Towards a Common GCC CurrencyAre the GCC Countries Ready?This paper focuses on the GCC countries macroeconomics factors to determine wether they are ready for such integration or not. The paper measures the ability of these countries through many factors that where concluded from an interview with the Kuwaiti representative in the Monetary Union. The paper concluded that GCC countries needs more time extension to become fully integrated.

2010

Aisha Al-OmranAmerican University f Kuwait

25-May-10

GCC COMMON CURRENCY

Index

1. Introduction…………………………………………………… 3

2. Objective………………...…………………………………….. 4

3. Literary Review………...…………………………………….. 4

4. Methodology………………………… ………………………. 6

5. Analysis………………...…………………………………….. 7

6. Results………………………………. ………………………. 12

7. Conclusion……………………………………………………. 17

8. References……………………………………………………. 18

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Introduction

On May 25, 1981, six countries in the Arabian Gulf, Bahrain, Kuwait,

Oman, Qatar, Saudi Arabia and the United Arab Emirates, established the

Cooperation Council for the Arab States of the Gulf (GCC countries

hereafter). In a top level meeting held in November 1981, the GCC leaders

chose an Economic Agreement (EA) providing the stage for a full economic

integration. The economic agreement envisaged different stages of a full

economic integration namely, a free trade area, a customs union, a common

market and economic union. In 2000 at Bahrain the leaders agreed to adopt a

common peg for the different currencies of the member states as a

preliminary step toward adopting a single currency, which is one of the key

points for achieving full economic integration.

During the December 2001, GCC summit in Muscat, the six GCC

countries planned for introduction of a single currency in the year 2010. The

choice of the type of exchange rate regime is one of the key issues to be

discussed by the GCC. They also agreed in the interim stage to keep the

American dollar as a common peg. Should the GCC peg the new currency to

the US dollar or have a basket of currencies where the dollar, euro and yen

have a high share or let the new currency float on its own? These are some of

the subjects which will be discussed in this assignment.

For achieving monetary integration and a common currency, GCC

believes that complete integration of product and factor markets should take

place which requires the elimination of the transaction costs and uncertainties

associated with separate currencies. In research, the viability of a common

currency has been usually tested by several parameters in the theory of

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Optimum Currency Areas (OCA) developed by Mundell (1961), McKinnon

(1963) and Kenen (1969).

Objective

The objective of this paper is meant to investigate the GCC’s common

currency, its efficiency for the region, whether the region is ready for such a

monetary union or not, and we will measure that according to some

measurement and factors that would lead us to know if the GCC region is

ready for such a union or not.

Literary review

This paper is meant to investigate the paper of “A Common Currency

Peg in the GCC Area: The Optimal Choice of Exchange Rate Regime” that

was written by Eisa A. Aleisa and Shawkat Hammoudeh which is focusing on

the best choice of exchange rate method for the region of GCC and testing

the exogenous factors that cause external shocks on the region. The paper

deals with the region as a single bloc. The research shows that in the region

the output in this area is mostly affected by domestic impacts in the short and

long run. However, foreign currencies such as the US Dollar or the Euro do

not affect the output movement as much. From this we can conclude that as

long as the correlation is not strong and does not affect the output movement

in the region, the GCC common currency should peg to a basket of currencies

other than the US Dollar, and adopt a more flexible regime. The paper

concluded that the findings from the estimations of the US Dollar and the Euro

show that GCC economies are mostly driven by the terms-of-trade and

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domestic shocks other than the foreign currencies such as the US Dollar and

the Euro. This means, GCC region must adopt more flexible exchange rate

regime. However, they must focus in the beginning on the credibility and

stability of the new currency as it will gains other currencies’ power by

pegging it to powerful currencies in the begging. To make it clear, it might be

optimal to construct a basket of currencies where the U.S. dollar and the euro

should have the largest shares. This indicates, a peg to a basket of

currencies is more flexible than that of a rigid exchange rate regime, and this

will help the economy to work towards a more flexible exchange rate regime.

