that do not meet domestic needs, is clearly a recipe for potential disaster for the home country’s monetary and exchange rate policy. Also, and as we have said, such a peg is of limited usefulness when the home country needs to pursue a monetary policy that is at variance with that pursued in the US. A second supposed advantage of fixed rates is that when exchange rates are flexible they are highly volatile and such volatility can impart uncertainty into trade and investment decisions, thereby having a negative influence on a country’s international trade and investment. Removing this source of uncertainty should therefore encourage international trade and investment. However, an alternative response to this argument is to say that trade and investment should be unaffected by exchange rate volatility since agents can hedge the exchange rate volatility in the foreign exchange market. Forward markets, though, are notoriously incomplete – being non-existent for some developing countries and only existing at very limited maturities for all countries. Initially, empirical studies failed to reveal a link between exchange rate volatility on trade and investment, but more recent estimates do in fact show an important link (see, for example, MacDonald, 2007). Given that diversification is an important element in the UAE it would clearly not be in the interests of the federation to move to a purely flexible rate Related to the trade and investment effects of exchange rate volatility, is the issue of exchange rate misalignment and its effects on international trade and investment. Misalignment occurs because exchange rates when they are flexible can often spend long periods away from their fundamentals-based equilibrium due to purely speculative influences. For example, the long swings in the dollar in the 1980s – its appreciation down to 1985 and the subsequent depreciation – are generally regarded as being driven by speculative factors. By fixing an exchange rate, such misalignments are removed and the deleterious effects on trade and investment are also removed, assuming a country locks its exchange rate at the correct rate in the first place. However, even if a peg is locked in at the correct rate to start with, relative (unfavourable) price movements away from the starting point can generate misalignment over time (although the most recent IMF Article IV agreement suggests that this is not an issue for the Emirates). The above two points have a particular resonance for hydrocarbon exporters such as the UAE and they can be bundled into the ‘Dutch disease case’ for pegging to the dollar. For a commodity exporter considering floating its currency, it is not just the flexible exchange rate that is

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potentially volatile – the price of its commodity is also likely to be volatile. For an oil producer, the price of oil is volatile and its currency would generally be expected to appreciate when the price of oil is high, but this would imply an exchange rate misalignment for its non-oil sector that, given the attempts to diversify trade in the federation are trying to develop (particularly in Dubai), would not be desirable. By pegging to the dollar, the country, in principle, avoids the consequences of Dutch disease for its non-oil sector. But the Dutch disease phenomenon is really about an inappropriate fiscal policy – that is, it is the spending from oil that creates the Dutch disease phenomenon and so, if like Norway, you only spend the income stream from the oil fund you will only have a limited effect on the real exchange rate. Also, fixing to the dollar when the price of oil is low could also be equally damaging to the oil producer. For example, if the dollar appreciates this will appreciate the home currency against its other trading partners, further exacerbating the deflationary consequences of the low price of oil. A further perceived advantage of a fixed exchange rate is in preventing competitive, or beggar-thy-neighbour, devaluations. Looking back at the inter-war experience of exchange rate flexibility, this was one of the key motivating factors for the architects of the Bretton Woods system who saw a system of fixed exchange rates as a means of obtaining a cooperative solution to the competitive devaluation issue. As Frankel (2003) points out, a recent update of this kind of argument is seen in the currency crises and contagion that occurred in the 1990s, where devaluation in one country immediately spread to neighbouring countries because they felt at a competitive disadvantage, but ultimately they did not gain from this. Again this may be important for the UAE in the context of its relations with its near neighbour GCC countries. To sum up, how does the case for fixing an exchange rate impact on the recent and current UAE experience? Fixing of the exchange rate in the Emirates has been argued to have conferred on the country a credible and familiar nominal anchor and this has been seen as one of the key benefits of pegging to the US dollar (see, for example, the recent IMF [2007] Article IV report at www.imf.org). But the recent scenario facing the UAE, as described in the preceding section, is one in which they face the well-known trilemma of incompatibility of a fixed exchange rate, high capital mobility and an independent monetary policy. The latter is especially important given the inconsistency of US monetary policy with the needs of domestic monetary policy in the UAE. Finally, recent work by Chinn and Frankel (2008) suggests that the dominance of the dollar as a reserve and vehicle currency is probably over and it would therefore be wise for a country that has invested so much in

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pegging to the dollar to anticipate this and to be working towards a regime change now rather than waiting for this to happen, and for a relatively disorderly transition to be avoided rather than imposed. If the Emirates were to move to a more flexible exchange rate regime what would the advantages of such a move be (for illustrative purposes we take here the case of a pure float as is the tradition in this kind of discussion although recognizing that flexibility less than a pure float could deliver many of the advantages of a pure float)? The Advantages of a Flexible Exchange Rate The original, traditional, case for flexible exchange rates was made by Milton Friedman in his classic 1953 essay ‘The case for flexible exchange rates’ and there are a number of strands to this case. The existence of a flexible exchange rate breaks the well-known trilemma, referred to above, and allows a country to have an independent monetary policy even if capital is perfectly mobile. This could have clear advantages for the UAE in any bid to control inflation. Specifically, having some exchange rate flexibility allows a domestic monetary/interest rate mix to reign in money supply growth and also to address the inflationary implications of adverse movements in the dollar (as we have seen in the recent past against the euro and yen), thereby restoring credibility. To address the former issue the Emirates could simply have a float or crawling peg against the dollar, but to address the latter issue the currency would probably need to float against a basket of currencies. Second, a fixed rate system fails to provide a country with an effective adjustment mechanism for its balance of payments, whereas a flexible rate offers an automatic adjustment mechanism; that is, fluctuations in a country’s terms of trade, particularly adverse movements, are automatically reflected in a country’s currency movement. This argument is seen as of special importance for a net hydrocarbon exporter since it means that as the price of oil rises, the currency will appreciate and as the price of oil falls the currency can depreciate. In other words, as the terms of trade changes the currency moves in the appropriate direction. This stabilizing role of a floating rate system is often taken to be the key element in favour of a flexible exchange rate (see Machlup, 1972), although of course such movements may not be entirely satisfactory for a country, such as the UAE, which is trying to diversify away from exclusive reliance on hydrocarbon production. The third supposed advantage of a flexible exchange rate is in terms of its insulating properties with respect to real shocks that show up in the form of trade shocks. For example, a fall in demand in the rest of the

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world for the home country’s exports would automatically be countered by an exchange rate depreciation and a fall in the terms of trade that produces an offsetting stimulus to demand. A fourth advantage of a flexible rate system is that it allows a central bank to maintain two potentially important advantages of an independent central bank, namely it can take advantage of any seigniorage and act as a lender-of-last-resort. The latter may be important in banking crises where the ability of the central bank to create unlimited funds is likely to be important in baling out banks. But banking crises are not an issue for the UAE and, given the extremely healthy reserve holdings of the country, the seigniorage aspect is also unlikely to be important either. A fifth advantage of a floating rate system is in terms of its ability to let a country, and more generally the world economy, function without recourse to trade barriers and tariffs, the idea being that if the exchange rate is free to equilibrate a country’s balance of payments the need for protectionist devices – such as tariffs and quotas – is likely to be limited. A sixth argument in favour of flexible exchange rates is in terms of the need to hold foreign exchange reserves. In principle with a floating exchange rate, the change in official reserves is zero. Since reserves earn a zero or low return compared with a longer-term investment there would be some, perhaps small, savings for the national economy (a central bank would still hold reserves in a free float to pay for official commercial transactions). But again this is unlikely to be a key concern or advantage for the Emirates in moving to a flexible exchange rate. To sum up the discussion here, the main advantage for a country that is an important commodity producer, such as the UAE, of having a flexible exchange rate is that it would allow the key element of providing a rapid exchange rate appreciation (both real and nominal) when the price of the commodity (oil) rises and an appropriate depreciation when the price of the commodity falls. Although a fixed rate system can provide the real aspects of such appreciation, as we shall see below, the process is likely to be long drawn out and indeed this can create its own problems and tensions. Some flexibility would also be good for misalignment reasons, and to stave off potential future misalignments, and to help in tackling the inflationary process by breaking the link between the US and foreign interest rate. The down side, of course, in moving to a more flexible exchange rate regime is that the stable nominal anchor component of the dollar peg is lost. This is something we consider again in more detail below when we consider the various monetary and exchange rate regime options available. Additionally, care would have to be taken in recognizing the needs of the non-oil sector in designing the appropriate exchange rate regime and this is something we return to later in the chapter.

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Table 6.1

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Exchange rate regime classifications

Floating Corner

Intermediate Regimes

Rigidly Fixed Corner

Pure float Managed or dirty float

Band Crawling peg Basket peg Adjustable peg

Currency board Dollar- and euro-ization Commodity standard Monetary union

VARIANT EXCHANGE RATE REGIMES In our discussions above we have followed the standard polarization of the fixed versus floating exchange rate debate and attempted to apply it to the case of the Emirates. In this section we note that the distinction between fixed and floating exchange rates, in reality, is not as stark as this polarization suggests, as there are a number of shades of grey between the polar cases – or corner solutions – and one of these shades or variants may be better suited to the needs of the UAE. The IMF has usefully fleshed out the rich variety of intermediate cases between the so-called corner positions of a pure float and a rigidly fixed exchange rate. In the context of our discussions of the appropriate regime for the UAE, it is worth listing what these are and we do this in Table 6.1, where we have eight intermediate cases between the two extreme corners of a pure float and participation in a monetary union, each of which can have numerous further variants. In the first cell we have the most flexible exchange rate regime and in the bottom right cell we have the least flexible and most rigid regime, in the form of a monetary union. These are the two extreme corner cases. In between the corner cases there are a range of options distinguished by the degree of exchange rate flexibility. A managed float can be very close to a pure float, if the monetary authorities only intervene occasionally and in small amounts, or it can approximate something closer to an intermediate regime if the authorities intervene on a more or less continuous basis to, say, satisfy an inflation target (such as has been the case in Singapore). Banded regimes are designed to capture the target zone arrangements of Bergsten-Williamson (in which the band is defined around the fundamental equilibrium exchange rate, or FEER) and Krugman (in which the band is defined around a fixed central parity). A crawling peg system is one in which the peg changes, usually to accommodate inflation – an indexed crawl – or is a pre-announced crawl to maintain competitiveness. A basket peg is where a currency is fixed relative to a basket of its trading partner currencies and an adjustable peg is one in which the currency has a fixed

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central rate but it can be changed to, say, accommodate disequilibria such as those occurring in the balance of payments (such as occurred in the Bretton Woods system). In the rigidly fixed corner we have the currency board solution that usually involves a country pegging to another currency (the dollar) and allowing the home currency to be transferred into the foreign at the going rate.1 A commodity standard is where a country fixes its exchange rate to a commodity, which is traditionally taken to be gold (that is, from the various gold standard experiences) and, finally, we have the monetary union case that is usually regarded as an irrevocable system of fixed exchange rates, although it may not be in the absence of full political union. For the UAE we immediately rule out the options of a pure float, a monetary union (although this is, we understand, a longer-term objective), a currency board and dollar/euro-ization, and argue that the regimes that are likely to be of most interest are the dirty float, the crawling peg, adjustable peg, basket peg or a commodity standard. These regimes are considered, along with other forms of monetary regime, in the Empirical Evidence section below.

THE DETERMINANTS OF EXCHANGE RATE REGIMES: THE OPTIMUM CURRENCY AREA CRITERIA What are the factors that make a country’s policy-makers choose a particular exchange rate regime? From a theoretical perspective perhaps the best-known guide to this issue is the so-called optimal currency area (OCA) literature. The OCA literature considers the following kind of issue. Consider two countries – the US (an oil importing country) and the UAE (an oil exporting country) – with each country having an independent monetary policy (that is, they have independent central banks, interest rates and exchange rates). The countries are considering relinquishing this monetary independence and forming a monetary union. Should they? Clearly, the UAE is not at this stage contemplating joining a monetary union with the US. However, by having a hard peg with the dollar, the Emirates, as we have said, has essentially relinquished its monetary control and the lessons for a hard peg versus a fixed peg are similar. But does the OCA literature suggest that a peg is the correct choice for the UAE? The OCA literature initially focused on criteria such as the degree of capital and labour mobility between the two countries (Mundell, 1961), their degree of diversification in trade (Kenen, 1969) or the degree of openness to trade of a country (McKinnon, 1963). Recently, the focus in this

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literature has turned from the single criterion approach to an analysis of the shocks affecting economies or regions, since ‘shock absorption’ is seen to combine the net influence of several of the traditional criteria. There are a number of different aspects to this approach, for example: are shocks symmetric or asymmetric? Are the shocks temporary or permanent? What are the origins of the shocks – are they supply side or demand side shocks? The policy response in an oil exporting country is likely to be different depending on the source of the oil shock – supply (exogenous changes in production) or demand (changes in consumption). For example, in the case of a supply side shock the oil exporting country would probably want to have a tight monetary policy to control inflation, while the oil importing country would want a more expansionary monetary policy to maintain demand for its other goods and services. If supply side shocks predominate this in itself would provide a convincing case for a move away from a dollar peg to more exchange rate flexibility. In contrast, if the high price of oil represents a demand shock (that is, an increased demand from China and India) then the policy response in both the importing and exporting currency should be the same, namely tighter monetary policy. So if demand shocks predominate, this would seem to favour pegging the currency of the oil exporter to take advantage of the benefits of a fixed exchange rate. However, in practice, and as we have seen, the oil importing country (the US) currently has an internal financial crises that requires a loosening of monetary policy that is currently entirely inappropriate for the oil exporter (the UAE). Again, therefore, this would indicate more flexibility for the currency of the oil exporter. It is, of course, often difficult in practice to gauge how much of an oil price change is coming from the supply side or the demand side, just as it is often difficult to gauge how much of a price change is due to permanent forces and how much is temporary (temporary changes would not necessitate the kind of real exchange rate response we have advocated above and therefore would not have implications for the regime choice). Therefore the key issue or criterion in the OCA literature on deciding whether to fix or to float boils down to whether the shocks hitting the two countries are symmetric or asymmetric. If the shocks are asymmetric, that is they have a differential effect on the two countries, then there may well be an advantage to each of the countries having flexible exchange rates and independent monetary policy, since with such policies the exchange rate would act as a shock absorber altering the real exchange rate and competitiveness. More specifically, the United States is a net oil importing country whereas the UAE is a net exporting country. A permanent or relatively permanent change in the price of oil, whatever its source – demand or supply side – requires an appropriate macroeconomic and exchange rate response.

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For example, a permanent increase in the price of oil requires reduced levels of consumption and investment in the oil importing country and a real depreciation of its currency, whereas the opposite should be happening in the oil exporting country: higher levels of consumption and investment and a real exchange rate appreciation. So the basic insight of Mundell’s (1961) seminal paper is that two countries with asymmetrical shocks such as the US and the Emirates should not have a fixed exchange rate, but should have some flexibility in their exchange rate behaviour. With a fixed exchange rate the countries in question have to wait on the appropriate inflationary mix to bring this about and this can be long drawn out and, indeed, by the time an appropriate adjustment has taken place it may be time for the opposite policy response. Having exchange rate flexibility clearly makes this process much easier.

EMPIRICAL EVIDENCE ON FIXED VERSUS FLOATING EXCHANGE RATES In this section we briefly consider the general question: which regime works best in practice – fixed or floating? There is a large literature that seeks to empirically assess the benefits of, and effects on, macroeconomic performance of different types of exchange rate regimes, particularly fixed versus flexible exchange rate regimes (see, for example, Levy-Yeyati and Sturzenegger, 2002; Ghosh et al., 2003). Rogoff et al. (2004), using the de facto exchange rate classification of Reinhart and Rogoff (2002), provide a nice overview of the performance of different exchange rate regimes.2 Their key findings may be summarized as follows. First, mature economies with mature institutional frameworks have the best hope of enjoying the advantages of flexible exchange rates without suffering a loss of credibility. Specifically, their review of the extant studies shows that free floats have registered faster growth combined with relatively low inflation for such countries. This is not so, however, for emerging markets and non-emerging market developing countries, the other country category groups considered by Rogoff et al. (2004). Since non-emerging market developing countries are not well integrated into international capital markets, they are probably best able to buy credibility with a fixed exchange rate and, indeed, it would seem that such countries have enjoyed relatively fast growth and low inflation when they have pegged their currencies. However, fixity is not seen as an option for emerging markets and, indeed, the evidence shows that such regimes have had a higher degree of crisis with fixed rate regimes, as noted above. This is because emerging markets have strong links with international capital

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markets, which are similar in nature to mature economies, but this is combined with institutional weaknesses (which show up in higher inflation, fragile banking systems and debt sustainability), which make their policy-makers less than fully credible and so some form of float, such as a crawling peg is their best option while they learn how to float freely. The analysis of Rogoff et al. (2004) also shows that macroeconomic performance under all forms of de facto regimes was weaker in countries with dual or multiple exchange rates that deviated from official rates, suggesting that important gains may be had from exchange rate unification. Razin and Rubinstein (2005) argue that in trying to detect the effect of an exchange rate regime on macroeconomic performance, specifically output growth, it is important to include a term that captures the probability of a crisis. They show using a panel data set of 100 low- and middle-income countries that the nature of the exchange rate regime, and also the degree of capital liberalization, has a negligible effect on a country’s economic growth, but that the probability of a crisis term has a significantly negative impact on economic growth and that the probability of a crisis increases with the switch to a fixed exchange rate. Edwards and Yeyati (2003) empirically examine two of the arguments in favour of flexible exchange rates, namely their role as absorbers of real shocks and the link between this role and the presence of downward rigid prices. Using a de facto classification, rather than the IMF de jure classification, they find that flexible exchange rate arrangements do help to reduce the impact of terms of trade shocks on GDP growth, in both emerging and industrial countries and found that real output growth is more sensitive to negative than to positive shocks. Reinhart and Rogoff (2002) note that the most popular exchange rate regime over recent history has been a pegged rate (33 per cent of observations for the sample 1970 to 2001) closely followed by a crawling peg, or a variant thereof, which accounts for over 26 per cent of observations. Reinhart and Rogoff (2002) also forcefully argue that it is important to introduce the exchange rate category ‘freely falling’, which is a floating rate regime in which inflation is over 40 per cent per annum. This type of regime is much more common than the traditional textbook discussion makes out. This classification makes up 22 and 37 per cent of observations in Africa and the Western Hemisphere, respectively, during 1970–2001 and in the 1990s freely falling accounted for 41 per cent of the observations for the transition economies. Hence they argue that given the distortions associated with inflation of 40 per cent and over, any fixed versus flexible rate comparison that does not separate out the freely falling episodes is ‘meaningless’.

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Using a monthly data set on official and market-determined exchange rates for the period 1946–98, Reinhart and Rogoff (2002) calculate the exchange rate chronologies of 153 countries and using these chronologies and descriptive statistics are able to group episodes into a much finer grid of regimes – 14 in all – than even the recent official IMF classifications and that given in Table 6.1 above. Nearly all empirical studies pertaining to exchange rate regimes use the official or ‘standard’ classification of an exchange rate regime published by the IMF in its Annual Report on Exchange Rate Arrangement and Exchange Restrictions. Until 1997, the IMF asked member states to make a self-declaration of their exchange rate relationship as belonging to four categories, namely, fixed, limited flexibility, managed floating and independently floating.3 However, as Calvo and Reinhart (2002), Levi-Yeyati and Sturzenegger (2002) and Reinhart and Rogoff (2002) point out, often when a regime was classified as either independently floating or a managed float, the reality was rather different, in the sense that the country had a de facto fixed peg or crawling peg. Furthermore, Reinhart and Rogoff (2002) point out that in the post-World War II period nearly every country has relied at some point in time on either capital controls or dual exchange rates and so the officially reported exchange rate is likely to be ‘profoundly misleading’. For example, they report that in 1950 45 per cent of countries in their sample of 150 countries had dual rates and many more countries had thriving parallel markets. Furthermore, amongst the more important currencies, the UK had multiple exchange rates into the 1970s, Italy in the 1980s and Belgium and Luxembourg until 1990. Indeed, on using market determined rates, instead of official rates, Reinhart and Rogoff (2002) find that de facto floating was not uncommon during the Bretton Woods period of pegged exchange rates – 45 per cent of countries that were supposedly on pegged regimes were in fact on some form of managed float and they go as far as to suggest that it is difficult to detect any change in exchange rate behaviour between the Bretton Woods and post-Bretton Woods regimes.

ALTERNATIVE EXCHANGE RATE REGIME OPTIONS In this section we expand on our previous discussions to consider a number of potential exchange rate regimes that the UAE could consider, including the current regime of pegging to the US dollar. Fixed exchange rate – fixing to the US dollar. The main advantages of this are, as we argued, the potential exchange rate stability and the

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credibility and familiarity it can confer on the Emirates. But for these advantages to be obtained the currency to which the dirham is pegged should itself be stable and not prone to volatility and there should be similarities in economic structure. But as we have noted, the dollar itself is currently flexible against other currencies and although the home currency is fixed to the dollar it will still import the volatility from third country trading partners. Furthermore, since the US is an oil importer and the UAE a net exporter of oil an important asymmetry is introduced between the two countries, and fluctuations in the value of the dollar will produce unnecessary volatility in the UAE’s inflation rate and particularly its international price competitiveness. The recent past, of course, is not unique in this regard as there have been a number of periods when the US dollar has exhibited long swings of depreciation and appreciation – mid-1980s, late 1990s – completely unconnected with the pegging country’s currency. The issue is of considerable concern when a country has a diversified export market (or is trying to diversify its economic structure) and it has a non-US traded sector, which is clearly the case for the UAE. A further key point here, and as we brought out in our discussions of the optimum currency area criteria, is that oil exporters and oil importers generally need different macroeconomic policies: a permanent shock to the price of oil requires a different adjustment in the oil exporting and oil importing country. For example, a permanent increase in the price of oil requires reduced levels of consumption and investment in the oil importing country and a real depreciation of its currency, whereas the opposite should be happening in the oil exporting country: higher levels of consumption and investment and a real exchange rate appreciation. The ball park figure for an oil exporter is that a 100 per cent increase in the price of oil should generate a currency appreciation of 50 per cent. Pegging to the dollar may work if economic conditions in the UAE are similar to the US, but if they are not, as they clearly have not been recently, then this results in inappropriate policy consequences in the oil exporting country. With a fixed exchange rate, clearly all of the inflation adjustment comes from changes in the price level. This process is slower than it should be and it can often still be working its way through the economic system after the oil price has stabilized or reversed, which is actually the current position. Furthermore, this process can create inflationary expectations that give the inflationary process its own momentum and will probably push up the real exchange rate even after oil prices have turned down, implying a misalignment in the form of a real overvaluation. The inflationary process can lead to dramatic swings in the real interest rate – in the inflationary

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boom real rates become zero or negative, further boosting the inflationary process. Equally, a fall in the price of oil needs a fall in domestic prices and this can produce a similar set of problems to the inflationary environment with the process being long drawn out, perhaps more so than the inflationary case, given the common consensus that there is an important asymmetry between rises and falls in prices. For the above reasons we do not regard continued pegging of the UAE dirham to the US dollar as a feasible option. Revaluation of the peg with the US dollar is an option and this would perhaps ease the short-term concerns about imported inflation. But there is no certainty when the US dollar is going to stabilize and therefore this is unlikely to be a one-off option, and it also opens up the possibility of a speculative attack – if the dirham is devaluated once and the same set of circumstances continue into the future then the process will have to be repeated again and the country does not enjoy the potential gains of fixity. Nor does revaluation of the dollar deal with the key issues of adjustment raised in the last topic and it further does not address the trilemma issue of having a fixed exchange rate, reserve changes and a non-independent monetary policy. We do not recommend a revaluation of the dirham as an appropriate alternative to the current regime. An alternative anchor/numeraire. Instead of sticking with the dollar fix, the UAE could peg to an alternative numeraire currency, such as the euro or yen. As we have noted, recent instability in the US economy has brought into question the dollar’s role as a reserve/vehicle currency and the euro has certainly taken on such roles that the dollar has traditionally held. However, the euro is still developing and has not yet quite reached the stage that the US dollar was at when it was the supreme reserve currency, which would have been at the time of the original peg. Also, the eurozone is a net oil importing region and so in pegging to the euro, the UAE would suffer from similar problems to pegging to the US dollar, noted above. Also, the euro is probably currently overvalued with respect to the dollar and therefore it is likely to depreciate in the future so it would be a bad policy to switch to the euro from the dollar and the euro then starts to undergo depreciation. An alternative numeraire would be the currency of another commodity exporter, since the forces that push up the price of oil generally also push up the price of commodities. For example, the Australian dollar is sometimes cited in this regard: the Australian dollar has moved more frequently with the price of oil than has the US dollar. But this correlation is unlikely to hold during a major oil price shock: Australia has a substantial current account deficit that makes its currency vulnerable to attack and is the opposite current account position of the oil exporters. The Canadian

