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    Towards aCommon GCCCurrencyGCCs Best Exchange Rate Regime

    This paper focuses on the best exchange rate system to peg the newGCC common currency to it, whether it is the US Dollar, or the basket ofcurrencies or to more flexible regime which is the floating regime andthen examine the empirical evidence on the delineation of regimes andtheir macro performance.

    2010

    Aisha Al-OmranAmerican University f Kuwait

    25-May-10

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    Index

    1. Introduction 3

    2. Literary Review..... 4

    3. Methodology . 5

    4. Data........ 5

    What is an OCA? .. 5

    Brief History of a Common GCC Currency.. 6

    Exchange rate regime of the Khaleeji.. 7

    The Optimal Exchange rate regime. 8

    5. Results and Discussion. . 12

    6. Conclusion. 13

    7. References. 15

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    Introduction

    Kuwaits last ruler has come up with the idea of establishing a Cooperation

    Council for the Arab States of the Gulf in the early eighties of the previous century.

    Kuwait, Saudi Arabia, United Arab Emirates, Qatar, Bahrain and Oman were

    members of this council (GCC countries hereafter). GCC leaders came up with an

    Economic Agreement to establish a complete economic integration. The economic

    agreement was meant to be a first block in the monetary and economic union.

    Arab Gulf Countries or the GCC countries are known to be of the worlds

    highest GDPs; So that, a monetary union within these countries could be one of the

    most important monetary unions around the world second after the European Union.

    As this Union is very important the exchange rate regime that would be used

    within the region would affect the worlds economy as the region is one of the most

    opened region to the world in terms of trade.

    Leaders of GCC countries agreed to adopt a common exchange rate regime to

    help them maintaining the parity between the GCC member countries as a first step

    towards the monetary union. This meeting has been held in Bahrain in year 2000.

    However, they have agreed on that the start date of pegging against the common

    currency is on 2003 and the common peg to be against the US Dollar.

    Starting from 2003, all the GCC currencies were fully pegged to the US

    Dollar. However, on the 2007 while the global crisis was taking place, the US dollar

    was depreciating dramatically against the major currencies of the world; So that,

    Kuwait depegged its currency from the US Dollar and pegged the Kuwaiti Dinar to a

    basket of currencies that was dominated by the US Dollar. Through all these doubts,

    this contributed to the delay of issuing the common currency plus the demurred of

    Oman and the UAE out of the convention for economic and political reasons

    respectively.US Dollar has a very strong relationship with currencies of the GCC currencies, since

    most of their currencies are pegged with the US Dollar except for Kuwait which has

    an exchange rate regime of a basket of currencies that is dominated by the US Dollar.

    As for the recent changes, GCC countries unofficially considered many

    options other than pegging the new common currency to the US Dollar, such as the

    basket of currencies and the more flexible regime which is the floating. This study

    tries to examine the optimal choice of the exchange rate system for the GCCMonetary Union.

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    Literary Review

    The research concentrated on two main articles, the first one is the paper

    written by Eisa A. Aleisa and Shawkat Hammoudeh which is A Common Currency

    Peg in the GCC Area: The Optimal Choice of Exchange Rate Regime. The paper

    discussed the best choice of exchange rate system that should be adopted for the

    region of GCC. The paper tested the exogenous factors that are based on exterior

    shocks on the region. The paper assumes that GCC region is a single bloc and fully

    integrated. The research results prove that the regions output is mostly affected by

    domestic impacts in the short and long run. In addition, it is not affected by the Euro

    or the US Dollar fluctuations as well. This would lead us to conclude that the basket

    peg would be more preferable as long as there is no huge effect from US Dollar and

    the Euro on the output movement in the region. In other words, if the output

    movement is more effected by the terms of trade other than other international

    currencies the region should adopt more flexible regime. The paper was wrapped up

    by the conclusion of that the optimal exchange rate regime is the adoption of a basket

    that is highly dominated by the U.S. dollar and the Euro. It also, recommends the

    basket peg as a more flexible regime that would lead a more flexible regime in the

    future.