Another paper was found which is “Are GCC countries ready for

currency union?” written by Belkacem Laabas and Imed Limam. This paper is

evaluating how ready the GCC countries are for being one economic bloc; the

study conducted using official examinations, based on G-PPP theory, and

unofficial examinations based on the Optimal Currency Areas literature. the

analysis shows that in spite of that there are steps forward achieved by GCC

countries in different areas, GCC countries aren’t really ready to establish a

currency union. The economy of the GCC region relays mainly on the oil

sector with narrow intra-regional trade, in addition to that there isn’t any proof

of convergence in their main macroeconomic essentials or harmonization of

their business cycles. The main factors that are favorable for the

establishment of CU are the implied obligation by all GCC to fixed exchange

rate regimes and a well-built political determination to achieve economic

integration.

Another paper was used, which is “Fixed or Flexible – Getting the

Exchange Rate Right in the 1990’s” that was written by Francesco

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Caramazza and Jahangir Aziz. The paper investigates the shift that was taken

by many countries from the fixed exchange rate regime –whether to peg the

domestic currency to one powerful currency or to a basket of two or more

currencies- towards a more flexible regimes which is the floating technique

that is to determine the value of the currency by the factors of supply and

demand. The paper recommends that the best exchange rate regime is

achieved by the strong dedication to it; in addition, it shows that the exchange

rate system adopted by a country cannot be unequivocally rated by the

countries’ economic performance. The study shows that developing countries

with pegged currencies benefits from relatively until recently when he inflation

rates in developing countries has been shrinking until it reaches the rates of

inflation in countries with pegged currencies that means lower inflation rates.

However, the study recommends that countries suffering from high inflation

rates should consider the fixed exchange rate mechanism at least for the

short term as the choice of exchange rate regime could be different over time

depending on every country’s special circumstances.

Methodology

This study of the GCC’s Common Currency adopts the expressive

analytical method that is based on anthology, categorization, association,

analysis of information and data collected, and then articulating them in order

to reach the best conclusion, that is whether to float or to peg the new GCC

currency to a fixed exchange rate regime to contribute in improvement and

revolutionize conclusion. The results have been presented by use of

quantitative and qualities methods and illustrated by statistics, tables, and

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graphs. I have tried to collect data from many different sources, such as

books, online, and from the ministry of finance of Kuwait in order to have the

ability to look at the problem from more than one perspective and I have read

through the literature on the topic of the GCC’s common currency. I have

relied on the previous researches and references that focused on this topic,

also I have reviewed applicable governmental periodicals, articles, reports,

researches, statistics, regulations, and laws in order to lay the proper

foundations for the study route, in general. I have depended on my internship

that was taken in the department of the Arab, and Gulf Cooperation in the

Economic Sector, of the Ministry of Finance to take many information that is

related to the topic as my manager is the former representative of Kuwait in

the Monetary Union.

Analysis

OCA is the short term of the economics term of Optimal Currency

Union. This means the area or the region that uses the same currency. For a

monetary union we need a common currency, thus a common central bank to

create single monetary policies. The availability of such a union needs some

work. Political integration is one of the most important factors in the region;

also economics relationships among countries of the OCA should show a high

correlation with the same shock expectations among the region (Aleisa et al.

2007). The monetary union reduces transaction costs within the region of the OCA

and the exchange rate insecurity. In an OCA economies of scale can be achieved by

release unoccupied reserves. An OCA may lessen the capability of speculators to

affect prices and disrupt the accomplishment of monetary policy. It can also make use

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of reserves in a productive manner in case of a problem in offsetting payments. In

inflation affected countries an OCA can also discipline and make the monetary policy

credible. Also, there are countries that adopt a common currency and peg it to a

credible currency in order to get the trust (Chabrier, 2002). An OCA does not allow

a country to follow independent and exchange rate policies. Exchange rates are

compulsorily fixed, interest rates are tied to foreign interest rates, and any increase in

money stock will result in balance of payment deficits (Aleisa et al. 2007). The main

benefits of CU are from the expansion of bilateral trade among the countries of the

Union (Rose, 2000) found that trade among the countries of a CU could rise three-

fold once the union started. However this may too optimistic due to some inherent

upward bias in the estimation due to the common decision to join a CU (Tenreyro,

2001).