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dollar may seem a better fit as a currency to peg to as it is a net energy exporter and has an external surplus. But Canada has a significant manufacturing sector and its economic cycle is closely correlated with the US economy. The Norwegian krone is another candidate as an alternative peg and it may seem suitable as it is an oil exporter, but its economy is closely integrated with the European economy and would therefore have to be ruled out. In sum, there is probably no single currency that would serve as an alternative to the US dollar. So what about the alternative of pegging to a range or basket of currencies? A basket peg may be a useful alternative to pegging against a single currency. For the UAE one key advantage of this would be in constructing a basket that better reflected its trade patterns; that is, with the euro area and Japan. In principle, by pegging to a basket of currencies a country should be able to gain the nominal anchor advantages of a straight fixed peg, discussed above. In practice, though, basket pegs seem to be less credible than a peg to a single currency and this could be due to the fact the basket itself is not traded and it is difficult for market participants to infer the true credibility of the currency. The difficulty here is that if neighbouring gulf countries continue to peg to the dollar this will put strains on the UAE pegging to its basket. The papers by Ogawa and Ito (2000) and Ito (1999), for the case of East Asian countries, show that a coordinated move to a basket peg by all countries in a region is better than the noncooperative solution in which all countries go it alone. However, the kind of frameworks proposed in these papers is for countries in a region that have close trade links – since the UAE’s trade links are essentially outside the region this would not seem to be such an issue here. Pegging to a basket also does not help an oil exporter to manage oil price volatility since the real price of oil has increased relative to a basket of currencies – euro, dollars, yuan and yen – and the currencies of oil exporting countries would face the same kind of pressure to appreciate in real terms against the basket. To avoid this, a crawling peg of the basket is a possibility where the peg is allowed to change, usually to accommodate inflation – an indexed crawl – or is a preannounced crawl to maintain competitiveness. For the UAE, the crawl could be linked to the price of oil to ensure the requisite adjustment takes place as the price of oil changes. An appropriate designed crawl could therefore allow the UAE to have a more appropriate monetary policy and, crucially, it would play the key role of providing appropriate real exchange rate changes in response to permanent changes in the price of oil. An appropriately designed crawling peg could therefore allow the Emirates to have a more appropriate monetary policy and, crucially, it would play the key role of providing appropriate real exchange rate

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changes in response to permanent changes in the price of oil. Since the peg would not be changing on a daily basis it would still provide the stability and credibility of the current US dollar peg, but of course without the very evident disadvantages of the current peg. Our proposal could be viewed as a more sophisticated variant of a managed float, which has in fact been the preferred option of many oil producers. For example, Canada and Norway have deliberately not joined monetary unions with their close trading partners because of their large oil exports. Brazil and South Africa also have substantially more flexibility of their currencies than is the norm in oil exporters and these regimes appear to have been successful (although admittedly they do intervene quite frequently in their foreign exchange markets). Inflation targeting is currently a very fashionable monetary rule for developed economies, and also for many commodity-based countries, and this usually manifests itself in a target for the CPI. The main problem with this rule, however, for a commodity exporting country is that adverse supply side or terms of trade shocks would normally require a currency depreciation to counteract the shock, but rigid inflation targeting normally requires a monetary tightening and a currency appreciation. The resulting effect in a country’s competitiveness can clearly have important implications for national output. Peg the export price (PEP). This can be seen as a variant of inflation targeting, only now the price pegged in terms of domestic currency (or that set as the value of domestic currency in terms of that commodity) is the export price (Frankel, 2003). PEP is seen as of most interest to countries that are heavily specialized in the production of a particular mineral or agricultural export commodity. The rule under this proposal is that oil producing countries would peg their currency to oil, gold producers to gold and coffee producers to coffee and so on. This could be implemented operationally in one of two ways. First, the government could hold reserves of oil and intervene whenever it is necessary to keep the price fixed in terms of the local currency. Or, alternatively, the central bank could on a day-to-day basis announce an exchange rate in terms of the dollar and during the day ensure that rate moves precisely in proportion to the day’s price of oil. However, this raises the key disadvantage of this approach, namely that pegging directly to the price of oil would result in volatility of the exchange rate as it swings in line with the volatile underlying asset (like a derivative). If the non-oil sector is important, as is the case for the UAE, the PEP policy could potentially destabilize the local currency price of other goods and services, which could be seen as a form of Dutch disease. Such countries may need a modified version PEP. Potential alternatives would

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be to define a band around the central parity, much as in a crawling peg, or to move to a basket which includes the price of oil. Pegging to a basket and the price of oil. An alternative to pegging to either a basket of currencies or simply to the price of oil is to define as the parity the basket that includes the export commodity as well as a weighted average of currencies of major trading partners – say, a quarter US dollar, a quarter yen, a quarter euro and a quarter oil. A key advantage of this variant of PEP, which we label PBO, is that it delivers one of the main advantages of a fixed exchange rate, namely the nominal anchor function through pegging to the basket of currencies, plus one of the main advantages of a floating rate regime, automatic adjustment in the face of fluctuations in the prices of the countries’ exports on world markets: under a PBO system when the dollar price of oil rises (falls) the currency appreciates (depreciates). Such accommodation of terms of trade shocks is exactly what is required and this is why this variant of the PEP is regarded as so attractive relative to conventional (CPI) targeting, which would not react to movements in the terms of trade. For instance, the terms of trade criterion suggests that a rise in the import price should be addressed by a local currency depreciation and although neither the PBO or CPI targeting regimes would deliver on that, the CPI inflation targeting regime would actually produce a tightening of monetary policy (because of the inflationary implications) and therefore an exchange rate appreciation. This kind of policy would be expected to exacerbate swings in the trade balance, and output. In operationally implementing such an approach, we would argue that it would be optimal for the price of oil to be smoothed using either some kind of mechanical filter or by calculating some fair value, or equilibrium, price of oil, in order to attenuate the volatility of the oil price. In so doing there would be a further issue of whether the smoothing rule was announced to the market or kept secret. Fixing the currency to the price of a unit of gold has historically been popular (see the two gold standards – the classical and inter-war standards) and has been popularized more recently by Robert Mundell and Richard Cooper and others. Many have argued that the so-called classical gold standard worked well and conferred on countries the credibility that seems to be so lacking in a fiat-based system (see Bordo and MacDonald, 2009). However, the key problem with this type of arrangement is that it crucially dependent on the world gold market and specifically the production of gold. For example, in the period 1873 to 1896, countries that had linked their money supplies and exchange rates to the price of gold had falling prices due to the absence of major discoveries of gold during this period. In contrast, the major gold rushes of the 19th century (California,

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1849, and Alaska and South Africa in the late 1890s) led to increases in liquidity with resulting inflationary pressures.

CONCLUDING COMMENTS In this chapter we have considered the literature on exchange rate regimes, and the experience of countries in using these regimes, and applied this to the case of the UAE. We have noted that for any country that relies predominantly on a single commodity for its trade revenue, that country should have the ability to rapidly adjust its real exchange rate to permanent price changes in the price of the commodity. Specifically, as the price of the commodity rises, the country’s real exchange rate should appreciate against the currency of a country that is an oil importer. The easiest way for this to happen is through flexibility in the nominal exchange rate. The adjustment properties of the nominal exchange rate are one of the key advantages, if not the key advantage, of a flexible exchange rate for a commodity producing country. Of course, and as we have noted, the Emirates trade is not exclusively in the export of hydrocarbons and any move to a more flexible exchange rate regime would need to recognize this. Indeed, and as we have argued, there are clear advantages of having some stability in the nominal exchange rate, particularly for the nonhydrocarbon sector, and some form of pegged exchange rate certainly offers this. Historically, the US dollar has offered a nominal anchor to the UAE and the familiarity for trade and investment that such a peg brings, and the benefits of this have been repeatedly emphasized in successive IMF Article IV agreements. However, and as we have argued in this chapter, the credibility of the US dollar peg has been greatly undermined by recent events and especially given the asymmetric nature of the US and UAE economies (this asymmetry shows up in two ways: the UAE is predominantly a hydrocarbon exporter while the US is predominantly a hydrocarbon importer; the monetary policy needs of the two countries are often very different). This asymmetry has to be recognized in the design of an appropriate exchange rate regime for the UAE and as we have argued in this chapter this would involve moving away from the current regime of pegging to the US dollar to one in which the dirham is pegged to an appropriate basket of currencies, thereby providing the non-hydrocarbon sector with the stability and credibility it needs to flourish while at the same time allowing the price of oil to influence the external value of the currency. We envisage the latter being achieved by either including the price of oil directly into the basket of currencies or by adjusting the basket, along the lines of a crawling peg, as the price of oil changes.

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NOTES 1. As Reinhart and Rogoff (2002) have argued, there are a number of different measures of dollarization. 2. Clearly the practical cost–benefit analysis of an exchange rate regime depends very much on getting the definition of the regime correct. Reinhart and Rogoff (2002) have argued that the official regime classification provided by the IMF often gets the de facto nature of the regime wrong. Using their own classification of exchange rate regimes, Reinhart and Rogoff show that the performance of a freely floating regime is dramatically different compared with the official IMF classification. For example, the IMF classification, over the period 1970–2001 produces an average annual inflation rate of 174 per cent and an average per capita growth rate of only 0.5 per cent for floating rate regimes, but with the Reinhart and Rogoff (2002) classification free floats deliver average annual inflation of less than 10 per cent, which is the lowest of any exchange rate arrangement, and an average per capita growth rate of 2.3 per cent. Reinhart and Rogoff argue that this seems to support Friedman’s advocacy of the superior properties of floating rate regimes. 3. In the post-1997 period the IMF has significantly revised and upgraded its official approach to classifying exchange rate arrangements.

REFERENCES Bordo, M.D. and R. MacDonald (2009), Credibility in Regimes of the International Monetary System, Cambridge: Cambridge University Press. Calvo, G.A. and C.M. Reinhart (2002), ‘Fear of floating’, The Quarterly Journal of Economics, 117(2), 379–408. Chinn, M.D. and J.A. Frankel (2008), ‘The euro may over the next 15 years surpass the dollar as leading international currency’, NBER Working Paper No 13909, National Bureau of Economic Research, Inc. Dornbusch, R. (2001), ‘Fewer monies, better monies’, NBER Working Paper No. 8324, National Bureau of Economic Research, Inc. Edwards, S. and I. Magendzo (2003), ‘A currency of one’s own? An empirical investigation on dollarization and independent currency unions’, NBER Working Paper No. 9514. Edwards, S. and E. Yeyati (2003), ‘Flexible exchange rates as shock absorbers’, NBER Working Paper No. 9867. Frankel, Jeffrey A. (2003), ‘Experience and lessons from exchange rate regime in emerging economies’, NBER Working Paper No. 0032, National Bureau of Economic Research, Inc. Ghosh, A.R., A.-M. Gulde and H.C. Wolfe (2003), Exchange Rate Regimes: Choices and Consequences, Cambridge, MA: MIT Press. Giavazzi, F. and Alberto Giovannini (1989), Limiting Exchange Rate Flexibility; The European Monetary System, Cambridge, MA: MIT Press. Ito, T. (1999), ‘Capital flows in Asia’, NBER Working Paper No. 7134, National Bureau of Economic Research, Inc. Kenen, P. (1969), ‘The theory of optimum currency areas: an eclectic view’, in R Mundell and A Swoboda (eds), Monetary Problems in the International Economy, Chicago: Chicago University Press. Levy-Yeyati, E. and F. Sturzenegger (2002), ‘Classifying exchange rate regimes: deeds vs. words’, mimeo.

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MacDonald, R. (2007), Exchange Rate Economics: Theories and Evidence, Routledge: New York. Machlup, F. (1972), ‘The case for floating exchange rates’, in G.N. Halm (ed.), Approaches to Greater Flexibility of Exchange Rates, Princeton: Princeton University Press. McKinnon, R.I. (1963), ‘Optimum currency areas’, American Economic Review, 53(4), 717–25. Mundell, R.A. (1961), ‘A theory of optimum currency areas’, American Economic Review, 51(4), 657–65. Ogawa, Eiji and T. Ito (2000), ‘On the desirability of a regional basket currency arrangement’, NBER Working Paper No. 8002, National Bureau of Economic Research, Inc. Razin, A. and Y. Rubinstein (2005), ‘Exchange rate and capital market regimes: resolution to confounding effects on macroeconomic performance’, mimeo. Reinhart, C.M. and K.S. Rogoff (2002), ‘The modern history of exchange rate arrangements: a reinterpretation’, NBER Working Paper No. 8963, National Bureau of Economic Research, Inc. Rogoff, K.S., A.M. Husain, A. Mody, R. Brooks and N. Oomes (2004), ‘Evolution and performance of exchange rate regimes’, IMF, Occasional Paper No. 229.

7.

Operational implications of changing to alternative exchange rate regimes Warren Coats1

INTRODUCTION In preparing to discuss the operational implications and requirements for alternative monetary policy regimes, I reviewed available information on how policy is currently conducted. Regrettably the main findings of the IMF assessment of the UAE’s observances of the Monetary Policy Transparency Code remain largely valid: ‘The main weaknesses relate to the lack of detail in (i) reporting on monetary operations, the CBUAE’s Balance Sheet, and macroeconomic developments, (ii) describing and explaining its monetary policy framework and instruments . . . . The CBUAE has no publication that explicitly outlines and explains its monetary policy framework and how it operates its policy instruments’ (IMF, 2003, pp. 46–7). While the CBUAE (Central Bank of the UAE) has now published a description of its monetary policy tools (‘Qualified Monetary Instruments’2), it has not published a guide to how it uses them for monetary policy. Policy has been firmly anchored to a fixed exchange rate for the US dollar for over a quarter of a century. The CBUAE will buy or sell dollars at the official exchange rate on demand (presumably with a small spread). As a result, the lack of a clear statement of its uses of its other instruments (minimum reserve requirements, FX swaps, Certificates of Deposit (CDs) auctions, advances and overdrafts) is not as important as it would be with a different policy regime. The primary consequence of its provision of extensive domestic liquidity management instruments and facilities for banks has been the pre-emption of the development of an active interbank market for liquidity. If the UAE (and the Gulf Cooperation Council) chooses a policy regime in which the exchange rate is market determined, this will change significantly.

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THE EXISTING SYSTEM Monetary policy in the UAE has been defined by a fixed exchange rate to the US dollar (officially set within a range for the SDR (special drawing rights) from November 1980 to February 2002 and pegged to the dollar since) and a completely open capital account. The CBUAE buys or sells dollars at the official price (presumably plus or minus a spread) on demand. Thus, as with the currency board that preceded the current regime, the money supply of the UAE is determined by market demand. An increase in market demand is fulfilled by sales of foreign currency to the CBUAE for dirham and vice versa. As the other members of the Gulf Cooperation Council (GCC) follow similar policies, the UAE dirham has maintained a fixed exchange rate with their currencies as well. As the result of oil exports and high oil prices, the UAE has enjoyed sizable balance of payments surpluses in recent years. The extent of the domestic expenditures of oil revenue through the federal budget, which is moderated and managed by investments of oil revenue abroad by the Abu Dhabi Investment Authority (ADIA), is a dominant factor effecting domestic liquidity conditions. Changes in domestic liquidity give rise to additional purchases or sales of dinar with the CBUAE by the public in order to maintain its desired money holding. The existing arrangements require minimal administrative capacity by the CBUAE. It responds passively to fill the market’s monetary needs by buying and selling foreign exchange as desired by the market. Nonetheless, the CBUAE has developed extensive instruments by which banks and others may manage short-term liquidity needs other than through the foreign exchange market. The CBUAE has imposed a minimum reserve requirement (14 percent on all demand deposits and 1 percent on time deposits) that must be met with dirham deposits with the CBUAE, and offers CDs with a wide range of maturities, dollar/dirham swaps, advances and overdraft facilities for banks. As a result, bank liquidity management is conducted almost totally through the CBUAE, which has undermined the development of interbank money and foreign exchange markets.

THE MONETARY POLICY REGIME OPTIONS The UAE and other members of the GCC are reviewing the policy regime options for the new common currency to be introduced in 2010. Understanding the operational implications of the choice is an important consideration. For this purpose, policy regimes may be divided broadly between fixed and not fixed (floating) exchange rate regimes. The

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operational requirements for the continuation of a fixed exchange rate regime are no different than those now in place. This is so whether the existing peg to the US dollar is continued or adjusted to a new level or the anchor currency is changed to the euro, the SDR or some other basket at the current implicit rate or at a new one.3 It would apply to crawling pegs as well. The CBUAE and regional central banks would continue to buy or sell the new currency in response to market demand. They would do so at the same or a new parity against the US dollar or whatever anchor currency or basket has been adopted. All other regimes will require some operational adjustments. The regimes examined here are those that target (as opposed to fix) a marketdetermined exchange rate, target a monetary aggregate or target inflation directly. These regimes all require the market determination of the exchange rate (even when the rate is influenced by the central bank in order to maintain an exchange rate target). The difference between fixing and targeting the exchange rate is that when targeting the exchange rate the desired rate is brought about through central bank interventions in the foreign exchange market. It also requires the central bank to continually review the appropriateness of the exchange rate target, which it is free to change from time to time.

EXITING FROM FIXED EXCHANGE RATES Preconditions Exiting from a fixed exchange rate to market-determined rates requires preparation.4 Allowing exchange rates to be determined in the market, whether the central bank targets them or something else, requires the existence of an interbank foreign exchange market. Historically, currency markets have been the most active and liquid financial market in almost every economy. They have taken many different forms from one or several organized trading sessions during the day (generally conducted by the stock exchange or the central bank) to continuous trading (over the counter (OTC)) by banks and other market participants as brokers and/ or dealers. Most currency markets around the world have evolved into OTC interbank markets. The most desirable and efficient currency market structure is itself a complex subject. In order to facilitate the development of an interbank market, the CBUAE needs to make bank adjustments of its foreign currency holdings through the central bank somewhat less attractive. The CBUAE should only deal (intervene) in the exchange rate anchor currency (currently the

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US dollar), and the bid/ask spreads for buying and selling the anchor currency should be widened modestly in order to make room for banks to find a better price in the market. It will take time for interbank trading of foreign currencies to develop and the central bank should consider chairing meetings with the market players to discuss the code of conduct and conventions by which they would deal with each other in this market. Even while the exchange rate remains officially fixed, a sufficiently wide bid/ask spread for buying or selling the anchor currency from or to the central bank will result in some limited exchange rate fluctuations in the market. Such variations in the rate introduce a two-way risk of exchange rate movements creating a financial incentive for banks (and other exchange rate dealers) to develop information and views on exchange rate movements and systems for managing the risks of such movements. This bid/ask spread can be further widened on the evolution toward floating rates (depending on the nominal anchor chosen). Prudential banking regulations limiting exposures to exchange rate gains and losses and requiring risk management systems should also be reviewed and may need to be strengthened. The development of satisfactory risk management by banks will take time. The gradual exposure of the economy to wider exchange rate volatility should strike a balance between confronting the market with the financial incentive to develop such capacity while protecting it from changes larger than it can absorb, before the training wheels can safely be removed. Both during and after the completion of the transition to floating, nearly all central banks stand ready to intervene in the foreign exchange market to soften large external shocks and/or prevent ‘excessive’ volatility. To help the market understand and deal with the new policy, and to help develop credibility for it, the CBUAE should clarify its intervention policy (to itself and to the market) and ensure that it is consistent with its new policy regime. Japan5 It is hard to think of many large, export-oriented, fast-growing economies in the early stages of catch-up that exited voluntarily from a peg. One analogy is Japan in the 1970s. After two decades of pegging at 360 yen to the dollar, Japan decoupled from the dollar on August 28th, 1971, repegging on December 18th at 308 yen in conjunction with the Smithsonian Agreement. The new peg lasted 14 months, after which greater flexibility was introduced.6

Maintaining Japan’s exchange rate had required regular and significant intervention by the Bank of Japan (BOJ) to buy dollars, resulting in large foreign exchange reserves accumulations. When it stopped intervening to

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the same extent, the yen appreciated steadily. The BOJ’s continued, but more modest, intervention kept the yen’s rate of appreciation modest and, according to Eichengreen and Hatase (2005) avoided negative impacts on Japan’s real economic growth that might otherwise have resulted in the absence of well-developed currency markets: Our analysis of Japanese currency experience in the 1970s suggests that a rapidly growing, export-oriented economy can operate a floating exchange rate in the presence of capital controls and despite the absence of deep and liquid foreign currency forward markets so long as the central bank manages that float. If the floating rate is appropriately managed, however, it should not be necessary to wait on the further development of forward markets before allowing the currency to exhibit significantly greater flexibility.7

ALTERNATIVE NOMINAL ANCHORS Exchange Rate Targeting Targeting rather than fixing the exchange rate requires the existence of a foreign exchange market in which the central bank can intervene. Central bank intervention in the foreign exchange market can take a number of forms depending on the structure of the market itself.8 The most widely used approach is for the central bank to enter the spot market as a buyer or seller whenever the exchange rate of the anchor currency deviates more than a modest amount from the central bank’s target rate. If the forces moving the exchange rate are thought to be temporary, the central bank can intervene with currency swaps, but then so can market speculators who have their own money at risk when judging whether exchange rate movements are temporary or not. This ‘indirect’ market-based control of the rate has much in common with market-based approaches to controlling interest rates or monetary aggregates discussed later. The bigger challenge for the central bank is to develop the capacity to determine the exchange rate target most appropriate for achieving policy objectives. The almost universal objective of minimizing volatility in the exchange rate should be relatively easily fulfilled by timely interventions to achieve or maintain the target exchange rate. From there, defining the goals for the exchange rate quickly becomes more complex. The primary goals are generally to maintain external competitiveness (leading exporters to favor ‘weak’ currency rates), control inflation (leading importers and consumers to favor ‘strong’ currency rates) and to achieve and maintain a viable balance of payments (balancing imports and exports). Any change in the exchange rate will please one group and upset another.

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Targeting the exchange rate in order to control inflation reflects the fact that while central banks might be able to control the nominal exchange rate, the market and fiscal policy ultimately determine the real exchange rate. If balance of payments factors require a real appreciation of the exchange rate, it will be achieved via domestic inflation of the local currency if the nominal exchange rate is not allowed to appreciate. The UAE seems to be experiencing this now. Because of the tendency for a dominant commodity export like oil to appreciate the exchange rate and make other exports uncompetitive (the Dutch disease), many oil exporting countries have introduced sovereign oil (commodity) funds (such as the ADIA) to shift some of the spending of oil revenues to future generations in order, in part, to moderate its impact on the exchange rate and thus to maintain more diversified exports. A major benefit of an adjustable exchange rate target is the capacity to absorb and moderate external shocks such as significant oil or food price changes via a change in the exchange rate target rather than domestic inflation or deflation. To determine an appropriate exchange rate target the central bank needs the capacity to monitor and forecast all those factors impacting on the country’s balance of payments. Developing this capacity requires a considerable investment in relevant data collection and its analysis. Once an interbank foreign exchange market has developed (though this is desirable, it is not essential) and the central bank has established the information collection, analysis and decision-making structures needed to set and implement an exchange rate target, it is ready for the transition. If the law fixes the exchange rate, the law will need to be amended to remove any obligation of the central bank to maintain a particular rate. If the change in regime does not include an initial adjustment in the exchange rate target, the manner of introducing the new regime would depend on whether the central bank normally supplied the market with foreign exchange or not. This assumes that the central bank regularly buys dollars from the government for dirham ‘off market’.9 In this case, rather than selling to the market at a fixed price, the central bank might begin to hold regular (daily, semi-weekly or weekly) auctions with no announced exchange rate. In actually cutting off bids, the central bank would choose the cut-off rate in light of its target but some modest variation in the rate would be desirable to signal the market that the rate is no longer fixed. Alternatively, especially if there is no interbank foreign exchange market, the central bank could announce its target exchange rate before each auction and satisfy market demand. If the exchange rate target is not adjusted regularly or sufficiently when needed by changes in balance of payments conditions, market pressure on reserves (or excessive reserve accumulation) can build. In these situations

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speculative attacks on the exchange rate are possible and the central bank should be prepared with a well-considered policy for dealing with such an attack. Monetary Aggregate Targeting If the determination of the exchange rate is left to the market, monetary policy needs an alternative anchor. One or another monetary aggregate is a candidate if the link between that aggregate and the price level (inflation) is reasonably stable or predictable. Controlling the behavior of the money supply, however defined, is not an objective in its own right, but rather is instrumental to the objective of a stable price level (the domestic value of the currency). Thus, a monetary target is referred to as an ‘intermediate target’ used to help achieve the ultimate target of price stability (low inflation). The first requirement of a monetary aggregate target regime is to define which aggregate to target. The options range from currency issued by the central bank, currency held outside of the central and commercial banks (the currency component of the money supply), narrow money (currency plus domestic currency demand or current accounts of the public with banks, usefully designated as M1), broad money (M2, which adds time and saving deposits in domestic currency), and a range of broader concepts that may or may not include central government deposits with banks, other deposits like bank liabilities and foreign currency deposits. Interbank deposits and cash items in the process of collection must be excluded to avoid double counting. Keeping in mind that the purpose of an intermediate monetary target is to promote price stability, the choice of the aggregate to target should be based on which aggregate has the most predictable impact on prices. Specifically, the best aggregate to target is the one with the most stable demand given the level of income. The extent of the central bank’s control over the aggregate (it controls directly only its own monetary liabilities) needs to be taken into account as well. In addition to choosing the aggregate to target, the central bank will need to determine on an ongoing basis the targeted behavior of that aggregate considered most appropriate for price stability. The behavior of monetary aggregates only affects prices with a lag (often long and variable) and the basic relationship with the price level (demand) can vary over time with developments in payment options and technology. Thus, the desired behavior of the target must be continuously reviewed. The central bank will also want to consider the state of the real economy in relation to business cycles as a subsidiary factor when setting its target over shorter periods of a year or two. The health and efficient functioning of banks

