The dollar is our currency, but your problem
Famously told by John Connally, President Nixon’s Treasury Secretary, to a delegation of Europeans worried about exchange rate fluctuations. Four decades since that famous remark was made, China replaced Europe, but the dollar worry continues. Since 2002, except for two brief episodes, the US dollar performed poorly against major international currencies. On several occasions, China has expressed its dissatisfaction over dollar’s persistent weakness, since China holds a large amount of dollar-denominated assets. Like China, the GCC countries have a high stake on the dollar owing primarily to the exchange rate peg which they maintain with the dollar (save Kuwait), and other investment-like interests.
The medium-term outlook for dollar appears weak in light of its huge external debt burden. However, the US is justifiably not worried about dollar’s persistent slide, because a weak dollar reduces the real value of its net external debt. But a weak dollar is a serious problem for the GCC region because it contributes, among others, to domestic inflation. More importantly, the opportunity cost of maintaining the existing exchange rate peg is enormous in light of the ongoing economic transformations that the GCC economies have witnessed in the past one decade. So how can the GCC countries protect themselves before the dollar’s decline become a crisis?
An effective option at hand is to vigorously work to materialize the planned GCC monetary union. Suppose, for the sake of the argument, the GCC monetary union is now ready to start its operation. The six member countries now share a common currency, the official value of which, say, is determined by a basket of currencies. However, conventional currency baskets—consisting three to four major currencies (similar to Kuwait)—are not that effective in cushioning the economy from volatile oil prices. For instance, under a currency basket, monetary policy tends to be more looser than it should be when oil prices are higher; and likewise, monetary policy tends to be more tighter than it should be when oil prices are lower. GCC can of course fine tune its currency basket by allowing for a ±band around the central rate and letting the central rate to change slowly (i.e. crawl). This type of basket, band, and crawl, or BBC, has been a good template for some East Asian countries, particularly Singapore.
However, in the GCC context, a better alternative to accommodate exogenous changes oil prices would be to include the price of oil in the basket alongside trading partners’ currencies: e.g. 1/3 dollars, 1/3 euro, and 1/3 oil. In this circumstance, oil prices works like an automatic stabilizer, helping the currency to appreciate at precisely the time when oil prices are soaring, and likewise letting the currency to depreciate when oil prices are falling. In a sense, the insulation from terms of trade shocks delivered by a basket including oil is similar to what only a floating exchange rates offer.
Despite a good amount of flexibility delivered by a currency basket including oil price, GCC can do even better. In particular, GCC could work towards transforming its new common currency into a major international currency. One way to achieve this is by pricing GCC’s exports (largely oil and gas) in its own currency. Pricing exports in the local currency will immediately create a sizable international market for the new GCC currency. Most of GCC’s exports do not face any competition in the international market, so there will be a natural demand for the new GCC currency. Countries that buy GCC’s export and/or have other trade interests, will have to buy the new GCC currency from international market, much like what is going on with the US dollar. Moreover, some foreign central banks may find it useful to hold the new GCC currency as a reserve currency, alongside other currencies.
The GCC monetary union with a brand new currency raises many positive possibilities. An own and independent currency will not only allow GCC economies to effectively manage external shocks, it will also positively contribute to the regional economy. For example, Yemen may find it attractive to peg its currency to the new GCC currency, or Iraq may wish to join the GCC monetary union as a new member. A well-designed GCC monetary union could trigger a much needed macroeconomic transformation throughout the MENA region, and may pave the way to eventually turn into a Pan-Arab monetary union.