After discussing the GCC Monetary Union with the head of the Arab, and

Gulf cooperation department in the Ministry of Finance, we have assigned 5

determinants to weight the possibility of creation an OCA within the region (Ministry

of Finance, 2010). These factors are:

1. Diversified Economy: A more diversified economy leads to better protection

against terms of trade, and other, shocks. Hence it might not use the exchange

rate to lessen the impact of the shock. Therefore, countries with diversified

economies are better candidates for currency union.

2. Openness: Small countries that depend on international trade are more likely

to be affected by exchange rate fluctuations and uncertainty since a large

portion of its goods is traded. McKinnon (1969) argues that the exchange rate

is of no use in the case of a small open-economy as an instrument to correct

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balance of payments problems. The exchange rate is associated to the price

level in the economy to the extent that any exchange rate variation leads to

variation in costs. Therefore, exchange rate becomes an ineffective tool to

improve competitiveness. Ishiyama (1975) also states that for a small open

economy where most of the consumed goods are imported, the exchange rate

becomes an ineffective corrective tool given the inelastic demand for imports.

Therefore, it is easier for a small open economy to enter into a currency

union.

Figure 1: Benefits of Monetary Union in an Open Economy

The above graph shows the benefits of a monetary union and the openness of a

country. The more open an economy is the more welfare gains it will receive

from a monetary union. The horizontal axis is a scale of the openness of the

country in relation with other countries within the union. And the benefits are

shown as a % of GDP on the other axis. The gains from a monetary union

increase with increasing openness towards other countries in the monetary

union (Grauwe, 80).

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3. Factor Mobility: High integration helps labor and capital to move within the

union without restraints. This leads to lesser use of exchange rate as corrective

tool in case of shocks. Therefore, factor mobility would play the role of the

exchange rate. (Ministry of Finance, 2010).

4. Policies Integration: Countries with similar policies can achieve full

monetary integration in a successful way. It has been seen that a

monetary union boosts economic growth. This can be seen using the

neoclassical growth model which is presented in the below graph Fig.2.

The horizontal axis shows the capital stock per worker and the vertical

axis shows the output per worker. The line f(k) is the production

function which has the usual concave shape, implying diminishing

marginal productivity. The equilibrium in this model is attained where

the marginal productivity of capital is equal to the interest rate

consumers use to discount future consumption. This is represented by

Point A in the graph where the line n is tangent to the production

function f (k). In this model growth can only occur if population grows or

if there is an exogenous rate of technological change (Ministry of

Finance, 2010).

This model can also be used to evaluate the growth effects of a

currency union as shown in Fig.3. We need to assume the elimination

of the exchange risk reduces the systemic risk. This will lower the real

interest rate. In a less risky environment, investors will require a lower

risk premium to make the same investment. Therefore in the neo

classical model the reduction of the interest rate due to the currency

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union temporarily increases the rate of growth of output. (Ministry of

Finance,2010).

Figure 2: The Neo Classical Model of Growth

Figure 3: Growth effects of a Monetary Union

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5. Other Factors: For the success of a currency union one of the

important factors is the political will and resolve of countries within the

union to achieve the goal of currency union. It has been seen through

experience that political factors are more important than economic

factors. In addition to that, social factors also plays a major role in this

region specifically, as families here prefers to live near each other are

which restricts the free factors mobility.

Results

Do GCC Countries qualify for OCA?