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and financial markets will also have to be taken into account as they may constrain the effectiveness of the transmission of monetary policy to prices as well as what policies can practically be adopted (without bankrupting banks). The central bank’s control over most monetary aggregates is indirect. The CBUAE can control the monetary base (M0) in the UAE by controlling the amount of its purchases or sales of foreign currency for dirham (but loses control of the exchange rate in the process), its sales and repurchases (or redemptions) of its CDs, and its advances to the government and to banks. However, the behavior of broader monetary aggregates such as M1 or M2 also depends on the public’s preferences for currency relative to bank deposits and the level of reserves (both required and excess) maintained by bank. These are summarized in the so-called money multiplier that links the monetary base to the broader aggregate. Thus, if the CBUAE were to target a monetary aggregate it would need to develop the capacity to choose the best aggregate to target, to choose and appropriately adjust the target value of that aggregate, and to use its influence on the behavior of that aggregate to hit the target. To cause the aggregate to hit the chosen target, the CBUAE would need to forecast the values of the factors determining the size and behavior of the money multiplier, and to forecast the autonomous factors influencing the monetary base so that it could appropriately set those components of base money that it controls.10 See Appendix 7.2 on ‘A Monetary Aggregate Targeting Framework’ for more details. On a day to day basis, central banks implementing a monetary aggregate target generally ‘operationally’ target aggregate bank excess reserves (vault cash plus current account balances with the central bank less required reserves) or a very short-term money market interest rate. The central bank estimates the level of excess reserves or the money market interest rate desired by banks at the target value of the monetary aggregate. These are the two price and quantity sides of the same market liquidity coin. The actual level of excess reserves or the interest rate relative to the desired levels indicates expansionary or contractionary pressure on the growth of monetary aggregates. If actual excess reserves are above (or interest rates are below) the estimated desired level, banks will tend to increase lending and thus increase monetary growth. The central bank will need to reduce banking sector liquidity (reduce the level of actual excess reserves or raise the interest rate) by selling securities or foreign exchange or tightening its lending. The data required by the central bank for these purposes is largely obtained from weekly or monthly balance sheet reports from banks and from the central bank’s own balance sheet. In addition, data on prices and

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real economic activity (GDP) are also needed (as is also the case when targeting – as opposed to fixing – an exchange rate). Once an interbank foreign exchange market has developed and the central bank has established the information collection, analysis and decisionmaking structures needed to set and implement a monetary aggregate target, it is ready for the transition. The new strategy should be thoroughly explained to the public. The monetary target should be announced along with the measures the central bank expects to take in a general way to achieve the target and the process for reviewing and adjusting the target. Unlike countries that were forced to abandon an exchange rate peg under crisis conditions, the UAE and GCC should have an orderly exit from the exchange rate peg. From the day the peg is abandoned and the central bank begins to control market liquidity via a money market interest rate target or/and excess reserves target, it should keep a close eye on the exchange rate. For some months more attention should be given to the exchange rate by intervening in the exchange market if needed to prevent the rate from moving too far too fast. The strategy should be to determine the central bank’s instrument settings (short-term interbank interest rate or excess reserves) judged to be appropriate for the monetary target, but to intervene to limit exchange rate movements if they are too large. Over time the exchange rate will move if necessary despite the day to day cap on movements. After a period of months of the market getting used to the new regime, larger daily exchange rate movements may be allowed if necessary to achieve the monetary target. Inflation Targeting Price stability is the ultimate objective of monetary policy with a marketdetermined nominal exchange rate. As noted above, a monetary aggregate target is really an intermediate target that is only chosen because the central bank has closer control over the monetary aggregate than inflation. The behavior of the monetary aggregate, in turn, should have a relatively predictable impact on inflation. Inflation targeting eliminates the intermediate target and focuses directly on the ultimate objective for inflation. ‘The key elements of the inflation targeting framework are the governance structure, the specification of the inflation target, and the arrangements for policy transparency and accountability’.11 The central bank must choose among inflation indexes (core inflation, headline CPI, and so on) and how it is represented (for example, year on year percentage change), whether the target is a point value or a range, what external events may lead to temporary departures from the target (for example, ‘escape’ clauses for things like oil price shocks), and the horizon over which the target is to be achieved (two to three years). The choice of the policy horizon reflects

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the fact that monetary policy measures taken today only effect inflation with a lag (usually from nine months to two years) and because longer horizons give more scope to moderate the temporary real income impacts of policy, but potentially at the expense of credibility. By its nature the target must be forward-looking but measurement and accountability can only be backward-looking. While inflation targeting central banks require much the same data as those targeting a monetary aggregate, a more central role is played by relatively simple policy models that forecast inflation and other key variables given alternative assumptions about the near-term (two to three years) behavior of key macroeconomic variables. Building such models generally takes several years of experimentation and a modeling team of six to ten economists with appropriate skills. Successful inflation targeting requires a very structured process of collecting and analyzing economic and financial data and discussing the stance of policy in light of model-assisted forecasts. Regular interaction between the policy-makers and the forecast team is critical. The same is really true for monetary targeting as well but tends to get stressed even more for inflation targeting.12 Inflation targeting’s success in stabilizing prices with minimal loss of real output is attributed to success in aligning public inflation expectations with the central bank’s inflation target. If wage and other pricing contracts are based on the expectation that the central bank will succeed over time with its inflation target, market behavior will support and contribute to the achievement of that target. This requires the central bank’s honest commitment to the target (over, say, two-year horizons) and good communication to the market about what the central bank is doing to achieve it. All inflation targeting central banks except Mexico use a short-term market interest rate as their operating target for implementing policy. There is a risk with the use of an interest rate operating target not present for a monetary aggregate target. If a central bank’s assessment of money demand is incorrect so that its target for money is also incorrect, achieving and sticking to the target will result in self-corrective market adjustments. The resulting price level will adjust (thus missing the implicit inflation target) and the resulting equilibrium will be sustainable and stable. This is not the case for errors in choosing the interest rate. If the targeted interest rate is actually too low for the inflation target, credit and economic expansion relative to potential output will result in higher than desired inflation. Rather than equilibrating the economy at the lower interest rate, the higher inflation reduces the real interest rate further, exacerbating the error and driving inflation still higher and real rates still lower. If not corrected by adjustments in the nominal interest rate target by the amount of the initial

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error plus any increase in the expected rate of inflation, inflation will accelerate and the system will explode rather than converge to a new equilibrium. Thus, inflation targeting central banks must be willing to adjust their target interest rate flexibly in light of revised inflation forecasts. The strategy for exiting from a fixed exchange rate into an inflation target is the same as the transition to a monetary target except that policy instruments are set in light of the inflation target rather than the intermediate monetary target.

NOTES 1.

2. 3.

4. 5. 6. 7. 8. 9. 10. 11. 12.

This paper has been commissioned by Economic Policy & Affairs Unit of the Dubai Council for Economic Affairs, Government of Dubai. The author, who retired from the International Monetary Fund in May 2003 after 26 years of service, is a Director of the Cayman Islands Monetary Authority. In addition, he is the Senior Monetary Policy Advisor to the Central Bank of Iraq and for Da Afghanistan Bank for the IMF. He is also an inflation targeting advisor to the National Bank of Kazakhstan for the Asian Development Bank. Available at: http://www.centralbank.ae/tools.php (accessed 24 November 2009). There may be legal implications of a change in the peg, for example for the implications for existing contracts denominated in UAE dirham. For one thing the domestic currency value of foreign assets and liability, including the foreign exchange reserves of the central bank and the ADIA will be affected. These are beyond the scope of this study. An excellent summary is presented in Duttagupta et al. (2004). Other country case studies for Brazil, Czech Republic, Chile, Israel, Poland and Uruguay can be found in Otker-Robe and Vávra (2007). Eichengreen and Hatase (2005, p. 1). Ibid., pp. 32–3. See Archer (2005). In some countries in which foreign currencies flow to the government, the government exchanges them in the market. See Schaechter (2000). Roger and Stone (2005, p. 6). See Laxton and Scott (2000).

BIBLIOGRAPHY Archer, David (2005), ‘Foreign exchange market intervention: methods and tactics’, BIS Papers No. 24, available at: http://www.bis.org/publ/bppdf/ bispap24d.pdf (accessed 24 November 2009). Central Bank of the UAE website: ‘Qualified Monetary Instruments’ available at: http://www.centralbank.ae/tools.php (accessed 24 November 2009). Central Bank of the United Arab Emirates, Annual Report 2006. Coats, Warren (1980), ‘The use of reserve requirements in developing countries’, in Warren Coats and D.R. Khatkhate (eds), Money and Monetary Policy in Less Developed Countries: Survey of Issues and Evidence, Oxford: Pergamon Press.

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Coats, Warren (1981), ‘Recent monetary policy strategies in the United States’, Kredit und Kapital Issue 4, Berlin: Duncker and Humblot. Coats, Warren (2007), One Currency for Bosnia: Creating the Central Bank of Bosnia and Herzegovina, Ottawa, IL: Jameson Books. Cooperation Council for the Arab States of the Gulf (GCC) (2001), The Economic Agreement Between the GCC States, adopted by the GCC Supreme Council (22nd Session; 31 December 2001), available at: http://library.gcc-sg.org/English/ Books/econagree2004.htm (accessed 30 November 2009). Duttagupta, Rupa, Gilda Fernandez and Cem Karacadag (2004), ‘From fixed to float: operational aspects of moving towards exchange rate flexibility’, Working Paper No. 04/126. Eichengreen, Barry and Mariko Hatase (2005), ‘Can a rapidly-growing exportoriented economy smoothly exit an exchange rate peg? Lessons for China from Japan’s high-growth era’, NBER Working Paper No. 11625. European Central Bank (2003), Review of the Foreign Exchange Market Structure, March, available at: http://www.ecb.int/pub/pdf/other/fxmarketstructure 200303en.pdf (accessed 30 November 2009). Friedman, Milton (1969), The Quantity Theory of Money and Other Essays, Chicago, IL: Aldine. IMF (2003), Country Report No 03/20, FSAP and ROSCs January 2003, available at: http://www.imf.org/external/pubs/ft/scr/2003/cr0320.pdf (accessed 30 November 2009). IMF (2007a), Country Report No. 07/347, United Arab Emirates: 2007 Article IV Consultation – Staff Report; Staff Statement. IMF (2007b) Country Report No. 07/357, United Arab Emirates: Financial System Stability Assessment, October 2007. Johnston, Barry and Odd Per Brekk (1989), ‘Monetary control procedures and financial reform: approaches, issues and recent experiences in developing countries’, IMF Working Paper No. 89/48. Laxton, Douglas and Alasdair Scott (2000), ‘On developing a structured forecasting and policy analysis system designed to support inflation-forecast targeting (IFT)’, Inflation Targeting Experiences: England, Finland, Poland, Mexico, Brazil, Chile, Ankara: The Central Bank of The Republic of Turkey, pp. 6–63. Lindgren, Carl-Johan (1991), ‘The transition from direct to indirect instruments of monetary policy’, in Patrick Domes and Reza Vaez-Zadeh (eds), The Evolving Role of Central Banks, Washington DC: International Monetary Fund. Otker-Robe, Inci and David Vávra (2007), ‘Moving to greater exchange rate flexibility: operational aspects based on lessons from detailed country experiences’, IMF Occasional Papers No. 256. Poole, W.D. ‘Optimal choice of monetary policy instruments in a simple stochastic macromodel’, Quarterly Journal of Economics, 84(2), 197–216. Roger, Scott and Mark Stone (2005), ‘On target? The international experience with achieving inflation targets’, IMF Working Paper No. 05/163. Schaechter, Andrea (2000), ‘Liquidity forecasting’, MAE Operational Papers No. OP/00/7, IMF. Schaechter, Andrea, Mark R. Stone and Mark Zelmer (2000), ‘Adopting inflation targeting: practical issues for emerging market countries’, IMF Occasional Paper 202. World Bank (1989), World Development Report 1989.

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APPENDIX 7.1

SUMMARY OF OPERATIONAL IMPLICATIONS OF POLICY REGIMES

To facilitate the discussion of policy regime options, this appendix summarizes in bullet point format the key operational features of exchange rate targeting, monetary aggregate targeting and inflation targeting regime options with regard to their (1) design, (2) requirements and (3) implications. A more complete discussion can be found in the main text. All central banks are expected to collect and publish economic and financial data broadly relevant for monitoring the behavior of the monetary and financial system. In addition to monetary, exchange rate and interest rate data, these include balance of payments, output and employment, credit and, at a minimum, banking data. These data are needed for any monetary policy regime, but their timeliness and analysis become increasingly important the more removed the regime is from one of fixed exchange rates. Exchange Rate Targeting An exchange rate target can be achieved by regular pre-announcements of the exchange rates at which the central bank will deal, or intervention in an interbank market via, for example, periodic or regular central bank auctions to buy or sell foreign currency. Requirements are close to those for a fixed rate regime and include: ● ●

●

data analysis of factors effecting equilibrium balance of payments (BOP) used to determine the exchange rate target; clear explanation to the market of the factors guiding choice of exchange rate targets and that would lead to a change in target; and contingency plans for how to deal with a speculative attack on the exchange rate.

Monetary Aggregate Targeting A monetary aggregate target is an intermediate variable used to achieve the ultimate inflation target. It requires allowing the market to determine the exchange rate and thus the establishment of an interbank foreign exchange market is a precondition for its implementation. Its requirements are much more complicated and demanding than for an exchange rate peg or target:

Operational implications of changing exchange rate regimes ●

●

●

●

●

●

133

The relationship between various monetary aggregates and inflation must be analyzed in order to identify the aggregate with the most predictable relationship. A target for the growth of this aggregate must be chosen, periodically reviewed and adjusted as necessary in light of the behavior of the real economy and the desired inflation. Central bank instruments for controlling the size of its balance sheet, in particular its monetary liabilities (currency in circulation and bank current account balances with the central bank) and rules for their use must be developed. The central bank must estimate and forecast the relationship between its monetary liabilities (the monetary base) and the monetary aggregate it has targeted and use its instruments to control the targeted aggregate via the behavior of its monetary liabilities. New data on monetary growth, interest rates, exchange rates, real income growth and employment, and inflation must be carefully analyzed with the aid of econometric models for indications of shifts in money demand that would require adjustments in the target. Central bank staff reviews and analysis of new data and its implications for the monetary target should be communicated and discussed with management (policy-makers) in a regular and structured way, which must be developed and put in place.

Inflation Targeting Inflation targeting reflects directly the ultimate objective of monetary policy, which is targeted directly without an intermediate target. Requiring a market-determined exchange rate, inflation targeting shares many requirements in common with monetary aggregate targeting: ● ● ● ●

●

The central bank and government must credibly commit to an inflation target, preferably in legislation. The price index to target must be chosen, along with the horizon over which the target is to be achieved. A forecasting team must be established to develop inflation forecasting models and to maintain and update them. A formal structured process for developing regular inflation forecasts and setting policy must bring staff and management into regular discussions of the forecasts. The process of communicating policy and of public accountability for policy must be put in place (inflation report and other communications).

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APPENDIX 7.2

A MONETARY AGGREGATE TARGETING FRAMEWORK

Regime Options There are several fundamentally different ways in which countries can pursue a price-level objective. One is simply to administer prices in accordance with that objective. This approach requires (ultimately, at least) stateadministered investment, production and distribution, and has historically been associated with central planning, inefficiency, low levels of income and long lines for poor-quality goods. The desire to allocate resources on the basis of the profit incentive and market-determined price signals of consumer demand and the cost of production require the abandonment of administered prices. This appendix discusses control of the value of money when the prices of goods and services are determined by the market. When individual prices are market-determined, the aggregate price level (that is, the value of money) is determined by the market so as to equate the public’s demand for money with the supply of it. The achievement of an inflation target, therefore, requires a quantity of money consistent with the public’s demand for it at the targeted price level.1 The three most common general approaches to determining the quantity of money are: (1) to limit its creation by banks by directly controlling the amount of credit they may extend, (2) to limit its creation by banks by controlling the amount of reserves available to them, and (3) to fix the exchange rate of the currency to another currency or unit whose value behaves in the desired way and to allow the quantity of money to be determined by the public’s demand for it at the value that has been fixed by the exchange rate. The first of these approaches, which generally takes the form of an aggregate target for bank credit that is administratively allocated among individual banks, retains some of the features and disadvantages of central planning. By determining the growth in individual bank assets administratively, the incentive for individual banks to work harder to deliver better service more efficiently (that is, at lower cost) is greatly diminished. The market is not allowed to determine the relative growth of individual banks on the basis of their success in satisfying their customers. Economic efficiency and growth are, therefore, better served by indirect techniques of monetary control, that is, approaches 2 or 3 above.2 The approach of a fixed exchange rate has considerable advantages (it is easy to administer and does not require knowledge of the public’s demand for money, which is particularly difficult to estimate during periods of economic reform), but requires that government borrowing be limited to amounts that can be raised from the public.3 Fixing the value of money

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exogenously (for example, to the dollar, euro, SDR, gold, or a commodity basket) is not only the easiest monetary policy to administer, assuming that the fiscal deficit can be appropriately limited, but probably provides the quickest way to establish faith in the stability of such money’s value. If the rules of a fixed exchange rate are followed, the value of money will be the same as the value of the currency or basket of currencies or goods to which the exchange rate of the currency has been fixed. Aside from dollarization (that is, no domestically issued currency at all), a currency board is the simplest monetary regime with an externally fixed value to administer and has the highest credibility. A currency board simply buys and/or sells its currency in exchange for the currency or commodity(s) in terms of which its value is fixed. The rules of a currency board require the monetary authority to hold the asset to which the domestic money’s value is fixed to the full extent of the currency it has issued (that is, at least 100 percent backing). The board would accomplish this by issuing its currency only by buying the currency (or other assets) to which its value is fixed. If anyone holding its currency wishes to exchange it for the asset(s) backing it, the board must redeem its currency at the currency’s fixed price (only small margins – bid/ask spreads – are allowed). These requirements, that the board must buy or sell its currency at a fixed price, ensures that the public has all, but just all, of the currency that it wants to hold at that price. In short, a fixed exchange rate as administered by a currency board supplies exactly the quantity of domestic currency the public wants to hold (that is, equates the supply of and demand for money) by an automatic market mechanism, while ensuring aggregate price behavior equal to that of the unit to which the currency’s value is fixed. Furthermore, there is no need for the monetary authority to estimate the public’s demand for money in order to know how much it needs to supply to hit the desired price target. A fixed exchange rate regime without the currency board restrictions would work in the same way to produce the quantity of money the public demands but would open the possibility for the central bank to buy and sell domestic assets as an additional instrument for influencing the quantity of money. The central bank’s monetary liabilities would no longer need to be fully backed by foreign assets. This has the advantage of accommodating various demand and external supply shocks without the need for adjustments in the domestic price level. However, it is subject to abuse or misjudgment that can result in a domestic money supply that is not matched with demand. Such a mismatch would put pressure on the fixed exchange rate and could result in the loss of the ability of the central bank to defend the exchange rate. For this very reason fixed exchange rate regimes that are not fully backed with foreign currency can be subject to speculative exchange rate attacks.

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Fixed exchange rate regimes are now relatively rare, though currency boards have staged a modest comeback since the collapse of the Soviet Union. However, many central banks target the exchange rate as the anchor to monetary policy in countries with market-determined exchange rates. The advantages of an exchange rate target are that it is simple to implement, very transparent and easily understood by the public, and can be changed to absorb supply shocks that would otherwise require potentially painful domestic price-level adjustments. However, the prospect of occasional, discrete changes in the target and hence market exchange rate can give rise to speculative pressures on the rate that can be very disruptive and that the central bank might not be able to resist. An alternative market approach to equating the supply of and demand for money is for the central bank to determine the money supply and allow the market to determine its value (that is, to determine the price level). This approach contrasts with the fixed exchange rate approach in which the value of money is fixed and the market determines its supply, and obviously requires that exchange rates be market-determined. Controlling the quantity of money in an effort to stabilize its value requires a reasonably good estimate of the public’s demand for money. This is a challenging task for any central bank. In most economies for which estimates have been made, money demand has been found to have a relatively stable relationship with nominal income and interest rates (or more exactly, with the opportunity cost of holding money – defined as the difference between the average rate of interest on financial market instruments and the average interest return on money). Estimates generally find a stable relationship between real money demand (money deflated by a general price index) and real income (nominal or money income deflated by the same price index) and an interest rate. These empirical findings are in keeping with economic theory. For a given level of real income and interest rates, the demand for money tends to be proportional to the price level, that is, other things equal, doubling the price level will tend to double the demand for nominal money and vice versa. A stable price level, therefore, generally requires that the supply of money grows at about the same rate as real income. The observed stability of the demand for money is far from perfect, however. For example, changes in the growth rate of money tend to effect prices with a long and variable lag (in the US nine months to two years). Furthermore, improvements in payment technology and financial market development cause trends in money demand over time that tend ultimately to economize (reduce) the amount of money held in relation to income, while wealth effects tend to go in the other direction. In the earlier phases of financial development the demand for money tends to grow with

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income and improved payment system efficiencies that lower the cost of using bank deposits.4 At later stages of development, the growing use of credit/debit cards and other modern means of payment reduce the demand for monetary aggregates such as M2 that exclude these means of payment. The usefulness of targeting the behavior of the quantity of money (an intermediate target) in order to achieve an inflation target (the ultimate target) depends on the accuracy with which the demand for money can be forecast. There is a large body of literature on the demand for money.5 The next section of this appendix presents a framework for control of the money supply by a central bank operating in, or wishing to promote, a market economy and adopting a market-determined exchange rate. For such a central bank, monetary control needs to be based on its control of the total of the quantity of currency held by the public and by banks, plus bank deposits with the central bank (base money), and its influence over the creation of deposits in banks in relation to their reserves. The General Framework of Monetary Control A common approach to the formulation of monetary policy is for the central bank to set an inflation target, estimate the economy’s demand for money given the price level implied by the inflation target and the forecast for real GDP growth, and then manipulate the policy instruments at its disposal so as to create the amount of money these estimates suggest will be demanded. Because many different combinations of instrument settings will result in the same money supply, central banks generally attempt to use the combination that will minimize the cost to the financial sector and will maximize the stability of interest rates and exchange rates. For many central banks the determination of the desired increase in the money supply is likely to be made in the context of a stabilization program supported by the IMF. The money target The Central Bank of UAE (CBUAE) can establish a money or base money target in the traditional way.6 An inflation target is chosen, real income growth is forecasted (guessed)7 and any factors that might influence the income elasticity of money demand (or velocity of circulation) are factored in. If inflation and interest rates are moderate and stable, a stable elasticity of one is a reasonable assumption (meaning that velocity, the inverse of k, would be constant).8 The demand for base money can be stated as follows: Bd ; kPq

(7.1)

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where B ; base money, k ; income elasticity of demand for B (inverse of velocity), P ; Price level, and q ; real income. Thus, to a first approximation: ΔBd/B = Δk/k + ΔP/P +Δq/q

(7.2)

This expression says that the rate of growth of base money demanded by the economy depends on the rates of growth of its demand, inflation and real income. If we assume, for example, an inflation target of 4 percent, a forecast for the growth of real income over the year of 6 percent and a forecast for the rate of change in the demand for base money of 2 percent (slowing of velocity), the target growth rate for base money (which will be indicated by a superscript *) would be 12 percent. This ‘target’ is the rate of growth that will produce the desired inflation rate if the assumptions for q k are correct. Market equilibrium requires: Bs = Bd

(7.3)

When money supply does not equal money demand, market forces are set in motion that bring about equilibrium. If the exchange rate is fixed, equilibrium is achieved by adjustments in the money supply. If the money supply (or its growth rate) is fixed, equilibrium is achieved by adjustments in the price level (or inflation rate). More detailed and sophisticated models of inflation elaborate the transmission channels by which these equilibrating adjustments are made. Such models provide more information on the pace with which monetary policy is transmitted to prices (lags in the effect of monetary policy on prices). In reality, none of these assumptions or forecasts is likely to be correct, but the simple money demand, money supply framework provides a useful structure in which to discuss the factors that might cause the inflation outcome to be different than desired by policy or that might cause the policy settings needed for the inflation target to be different than initially thought. Central banks generally have a Monetary Policy Committee (MPC) that is specifically responsible for monetary policy decisions.9 Thus, the framework can be a useful way to focus a discussion among members of the MPC and between them and staff on whether the current stance of policy is appropriate or not in light of the inflation objective. The money supply The framework of monetary control presented here builds on the link between the liquidity supplied by the central bank and the deposits and

Operational implications of changing exchange rate regimes

Table A7.1

139

The central bank balance sheet

Assets

Liabilities

Gold and foreign currency (FA) Dollar/dirham swaps (SW)

Currency Outside banks (C) Inside banks (VC)

Claim on banks Credit to banks (CB) Claims on government Credits to government (CG) Government securities (GS)

Other assets (OA)

Deposits Banks’ current account (Rb) Government (Rg) Short-term notes (Certificates of Deposit – CDs) Other liabilities (OL)

Note: FA = foreign assets; C = currency held outside banks; VC = vault cash; R = reserves.

credit created by banks. In particular, it builds on the distinction between the initial creation of money balances – which is reflected in the balance sheet of the central bank (currency in circulation and bank current account or clearing deposits with the central bank – see Table A7.1) – and secondary money creation by the commercial banks in the form of deposits of the public. The distinction between the initial increase in base money and the secondary creation of broad money by commercial banks makes it useful to examine separately the balance sheets of the central bank and of the commercial banks. For purposes of controlling the domestic monetary supply we are interested in those liabilities of the central bank that are a part of domestic money or are the basis of commercial banks ‘creating’ the deposit part of domestic money or what is generally called high-powered money, or base money. Base money (B) comprises two elements: currency held outside banks (C), which is directly a part of the money supply, plus bank reserves (R), which include both cash held as assets by commercial banks (vault cash = VC) and current account or clearing deposits of the commercial banks with the central bank (Rb). Thus, base money is defined as: B ; C + R,

(7.4)

where R ; Rb + VC, and Rb is current account deposits of the commercial banks with CBUAE.10 This formulation is sometimes referred to as the ‘uses’ of base money.

140

Table A7.2

Currency union and exchange rate issues

Consolidated balance sheet of the banks

Assets

Liabilities

Foreign assets (FAb)

Deposits of non-bank public (D) of the government (Dg) of other banks (Db) of foreign currencies (Df) Credits from the central bank (CB) from abroad (Cf) central bank swap (SW) Other items net – including capital (OIN)

Loans (L) Securities (S) Deposits with other banks (Db) with CBUAE (Rb + CD) Currency (VC)

The initial creation of money balances, defined here as base money, helps finance the subsequent monetary expansion by the commercial banks. The secondary expansion of the money supply by the commercial banks is achieved through the ‘multiplication’ of the initial amount of base money supplied to banks. The additional base money supplied to banks by the CBUAE creates holdings of reserves by banks in excess of their requirements (of required and voluntarily held precautionary reserves) that are available to finance new loans. The new deposits of the public created along with new loans, when spent by the borrowers, are transferred to other commercial banks as new deposits. The part of these new deposits corresponding to excess reserves at these other banks can again be loaned out. The end result of this round-by-round process is that the amount of deposits created exceeds the original amount of resources placed with the commercial banks. The multiplication of bank deposits is limited by the amount of base money supplied by the central bank to the public (B), the amount of that base money deposited with banks (R) and the amount of such reserves banks wish to hold in relation to their deposits – which must be at least as much as needed to meet their minimum reserve requirements. These points are discussed in more detail in the following pages. These relationships and the banks’ contribution to the public’s money supply (that is, D) are seen in the consolidated balance sheet of the commercial banks. This balance sheet is shown in Table A7.2. Several observations about Table A7.2 will deepen the understanding of this monetary framework. The most important observation is that only the deposits of the non-bank public (households, private enterprises, state enterprises) are included in the money supply (see the next paragraph for an explanation). The banking sector’s balance sheet can be ‘solved’ for D

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so that the deposit component of the monetary supply is equal to all bank assets less other liabilities (other than D). Net interbank deposits for all banks, which are not generally shown in the consolidated balance sheet, are, of course, zero. The foreign assets less deposits of foreign currencies and any other liabilities in foreign currencies (for example, outstanding foreign debts) are the net foreign assets of the banking sector (NFAb = FAb – Df – Cf). Loans and securities held by banks, including CDs from the central bank, less deposits of the government and the forward repurchase obligations to unwind FX swaps with dirham are the net domestic assets of the banking sector (NDAb = L + S + CDs – SW – Dg). This might also be broken into net domestic credit to the private sector plus net domestic credit to the government. As a simplification, the text assumes that reserves that can be used to meet the reserve requirement (R) consist of all deposits of banks with the central bank plus VC. With these observations in mind, and ignoring OIN, the following balance sheet identity can be written: D + CB + SW + Dg = NFAb + L + S + Rb + CDs + VC, or D = NFAb + NDAb + R – CB

(7.5)

where: R = Rb + VC The definition of money used here (M) is very broad, encompassing all categories of the public’s deposits with banks (D) and currency held outside banks (C) and is commonly referred to as broad money, M ; C + D,

(7.6)

where D is the demand, savings and time deposits of private enterprises, state enterprises and households. For both theoretical and empirical reasons, the money supply is generally defined as the currency and deposits of the non-bank public. Empirically, the definition of money that should be adopted for policy purposes is that monetary aggregate with the most stable demand in relation to real income, the price level and interest rates. In order to distinguish between the initial creation of money balances by the central bank and the secondary expansion of the money supply by the commercial banks, it is customary to represent the money supply

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as the product of base money and a variable that is called the ‘money multiplier’, M ; mB

(7.7)

where m is the money multiplier. If there is a stable relationship between base money and the money supply, that is, if the money multiplier is constant or can be predicted, the money supply can be controlled by controlling base money. The first difference of equation (7.7) can be used to explain the changes in the money supply caused by changes in base money and the money multiplier. These changes can be approximated by the expression, ΔM = ΔmB–1 + m–1ΔB + ΔmΔB,

(7.8)

where Δ is the difference operator, that is, ΔM ; M – M–1, and the indicator –1, as in M–1, denotes the value of M in the previous period. The first term in equation (7.8) on the right-hand side of the equation represents the contribution of changes in the money multiplier to the increase in the money supply, the second term represents the contribution of changes in base money and the last term results from the interaction of these two factors. The introduction of an assumption about the behavior of the multiplier converts the above identity into an equation that will be only as accurate as is the predicted behavior of m, that is, m*, so that the predicted value of M is: M = m*B

(7.9)

The behavior of m* may be estimated econometrically on the basis of past behavior, which is not likely to be very reliable when changing from direct to indirect means of control (this is discussed in greater detail in the next section). It is more usual, however, to exploit knowledge of the structural factors embedded in the multiplier in order to refine estimates of its behavior. The structural components of m may be derived in a variety of ways. A straightforward approach is to substitute the definition of broad money from equation (7.6) and of base money from equation (7.4) into equation (7.7), which gives, (C + D) = m*(C + R)

(7.10)

Dividing both sides of equation (7.10) by D gives, (C/D + 1) = m*(C/D + R/D)

(7.11)

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143

or m* = (c + l)/(c + r)

(7.12)

where c is the ratio of currency outside banks to deposits held at banks by the public and r is the ratio of bank reserves to deposits. This formulation is interesting because it highlights the main factors that play a role in the money supply process. The money multiplier is described in equation (7.12) as being affected by two factors: the ratio of currency outside banks to deposits, which is assumed to depend predominantly on the behavior of the public, and the ratio of bank reserves to deposits, which is a function of the behavior of the commercial banks and the central bank’s minimum reserve requirement. Because r is less than 1, a decrease in c increases the multiplier as does a decrease in r. Finally, base money is created, and thus is controlled, by the monetary authorities. As indicated above, the strategy of monetary control based on this framework is to calculate what level of base money would be consistent with the target for monetary expansion under the financial program: B = M*/m*

(7.13)

where M* is the target level for broad money, and m* is the central bank’s prediction/forecast of the multiplier. Armed with the resulting estimate of the base money target, and taking into account those factors affecting base money that are outside the central bank’s control, the central bank can estimate the increase or decrease in the sources of base money that it does control that are required to hit the target. A strategy for controlling base money is developed below. Managing the money multiplier The above strategy assumes that the central bank can project the value of the multiplier with reasonable accuracy. The management of the money multiplier can be best understood by examining the factors that affect each of the determinants of the money multiplier. As may be seen in equation (7.12), the money multiplier is a function of the ratio of currency to deposits and of the ratio of bank reserves to deposits. An increase in the ratio of currency to deposits reduces the money multiplier, as it reduces the amount of base money in banks and thus curtails the opportunities for the banking system to engage in secondary money creation. Similarly, an increase in the ratio of bank reserves to deposits (r) means that some of the monetary creation potential of the banking system is being ‘sterilized’. This again reduces the money multiplier.

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Currency union and exchange rate issues

The currency-to-deposits ratio reflects the public’s preferences for one form of payment medium over the other, which will be influenced by the relative convenience and return (interest rate) from holding liquidity and making payments one way or the other. This choice, hence the C/D ratio, will depend primarily on the quality of bank deposit services (location of office, deposit interest rates, cost of funds transfers – that is, non-cash payments, and so on) and seasonal factors and is little influenced by central bank monetary policy.11 For the purpose of determining the appropriate setting of monetary policy instruments, the central bank’s task is to estimate or forecast the likely behavior of the ratio, in order to take its impact on the multiplier into account. The central bank enjoys considerable influence over the ratio of bank reserves to deposits. The nature of this influence is clarified by dividing bank reserves into that part banks are required by central bank regulations to hold (minimum reserve requirement, RR), and the rest, known as ‘excess reserves’ (ER), or, R = RR + ER Dividing both sides by D gives, r ; rr + e, where rr is the ratio of RR to D and e is the ratio of ER to D. The money multiplier can, therefore, be written as,12 m = (c + l)/(c + rr + e)

(7.14)

The minimum reserve requirement is fixed by the central bank, and hence rr is under the central bank’s direct control. The observed value of ‘e’ can be a very useful indicator of the state of bank liquidity and thus of the central bank’s impact on monetary growth. It summarizes the impact of all factors effecting base money whether within or outside the central bank’s control. However, whether the observed value of ‘e’ is high, and thus leading to increased growth in the money supply, or low, and thus leading to reduced growth in the money supply, depends on whether the observed value is above or below banks’ demand for excess reserves. Thus, evaluating the level of ‘e’ requires estimating bank demand of excess reserves. The ratio of excess reserves to deposits desired by banks reflects banks’ preferences for liquidity and will be influenced by such things as the nature of the payment system, the exact nature of the reserve requirement (for

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example, the use of the daily average reserve holdings versus the end-ofperiod level), the severity of the penalty for violating the requirement, the efficiency of financial and interbank money markets and the interest rate on the best alternative to holding excess reserves that is forgone. An increase in lending interest rates, for example, that results from an increased demand for credit will make it more costly (in terms of opportunity cost) for banks to hold excess reserves. Thus, an increase in a bank’s lending rates will reduce its desired level of excess reserves. An increase in the interest rate the central bank charges on its advances will make such borrowing a more costly source of liquidity and will thus tend to increase banks’ desired level of excess reserves (an alternative source of liquidity). Thus, an increase in the interest rate on advances from the central bank (relative to market rates) or a fall in market loan rates can be expected to increase the demand for excess reserves by banks, thus reducing the money multiplier. There are thus a number of instruments that the central bank can use to influence the money multiplier. It determines rr, has some influence over e, and can generally estimate c with some degree of accuracy. Combining these, the central bank should be able to forecast the value of m with relative accuracy, but as mentioned above, this requires up-to-date information on the banking sector. Controlling base money Given the target for M and the forecast value of m*, the central bank can derive the desired behavior of B. The factors that affect the behavior of base money can be analyzed by examining the balance sheet of the CBUAE (see Table A7.1 above). A very important assumption of this framework is that currency is freely provided on demand.13 Thus, the central bank is assumed to control the monetary base, that is, the total of C + R, but not the mix, thus the amounts, of its individual components. Data on base money and even more so on M is available only with a lag. Data on banks’ excess reserves are generally available daily at the end of each day and data on interbank interest rates are generally available instantly and continuously throughout the day. Thus, the strategy of monetary control outlined in the preceding paragraph can be usefully supplemented by monitoring and controlling the observed value of ‘e’ relative to its estimated demand (the level desired by banks). Raising ‘e’ above its desired level will reduce money market interest rates and increase money supply growth. Reducing ‘e’ below its desired level will increase money market interest rates and slow monetary growth. The items summarized in the central bank’s balance sheet in Table A7.1 can be usefully set out in an equation with the ‘uses of B’ on the left-hand

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Currency union and exchange rate issues

side and the ‘sources of B’ on the right-hand side. Netting government deposits with both direct and indirect credit to the government (NCG ; CG + GS – Rg), and other liabilities against its other assets (NOA ; OA – OL),14 and equating CBUAE’s assets and liabilities gives, B ; C + R ; NFA + CB + NCG – CDs + NOA

(7.15)

Market-based instruments of monetary control are those policies or actions of the central bank that affect one or more of the right-hand terms in equation 7.15 as a way of influencing the value of the uses of base money (the left-hand side, that is, C + R). These instruments, and the effects they have on particular right-hand terms, are used, along with forecasts of the right-hand items the central bank does not control, in order to hit the base money target previously calculated. Each of these components of base money will be considered in turn, while the instruments by which they can be influenced or determined are discussed in the section following. Net foreign assets – NFA The net foreign assets of the CBUAE reflect its purchases of foreign exchange less sales. If the CBUAE had a marketdetermined exchange rate and thus no obligation to buy or sell foreign exchange, changes in its net foreign assets (the difference between the foreign exchange it buys – FXP – and sells – FXS) would reflect its desire to add to or reduce its foreign exchange reserves (or temporary interventions to smooth exchange rate fluctuations) and the effect that has on base money.15 ΔNFA ; FXP – FXS

(7.16)

If the CBUAE buys foreign exchange, NFA is increased. If nothing else changes (for example, if the initial increase in government deposits of UAE dirham when the government sells dollars to the CBUAE are spent so that NCG remains unchanged) on the right-hand side, base money will be increased by the amount of the purchase. The CBUAE determines the amount it will increase by deciding the size of its foreign exchange sales. Credit to banks – CB The CBUAE’s advances to banks (the next term in equation 7.15) are a source of base money largely under the control of the central bank. The CBUAE can influence the amount of credit provided under its standing credit facility by setting the interest rate charged and other conditions (for example, collateral) for these loans. An increase in credit to banks will generally directly increase base money.

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Net credit to government – NCG The CBUAE lends limited amounts directly to the government at the initiative of the government. It can also do so indirectly by buying government securities (GS) in the secondary market. Changes in the level of government deposits with the CBUAE (Rg) also change NCG and base money by a like amount but in the opposite direction, and careful forecasts of these amounts should be prepared by the government and communicated to CBUAE. The amount of government securities held by the CBUAE (GS) is under its direct control. Purchases of such securities from the public (including banks) by the CBUAE will increase the amount of base money, while sales from its existing holdings will reduce B. In most developed economies, these so-called open market operations are the primary instrument by which central banks control base money. Thus net credit to the government consists of components controlled by the government, which must be forecast, and components controlled by the CBUAE: ΔNCG ; ΔGS + ΔCG – ΔRg Short-term notes (certificates of deposit) – CDs Because it does not generally hold government securities in its portfolio, and because of excess liquidity in banks, the CBUAE conducts open market operations in its own security (CDs). Increases in these notes outstanding will reduce base money and vice versa. The CBUAE seems to passively supply CDs as desired by banks for their liquidity management. Thus, it is not now an active instrument for controlling B. Dollar swaps (SW) When banks swap dollars for dirham with the obligation to reverse the operation in one week, one month, or three months, it increases bank reserves and base money for the same period of time. Net other assets – NOA Other assets less other liabilities, that is, other assets (net), should be negligible, or at least changes in NOA should be negligible. The value and behavior of NOA should be determined from historical data and its behavior in the future closely monitored. If this behavior becomes a significant cause of changes in base money, the components of NOA should be identified and examined in order to understand the factors giving rise to their behavior. Thus, the CBUAE can control the growth in base money by forecasting the behavior of those sources of base money growth that it does not control (parts of NCG, and NOA) and setting accordingly the sources it does control (FXS, FXP, GS, CDs). CB and SW fall a bit in between as

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CBUAE controls them indirectly via the interest rates (and other conditions) it sets on standing facilities. They are meant to limit interest rate and liquidity fluctuations and not as instruments of base money control. FXP – FXS + ΔGS – ΔCDs + ΔSW + ΔCB ; ΔB* – ΔCG + ΔRg – ΔNOA (7.17) where ΔB* is the base money target growth and ΔCG, ΔRg, and ΔNOA are the projected values of those variables that CBUAE does not directly control. Thus the CBUAE controls the growth in base money by determining the size of its net foreign exchange sales, its loans to banks, its temporary purchases of dollars in swaps, its sales of Ministry of Finance bills it owns and its sales of its own notes (CDs), plus the influences it exerts on the money multiplier outlined earlier. These constitute its instruments of monetary policy. These instruments are examined in greater detail in the next section. Instruments of Control The indirect instruments with which central banks control the money supply can be divided into statutory (or regulatory) ones, such as minimum reserve requirements (which are, in fact, rather direct) and those that are market based.16 Market-based instruments may operate more slowly and uncertainly, but they are the most compatible with market allocation and efficiency. The ultimate aim of market-based instruments is the control of base money via control of the amounts of NFA, CB, CDs, SW and NCG. How such control over NCG is achieved, for example, (whether through shifts of government deposits from the CBUAE to commercial banks – Rg to Dg – and back again, or through purchases and sales of government securities) is of secondary importance. The importance of the particular manner in which the quantity of base money is controlled resides in the efficiency of the instrument and other secondary consequences of its use. These are discussed in this section. Foreign exchange operations The net purchase or sale of foreign currency by the central bank for domestic currency (the first two terms in equation 7.17) directly increases or decreases base money. This activity is a form of open-market operation and has the same effect on the monetary base as do open-market operations (OMO) in domestic securities, which are discussed below. With a floating exchange rate the central bank generally acquires foreign exchange as required by its foreign exchange reserves objectives and as a

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result of temporary intervention to smooth exchange rates leaving OMO in domestic securities to control base money. Reserve requirements Minimum reserve requirements (rr in equation 7.14) can have a very significant effect on the money multiplier. In addition, however, if the central bank does not pay market rates of interest on the required reserve balances it holds, they reduce the earnings banks receive on their assets. If they are not remunerated, required reserves constitute a tax on the deposit liabilities of banks to which they apply. These considerations suggest several general principles for the design and use of reserve requirements.17 Reserve requirements should be low or pay interest at market rates; a heavy tax will discourage the development of the banking sector. Reserve requirements should be uniform; this is a canon of good (neutral) taxation and simplifies forecasting the multiplier, hence simplifying monetary control. Reserve requirements should be defined so as to be enforceable and to provide some flexibility to banks in the management of their reserves (for example, they should be met by daily average, rather than absolute minimum, amounts). They should be satisfied by domestic currency vault cash and current account deposits with the central bank only (not FX). Reserve requirements should not be used actively. In general, as with most taxes, they should be set at a predictable and stable level. Open-market operations – short-term notes OMOs – the sale or purchase of securities by the central bank to withdraw or inject base money – have become a favored instrument of monetary policy not only in developed countries but increasingly also in developing countries. This preference includes the use of OMOs both for temporary adjustments to the monetary base or to offset changes in other sources of the monetary base and to provide for long-run growth in the monetary base. Several reasons explain this preference. First, open-market operations are a very flexible instrument: in developed financial markets, the central bank can buy and sell securities for whatever amounts it wants. Second, in such markets, OMOs can be carried out continuously, even several times within a single day. Third, with OMOs it is the central bank that has the initiative, whereas in the case of lending to banks, for example, it is the financial institutions that decide whether and how much to borrow. Fourth, OMOs are voluntary transactions and do not have the taxation affect that reserve requirements have. Open-market operations can be carried out in either primary markets (that is, through new issues and redemptions) or in secondary markets (purchases and sales of pre-existing securities).

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Purchases and sales are generally by auction. In countries with secondary markets having many potential transactors, central banks generally prefer to operate in these markets. But operations in primary markets, though not quite as flexible, have the same sorts of effects, and are the dominant form in countries with less developed financial markets.18 Most commonly, OMOs are undertaken in government securities (the third term in equation 7.17) because of their homogeneity and negligible default risk. A central bank sale of government securities it owns will reduce base money. If the central bank does not own government securities and needs to absorb market liquidity (that is, reduce B) it might ask the government to over-issue securities beyond the government’s own borrowing needs in order to provide the central bank with a portfolio of government securities. The funds raised by the government in such an operation would be impounded in a blocked account at the central bank. Since net new issues of government debt would be serving a dual purpose in this situation, the need for close coordination between monetary policy and public debt management is particularly important. Alternatively, when the central bank does not hold government securities OMOs are sometimes carried out using the central bank’s own securities (the fourth and fifth items in equation 7.17). The issue and sale of central bank CDs or purchases of FX in swaps (an increase in a central bank liability) reduces base money. In addition, OMOs in secondary markets can also be undertaken in private sector securities, although the central bank needs to ensure that the paper involved is of good quality. OMOs in government securities have the further advantage that they can help stimulate the development and growth of secondary markets in government debt. The existence of a money market is to some extent a precondition for the use of OMOs; the public (including banks) must be prepared to buy and sell government securities. But OMOs increase the demand for such transactions, familiarize market participants with their mechanics and stimulate the development of lower-cost arrangements for conducting them. The benefits of an efficient money market extend far beyond its contribution to the central bank’s ability to use market-based instruments of monetary control. Financial resources, like an economy’s other scarce resources, must be used efficiently if the economy is to function effectively and to yield the standard of living of which it is capable. In addition to directing the economy’s savings to their most productive uses at the lowest possible cost, an efficient financial system minimizes the amount of savings that are needed for the smooth operation of the economy (that is, working capital of banks, firms, households and government). Smoothing spending in the face of uneven revenues, and financing inventories at the least

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possible cost, requires the ability of a firm (for example, a bank) to adjust its liquid asset holdings quickly, easily, at low cost, and with minimal risk. A well-functioning money market contributes to that ability. Standing facilities Whereas OMOs are conducted at the initiative of the central bank, on a multilateral basis and at specific times, standing facilities (SFs) are available at the initiative of the commercial banks, on a bilateral basis, and are normally available at any time: When. . .financial markets, and more broadly financial systems, are not well developed, central banks have to place greater reliance on standing facilities than on open market operations. In that regard, standing facilities can act as a safety valve in response to unexpected liquidity developments or to various obstacles or inefficiencies that prevent a smooth redistribution of reserves via the interbank market. The safety valve function is also important when the liquidity forecasting framework is weak.19

The purpose of standing credit (the sixth term in equation 7.17) and term deposit facilities (not used by the CBUAE) is to provide assurance to banks that they can manage their excess liquidity within a modest range of interest rates that straddle prevailing market rates. The standing lending and deposit facilities will provide an interest rate spread between placing and receiving funds from the central bank overnight. To maximize this safety net function, the rate of spread should be small. On the other hand, the spread should be wide enough to encourage banks to develop an interbank market and manage their liquidity with each other in the first instance, rather than always dealing with the central bank. To the extent that the CBUAE’s CDs and FX swaps are passively administered, that is, are available at the discretion of qualifying banks, they should be categorized as standing facilities rather than OMO. Standing credit and deposit facilities are meant for occasional rather than regular use. Excessive use of either is an indication of general excess or deficient liquidity in the economy, which should be removed with open market operations. Management of government deposits Base money can also be controlled by shifting government deposits back and forth between commercial banks and the central bank. This instrument has the advantage of being under the full control of the central bank (assuming that the Ministry of Finance delegates to it the responsibility for the distribution of government deposits between itself and commercial banks). Government deposits can be shifted quickly and easily between

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the central bank and commercial banks, which makes this instrument quite flexible and useful for offsetting short-term swings in the amount of other sources of base money. To use this instrument, the government must determine the banks in which it will place or from which it will withdraw funds and the interest rates paid on them. A market-oriented approach to placing deposits with commercial banks is for the government to hold regular deposit auctions. As this deposit management instrument is an alternative to buying and selling securities (open market operations), its use has the disadvantage of discouraging the development of a secondary securities market, if one does not already exist.

NOTES 1. 2. 3. 4. 5. 6. 7. 8.

9. 10. 11. 12.

For a more general discussion of these issues see any standard textbook on money and banking or monetary theory. The advantages of indirect techniques of monetary control are discussed in greater detail in Johnston and Per Brekk (1989). A modest amount of borrowing from the central bank might be consistent with the monetary growth desired by the public under a fixed exchange rate. However, these very developments tend to reduce the currency/deposit ratio and thus increase the money multiplier. As a result, slower growth in base money is needed for a given rate of growth of broad money. See, for example, the classic article on this subject by Friedman (1969). This is more or less the simplest model possible. Modestly elaborated models should also be developed that include the real sector more explicitly (output gap), financial markets, the external sector and possibly the fiscal sector. It is appropriate and customary that the inflation target and real income forecast be agreed government-wide for budget and other purposes. For the sake of simplicity, the following formulation is in terms of base money rather than M1 or M2. This assumes a stable multiplier relating B to an M. However, the multiplier is almost certain to increase over the next few years from improvements in the payment system, banks and liquidity management capabilities. In the United States this committee, consisting of members of the Board of Governors and Federal Reserve Bank Presidents, is called the Federal Open Market Committee (FOMC). In the subsequent discussions of the reserve requirement, it is argued that vault cash should be included along with current account deposits with the central bank in the reserves that can be used to satisfy the minimum reserve requirement. Central bank policies more broadly may, however, influence the relative attractiveness of deposits (and non-cash means of payment) and hence the currency/deposit ratio. This relatively simple formulation assumes that the CBUAE imposes a uniform reserve requirement on all deposits. Its differentiated requirement makes the calculation and estimation of required reserves much more difficult. The ratio of each deposit type subject to a different reserve requirement to total deposits needs to be estimated, taking account of the possible effect of interest rates and other economic factors on shifts between deposit types. A uniform requirement, in addition to simplifying and improving monetary management, is also more efficient in the economic sense of not discriminating between types of deposits (bearing in mind that a reserve requirement that does not pay a market interest rate on the reserves held is a tax on the bank liabilities to which it applies).