Do the GCC countries qualify for OCA on the basis of the above criteria? We

will check it out against the criteria already given to check if the GCC region is

ready for a monetary union or should they postpone it further more according

to the classifications were discussed with the head of the Arab, Gulf

Cooperation Department in the Economic Sector of the Ministry of Finance,

Mr. Yousef Al-Roumi who is the representative of the Monetary Union in

Kuwait which are four criteria (Diversification of the Economy, Openness,

Factor Mobility, Policies Integration, and some other factors) we are going

now to test these characteristics and apply them to the GCC region:

Diversified Economy: GCC exports are mainly consists on Oil, yet they are

trying to diversify their economies, but still, oil has the biggest share of their

exports and revenues as it is shown in Table 2. This would explain the

correlation between the oil prices and the economies of the GCC region.

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Actually, Economic policy adjustments are done through the Government

expenditures.

Table 1: Export Concentration Indices for GCC Countries

Openness: As a fact, GCC Region is by natural a very open economy as it

depends on one good to export which is the Oil as is shown in Table 1.

Therefore, it imported most of the products from abroad to satisfy the need of

the consumers. Therefore the use of exchange rate is limited as a measure to

improve competitiveness or to transfer resources among sectors within the

region. Table 3 shows Selected Macroeconomic Indicators for the GCC

countries (1998-2003). GCC countries have highly open economies as

evidenced by the high ratios of imports and exports to GDP (Aleisa et al.

2007).

In table 4 it is obvious that the trade between the GCC countries is so

inadequate. Except for Saudi Arabia, the intra-trade between other members

is mainly unseen. I addition, the same table shows that the exports were

concentrated in Asia, except for Saudi Arabia. However, the imports were

imported from Europe mostly, as it is shown in table 5 (Aleisa et al. 2007).

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Table 2: Openness of GCC countries

Table3: Selected Macroeconomic Indicators for the GCC countries (1998-2003)

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Table 4: Directions of GCC countries exports

Table 5: Direction of GCC countries Imports

Factor Mobility: The GCC agreement encourages the movement of capital

and work force across the region and gives them the freedom to exercise

economic activities (Unified Economic Agreement, 2001). However, workers

would not like to go to other GCC countries far away from their families for

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cultural and social reasons. Also, for women it would be more restrictions, as

for the religious factors.

Policies Integration: In GCC countries, inflation rates are not highly

correlated in spite of the similar fiscal, monetary and exchange rate policies.

The differences in inflation among GCC countries may be due to a difference

in the determinants of inflation (i.e. affecting the supply of and demand for

goods and services) notably, the inelasticity of price. In addition, GCC policies

suggesting coordination in the context of currency union have already

common features in the countries of the region. Usually, monetary and

exchange rate policies are centered around maintaining a difference between

domestic and foreign interest rates so as to stabilize the exchange rate and

stem capital outflows. (Tenreyro, 2001). However, GCC countries are primed

towards a currency union as they can withstand shocks using common

policies.

Other factors: There exists a strong commitment to the GCC between the

GCC leaders. This comes from the fact that many common traits are shared

by GCC countries in their political, social, demographic and cultural

structures. Despite economic differences the leaders are resolved to move

ahead with the economic integration. GCC countries have been praised for

using a pragmatic approach towards achieving integration. In addition to that

there are some social and cultural powers that could affect the effectiveness

of such a union, which are the cultural and traditional restrictions. Such as the

restrictions on females not to travel alone and the cultural factors that people

in this region would prefer to live close to their families not so far away from

them.

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Conclusion

It is yet to be determined when exactly the GCC’s common currency

will be launched. At present it looks like the GCC could miss the initial 2010

deadline by at least two years. The GCC countries are not yet very ready for

the integration as they should consider some factors to go across which is the

factor mobility as for workers and the cultural and social reasons. In addition

to that, many policies are not fully implied, so further policy integration

strategies would be appreciated. However, in this region, as economy is lead

by political forces, a strong commitment from GCC rulers would encourage

this monetary union to be set soon.

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