Operational implications of changing exchange rate regimes 13. 14. 15.

16. 17. 18. 19.

153

Providing currency freely does not mean providing it free of charge. Currency should be provided by the central bank only in exchange for some other asset (for example, reductions in reserve balances) one for one. These two items are shown separately in gross form in Table A7.1 because of the importance of each one for the control of base money. The exchange rate is basically determined by domestic interest rates relative to international rates, inflationary expectations, oil production and prices and international competitiveness. Hence, in the long run, the real exchange rate cannot be determined by intervention in the foreign exchange market by the central bank. This terminology is taken from Lindgren (1991), which provides an excellent discussion of the transition to market-based instruments of monetary control. See Coats (1980). Sometimes, the term ‘OMO’ is used to refer exclusively to operations in secondary markets. To distinguish them from operations in the secondary market, operations in the primary market are sometimes called ‘open-market type’ operations. IMF (2004). See also Bank for International Settlements (1999).

REFERENCES Bank for International Settlements (1999), ‘Monetary policy operating procedures in emerging market economies’, Policy Paper No. 5. Coats, Warren (1980), ‘The use of reserve requirements in developing countries’, in Warren Coats and D.R. Khatkhate (eds), Money and Monetary Policy in Less Developed Countries: Survey of Issues and Evidence, Oxford: Pergamon Press. Friedman, Milton (1969), The Quantity Theory of Money and Other Essays, Chicago IL: Aldine. IMF (2004), ‘Monetary policy implementation at different stages of market development’, International Monetary Fund, Monetary and Financial Systems Department. Johnston, Barry and Odd Per Brekk (1989), ‘Monetary control procedures and financial reform: approaches, issues and recent experiences in developing countries’, IMF Working Paper No. 89/48. Lindgren, Carl-Johan (1991), ‘The transition from direct to indirect instruments of monetary policy’, in Patrick Domes and Reza Vaez-Zadeh (eds), The Evolving Role of Central Banks, Washington DC: International Monetary Fund.

8.

The United Arab Emirates: exchange rate regime options* Zubair Iqbal

INTRODUCTION This study aims to evaluate the United Arab Emirates’ (UAE) experience with the current exchange arrangement that pegs the dirham to the US dollar at a fixed rate, assess merits of continuing with the arrangement in the period ahead, review exchange rate options that the UAE could consider to address its changing national economic priorities and recommend an alternative regime. The political economy considerations pertaining to the planned GCC monetary union or non-economic reasons for the retention of the existing arrangement are not addressed. The peg to the US dollar, in effect for the last three decades, has provided the UAE economy with a credible nominal anchor. This policy has been consistent with the various criteria for adopting a fixed exchange rate, including labor market and wage flexibility, trade and payments openness, business cycle synchronicity with the US economy and preponderance of real shocks. Wage flexibility and abundant international reserves have allowed an effective mixture of adjustment and financing to address the wide fluctuations in the global oil prices. The exchange arrangement has, until recently, helped maintain inflation at close to that of the UAE’s major trading partners and supported external stability, notwithstanding the real terms-of-trade shocks relating to oil prices. However, this policy has had its limitations. Fiscal policy has had to bear additional burden in the absence of an active monetary policy and a fixed exchange rate to sustain internal stability and growth. Instability of non-oil exports and imports has increased over time, and exchange rate fluctuations vis-à-vis non-dollar currencies have led to higher costs by increasing the exchange rate risk for trade and capital transactions. While this policy has so far served the UAE economy well, it has started to come under pressure to meet the evolving national objectives, including increasing focus on economic and export diversification, low inflation and regional integration. The emerging economic environment in the 154

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UAE and in the global economy is becoming less compatible with a fixed exchange rate regime. Although a significant part of the current higher inflation can be attributed to supply bottlenecks in the face of rapidly rising public expenditures and private investment spending, any further depreciation of the US dollar would add to such inflationary pressures. Even if the US dollar were to start appreciating, exchange rate fluctuation vis-à-vis other currencies will remain significant with the attendant costs. Moreover, the weakening synchronization of the US and the UAE business cycles will increase the cost of maintaining the dollar peg. In addition, in the absence of a relatively independent monetary policy, the ability to address inflation will be negatively impacted unless fiscal policy can be tightened significantly and its countercyclicality enhanced. At the same time, with the UAE financial sector becoming deeply integrated with the global system, the UAE economy would become more vulnerable to exogenous financial shocks. Currently, the authorities do not have enough policy tools to address these emerging challenges as well as to sustain high non-oil growth, therefore, there is a need for modifying the overall macroeconomic policy stance. This should include greater exchange rate flexibility to not only respond to increasing global exchange rate and financial volatility, but also to support fiscal and monetary policies in promoting economic diversification and containing inflation. A number of alternative exchange rate regime options could be considered to assign a more active role to the exchange rate. These options range from pegs with wider bands, to currency basket pegs, managed and free floating regimes and the oil price peg. Given the strong external position of the economy, there is no need for an abrupt change that would disrupt the existing market credibility. A gradual step-by-step approach would be advisable that provides for, initially, a shift to a currency basket peg to allow flexibility, widening of margins to permit a greater role of the market in the determination of the rate, followed by the introduction of nominal exchange rate targeting as a nominal anchor. Simulations for the past ten years or so show that a relatively small currency basket would have been characterized by moderate exchange rate volatility while allowing an appropriate movement in the Dh/US$ rate. During the initial phase of rate flexibility, steps could be taken to establish the needed institutional infrastructure for managing a more flexible exchange rate system. These include a deep and liquid foreign exchange market, central bank intervention policy, establishment of a mechanism to ensure effective management of exchange risk, and strengthened regulation. Even though this study does not address the issue of GCC coordination

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toward monetary integration and a common currency, there is merit in all GCC countries – which have broadly similar characteristics – pursuing a flexible exchange rate regime. During the transition phase, such flexibility would permit the establishment of market-based cross-rates among these countries and thus provide a firmer basis for defining a common currency. The following section assesses the UAE’s experience with the current exchange rate regime, followed by a brief description of pros and cons of alternative exchange rate arrangements in the third section. The experience of countries shifting from fixed to flexible exchange rate systems is reviewed in the fourth section. The fifth analyzes various options for introducing exchange rate flexibility and recommends the introduction of a gradual, step-by-step mechanism. In the sixth, operational steps for introducing flexibility are summarized. Appendices 1 and 2 discuss the oil price peg and the mechanics of managing a basket peg-based nominal exchange rate path, respectively.

THE EXPERIENCE WITH THE CURRENT EXCHANGE RATE REGIME Exchange rate policy in the UAE has been driven by the need to ensure external stability, market credibility and – in conjunction with fiscal and structural policies – to facilitate development of the non-oil sector in order to reduce excessive dependence on oil exports. For this purpose, the authorities have adhered to an exchange rate regime that pegs the UAE dirham to the US dollar. Since 1980, the dirham, though formally linked to the SDR (special drawing rights), until 2000, has been effectively pegged to the US dollar at the rate of 3.671 = US$1 with narrow margins around the peg. Since 2000, when the peg to the US dollar was formalized, the exchange rate regime also served as a first step toward the planned monetary union among GCC countries by ensuring stable exchange rates between GCC countries. The choice of the peg also appears to be driven by the need, during periods of the US dollar depreciation, to undertake a gradual, almost invisible, depreciation with regard to other major currencies and thus encourage/insulate non-oil activity. It also appears that the pegging arrangement was driven by the need to reduce the operational and transaction costs of managing foreign assets (both official and private), which remain heavily denominated in the US dollars, as are much of current international transactions. The pegged exchange rate regime has important advantages. It can provide a useful and credible nominal anchor for private expectations

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about the behavior of the exchange rate and the requisite supporting monetary policy. It avoids many of the complexities and institutional requirements for establishing an alternative anchor, such as an inflation target that requires, among other things, an operationally independent central bank. The peg also appears to deliver lower inflation, especially if it is an explicit, publicly announced policy goal and acts as a disciplining device. Also, in the absence of a relatively deep and broad market for foreign exchange that would be needed for reasonable stability of the exchange rate, a pegged rate associated with official commitment to sustain it would provide the needed guidance while reducing transaction costs. Moreover, pegged exchange rates would seem to be suitable for small open economies with a dominant trading partner that maintains a reasonably stable monetary policy, thus obviating the need for managing an independent and costly monetary policy. Finally, a fixed exchange rate better insulates against monetary shocks regardless of the degree of capital mobility.1 However, there are a number of limitations. In particular, adjustment to changing economic conditions affecting the equilibrium real exchange rate, including temporary real shocks (such as temporary oil price shocks), must be made by other means, including changes in the level of domestic prices and costs leading to changes in the level of economic activity – growth – and employment. In particular, adjustment to negative real shocks will have to be effected through a contractionary fiscal policy as monetary policy is assigned primarily to maintain the exchange rate, which could make it more difficult to simultaneously achieve internal and external objectives.2 Moreover, greater terms-of-trade volatility implies higher costs associated with a pegged exchange rate. Also, if the pegged regime is adopted when conditions are favorable, but without adequate policy commitment and institutional foundations to withstand the potential strains on the peg, it can entail a costly crisis when conditions turn unfavorable, particularly in an environment of capital mobility. There is also evidence from the 1990s that rigid exchange rate regimes are more frequently associated with banking crises as such regimes may promote excessive risk-taking during periods of booms when the expectation of an exchange rate guarantee by the central bank reduces the incentive to hedge foreign currency exposure. The sudden withdrawal leaves the domestic financial sector susceptible to distress. In addition, given the increased globalization and diversification of sources of imports and capital movements, countries with single-currency pegs remain significantly exposed to the wide fluctuations among major currencies. The UAE economy meets a number of considerations for pegging to the US dollar. Its trade and external financial transactions are mainly denominated in US dollars, its fiscal policy is sustainable with little debt

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140.0 120.0

CPI

100.0 80.0 60.0 40.0 CPI UAE CPI US

20.0 0.0 1986 Note:

1988

1990

1992

1994

1996

1998

2000

2002

2004

2006

CPI = consumer price index.

Sources: International Monetary Fund, International Finance Statistics (several issues); author’s estimates.

Figure 8.1

UAE and US: CPIs 1986–2006

burden, infrastructure for an independent monetary policy is still not fully developed, labor is available at flexible market-based wages and it has abundant international reserves to defend the rate against speculative attacks (see the next section for details). The UAE’s experience with the pegged exchange rate regime has evolved over time. At the initial stages, when the institutional structure for effective monetary policy was lacking, the choice of the US dollar as a nominal anchor – thus giving up its monetary autonomy – allowed the UAE to ‘import’ the US monetary policy credibility and lower inflation. Until recently, inflation remained relatively low and broadly aligned to that in the US (Figure 8.1). This phenomenon has also benefited from the maintenance of an open trade regime, flexibility of the labor market in light of the highly elastic supply of labor from the region at market-based wages, prudent fiscal policy and benign global inflationary conditions. Openness ensured the availability of goods and services at internationally competitive prices, while the sterilized accumulation of large foreign assets, given the fiscal policy stance, contained monetary expansion. However, the recent rapid increase in private sector demand, particularly in the non-tradable sector, increase in the cost of imports from non-dollar areas and the emerging supply constraints have intensified

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110.0 105.0 100.0 95.0

Index

90.0 85.0 80.0 Exchange rate index

75.0 70.0

Nominal effective exchange rate (NEER)

65.0

Real effective exchange rate (REER)

60.0 86 87 88 89 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06

Sources: International Monetary Fund, International Finance Statistics (several issues); author’s estimates.

Figure 8.2

UAE: behavior of NEER and REER, 1986–2006

inflationary pressures. To the extent that, until recently, there was close cyclical synchronicity between the UAE and the US business cycles, the cost associated with the loss of monetary flexibility on account of the peg (arising from the inability to use monetary policy to respond to external terms-of-trade shocks and smooth business cycles) had been small. This may not be the case in the period ahead as the US pursues more expansionary monetary policy to address economic slowdown, thus breaking cyclical synchronicity and forcing the UAE to ease monetary policy – in line with the reduction in the US interest rates – when tightening may be in order to contain credit growth and inflation. The impact on external stability is much more nuanced. It is generally understood that, in a general equilibrium context, exchange rate stability alone cannot guarantee overall external and internal stability. However, exchange rate stability affects broad macroeconomic stability, in particular, demand for imports and exports. It should be noted that as the nominal effective exchange rate (NEER) of the dirham has undergone fluctuations along with the US dollar over the past 25 years, volatility of the NEER has increased, implying an increase in external volatility (Figure 8.2). Elasticity estimates for the various components of the trade account with respect to the peg show that the instability for non-oil exports and imports has increased over time; this instability has also increased relative

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to a hypothetical currency basket peg (see Erbas et al., 2001; Abed et al., 2003). The peg to the US dollar has, in view of the wide fluctuations in oil prices, placed excessive burden on fiscal policy to sustain internal stability and growth. The UAE, during past periods of sustained oil price downturns, had had to draw upon its official foreign assets to protect the budget from revenue volatility and to ensure external sustainability. The expansionary countercyclical fiscal policies reduced foreign assets and thus sources of non-oil revenues in the long run, leading to increased vulnerability to future negative terms-of-trade shocks. More importantly, such fiscal stance has tended to permanently raise the level of government spending, thus reducing room for a more flexible fiscal policy in the period ahead. Simulations of a more flexible exchange rate regime as compared with the US dollar peg show that the former would have implied a better distribution of burden between the exchange rate and the budget while containing the loss/slower accumulation of official foreign assets. Weakening of business cycle synchronicity with the US economy in the period ahead may call for even greater burden on the budget under the existing exchange rate regime. The impact of the dollar peg on the UAE’s competitiveness of the nonoil sector has at best been neutral. It should be recognized that external stability and competitiveness cannot be achieved with a single instrument, that is, the choice of the exchange rate regime. Reflecting fluctuations in the US dollar and the domestic price developments, the real effective exchange rate (REER) of the dirham has varied considerably since 1986 (Figure 8.2). After depreciating in real effective terms during the second half of 1980s, mainly on account of a depreciating dollar, the dirham appreciated in real effective terms through the 1990s without affecting the growth of non-oil exports excluding re-exports. Similarly, notwithstanding fluctuations in the REER during 2000–07, such exports have shown an average annual rate of increase of about 20 percent. While the depreciation of the US dollar with regard to other major currencies may have had a beneficial effect, much of the increased competitiveness and growth of non-oil exports reflect structural reforms such as the improvement in the business climate, modernization of large segments of the economy, and the highly elastic supply of expatriate labor. In the event, the UAE nonoil sector has registered significant productivity gains and growth, but its links to the exchange rate regime are indeterminate. To the extent that the peg to the US dollar has resulted in exchange rate fluctuations with regard to other currencies, the peg has resulted in higher costs by increasing the exchange rate risk for trade and capital transactions, in addition to altering relative prices affecting production and

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investment decisions. However, exposure to foreign exchange risk appears well-contained with most foreign exchange operations by UAE banks in US dollars. Although net foreign exchange positions in US dollars are declining, they are the equivalent of about 25 percent of bank capital with most banks holding significant positive foreign exchange positions. Consequently, any exchange rate shock (including a further depreciation of the dollar) would affect negatively the capital ratios of the banking system. On balance, the prevailing exchange rate policy has been effective in the past, but has increasingly come under pressure to meet its objectives. It has been an effective nominal anchor for most of the period under review and – given the nominal wage flexibility, open capital mobility and a free trade and payments system – has facilitated adjustment to real external shocks. A recent International Monetary Fund study has determined that the real effective appreciation of the dirham over the past two to three years of about 6 percent was not inconsistent with the underlying equilibrium real exchange rate that has been affected by the positive oil price-related terms-of-trade shock.3 The estimation of the long-run equilibrium real exchange rate derived from key macroeconomic fundamentals, such as the overall fiscal balance and the terms-of-trade, shows that in 2006, the UAE dirham was undervalued by about 2 percent with respect to its estimated equilibrium level.

EXCHANGE RATE OPTIONS FOR THE FUTURE: THEIR COSTS AND BENEFITS The UAE economy has started to encounter new challenges that call for a re-evaluation of its overall macroeconomic policy stance, including exchange rate policy. The economy’s objective function is undergoing a change toward a better balancing of preserving external competitiveness of the non-oil sector and openness to the global capital markets. The recent positive oil price shock, though eased over the past 12 months, appears to be long-lasting rather than a short-run phenomenon and calls for a durable adjustment rather than – as in the past – financing of the fiscal and external imbalances. Even though the recent increase in inflation can partly be attributed to domestic capacity constraints, a persistent weakness of the US dollar against other major currencies would increase imported inflation. It would also cause a widening divergence between the equilibrium real exchange rate and the REER, implying exchange rate misalignment. In contrast with the past, the synchronicity of the UAE-US business

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cycle has weakened, implying increasing incompatibility of UAE’s economic interests and those of the US monetary policy, with implications for the effectiveness of the current exchange rate policy even if the US dollar were to start appreciating. In the latter case, the accompanying appreciation of the dirham would generate competitiveness problems for the UAE at a time when attempts are being made to diversify away from the heavy dependence on oil. More importantly, the US dollar has imposed a pattern that derives from movements of the dollar vis-à-vis other international currencies that have limited bearing for the UAE economy. Hence, adherence to the US monetary policy as an anchor for the peg has caused wide swings of dirham’s exchange rate in terms of other major currencies. At present, the policy setting that is right for the US economy is inconsistent with UAE’s interests especially when oil prices are starting to rise again. While a one-time revaluation of the dirham would serve the present dilemma – notwithstanding a one-time loss in the value of heavily dollardenominated foreign assets – it would not address the underlying problem of policy inflexibility and keeping it tied to monetary policy objectives of oil importers. The UAE economy has undergone major structural changes, including a further strengthening of external asset position, expanding non-oil sector and exports, deeper and self-sustaining domestic financial sector with increased interaction with the global capital market. These changes will modify the role that the exchange rate will play to achieve internal and external objectives. Moreover, competing considerations of increased dependence on expatriate labor and possible changes in policy with regard to labor market flexibility to ensure employment to the rapidly expanding local labor at higher wages – market segmentation – may also impact on the effectiveness of the exchange rate regime in preserving competitiveness. Finally, political economy considerations – in particular, the planned establishment of the GCC monetary union – would guide regime choice. There are a wide variety of exchange rate regimes, ranging from strict pegging as under currency board arrangements to pegs with limited flexibility – a variant of which is being practiced presently in the UAE – crawling peg, inflation or nominal exchange rate targeting and to freely floating rates. In addition, they are characterized by variations in permissible bands or margins around the declared rate with the aim of seeking an appropriate mix of market forces and monetary policy action to achieve internal and external objectives. Recently, options have been explored that would link the value of an oil producer’s currency to the oil price. The success of these exchange rate regimes depends critically on the compatibility of exchange rate policy with monetary and fiscal policies.4

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163

This section evaluates the alternative exchange rate regimes as a guide for policy choices for the authorities. No attempt is made to determine the level of the rate that would be suitable for the UAE in the period ahead. It should be recognized that each of these regimes requires its own set of supporting macroeconomic policies that should be followed for the respective regime to be effective. There is extensive literature on criteria to guide the selection of alternative exchange regimes.5 These include the degree of involvement with international capital markets, trade integration and direction, labor market and wage flexibility, nature of shocks – real or nominal, their frequency and synchronicity – fiscal policy flexibility and the effectiveness of monetary policy in addressing external shocks and the level of external reserves. It should be emphasized that there is no agreement on how precisely to quantify these criteria into unique recommendations for specific exchange rate regimes: these, in their totality, primarily provide a direction for choosing a suitable regime. Moreover, sound fiscal and monetary policies are a prerequisite for any exchange rate arrangement to function well. Hence, optimality of any regime cannot be judged independently of those policies. Finally, broader institutional structure is also an important element in the choice of an exchange rate regime. Effectiveness of alternative regimes is measured in terms of internal (promotion of non-oil growth and control of inflation) and external (sustainable external current account position, relative stability of the exchange rate, and external competitiveness) objectives. The possible spectrum of exchange rate regimes ranges from strict pegging as under a currency board arrangement, fixed peg, target bands around declared exchange rates (crawling peg with wide and narrow margins) and to varying degrees of floating (independent and managed floating) in the open market. In addition, pegs could be to a single currency – as at present in the case of the UAE – or to a basket of currencies – as is the case of Kuwait. Table 8.1 summarizes compatibility of important economic indicators with different types of exchange rate arrangements based on the above criteria. It should be recognized that the appropriateness of an exchange rate regime should be based not only on how it performs under stress, but also how it performs on average over time. Change in the objective function, say, from increased focus on inflation control to competitiveness and growth would alter the decision about the choice of the exchange rate regime and the corresponding macroeconomic policies. Therefore, the choice of an exchange regime is not between two extremes – fixed or floating – but to determine a regime that, in combination with other macroeconomic policies, best achieves its internal and external objectives. Should the exchange rate and the underlying regime be left unchanged, other macroeconomic

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Table 8.1

The UAE – consistency between exchange rate regimes and selected economic indicators Peg Single

Basket

Band Narrow Wide

Inflation High Low Yes Yes Growth High Low Yes Yes Capital mobility High Low Yes Yes Labor mobility High Yes Yes Low Reserve Level High Yes Low Yes Fiscal policy flexibility and sustainability High Yes Yes Low Trade integration with partner countries High Yes Yes Low Business cycle synchronicity Symmetric Yes Yes Asymmetric Nature of shock Real Nominal Yes Yes Source:

Float Crawl Managed Free

Oil Price Peg

Yes

Yes Yes

Yes Yes

Yes Yes

Yes Uncertain Yes Yes

Yes Yes

Yes

Yes

Yes Uncertain

Yes

Yes

Yes Yes

Yes

Yes

Yes

Yes Yes

Yes

Yes Yes

Yes Yes

Yes

Yes

Yes

Yes

Yes

Yes

Yes

Yes Yes

Yes

Yes Yes

Yes Yes

Yes

Yes

Yes

Yes Yes

Yes

Yes Yes

Yes Yes

N.A.

Yes

Yes

N.A.

Yes Yes Yes Yes

Yes

Yes Yes

Yes

Yes

Yes

Yes

N.A.

Based on data in Eichengreen and Masson (1998).

policies will have to take up the additional burden, which could have a detrimental effect on achieving other economic objectives. Baskets, Bands and Crawls – Flexible Exchange Rates A wide variety of exchange rate options are available that allow varying degrees of flexibility around a declared exchange rate. These include a single currency peg with a wider target band; basket pegs whereby the currency is pegged to a basket of currencies – such as the SDR – based on their relative share in the country’s international transactions and subject

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165

to narrow or wide bands; and crawling peg or band, such as the one where the parity is adjusted for, say, past inflation to keep the rate in line with economic fundamentals or to correct the emerging external current account imbalances. In addition, a hybrid two-tier exchange regime can also be considered under which a currency is linked simultaneously to the US dollar and a basket, allowing the US dollar rate to change whenever the dollar’s movement vis-à-vis the basket in the market exceeds specified margins. One way to minimize the adverse effects of fluctuations among the exchange rates of major currencies is to peg to a currency basket. The weights of the various currencies in the basket could reflect either the currency composition of trade, or the country’s direction of trade, or the currency weights of the SDR. Although less transparent than a single currency peg, the basket peg regime has the advantage of reducing volatility of the nominal and real effective exchange rates. While the transaction cost may also increase, this arrangement will, under appropriate macroeconomic policies, reduce inflation and moderate the adverse competitiveness effects of the appreciation of the dominant currency (US dollar in the case of the UAE). Wider margins around the basket peg would allow the authorities to use monetary policy for supporting fiscal policy in meeting internal objectives, and – as under the fixed single currency peg – insulate against monetary shocks. Given the moderate rate flexibility, the basket arrangement, especially with capital mobility, would also address real shocks somewhat better than the fixed rate regime while reducing the level of foreign reserves needed to support the exchange rate. To the extent that the arrangement allows continuous market-based alignment of the REER to the equilibrium exchange rate, it should facilitate faster and sustainable growth. When the inflation rate in the economy is significantly and persistently higher than in the trading partners, the authorities could choose a crawling peg or a crawling band regime (with both single or basket currency pegs). Under this regime, the rate or the band is adjusted for past inflation so that the real effective exchange rate remains broadly unchanged and consistent with economic fundamentals. More generally, the crawling peg could be linked to any selected economic indicator and not specifically to the inflation rate. The degree of exchange rate flexibility under this arrangement is a function of the width of the band. One disadvantage of this arrangement is that, by committing to maintaining the exchange rate or the band, it imposes constraints on monetary policy, where the degree of constraint is measured by the width of the band. Also, although it provides short-term stability, it fails to provide a basis for medium-term stability, unless the pace of crawl is preannounced to influence inflation or other

166

Currency union and exchange rate issues

policy expectations. Moreover, such an arrangement calls for a strong policy infrastructure, a comprehensive database, and the authorities must be viewed to have a firm commitment to the arrangement. Crawling peg arrangement has limited applicability to the UAE under the current scenario. Any adjustment in the dirham/dollar rate to reflect a faster rate of inflation in the UAE would call for a depreciation of the dirham rather than an appreciation to reflect the large external surplus and inflationary pressures emanating from the depreciation of the US dollar against other major currencies. A two-tier exchange rate peg would call for the authorities to link the dirham simultaneously to the dollar through an ‘operational’ rate and declare an official parity in terms of a currency basket, with the accompanying rules for changing the ‘operational’ rate whenever the dollar’s movement vis-à-vis the basket exceeds specified margins.6 Up to the specified margin, the rate with the US dollar will remain unchanged but will vary with respect to other currencies. However, beyond that margin, the rate of the dirham will remain unchanged with the basket but will vary with respect to the dollar based on market conditions. The extent of margins would have to be determined in light of past behavior of the exchange rate; past experience of exchange rate movements shows that margins between 5 and 10 percent would be suitable for the UAE. Such an arrangement will not allow minor variations in the value of the dollar to affect the dollar/ dirham rate and thus not affect the market in the UAE and continue to provide the convenience and a degree of certainty to the private sector. It would also provide the much-needed certainty with respect to budgetary oil revenues. This arrangement would ensure that large movements of the dollar do not drag the dirham into prolonged bouts of over- and under-valuations with regard to non-dollar currencies, resulting in competitiveness or inflation problems. The US dollar could be excluded from the basket since it is already being accorded due importance through the operational rate. If the proposed two-tier arrangement with 5 percent margin were in place during the last ten years, 1997–2007, the dirham would have appreciated against the dollar by about 10 percent in 2007. Though simple and sensitive to the adverse effects of wide fluctuations in the dollar, the two-tier regime will require an active and independent monetary policy (with the attendant institutional structure). The authorities would be expected to anticipate global currency developments and also respond effectively to private capital flows so as to minimize effects on domestic money growth. More importantly, in the absence of similar arrangements in other GCC countries, this regime will cause significant fluctuations in the intra-GCC cross-rates, increase transaction costs for

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167

intra-GCC payments and further complicate the process of monetary integration. Managed and Free Floating Exchange Rates Floating exchange rate regimes range from a managed float where the value of domestic currency could be tightly linked to a foreign currency (or a basket of currencies) over an extended period to a loosely managed float where the exchange rate is regularly seen as determined by market forces without official intervention to counter the market forces, except under extreme and infrequent conditions. In the extreme, unfettered float implies use of monetary policy for domestic objective with benign neglect of the exchange rate. The managed float involves exchange rate interventions and frequent adjustments in monetary and fiscal policies to ensure consistency of policies and objectives. For this option to work, there needs to be some flexibility in the exchange rate, supported by explicit official commitments for maintaining a credible exchange rate that can be defended in the market. In the process, managed floats provide a nominal anchor in the form of a nominal exchange rate path and help to stabilize expectations about the rate and the underlying macroeconomic policies. It is important that the exchange rate actually moves in response to changes in market conditions, even in the short run, to ensure that the market participants respond prudently and allow the economy to adjust to changes in the relative prices of tradables and non-tradables. In the case of free floating, inflation targeting has served as an effective alternative anchor for monetary policy supported by an independent central bank. However, if the exchange market is thin and thus amenable to exchange rate volatility, there will be a need for the authorities to provide guidance to ensure that hedging against exchange rate risk is reduced and the cost of volatility is mitigated. Moreover, the real exchange rates are more variable and exchange rate flexibility is higher under managed and freely floating regimes than under pegged and limited flexibility regimes. Floating exchange rate regimes, especially if associated with inflation targeting, call for rigorous institutional arrangements and comprehensive databases, development of policy instruments and communication strategies. In particular, central bank independence is important to help mitigate fears of loose monetary policy, which, in turn, will need to be characterized by transparency and accountability.7 Money growth targets would need to be established to reinforce inflation targeting objectives that, in conditions of rapidly changing money demand especially in countries like the UAE that are being affected by large real shocks (oil prices), would be difficult to manage. Moreover, financial sector

168

Currency union and exchange rate issues

regulation will have to be strengthened to take account of the financial institutions’ large foreign currency exposure. Steps would also be needed to improve the effectiveness of interest rate adjustments and official intervention – sterilization – to influence the exchange rate under open capital mobility. Therefore, given the time required to establish the needed foundations, any transition to floating exchange rates would call for cautious gradualism. Pegging to Oil Price Frankel (2003) has proposed that countries dependent upon primary export commodities could peg their currencies to either the price of their main export, or incorporate this price in a currency basket under a basket peg.8 The export price peg would allow the exchange rate to fluctuate with the export price and thus accommodate terms-of-trade shocks. While such a peg would have benefits similar to that of the floating exchange regime, it would expose the domestic economy to oil price volatility and discourage growth of the non-oil economy by raising the cost of non-oil exports in line with the increase in oil prices. Finally, other options as discussed above would provide the needed exchange rate flexibility without incurring the additional costs associated with the oil price peg or its variants. Summary of Economic Effects Lessons, though ambiguous, from experiences with the various exchange rate arrangements and countries are particularly useful for evaluating challenges that the UAE will have to face in assessing its options. These are: ●

●

Inflation under the fixed exchange rate regime is lower than under flexible or floating exchange rates in developing and emerging market economies, in part due to greater confidence in the currency and the associated lower money growth. In developed countries on the other hand, inflation declines with flexible and floating exchange rates. Although there is limited conclusive evidence on the relationship between the exchange rate regime and growth, a study (Levy-Yeyati and Sturzenegger, 2003) finds that flexible exchange rates, because of shock absorbers and fewer distortions following real shocks, are associated with higher growth in developing and emerging market countries.

The United Arab Emirates: exchange rate regime options ● ●

●

●

●

169

Fixed exchange rate regimes may increase volatility of output on account of real shocks. Fixed and limited flexibility exchange rate regimes with high and volatile international capital mobility are more exposed to currency, banking and financial crises than the flexible and floating exchange rate regimes. Experience has shown that an adjustable peg or a tightly managed float with occasional large adjustments is a difficult regime to sustain under high capital mobility. The advantages of exchange rate flexibility increase as countries become more integrated into global capital markets and develop a sound financial system. Sound fiscal and monetary policies are a prerequisite for any exchange rate arrangement to function effectively. Since the requisite macroeconomic policies are different for different exchange rate regimes, the optimality of a regime cannot be determined independently of those underlying policies.

THE EXPERIENCE WITH TRANSITION FROM FIXED EXCHANGE RATE REGIMES Over 140 exits or transitions of exchange arrangements, lasting for at least one year, have been experienced since 1990. While these include exits from bands to floats and from managed bands to independent floats, the bulk of transitions have been from hard fixed and crawling pegs to more flexible arrangements including basket pegs with wider bands and to floats. An important overall lesson of these exits is that, by and large, currency crises were precipitated by inappropriate macroeconomic policies that had increased the costs of maintaining the existing exchange rates. A large share of exits from fixed to flexible regimes has been abrupt and disorderly, precipitated by financial or external crises. Data show that about 55 percent of total exits during the period 1990–2002 were disorderly. Important cases include Brazil, Mexico, Turkey and Thailand. In many cases, currency crisis involved monetary expansion that led to progressive depletion of official reserves and speculative attacks on the currency. These developments, in most cases, were associated with loose fiscal policies and the inability to generate the needed increase in public and private savings in order to prevent unsustainable external current account deficits. These underlying weak macroeconomic conditions were combined with high unemployment, weak banking institutions and high

170

Currency union and exchange rate issues

public debt that constrained the authorities’ ability to tighten policies sufficiently to defend the exchange rate. The experience of Mexico’s (1994–95) transition is quite instructive. Notwithstanding a favorable macroeconomic environment, the exit was precipitated by a general loss in investor confidence in the exchange rate associated with real and financial costs that depreciated the peso to the lower band. The banking crisis ensued and the authorities initially widened the band while devaluing the peso and then abandoned the crawling band in 1995 in order to save the rapidly depleting external reserves; an increase in interest rate to defend the band had become unfeasible. The Mexican experience shows that mainstream prudent fiscal policies alone may not be sufficient to sustain a large external current account deficit in a globally integrated economy. Unless the financial system is healthy and the authorities are able to address emerging crises promptly, the exchange rate may not be sustainable. On the other hand, countries that voluntarily shifted out of the fixed pegs on account of upward pressures on their currencies – such as Chile and Poland – did it gradually in a non-crisis and orderly fashion. Among the orderly exits to flexible regimes, just 39 percent characterized a one-step move from hard, fixed, or crawling pegs to floats with most countries following a gradual approach. While the consequent appreciation had temporary unwanted effects on exports, the shift to the new exchange arrangement did not damage policy credibility or cause economic disruptions. The case of Poland is particularly relevant. In this case, exchange rate policy has been considered as integral to the overall economic policy package to ensure its consistency with growth, employment, inflation and external objectives. The exchange rate regime has, therefore, been adapted to the changing economic conditions. In line with the comprehensive reform package that was introduced in 1990, the exchange rate regime was initially changed from a fixed peg to the US dollar to a fixed peg to a basket, before shifting to a preannounced crawling peg to ensure a compromise between competing goals of disinflation and competitiveness that had been complicated by persistent capital inflows. The preannounced band allowed for market-driven appreciation. In the mid-1990s, the band around the crawling band was widened to allow greater market determination of the exchange rate. It is worth noting, as shown by the experience of a large number of cases of exits, that economic recovery and growth with relative exchange rate stability takes longer to resume under a crisis-driven shift to exchange rate flexibility than under conditions of an orderly and gradual exit.9

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171

AN ALTERNATIVE EXCHANGE RATE REGIME FOR THE UAE Currently, the UAE continues to meet some of the criteria for pegging the dirham to the US dollar. However, significant structural changes in the past few years, a changing national objective function attaching increasing attention to economic diversification and close integration with the global capital markets, as stresses following Dubai’s debt pressures are taken care of, would call for a shift in the overall macroeconomic policy framework, including a new look at the exchange rate regime. The potential conflicts between the economy’s internal and external objectives, the increasing asymmetry of shocks (with the UAE primarily subject to real shocks), a rising inconsistency of business cycle with the US economy, a declining (though still large) share of the US dollar in trade and financial transactions, and capital mobility, appear to have increased the cost of maintaining the US dollar peg. As noted earlier, the present phase of US dollar depreciation has added costs not only in terms of inflation and higher budgetary expenditures invoiced in non-dollar currencies, but also in that any subsequent dollar appreciation will not only create competitiveness problems for the non-oil sector but also increase volatility in terms of non-dollar currencies. The foregoing problems for the UAE would tend to become correspondingly more acute as the dollar’s movements against other major currencies increase in range and volatility. Also, if the US dollar were to depreciate further, its inflationary impact would become more dominant, notwithstanding the current supply constraints. Under the unchanged macroeconomic policy stance and the currency arrangement, the UAE economy would likely continue accumulating foreign assets. While supply constraints would ease over time, non-oil growth would likely moderate. The financial sector has become more closely integrated with the global economy, thus increasing vulnerability to exogenous shocks. In the absence of a more autonomous monetary policy, the authorities’ ability to address inflation would be limited unless fiscal policy can be tightened significantly. The latter would be constrained since fiscal policy is subject to political and structural impediments in the near term. It is unclear as to how an exogenous shock would be addressed if monetary policy cannot actively support fiscal policy. Fiscal reforms in the pipeline will take time to materialize and it is unclear whether they will be sufficient to fully address challenges emanating from a fixed exchange rate regime. A more suitable response would be to allow a greater degree of exchange rate flexibility, freeing up monetary policy to supplement a tighter fiscal policy so that inflation can be kept in check and growth

172

Currency union and exchange rate issues

maintained at a long-term sustainable path with external stability, while more adequately addressing any exogenous financial shocks. Pegging to a Currency Basket In light of the assessment of options for the exchange regime in the sections above, presented below is a strategy that calls for a step-by-step gradual transition to managed floating. At the initial stage, a currency basket or SDR peg with narrow bands would be a suitable step, followed by a widening of bands to allow greater market determination of the rate. At a later stage, introduction of narrowly managed floating currency basket peg targeting a nominal exchange rate path, as a nominal anchor, should be considered. The nominal exchange rate targeting would call for the formulation of a medium-term strategy about the role of exchange rate policy in the overall mix of macroeconomic policies. Further modifications could be made in the period ahead to reflect evolving global economic and financial conditions.10 As a first step, the UAE could peg the dirham to a basket of currencies of major trading partners (possibly, the SDR) with margins of about 2.5 percent on either side with the US dollar as the intervention currency; alternatively, it could adopt the two-tier exchange system as described above.11 In the former case, the peg will be adjusted whenever the value of the dirham exceeded the margin for a specified period. Within the margins, the value in terms of the dollar would change in line with the market value of the dollar for the basket. In the latter case, the dirham would be allowed to vary, in relation to the basket, as long as the dollar’s variations with respect to the basket remained within the margins; beyond those margins, the exchange rate would become pegged to the basket and would be allowed to vary with respect to the dollar. The monetary authorities would be expected to intervene as needed (in contrast to the rules-based sales and purchases under fixed currency pegs) in the foreign exchange market to address temporary speculative pressures to ensure stability around the trend exchange rate. While these proposals would allow flexibility of the dirham exchange rate, they will be tantamount to benign neglect by policy-makers. If the two-tier arrangement were in place (with SDR peg) during the last ten years with a 5 percent margin, the dirham would have shifted from the dollar peg in 1995–98 and during 2004–07. At end 2007, it would have stood at about Dh3.30 per US dollar, implying a revaluation of about 9 percent over the declared parity of Dh.3.67 per dollar. The currency basket pegging arrangement could be built upon over time through managed float. Data collected from the operation of the benign basket peg as described above could help develop steps toward

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173

managed floating including market sensitivity to the exchange rate. A target nominal exchange rate in terms of dollars as an anchor – either as a stable or a predictable average exchange rate path over time that minimizes inflation differentials with trading partners – could be established to guide policies over the period ahead. Such exchange rate targeting would call for flexible monetary policy and an active countercyclical fiscal policy to manage demand. Targeting of nominal exchange rate within a defined range implies that the domestic credit policies will be conducted to respond to the deviations in the nominal exchange rate. On the other hand, competitiveness and diversification objectives would also be met through structural reforms and an appropriate incomes policy aimed at ensuring nominal wage flexibility and labor mobility. Illustrative Examples What could a basket peg look like? UAE’s exploration for a more flexible exchange rate regime could, as stated above, aim at targeting the path of an average peg to the US dollar with which the general public and the global market are familiar. Many countries that have experienced inflation instability have found it more operationally credible to target the nominal exchange rate where targeting inflation is difficult. On the assumption that the basket consists of only two currencies – the US dollar and the euro – a basket peg may be designed as: e·Dh = w1·US$ + w2·euro In the equation, w1 and w2 are weights (w1 + w2 = 1), which may be chosen on the basis of trade weights with the US dollar and the eurozone, as well as on the basis of the weight of the dollar-denominated exports in UAE’s total exports and dollar-denominated assets in UAE’s financial portfolio, and other considerations deemed important by policy-makers. In addition to w1 and w2, notice that E is also a control variable at the disposal of policy-makers, which can be chosen to target the nominal Dh/ US$ exchange rate over the longer run that would be consistent with the authorities’ objectives. At the same time, the weights can be adjusted to respond to the shorter-run policy goals, as the circumstance may dictate.12 For example, if E = 0.27235 and w1 = 1, then Dh/US$ = E = 1/e = 3.6710, which is the exchange rate under the prevailing dollar peg (that is, the basket contains only one currency, the US$, whose weight is 1). For details of how variations in currency weights and E could affect the exchange rate, see Appendix 8.2.

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Currency union and exchange rate issues

Alternatively, if w1 and w2 (= 1 – w1) are less than unity, then the Dh/US$ and the Dh/euro exchange rates are, respectively, Dh Euro 1 Euro 5 aw1 1 w2 b a b 5 aw1 1 w2 bE; US$ US$ e US$ US$ 1 US$ Dh 5 aw1 1 w2 b a b 5 aw1 1 w2 bE. e Euro Euro Euro For example, if w1 = 0.80, w2 = 0.20, E = 3.83, and euro/US$ = 0.80 (or, US$/euro = 1.20), then Dh/US$ = 3.67 and Dh/euro = 4.61, which was the case in 2006.13 Changing the values of w1, w2 and E, the authorities can drive the nominal exchange rates in line with the chosen path. In practice, the adjustments in those values need only be known to the policy-making authorities. However, the authorities may find it advisable to announce the nominal exchange rate path so as to guide the market participants. In keeping with the economic developments, the authorities may wish to achieve an appreciation or depreciation of the dirham. Of course, such decisions on the Dh/US$ exchange rate need to be supported by the underlying macroeconomic fundamentals and policies. For example, a desired appreciation of the currency with the goal of reducing inflationary pressures needs to be supported by tighter monetary and fiscal policies. However, given the monetary and fiscal policies (for example, a desired rate of expansion in domestic credit and a desired level of budget deficit or surplus), the basket peg allows the leeway for an appreciation of the dirham in terms of the dollar. The simulations in Figures 8.3a and b are carried out on the assumption that the US$ and euro basket weights are chosen as w1 = 0.80; w2 = 0.20, and, the average of the Dh/US$ exchange rate during 1988–2006 remains at the prevailing peg of Dh/US$ = 3.67, which is ensured if E is assumed as equal to 3.77. As shown in Figure 8.3a and Table 8.2, the Dh/US$ exchange rate deviates from the average of 3.67 by relatively small margins (within maximum ranges of +5 and –2.5 percent) and, therefore, the Dh/euro exchange rate, shown in Figure 8.3b, is very close to what it actually turned out to be during 1988–2006. At the same time, under the basket peg, Dh appreciates by about 5 percent relative to US$ during 2002–06, when average oil prices increased sharply, resulting in a major improvement in UAE’s terms-oftrade relative to the rest of the world. A 5 percent nominal appreciation of Dh relative to the US dollar may have had enough impact to abate to some extent inflationary pressures (including, by moderating increase in nominal wages). Considering that CPI inflation averaged 6 percent per

The United Arab Emirates: exchange rate regime options

175

4.20 4.00

Dh/US$

3.80 3.60 Peg –5% Peg +5% Peg –10% Peg +10% $Basket Dh/US $Actual Dh/US

3.40 3.20 3.00

86 87 88 89 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06

Sources: International Monetary Fund, International Finance Statistics (several issues); author’s estimates.

Figure 8.3a

UAE: behavior of Dh/US$ exchange rate under a hypothetical peg basket with a high US dollar weight (80%)

6.00 5.00

Dh/Euro

4.00 3.00 2.00 1.00

Basket Dh/EU Actual Dh/EU

19 86 19 87 19 88 19 89 19 90 19 91 19 92 19 93 19 94 19 95 19 96 19 97 19 98 19 99 20 00 20 01 20 02 20 03 20 04 20 05 20 06

0.00

Sources: International Monetary Fund, International Finance Statistics (several issues); author’s estimates.

Figure 8.3b

UAE: behavior of Dh/euro exchange rate under a hypothetical peg basket with a high US dollar weight (80%)

176

Oil price

1.00 0.95 0.90 0.80

US$

0.00 0.05 0.10 0.20

Weights

0.00 0.05 0.10 0.20 0.30 0.40 0.50

1.00 0.95 0.90 0.80 0.70 0.60 0.50

Peg to Oil Price

Euro

US$

Weights

0.00 0.00 0.00 0.00 0.00 0.00 0.00

Yen

75.43 38.15 25.53 15.37

E Parameter Value

3.67 3.69 3.72 3.77 3.81 3.87 3.92

E Parameter Value

−55.0 −21.8 −13.1 −6.7

Appreciation (−) or Depreciation (+) of Dh/US$ 2002–2006

0.0 −1.3 −2.6 −5.2 −7.7 −10.3 −12.7

Appreciation (−) or Depreciation (+) of Dh/US$ 2002–06

57.1 27.4 17.4 9.3

Maximum Deviation from Dh/US$ = 3.67 1986–2006

%

0.0 1.2 2.4 5.0 7.5 10.2 12.9

−68.0 −32.7 −20.7 −11.1

Minimum Deviation from Dh/US$ = 3.67 1986–2007

0.0 −0.6 −1.2 −2.5 −3.8 −5.1 −6.5

Maximum Deviation Minimum from Dh/US$ Deviation from 1986–2006 Dh/US$ 1986–2007

%

UAE: summary indicators of behavior of Dh/US$ exchange rate under different peg baskets

Peg to a Basket of US$ and Euro

Table 8.2

177

0.70 0.60 0.50

0.33 0.20 0.20

0.56 0.69 0.75

0.11 0.11 0.05

Yen

4.94

E Parameter value

0.26 0.26 0.52

E Parameter Value

10.99 8.55 7.00

−13.8

Appreciation (−) or Depreciation (+) of Dh/US$ 2002–06

%

0.34 0.64 0.08

Appreciation (−) or Depreciation (+) of Dh/US$ 2002–06

−4.1 −2.7 −1.8

32.4

Maximum Deviation from Dh/US$ = 3.67 1986–2006

35.6 35.5 33.0

Maximum Deviation from Dh/US$ = 3.67 1986–2006

%

5.8 3.9 2.7

−11.4

Minimum Deviation from Dh/US$ = 3.67 1986–2007

−21.9 −21.9 −20.3

Minimum Deviation from Dh/US$ = 3.67 1986–2007

−6.9 −4.6 −3.2

Source:

Author’s calculations

Note: In all cases in the table, the value for 1/E is chosen such that the 1986–2006 average for the Dh/US$ exchange rate is 3.67, that is, the value under the prevailing peg only to US$.

1.00

SDR

Weights

Peg to the SDR Basket

Euro

US$

Weights

Peg to Basket of US$, Euro and Japanese Yen

0.30 0.40 0.50

178

Currency union and exchange rate issues 4.40

Peg –5% Peg +5% Peg –10% Peg +10% $Basket Dh/US $Actual Dh/US

4.20

Dh/US$

4.00 3.80 3.60 3.40 3.20 3.00

86 87 88 89 90 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06

Sources: International Monetary Fund, International Finance Statistics (several issues); author’s estimates.

Figure 8.4a

UAE: behavior of Dh/US$ exchange rate under a hypothetical peg basket with a lower US$ weight (60%)

year in the UAE during 2006 and rose further in 2007, a 5 percent appreciation of the dirham against the dollar would have significantly helped in containing inflation.14 Of course, it would be possible to create a greater appreciation in Dh relative to the US$ dollar by changing the policy parameters of the basket. For example, as shown in Figures 8.4a and b, simulations indicate that, if a lower dollar weight were chosen as a = 0.60, with E = 3.87, the nominal Dh appreciation relative to US dollar would have been about 10 percent during 2002–06, while keeping the 1986–2006 average Dh/US$ rate at the prevailing rate of 3.67. However, as shown in Table 8.2, the volatility of the Dh/US$ exchange rate would increase, within the maximum range of +10.2 and –5.1 percent around the prevailing peg of Dh/US$ = 3.67 (Table 8.2). At the same time, the Dh/euro exchange rate would become somewhat more volatile (Figure 8.4b). Peg to a larger basket of currencies: US$, euro and Japanese yen In order to accord due importance to the growing role of East Asia in UAE’s external transactions, pegging to a basket of three currencies, US$, euro and yen may be considered. Figure 8.5 illustrates such a case, where the currency basket weights are chosen as US$ = 0.56; euro = 0.33; and Japanese yen = 0.11.15

The United Arab Emirates: exchange rate regime options

179

5.00 4.80 4.60

Dh/euro

4.40 4.20 4.00 3.80 3.60 3.40

Basket Dh/EU Actual Dh/EU

3.20 3.00

86 87 88 89 90 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06

Sources: International Monetary Fund, International Finance Statistics (several issues); author’s estimates.

Figure 8.4b

UAE: behavior of Dh/euro exchange rate under a hypothetical peg basket with a lower US$ weight (60%)

As shown in Figure 8.5 and in Table 8.2, this expanded peg also produces a significant degree of volatility in the Dh/US$ exchange rate, such volatility being in the maximum range of range of +36 percent and –22 percent. As expected, as the US$ weight is increased, volatility declines. Interestingly, reflecting the larger US$ weight relative to the euro and Japanese yen and the depreciation of the US$, dirham appreciates during 2003–06 with respect to US$ by very small margin. The SDR peg A more suitable approach would be to consider peg to a wider basket such as the SDR, which may be more representative of UAE’s external economic relations. If dirham were pegged to the SDR, then as Figure 8.6, shows, the Dh/US$ exchange rate fluctuations would have been lower and dirham appreciation with respect to US$ would have been 8 percent during 2003–06 (Table 8.2). Nevertheless, peg to the SDR would produce substantial volatility in the Dh/US$ exchange rate, ranging in the maximum range of +32 and –11 percent.

180

Currency union and exchange rate issues 4.50

4.00

Dh/US$

3.50

3.00 Peg –5% Peg +5% Peg –10% Peg +10% $Basket Dh/US $Actual Dh/US

2.50

2.00 86 87 88 89 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06

Sources: International Monetary Fund, International Finance Statistics (several issues); author’s estimates.

Figure 8.5

UAE: behavior of Dh/US$ exchange rate under a peg to US$, euro and Japanese yen

STEPS TO EXCHANGE RATE FLEXIBILITY Country experiences indicate that at least the following four critical ingredients are needed for an effective gradual transition to exchange rate flexibility to managed float: ● ● ● ●

a deep and liquid foreign exchange market; a well-defined and coherent policy governing central bank intervention in the foreign exchange market; effective mechanisms for reviewing and managing the exposure of both public and private sectors to exchange rate risks; and effective contracyclical fiscal policies.

The UAE already has a number of preconditions in place for an orderly shift to a more flexible exchange rate regime. It has an open capital market that, combined with large external reserves and current account surpluses, would allow asset adjustments without affecting market stability following a shift to a more flexible exchange rate system. While fiscal policy is constrained by a lack of policy instruments – primarily limited to changes in

The United Arab Emirates: exchange rate regime options

181

5.00 Peg –5% Peg +5% Peg –10% Peg +10% Dh/US $Actual Dh/US

4.80 4.60 4.40

Dh/US$

4.20 4.00 3.80 3.60 3.40 3.20 3.00 86 87 88 89 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06

Sources: International Monetary Fund, International Finance Statistics (several issues); author’s estimates.

Figure 8.6

UAE: behavior of Dh/US$ exchange rate under peg to the SDR

fiscal expenditures – room exists for introducing the needed fiscal contracyclicality through development of new instruments. The central bank has acquired experience of the foreign exchange market intervention while major private participants in the foreign exchange market are not alien to operating in a market characterized by flexible exchange rates and, thus, taking positions. Foreign Exchange Market Operating a flexible exchange rate regime requires a foreign exchange market that is liquid and efficient enough to allow the exchange rate to respond to market forces and that limits excessive volatility and deviations from the equilibrium exchange rate. This will require the development of both the wholesale interbank (where authorized dealers including banks trade with each other) and the retail (where dealers deal with final customers) markets. In the case of the UAE, there is an active retail market, but the wholesale market is limited on account of the generally large external surpluses and the central bank acting as the main provider of external

182

Currency union and exchange rate issues

liquidity. The latter factor may have kept the market participants from acquiring experience in price formation and exchange rate risk management, which is presently borne by the central bank. Similarly, the liquidity of the market is limited and the extent of forward market activity may have been discouraged by the existence of a pegged exchange rate. Development of the exchange market will call for a gradual reduction in the central bank’s market-making role by cutting back in trade with banks to allow market forces to play a larger role. Also, more current information to the market on balance of payments trends will allow market participants to have a real-time bid and offer quotations in the interbank market. In addition, the authorities may need to improve the market’s microstructure by eliminating any remaining market segmentations and further strengthening the settlement system. Central Bank Intervention Exchange rate markets are, by their very nature, imperfect and need not always reflect misalignment. As long as the authorities have appropriately designed the nominal average exchange rate path, focus of intervention should be to minimize volatility around that average and to calm disorderly conditions. For that to be effective, the chosen exchange rate path should reflect the underlying fundamental exchange rate. The central bank may also intervene to meet its foreign exchange reserve objectives. However, intervention should be selective and infrequent, thus ensuring market confidence in intervention policy. In the case of the UAE, where pressures are likely to be largely one-sided in the period ahead, a rulesbased intervention may be useful. Managing Exchange Rate Risk As the UAE shifts from a pegged to a flexible exchange rate system, the exchange rate risk will be shifted from the central bank to the private sector. The ease with which risk is transferred will have an important bearing on the pace of transition. The management of exchange risk requires an information system to monitor sources of exchange risk including sources of funding; methodology for measuring exchange rate risk, including the overall foreign currency position; internal risk policies and procedures, particularly provisions for credit risks associated with foreign currency lending; and prudential regulation and supervision of foreign exchange risk, including limits on net open positions, foreign currency lending and capital requirements. In the case of the UAE, there may be room for revisiting legal foundations for bank trading of derivatives

The United Arab Emirates: exchange rate regime options

183

leading to standardization, strengthened accounting standards for fair valuation, and contract enforcement. Improved market transparency and high reporting standards will be crucial for an orderly transition to a flexible exchange rate regime.

NOTES * 1. 2.

3. 4.

5. 6. 7. 8. 9. 10.

11.

This chapter was written in 2008, before oil prices started to decline and the global financial crisis deepened. It should be recognized that that much of the potential benefits of the peg regime require establishing a successful track record over time of consistent and sound macroeconomic policies. Fiscal sustainability and flexibility are crucial to the operation of the fixed exchange rate regime. Also, while monetary policy may have limited flexibility to pursue other objectives, it is essential that the expansion of domestic money and credit does not undermine the exchange rate regime. IMF (2007, p. 15). It has been argued that the UAE, being a small open economy with traditionally close financial links to the US dollar and less developed monetary institutions, should continue to retain the existing exchange rate regime. There is strong evidence that economies with GDP of less than US$5 billion and a high degree of trade openness have maintained a pegged exchange rate with the currency of their trading partners. It is asserted that there is little point for such small countries to incur the costs of attempting to run an independent monetary policy. The key consideration for these highly open economies is that, where trade represents a large fraction of domestic production and consumption, the benefits of reducing transaction costs and exchange rate risks by pegging the rate can be substantial. The small open economy argument is also relevant where the economy is not closely linked to the global capital market, thus, minimizing volatility caused by capital movements. In many of these countries, while the single currency is the norm, economies with a diversified trade pattern have tended to peg to currency baskets. Also, if the benchmark is raised to $20 billion, it turns out that a vast majority of countries maintain flexible exchange rate arrangements. As noted in Mussa et al. (2000), this is largely because the cost of having an effective independent monetary policy and maintaining an efficient domestic financial market grow less than proportionally with the size of the economy. It is, therefore debatable whether the small open economy argument would apply to the UAE, which had an estimated GDP of the equivalent of US$185 billion in 2007 with a vibrant integration with the global capital market. For details, see: Aghelvi et al. (1991); Alesina and Wagner (2003); Ghosh et al. (2003) and Rogoff et al. (2004). This option has been elaborated in a study for the Arab Monetary Fund in 1996 to respond to the last significant episode of the US dollar downturn. See Mohammed (1996). For details, see Mussa et al. (2000). See Appendix 8.1 for an analysis of a possible oil price pegging arrangement for the UAE. Eichengreen and Masson (1998) and Dattagupta et al. (2004). The discussion in this section abstracts from the issues relating to GCC-wide coordination of exchange rates as a step toward the planned monetary union. However, it would seem advisable for all GCC countries to consider implementing flexible exchange rate regimes in order to establish a market-based set of cross-rates. Alternatively, a narrower currency basket – including the US dollar, euro and the yen – could be considered.

184 12. 13. 14.

15.

Currency union and exchange rate issues In practice, the value of E is influenced by the central bank interventions in the foreign exchange market, credit growth and the net fiscal injection to the domestic economy. Thus the choice of E at 3.83 can ensure that, at the point of transition to a basket peg from the US dollar peg, the change in the Dh/US$ exchange rate is not so dramatic as to result in market turbulence and loss of confidence in the currency. Through the balance of payments channel, an appreciation of the dirham against the US dollar would imply an increase in imports and a corresponding decline in the balance of payments surpluses. In turn, lower surpluses would correspond to lower increase in net foreign assets. For a given rate of expansion in domestic credit, lower increase in net foreign assets would imply lower increase in money supply, and, for growth rates and velocity of circulation, inflation would be lower. Thus, the policy leeway to effect an appreciation in the Dh/US$ exchange rate would help dampen inflationary pressures. The weights chosen for the euro and the yen are historical (1986–2006) averages of trade (exports plus imports of goods) with the eurozone and Japan. The residual is attributed to the US$ reflecting the large share of total trade (importantly, exports) in US dollars.

REFERENCES Abed, George, S. Nuri Erbas, Behrous Guerami (2003), ‘The GCC Monetary Union: some considerations for the exchange rate regime’, IMF Working Paper No. 03/66, Washington DC: IMF. Aghelvi, Bijan, Mohsin Khan and Peter Montiel (1991), ‘Exchange rate policy in developing countries: some analytical issues’, IMF Occasional Paper No. 78, Washington DC: IMF. Alesina, Alberto and Alexander Wagner (2003), ‘Choosing (and reneging on) exchange rate regimes’, NBER Working Paper No. 9809, Cambridge, MA: National Bureau of Economic Research. Dattagupta, Rupa, Gilda Fernandez and Cem Karacadag (2004), ‘From fixed to float: operational aspects of moving toward exchange rate flexibility’, IMF Working Paper No. 04/126, Washington DC: IMF. Eichengreen, Barry and Paul Masson (1998), ‘Exit strategies policy options for developing countries seeking greater exchange rate flexibility’, IMF Occasional Paper No. 168, Washington DC: IMF. Erbas, S. Nuri, Zubair Iqbal and Chera L. Sayers (2001), ‘External stability under alternative nominal exchange rate anchors: an application to the Gulf Cooperation Council countries’, in Zubair Iqbal (ed.), Macroeconomic Issues and Policies in the Middle East and North Africa, Washington DC: IMF. Frankel, Jeffrey A. (2003), ‘A proposed monetary regime for small commodity exports: peg the export price’, Harvard University Faculty Research Working Papers Series. Ghosh, Atish, Anne-Marie Gulde and Holger C. Wolf (2003), ‘Exchange rate regimes: choices and consequences’, Cambridge MA: MIT Press. IMF (2007), United Arab Emirates – Staff Report for the 2007 Article IV Consultation (SM/06/302). Levy-Yeyati, Eduardo and Federico Sturzenegger (eds) (2003), Dollarization, Debates, and Policy Alternatives, Cambridge, MA: MIT Press.

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Mohammed, Azizali F. (1996), ‘Alternative currency pegs for GCC countries’ (unpublished mimeo). Mussa, Michael et al. (2000), ‘Exchange regimes in an increasingly integrated world economy’, IMF Occasional Paper No. 19, Washington DC: IMF. Rogoff, Kenneth, Aasim Husain, Ashoka Mody, Robin J. Brooks and Nienke Oomes (2004), ‘Evolution and performance of exchange rate regimes’, IMF Occasional Paper No. 229, Washington DC: IMF.

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APPENDIX 8.1

PEGGING TO OIL PRICE ONLY

It has been argued frequently that the terms-of-trade of a major oil exporter like UAE is largely determined by the oil price, with a high oil price implying an improvement in terms-of-trade, and conversely (see ‘Exchange Rate Options for the Future’ in the main chapter). Therefore, the argument goes, the value of Dh should be inversely tied to oil price so that Dh appreciates when oil price is high and it depreciates when oil prices are low. However, oil prices are highly volatile, and even if the 1986–2006 average for illustrative purposes is maintained at the prevailing Dh/US$ peg of 3.67, pegging the Dh to oil price would increase its volatility significantly. Figures A8.1a and b illustrate the case when Dh is pegged only to oil price. As can be observed from Figures A8.1a and b and Table 8.1, Dh/US$ volatility increases to very high levels, even if the 1986–2006 average is kept at the prevailing peg of Dh/US$ = 3.67. While with pegging only to (the inverse of) oil price, the appreciation of Dh with respect to US$ during 2003–06 (when oil prices jumped to historically high levels) would be 55 percent but the Dh/US$ exchange rate during 1986–2006 would deviate from 3.67 by a maximum of 57.1 percent and a minimum of 68 7.00

Peg –5% Peg +5% Peg –10% Peg +10% Oil price peg Dh/US$ $Actual Dh/US

6.00

Dh/US$

5.00

4.00

3.00

2.00

1.00 86 87 88 89 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06

Sources: International Monetary Fund, International Finance Statistics (several issues); author’s estimates.

Figure A8.1a

UAE: behavior of Dh/US$ exchange rate under peg to oil price only

The United Arab Emirates: exchange rate regime options 70 Oil price peg Dh/US$ Actual Dh/US$ Oil price (US$/b, right axis)

6.00

60

5.00

50

4.00

40

3.00

30

2.00

20

1.00

10

US$/b

7.00

Dh/US$

187

0

0.00 86 87 88 89 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06

Sources: International Monetary Fund, International Finance Statistics (several issues); author’s estimates.

Figure A8.1b

UAE: behavior of Dh/US$ exchange rate and oil price under peg to oil price only

percent. Such volatility in the Dh/US$ does not appear to suit the needs of the UAE. Pegging both to oil price and US$ is also an option, as illustrated in Table 8.1. As expected, the higher the weight of the US$ in the oil price-US$ basket, the smaller the volatility in the Dh/US$ exchange rate but the lower the depreciation of Dh with respect to the US$, and, hence, the smaller the monetary independence from the US$ policies.

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Currency union and exchange rate issues

APPENDIX 8.2

EPISODIC INTERVENTION THROUGH ADJUSTMENTS IN THE BASKET WEIGHTS AND E

A Managed Float: Adjustments in Basket Weights Only (E Parameter Kept Constant) It is possible to manipulate the policy parameters of the basket during episodes where a depreciation or appreciation might be needed. In the most recent episode when oil prices jumped by 156 percent since 2002, it may have been possible under a basket peg to achieve a large appreciation in dirham relative to the US dollar during 2002–06, in line with the large improvement in terms-of-trade in favor of UAE. Although the revaluation in line with oil price increases since 2002 seems rather large, potentially implying credibility and stability problems, it is entirely feasible to enact adjustments in the basket weights on a yearly basis (or more frequently), which in turn can minimize fluctuations around an average nominal Dh/ US$ exchange rate over time.1 This is the essence of a managed float, whether the float band is wide or narrow, responding to the particular needs of the economy in a particular episode. The simulations shown in Figure A8.2 illustrate a hypothetical managed float UAE might have followed during 1986–2006 using a peg basket of US$ and euro. In that figure, short-term fluctuations in oil prices are taken as a benchmark and the weights are adjusted for a given value of E = 3.67170; this value for E is chosen to show what course the Dh/US$ exchange rate might have followed, if it started as of 1986 from the peg only to the US dollar at the rate of Dh/US$ 3.67170. The hypothetical small manipulations in the US$ weight in the example in Figure 8.6 are chosen to reflect the oil price fluctuations, allowing Dh/US$ exchange rate to appreciate when oil prices rise, and conversely, up to a desired (or targeted) level of deviation in the Dh/US$ exchange rate from a desired average.2 Such an exchange rate policy primarily targets the Dh/ US$ rate and maintains it at a stable and predictable rate, while allowing enough leeway to respond to some economic variables (in these simulations, only oil prices) during specific episodes such as the current one. Relatively small manipulations in the US$ weight in the basket would have achieved a rather stable path, allowing fluctuations within the +/–6 percent range, and a significant appreciation of Dh relative to US$ by nearly 10 percent during 2002–06. At the same time, corresponding to the overall upward trend in oil price since 1986, Dh would have appreciated relative to US$ by about 7 percent during 1986–2006, all the while the

189

3.80

70.00

3.70

60.00

3.60

50.00

3.50

40.00

3.40

30.00

3.30

20.00

3.20

Prevailing Dh/US$ Average Dh/US$ under managed float

Dh/US under managed float Oil price (US$/b, right axis)

US$/b

Dh/US$

The United Arab Emirates: exchange rate regime options

10.00 0.00

3.10 86 87 88 89 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06

Sources: International Monetary Fund, International Finance Statistics (several issues); author’s estimates.

Figure A8.2

UAE: behavior of Dh/US$ exchange rate under a hypothetical basket peg with adjustments in the US$ weight during 2002–06 (E constant)

Dh/US$ exchange rate averaging at 3.58 during the same period, a value rather close to the prevailing peg of 3.67. A Managed Float: Adjustments in E Parameter Only (Basket Weights Kept Constant) Alternatively, a managed float could be achieved through choosing the appropriate values for E, without changing the basket weights. This is illustrated in Figure A8.3, which indicates that by choosing the weight of the US dollar at 0.8 and of the euro at 0.20, the value for E could be chosen at approximately 3.75, which would deliver an average Dh/US$ exchange rate of 3.67 during 1986–2006; during the same period, the fluctuation of the Dh/US$ exchange rate around 3.67 would be in the maximum range of +8.5 to –3.0 percent, with an appreciation in the Dh/US$ exchange rate by about 10 percent. Finally, the appreciation of the Dh/US$ exchange rate during 2002–06 would be about 6 percent. Of course, it is also possible to adjust the basket weights as well as the value of E in order to achieve the desired appreciation or depreciation in the Dh/US$ exchange rate. Arguably, adjustments in weights are more suitable to manage short-term fluctuations, while adjustments in the value

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Currency union and exchange rate issues

4.10

Prevailing Dh/US$ Dh/US under managed float

4.00

Oil price (US$/b, right axis) 3.90

70.00 60.00 50.00 40.00

3.70 30.00

US$/b

Dh/US$

3.80

3.60 20.00

3.50

10.00

3.40

0.00

3.30 86 87 88 89 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06

Sources: International Monetary Fund, International Finance Statistics (several issues); author’s estimates.

Figure A8.3

UAE: behavior of Dh/US$ exchange rate under a hypothetical basket peg with adjustments in the E during 2002–06 (US$ weight constant)

of E are more suitable to steer the longer-term average exchange rate towards an anchor.

NOTES 1. Such manipulations in the peg basket weights could be managed as follows: the monetary authority makes an adjustment in the weights (in particular, the US$ weight) in the currency basket and calculates a Dh/US$ exchange rate for a given period; during that period, the monetary authority buys or sells US$ at that rate, as is usual under a currency peg. 2. Of course, oil prices are not the only variable that the policy-maker may choose to reflect on the exchange rate. For example, simple regressions in the case of Kuwait for 1988– 2006 do not show a statistically significant correlation between the KD/US$ exchange rate and oil prices. So, in addition to oil prices, the policy-maker may have a multiple of factors to guide its exchange rate policy, for example, the size of capital inflows and outflows, the desired level of central bank reserves, growth of domestic credit, US monetary policies and interest rates, and so on.

Index Abu-Bader, Suleiman 10, 51 Abu-Qarn, Aamer S. 10, 51 accountability 65–6, 128, 129, 133, 167 adjustable peg 72, 106–7, 169 see also Bretton Woods system; Exchange Rate Mechanism (ERM) Africa 7, 64, 83, 110–11, 115, 117 appreciation and exchange rate regime choices for currency union in GCC countries 89–90, 94 exchange rate regime in United Arab Emirates (UAE) 100, 104, 105, 114, 115, 116, 161, 174–8 Arab Monetary Fund (AMF) 19, 21, 22, 24 asymmetric shocks 44, 50–52, 108, 109, 171 auctions 125, 150 Australian 47, 50, 113 Australian dollar pegging 113 Austro-Hungarian Empire currency union 65 Badr-El-Din, Ibrahim 10 Bahrain criteria for currency union in the GCC countries 19, 20, 21, 22–3, 24, 25, 26, 39, 84 deflation 17 exchange rate regimes 9, 14, 42, 83–4, 87 exchange rate trends 39 GDP 46 international trade 46–7, 48–9 population 46 real labour mobility 53 Bakardzhieva, Damyana 11 balance of payments 86, 104, 121, 124, 125–6, 132, 182

balance sheet stability 86, 92 balance sheets 127–8, 133, 139, 140–42, 145–8 banded exchange rate regimes 106, 116, 164–5, 172 Bank of England 37, 66 banking crises 17–18, 36–7, 105, 157, 169, 170 banking sector 36–8, 126–7, 133, 140–42, 146, 148, 151–2, 169–70 basket peg described 106–7 exchange rate regime choices for currency union in GCC countries 92–3, 96 Kuwait 9, 22, 30, 42, 85, 93 United Arab Emirates (UAE) 30, 104, 107, 114–15, 116, 117, 155, 164–7, 172–80, 181, 188–90 see also European Currency Unit (ECU) basket peg and price of oil (PBO) 116, 117, 168 Bayoumi, Tamim 55, 56 Belgium-Luxembourg monetary unification 64 Ben Naceur, Samy 10, 46, 47, 51 Berengaut, Julian 12, 83 bid/ask spread 123, 135 Bretton Woods system 71, 72, 74, 103, 107, 111 broad money (M2) 126, 127, 137, 139, 141, 143 budget deficit 14, 16, 23–5, 57, 58–9, 84 Buiter, Willem H. 33, 36, 37, 56, 59, 61, 84 Bundesbank 74–5 business cycle synchronicity 10, 11, 14–15, 51–2, 154, 159, 160, 161–2, 164 business cycles 126

191

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Currency union and exchange rate issues

Canada 55–6, 113–14, 115 Canadian dollar pegging 113–14 capital flight 15 capital mobility currency union in the GCC countries 35–6, 88, 91 economic integration in the GCC countries 9 and exchange rate regime in United Arab Emirates 99, 103, 104, 157, 164, 165, 168, 169 and fixed exchange rate incompatibility 73 and optimal currency areas (OCAs) 43, 53, 54, 107 Caribbean Currency Area 64, 83 central bank dependence 12 central bank independence 57, 92, 105, 167 central bank interventions 92, 122, 124, 168, 182 Central Bank of the United Arab Emirates (CBUAE) 120, 121, 122–3, 127, 137, 181–2 central banks 15, 23, 35, 36–7, 38, 75 see also central bank dependence; central bank independence; central bank interventions; exchange rate targeting; inflation targeting; monetary aggregate targeting; supranational central banks; individual central banks CFA Franc Zone 64 Chinn, M.D. 103–4 CIS currency union 35, 65 citizen mobility 9 commitment to economic and political integration 11 commodity standard 93–4, 107, 115–16 Common Agricultural Policy (CAP) (EU) 75 common market (GCC) 8–9, 30, 84 compatibility of GCC countries 10–11 constitutional aspects of currency unions 61–6 convergence criteria for currency union in GCC countries

budget deficit criterion 14, 16, 23–5, 58–9, 84 countries performance 7, 11, 18–25, 26, 38–42, 84–5, 90 definitional and data problems 16–18, 26–7 evaluation 10–11 foreign exchange reserves criterion 14, 22–3, 58, 60, 84 inflation rate criterion 11, 13, 14, 16–17, 18–20, 38–42, 58, 59–60, 84–5, 90, 95 interest rate criterion 13–14, 17–18, 20–22, 57, 58, 60, 84 public debt criterion 14, 15–16, 25, 26, 58–9, 84 relevance 14–15, 58–60 convergence criteria for European Monetary Union (EMU) 57, 60, 76–80, 81 cost–benefit analysis, of convergence criteria of currency union in the GCC countries 10 Coury, Tarek 11 CPI (consumer price index) data 17, 115, 116, 128, 158, 174–5 crawling peg described 106 empirical evidence 110, 111 Poland 170 United Arab Emirates (UAE) 104, 107, 114–15, 117, 164, 165–6 credibility and exchange rate regime choices for currency union in GCC countries 87, 90, 93, 94 and exchange rate regime in United Arab Emirates (UAE) 100, 101–2, 103, 111–12, 115, 117, 156–7, 158, 167, 173 and exchange rate regimes 109, 135 and exiting from fixed exchange rate regimes 170 and inflation targeting 92 and spillover costs of currency unions 13 credit to banks 134, 139, 140, 141, 146, 148

Index currencies see appreciation; depreciation; devaluation; devaluation prohibition; euro and basket of currencies; euro pegging; Japanese yen and basket of currencies; national currencies; overvaluation; revaluation; US dollar and basket of currencies currency boards 64, 107, 121, 135–6, 162, 163 currency creation in currency unions 83 currency crises 169–70 currency union in the GCC countries background 8–9, 30, 83–6 convergence criteria see convergence criteria for currency union in GCC countries exchange rate regime choices see exchange rate regime choices for currency union in GCC countries fiscal sustainability membership condition 58–9 importance 7, 83 literature review 9–11 macroeconomic stabilization: optimal currency areas 38–56, 84 asymmetric shocks, impacts of 50–52 nominal cost and price rigidities 43, 44–5 real factor mobility limitations 52–4 small size and openness of GCC countries, impacts of 45–50, 57 supranational federal fiscal authority, as unnecessary 55–6 microeconomic efficiency and financial stability 31–8 political and constitutional aspects 61–2, 65–6 pros and cons of currency unions 9–10, 11–13 currency unions 11–13, 31–2, 47, 50, 61–6, 83, 107 see also CIS currency union; currency union in the GCC countries; European Monetary Union (EMU) current account deficits 113, 169–70

193

current account surpluses 89–90, 114, 180 customs unions 8, 30 Czech-Slovak monetary union 65 Dar, Humayon A. 10 data problems, convergence criteria for currency union in the GCC countries 16–18, 26–7 Dave, Chetan 11 De Grauwe, Paul 51, 76, 79 decentralized implementation, in currency union in the GCC countries 35 decentralized issuance, in the CIS currency union 35 deflation 17, 99, 103, 125 demand shocks 51, 104–5, 108–9 deposit insurance 38 depreciation and exchange rate regime choices for currency union in GCC countries 94 and exchange rate regime in United Arab Emirates 100, 104, 105, 113, 115, 116, 166, 176–7 and national currencies of European Union countries 76 US dollar 9, 14, 20, 30, 38–41, 88, 89, 95, 99, 155, 156, 160, 161, 166, 171 devaluation 42, 103, 113 devaluation prohibition 77, 79 developed countries 109, 110 developing countries 109, 110, 168 Dutch disease 94, 102–3, 115, 125 ECOFIN 75 Economic Agreements (GCC countries) 8, 9, 30 economic diversification and budget deficit criterion for currency union in the GCC countries 24–5 and exchange rate regime choices for currency union in the GCC countries 85–6, 88, 91, 95 and exchange rate regime in United Arab Emirates (UAE) 98, 102, 112, 154, 155, 162, 173

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Currency union and exchange rate issues

long-term benefits of currency union in the GCC countries 9 and revaluation 89 economic efficiency 9, 11–12, 31–2 economic growth 11, 15–17, 110, 128, 133, 157, 163, 164, 165, 168, 170, 171–2 economic integration 8–9, 11, 30, 51–2, 154 economies of scale 12 Edwards, S. 101, 110 Eichengreen, Barry 61, 123–4, 164 Elborgh-Wyotek, Katrim 12, 83 emerging-market countries 109–10, 168 employment 9, 50, 53–4, 85–6, 133, 157, 170 see also expatriate labour supply; labour market flexibility; labour mobility; national labour supply; nominal wage rigidities; wage flexibility equality 8, 9 euro and basket of currencies 93, 96, 173–9, 180, 188–90 euro pegging 113 European Central Bank 17, 35, 37, 57, 60, 66, 70, 75, 80, 84 European Commission 31, 37, 51–2, 56, 57, 60–61, 62, 70, 80–81 European Currency Unit (ECU) 72, 73, 75 European Monetary System (EMS) 71–5 European Monetary Union (EMU) centralized decision-making 35 convergence criteria see convergence criteria for European Monetary Union (EMU) currency creation 83 exchange rate pegging 74–6 foreign exchange transaction costs savings 31, 32 historical background 71–4 institutions 70–76 and lender of last resort 37 opt-outs 30 and optimal currency areas (OCAs) 78 political and constitutional aspects 62

real/structural convergence 60–61 and single banking and financial regulator 36–7 switching costs 32 trade increases 12 European Parliament 66, 70, 80–81 European Payments Union (EPU) 71 European Union (EU) 30, 56, 62, 71, 113, 114 European Unit of Account (EUA) 75–6 excess reserves 125–6, 127, 128, 140, 144–5 exchange rate convergence 57, 60, 71, 75–6, 77, 79–80 exchange rate costs 154, 157, 167 Exchange Rate Mechanism (ERM) 57, 60, 71, 72, 75, 77, 94 exchange rate misalignment 102, 105, 112–13, 135, 155, 159–60, 161–2 exchange rate pegging 74–6, 113–14, 134–5, 164 see also adjustable peg; Australian dollar pegging; basket peg; Canadian dollar pegging; crawling peg; currency boards; euro pegging; fixed exchange rates; Japanese yen and basket of currencies; Norwegian krone pegging; peg the export price (PEP); SDR (special drawing rights) pegging; US dollar pegging exchange rate regime choices for currency union in GCC countries alternative regimes 60, 87–94 basket peg 92–3, 96 export oil price peg 93–4 managed float 91–2, 96 US dollar pegging 90–91, 94–5 appropriateness 88–90 general considerations 86–7 exchange rate regime in United Arab Emirates (UAE) basket of currencies 30, 104, 107, 114–15, 116, 117, 155, 164–7, 172–80, 181, 188–90

Index exiting from fixed exchange rates 122–3, 180–83 fixed versus flexible regimes 101–5, 107–9, 121–2, 164, 168–9, 171–2 monetary targeting 127, 137–52 oil and natural gas sector versus non-hydrocarbon sector 98 optimal currency area (OCA) criteria 107–9, 112 SDR pegging 42, 121, 156 US dollar pegging 9, 14, 42, 83–4, 87, 98, 99–100, 102–4, 107, 108, 111–13, 117, 120, 121, 154–5, 156–62, 170 variant regimes 107, 111–17, 155, 164–9, 171–3 exchange rate regimes see exchange rate regime choices for currency union in GCC countries; exchange rate regime in United Arab Emirates (UAE); exchange rate regimes in GCC countries; operational implications of changing to alternative exchange rate regimes; optimal currency areas (OCAs) exchange rate regimes in GCC countries 38–42, 58 exchange rate risk 90, 91, 92, 93, 154, 160–61, 167 exchange rate risk management 123, 182–3 exchange rate stability 111–12, 115, 117, 154, 157, 159, 165–6 exchange rate targeting 124–6, 132, 136 exchange rate trends in GCC countries 38–41 exchange rate volatility and exchange rate regime choices for currency union in GCC countries 92, 93 and exchange rate regime in United Arab Emirates 102–3, 104, 105, 115, 155, 159–61, 171 US dollar 90, 112 expatriate labour supply 53, 83, 88, 160, 162

195

export price of oil pegging 93–4, 115, 116, 164, 168, 176–7, 186–7 exports 8, 93–4 see also export price of oil pegging; international trade; manufacturing exports; non-oil exports; oil exporting countries; oil exports; peg the export price (PEP); services imports and exports external common custom tariff (ECT) 8, 9, 84 external instability 159–60 external shocks 125, 171 external stability 86, 91, 94, 95, 154, 156, 159–60, 172 familiarity 91, 100, 101–2, 103 Fasano-Filho, Ugo 18, 51 Federal Reserve System 14, 15, 35, 38, 63, 66, 93 financial crises 15, 17–18, 36–7, 99, 100, 169 financial difficulties, spillover costs of currency unions 13 financial integration 84 financial markets 92, 127 financial sector 7, 10, 17, 36–7, 50, 57, 155, 162, 167–8, 171 financial sector regulations 167–8 financial shocks 155, 157, 172 financial stability 31–8, 86–7 fiscal policy and currency union in GCC countries 10, 15–16, 18, 88, 90, 91 and exchange rate targeting 125 and exiting from fixed exchange rate regimes 169, 170 United Arab Emirates 103, 154, 155, 157–8, 160, 164, 165, 167, 169, 171–2, 174, 180–81 fiscal stabilization 55–6, 91 fiscal sustainability 58–9 fiscal transparency 18, 26 fixed exchange rates and exchange rate regime in United Arab Emirates (UAE) 164, 168–9, 171–2 versus flexible exchange rates 101–5, 109–11, 121–2

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operational implications of exiting 122–4, 169–70, 180–83 see also US dollar pegging flexible exchange rates described 106, 107, 134–6 and exchange rate regime choices for currency union in GCC countries 88 and exchange rate regime in United Arab Emirates 104–5, 107, 108– 9, 155, 164, 167–9, 171–2 versus fixed exchange rates 101–5, 109–11, 121–2 forecasting and exchange rate targeting 125 and inflation targeting 129, 133 and monetary aggregate targeting 92, 127, 133, 137, 138, 142, 144, 145, 146, 147 foreign direct investment 10, 84, 88 foreign exchange markets 52, 148–9, 181–2 foreign exchange reserves criterion for currency union in GCC countries 14, 15, 58, 60 GCC countries’ performance 7, 22–3, 84 and exchange rate regime choices for currency union in GCC countries 87 and exchange rate regime in United Arab Emirates 105, 154, 156, 158, 160, 164, 165, 180, 182 and monetary aggregate targeting 146, 148–9 foreign exchange swaps 124, 150, 151 forward markets 91, 102, 124, 182 France 41, 64, 71, 72, 76, 81 Frankel, Jeffrey A. 45, 76, 84, 93, 103–4, 115, 168 free trade 8, 105 Friedman, Milton 104–5 FSA (Financial Services Authority) (UK) 36, 37 gas exports 90 gas prices 50–51 gas resources 98 gas revenues 58–9 gas sector 98

GCC Central Bank 17, 35, 36, 37–8, 61, 62, 65–6, 84 GCC countries economic and geographic conditions 7, 46 US dollar pegging 9, 14, 38–42, 58, 83–4, 85, 87, 88, 121 see also currency union in the GCC countries; individual countries GCC financial committee 9, 13 GCC regulator 36 GDP, of GCC countries 7 GDP growth 11, 16, 17 General Data Dissemination System (GDDS) 27 geographical size, GCC countries 7 Germany 41, 46, 63–4, 72, 74–5, 76, 77, 78, 81 globalization 7, 88, 155, 157 gold standard exchange rate regime 107, 116–17 goods 8, 9, 17, 34, 108, 158 government deposits 151–2 government expenditure 20, 160 Government Finance Statistics (IMF) 18, 27 government securities 139, 147, 148, 150 Gulf Monetary Council (GMC) 35, 66, 84 Hatase, Mariko 123–4 hedging exchange rate risk 91, 93, 102 hyperinflation 35, 65 IMF (International Monetary Fund) 15, 18, 26, 27, 84, 89–90, 98, 99, 101–2, 103, 106, 111, 117, 120, 137, 158, 159, 161, 175, 178, 186, 187, 189, 190 see also SDR (special drawing rights) pegging import prices 94 imported inflation 88, 113, 158, 161 imports 8, 14, 22–3 see also import prices; imported inflation; international trade; non-oil imports; oil importing countries; open economies; services imports and exports; tariffs

Index income redistribution 55 inflation rates criterion for currency union in GCC countries 13, 14, 16–17, 58, 59–60, 95 criterion for European Monetary Union 17, 57, 60 and currency unions 12 and exchange rate regime choice for currency union in GCC countries 86, 87–8, 89, 90, 92, 95 and exchange rate regimes 109, 110, 168 and exchange rate targeting 124, 125 GCC countries 11, 18–20, 38–42, 84, 90, 99 Kuwait 9, 19, 30, 39, 84 United Arab Emirates 19, 20, 41, 84, 85, 99, 100, 101, 105, 112–13, 154, 171–2, 173, 174, 178 Germany 78 imported inflation 88, 113, 158, 161 and monetary aggregate targeting 126, 133, 137, 138 US 88, 90, 113 and US dollar pegging 15, 90 inflation targeting 92, 115, 116, 128–30, 133, 167 inflation tax 33–5 information 36–7, 93, 123, 125, 127–8, 129, 132, 133, 182 institutions 70–76, 155, 157, 158, 167, 169–70 interbank interest rates 14, 17, 128, 145 interbank markets 120, 121, 122–3, 124, 125–6, 132, 145, 151, 181–2 interest rates criterion for currency union in GCC countries 13–14, 17–18, 57, 58, 60 criterion for European Monetary Union 17, 57 and exchange rate regime choices for currency union in GCC countries 91 GCC countries 20–22, 84 United Arab Emirates (UAE) 99, 100, 112–13, 159, 168

197

Germany 74 and inflation targeting 129–30 and monetary aggregate targeting 127, 128, 133, 136, 137, 141, 145, 148, 149 US 14–15, 20, 100, 159 internal stability 154, 159, 160 international capital markets 91, 109–10, 162, 169 international competitiveness and exchange rate regime choice for currency union in the GCC countries 86–7, 89, 90–91, 95 and exchange rate regime in United Arab Emirates 99, 100, 115, 158, 160, 171, 173 and exchange rate targeting 124 and revaluation 89 International Financial Statistics (IFS) 26 international seigniorage 35 international trade 10, 12, 46–7, 48–9, 102, 114, 121 see also exports; free trade; imports; tariffs; terms-of-trade shocks; trade diversification; trade integration; trade openness investment 43, 100, 102 investment saving shocks 51 Ireland 64, 72, 80 Italy 63, 64, 71, 72, 76, 78, 80, 111 Ito, T. 114 Jadresic, E. 9–10, 12, 13 Japan 113, 114, 123–4, 176, 177, 178–9 Japanese yen 113, 123–4 Japanese yen and basket of currencies 176, 177, 178–9 Kamar, Bassem 10, 11, 46, 47, 51 Kenen, Peter B. 43, 52, 61, 107 Krugman view of asymmetric shock likelihood 51 Kuwait basket of currencies 9, 22, 30, 42, 85, 93 criteria for currency union in the GCC countries 19, 20, 21, 22, 23, 24, 25, 26, 39, 84 exchange rate trends 39, 40

198

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GDP 46 inflation rate 9, 19, 30, 39, 84 international trade 46–7, 48–9 population 46 real labour mobility 53 speculation 89, 93 US dollar pegging 9, 40, 42, 85 Laabas, Belkacem 10–11, 12 labour market flexibility 83, 87, 88, 90, 91, 154, 158, 162 labour mobility 9, 53–4, 78, 107, 164 Latin Monetary Union 64 laws 62, 125, 133, 182–3 lender-of-last-resort (LOLR) 36–8, 105 Limam, Imed 10–11, 12 liquidity management 92, 120, 121, 147 long-term government bonds 17, 18, 80 Lucas critique 44–5 Maastricht convergence criteria see convergence criteria for European Monetary Union (EMU) MacDonald, R. 102, 116 macroeconomic efficiency 31–8 macroeconomic policy harmonization 9–11 macroeconomic stability 43, 86–7 managed/dirty float described 106 empirical evidence 111 exchange rate regime choices for currency union in GCC countries 91–2, 96 United Arab Emirates (UAE) 107, 115, 164, 167–8, 169, 172–3, 188–90 manufacturing exports 88 manufacturing sector 50, 98, 114 Masson, Paul R. 43, 55, 56, 164 Medas, Paulo 15 menu cost theory 45 Mexico 129, 169, 170 minimum reserve requirements 144–5, 149 mobility 8, 9 see also capital mobility; labour mobility; real factor mobility monetary aggregate targeting described 126–8, 132–3

and exchange rate regime choices for currency union in GCC countries 92 general framework of monetary control controlling base money 145–8 managing the money multiplier 143–5 money supply 138–43 money target 137–8 instruments of control 148–52 regime options 134–7 monetary base (M0) 126, 127, 134, 137–8, 139–40, 142, 145–8 monetary issuance 35, 37 monetary policy Poole’s model of optimal monetary policy 51 United Arab Emirates 100, 107, 108, 109, 113, 114–15, 116, 120, 155, 165–6, 167, 169, 171–2, 174 US 14–15, 99, 107, 108 see also exchange rate targeting; inflation targeting; monetary aggregate targeting Monetary Policy Committees 66, 138 monetary policy coordination 10, 11 monetary policy dependence 14–15, 100, 103, 107, 113 monetary policy independence 14, 87–8, 91, 104, 107, 108, 109, 114–15 monetary policy independence costs 14–15 monetary spillover costs 13 Monetary Union Agreement (MUA) 84 monetary unions see currency unions money demand 92, 129, 133, 134, 135, 136–8, 141, 167 money demand shocks 51 money multiplier 127, 135, 140, 141–5, 149 money supply 126, 134, 135, 136, 138–43 money supply shocks 51 monitoring, and exchange rate targeting 125

Index Mundell, Robert A. 43, 78, 107, 109, 116 Muscat summit 8–9, 13 narrow money (M1) 126, 127 national currencies 61–2, 76 see also Australian dollar pegging; Canadian dollar pegging; Japanese yen; Japanese yen and basket of currencies; Norwegian krone pegging; US dollar; US dollar and basket of currencies; US dollar pegging national labour supply 9, 53–4, 85–6, 88, 91, 162 national sovereignty 12, 43, 61–5 national treatment 8, 9 net credit to government 146, 147, 148 net foreign assets 141, 146, 148 net other assets 146, 147–8 Netherlands 60, 64, 72 see also Dutch disease New Zealand 47, 50 nominal cost rigidities, and optimal currency areas (OCAs) 43, 44–5 nominal price rigidities, and optimal currency areas (OCAs) 43, 44–5 nominal shocks 43, 86, 90, 164 nominal wage rigidities 43, 44–5 non-oil exports 89, 94, 100, 125, 154, 159–60, 162, 168 non-oil imports 158–60 non-oil production 92 non-oil revenues 24, 25 non-oil sector and exchange rate regime choices for currency union in the GCC countries 85–6, 88, 90 and exchange rate regime in United Arab Emirates (UAE) 98, 102, 105, 155, 156, 158–9, 160, 162, 168, 171 national labour supply 85–6, 88, 91 Northern Rock 37 Norway 64, 103, 114, 115 Norwegian krone pegging 114 numeraire, alternative 113–14 Ogawa, Eiji 114 oil demand shocks 108–9

199

oil exporting countries 83, 93, 99, 107, 108–9, 112, 114, 125, 186 oil exports 85, 90, 115, 121, 125, 156 oil importing countries 93, 107, 108–9, 112, 113, 117, 162 oil price pegging 93–4, 115, 116, 164, 168, 176–7, 186–7 oil price shocks 15, 108–9, 112–13, 125, 157, 161, 167 oil price volatility and exchange rate regime choices for currency union in GCC countries 92, 94 and exchange rate regime choices for oil-producing countries 99 and exchange rate regime in United Arab Emirates (UAE) 100, 103, 104, 105, 114, 115, 116, 154, 160, 168 oil prices and exchange rate regime choices for currency union in GCC countries 88–9, 92, 93–4 and exchange rate regime in United Arab Emirates (UAE) 113, 114–16, 117, 162, 164, 168, 186–7, 188, 189, 190 and fiscal criteria for currency union in the GCC countries 14, 15, 23 and inflation rate criterion for currency union in the GCC countries 19 see also oil price shocks; oil price volatility oil production 50–51, 85, 94 oil resources 98 oil revenues 24, 25, 34, 58–9, 85, 92, 121, 125, 160 oil sector 10–11, 98 oil shocks 88, 108–9 oil supply shocks 108–9 Oman criteria for currency union in the GCC countries 16, 19, 20, 21, 22, 23, 24–5, 26, 84 exchange rate trends 40 GDP 46 international trade 46–7, 48–9 opting out of currency union in the GCC countries 24–5, 26, 30, 85

200

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population 46 US dollar pegging 9, 14, 42, 83–4, 87 OPEC Reference Basket 14 open economies 45–50, 57, 83, 93, 154, 157, 158 open market operations (OMO) 147–51 operational implications of changing to alternative exchange rate regimes alternative nominal anchors exchange rate targeting 124–6, 132 inflation targeting 128–30, 133 monetary aggregate targeting see monetary aggregate targeting exiting from fixed exchange rates 122–4, 169–70 optimal currency areas (OCAs) asymmetric shocks, impacts of 50–52 criteria 43–4, 107–8 for currency union in the GCC countries 10–11 and European Monetary Union (EMU) 78 and exchange rate regime in United Arab Emirates (UAE) 107–9, 112 nominal cost and price rigidities 43, 44–5 real factor mobility limitations 52–4, 78 shortcomings of 43 small size and openness of GCC countries, impacts of 45–50, 57 supranational federal fiscal authority, as unnecessary 55–6 optimal monetary policy 51 over the counter (OTC) interbank markets 122 overvaluation 112–13 peg the export price (PEP) 93–4, 106, 115–16, 164, 168, 176–7, 186–7 permanent real rigidities, and optimal currency areas (OCAs) 43 permanent shocks 43, 108–9, 112 Poland 170 policy coordination costs 13 political aspects of currency unions 9, 10, 11, 61–6, 162 political costs 87 Poole, William 51

population, of GCC countries 7, 46 Presley, John R. 10 price indexes 14, 17, 115, 116, 127–8, 133, 158, 174–5 price stability and European Monetary System 75 and fiscal policy 90 and inflation rate criterion for currency union in EMU 17, 60 and inflation rate criterion for currency union in the GCC countries 16, 38, 42 and inflation targeting 128, 129 and monetary aggregate targeting 92, 126, 136 price transparency 32 prices 20, 126, 127–8, 134, 135, 136, 141 proven oil and gas reserves 7, 24 prudential banking regulations 83, 123 public debt 14, 15–16, 25, 26, 57, 58–9, 78, 84, 170, 171 Qatar criteria for currency union in the GCC countries 19, 20, 21, 22, 23, 24, 25, 26, 41, 84–5 exchange rate regimes 9, 14, 42, 83–4, 87 exchange rate trends 40 GDP 46 international trade 46–7, 48–9 population 46 real labour mobility 53 Razin, A. 110 real costs 45 real factor mobility 52–4 real income 128, 133, 137, 138, 141 real interest rates 15 real shocks 43, 53, 91, 104–5, 110, 164, 165, 167, 168, 169, 171 real/structural convergence, European Monetary Union 60–61 recapitalization 37 Reinhart, C.M. 109, 110–11 reporting 18, 26–7, 183 see also balance sheet stability; balance sheets retail foreign exchange markets 181–2 revaluation 89, 113, 162

Index reviewing, and monetary aggregate targeting 128, 133 Rogoff, K.S. 109–11 Rubinstein, Y. 110 Sachs, Jeffrey 55, 56 Sala-i-Martin, Xavier 55, 56 Saudi Arabia criteria for currency union in the GCC countries 19, 20, 21, 22, 23, 24, 25, 26, 41, 84 deflation 17 dominance, and currency union in the GCC countries 10 exchange rate regimes 9, 14, 42, 83–4, 87 exchange rate trends 41 GDP 46 international trade 46–7, 48–9 population 46 Scandinavian monetary union 64 Schaechter, Andrea 18, 51 SDR (special drawing rights) pegging and exchange rate regime choices for currency union in GCC countries 92 GCC countries 42 United Arab Emirates (UAE) 42, 121, 156, 164, 165, 172, 177, 179, 181 seigniorage 32–5, 105 services 8, 9, 17, 22, 30, 34, 50, 108, 158 see also financial sector; services imports and exports; social services services imports and exports 8, 9, 44, 45, 46, 66, 88 shocks 91, 108–9 see also asymmetric shocks; banking crises; currency crises; demand shocks; external shocks; financial crises; financial shocks; investment saving shocks; money demand shocks; money supply shocks; nominal shocks; oil shocks; permanent shocks; real shocks; supplyside shocks; symmetric shocks; temporary shocks; terms-oftrade shocks; wealth shocks

201

short term notes (certificates of deposit) 139, 141, 147, 148, 149–51 Sibert, Anne C. 56, 59 Single Customs Declaration (SCD) 8 small economies 45–50, 57, 93–4, 157 social services 7, 16 sociopolitical differences 13 Sovereign Wealth Funds 15, 23 speculation 15, 89, 93, 102, 113, 124, 126, 132, 135, 169 spillover costs 12–13 standards and codes 18, 26, 27 standing facilities 151 subnational fiscal stabilization authorities 55, 56 supply-side shocks 50–51, 108–9, 115 supranational central banks 11, 35, 61, 62 supranational federal fiscal authority 55–6 supranational monetary authority 35 Supreme Council 8–9 switching costs 31, 32, 44, 87 symmetric shocks 10, 44, 50, 51, 108 tariffs 8, 9, 76, 84, 95, 105 tax-transfer systems 55 technical efficiency 52 temporary shocks 43, 108, 157, 170 terms-of-trade 104, 174, 188 terms-of-trade shocks exchange rate regime choices for currency union in GCC countries 88, 93, 94 and exchange rate regime in United Arab Emirates 104–5, 115, 116, 154, 157, 159, 160, 161, 168 and exchange rate regimes 110 trade diversification 107 trade integration 84, 164 trade openness 88, 107, 154, 158 transaction costs 87, 92, 160–61, 165, 166–7 transaction costs savings 12, 31–2, 91, 100, 156, 157 transparency and exchange rate regime choices for currency union in GCC countries 94

202

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and exchange rate regime in United Arab Emirates (UAE) 167, 183 and exchange rate targeting 125, 132 GCC central bank 65–6 and inflation targeting 92, 128, 133, 167 and monetary aggregate targeting 128, 133 see also fiscal transparency; price transparency; transparency, lack of transparency, lack of 93, 114, 165 UK 30, 36, 37, 64, 66, 71, 72, 76, 80, 111 uncertainty 17–18, 87, 92, 102 undervaluation 89–90, 161 unilateral currency valuation changes, loss of 12 United Arab Emirates (UAE) capital mobility 99 criteria for currency union in the GCC countries 19, 20, 21, 22–3, 24, 25, 26, 41, 84–5 exchange rate regime see exchange rate regime in United Arab Emirates (UAE) exchange rate trends 41 fiscal policy 103, 154, 155, 157–8, 160, 164, 165, 167, 169, 171–2, 174, 180–81 GDP 46 inflation rate 19, 20, 41, 84, 85, 99, 100, 101, 105, 112–13, 154, 171–2, 173, 174, 178 interest rate 20, 21, 84, 99, 100, 108 international trade 46–7, 48–9 monetary policy 100, 107, 108, 109, 113, 114–15, 116, 120, 155, 165–6, 167, 169, 171–2, 174 oil revenues 121 opting out of currency union in the GCC countries 85 population 46 real labour mobility 53 US financial crises 15, 99, 100

income redistribution and taxtransfer systems 55–6 inflation rates 88, 90, 113 interest rates 14–15, 20, 100, 159 monetary policy 14–15, 99, 107, 108 as oil importing country 107, 108–9, 112 political unification 63 trade with GCC countries 90 see also Federal Reserve System; US dollar US dollar depreciation 9, 14, 20, 30, 38–41, 88, 89, 95, 99, 155, 156, 160, 161, 166, 171 volatility 90, 112 see also US dollar and basket of currencies; US dollar pegging; US dollar swaps US dollar and basket of currencies 93, 96, 165–7, 172–80, 188–90 US dollar pegging Bahrain 9, 14, 42, 83–4, 87 exchange rate regime choices for currency union in GCC countries 90–91, 94–5 GCC countries 9, 14, 38–42, 58, 83–4, 85, 87, 88, 121 Japan 123 monetary policy independence costs 14–15 oil producing countries 99 Poland 170 and preparation for currency union in the GCC countries 9, 13, 30 United Arab Emirates (UAE) 9, 14, 42, 83–4, 87, 98, 99–100, 102–4, 107, 108, 111–13, 117, 120, 121, 154–5, 156–62, 171 US dollar swaps 139, 141, 147, 148 wage flexibility 83, 154, 158 wealth shocks 50–51 wholesale interbank markets 181 Yeyati, E. 110 Yugoslavia currency union 65 Zakharova, Daria 15