    Another article is The choice of exchange rate regime: An empirical analysis

    for transition economies that was written by Jrgen, Hagen and Jizhong Zhou. The

    article explored the alternative exchange rate systems within Europe. The sample is

    constructed using the data of the 25 transition economies in that area after 1990. The

    empirical results prove that the traditional OCA literature presents applicable methods

    to help choosing the optimal exchange rate regime within the choices in these

    countries. Furthermore, these choices depend on many measurements, such as,

    inflation rates, cumulative inflation differentials, and the availability of internationalreserves. This means that economic performance and many other factors play a very

    important role on choosing the optimal exchange rate regime for the OCA region.

    Yet, Government debit has an uncertain role in this scenario; it works both sides;

    whether moving towards the more flexible regime or towards a more fixed regime.

    So, the effect of such an indicator was not clear or hard to follow.

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    Methodology

    This study of the optimal choice of the exchange rate policy for the GCC

    Common Currency is expressed by an expressive analytical model throughout

    collecting data, study the implications of these data in order to reach the best

    conclusion which is the optimal exchange rate regime that should be taken within the

    GCC monetary union to contribute in improvement and development in the region of

    the GCC. The findings of this study were presented by the quantities and qualities

    methods. Data of the study were collected from many different resources, such as,

    books, recent researches, statistics, IMF reports, regulations and laws, and some

    newspapers. I also have worked within the process of the Monetary Union in the

    region. The research includes some details from the meeting minutes of the GCC

    meetings regarding this issue. So, I have also interviewed many people who are in

    power within the ministry.

    Data

    What is an OCA?

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

    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

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    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).

    Brief History of a Common GCC Currency

    A European Central Bank delegation visited the secretariat of the Gulf

    Cooperation Council in the first week of June 2002. They were invited in order to

    discuss the main themes of the workshop which will be held in cooperation with

    European Central Bank in Riyadh on October. (Ministry of Finance, 2010)

    The technical committee which was setup agreed to determine a timetable that

    is divided into three phases to achieve the main goal, which is the GCC common

    currency. The first stage was the adoption of a common currency to peg their

    currencies with it, and they agreed on the US Dollar to be the currency other that the

    basket of currencies. This step was planned to be achieved by the end of the year

    2002. The next step was the configuration of a monetary union. This point includes

    the specification of the economic performance criteria that are related to financial,

    monetary, and ratio stability. This was to be agreed before the end of 2005. The third

    and the final phase scheduled is the physical issuing of the GCC common currency

    with the deadline of January 2010. This was the plan, however, we are now in 2010,

    and the deadline has been further postponed due to many things, such as, the delay in

    the customs union, the withdrawal of Oman and the UAE out of the monetary union,

    in 2007 and 2009 respectively, and the depreciation of US Dollar (Ministry ofFinance, 2010).

    This monetary union in the GCC countries is expected to raise the efficiency

    of the financial institutions, reduce the cost of financial and commercial transactions

    in the region, better use of the available resources, and to create a new economic

    force. Furthermore, there is a significant economic convergence between GCC

    countries. On the other hand, there is a considerable variation between GCC countries

    in number of criteria, such as, budget deficit, public debt, unemployment rates, depth

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    of financial markets, degree of transparency of data, and type, timing and

    comprehensiveness of economic statistics (Ministry of Finance, 2010).

    The central banks of GCC states agreed on the monetary union. As a result

    Bahrain, Kuwait, Qatar, and Saudi Arabia have stopped lending money to the public

    sector entities in a step towards the establishment of Khaleeji, because it is a part of

    the agreement that the four countries have agreed on. In addition, they need to sell the

    loan portfolios of the public sectors, after which, countries can establish a common

    central bank that will not lend to public sectors like the European model (Ministry of

    Finance, 2010).

    Exchange rate regime of the Khaleeji

    There are differences in opinion of the kind of policy which needs to be

    adopted. Should it be a dollar or basket pegged exchange rate regime or a free floating

    exchange rate system?

    The issue of depegging the GCC common currency to the US Dollar came up

    when the US Dollar value was decreasing and oil prices were highly affected. In the

    past, GCC countries adopted fixed exchange rate systems to stabilize the currency and

    the economy as a whole. But now, a single currency like the US Dollar may affect the

    economy hardly by importing inflation overseas. Economies which depend on human

    capital and trade need to adopt more flexible exchange rate regime so that they could

    be better off (Aleisa et al. 2007).

    In addition, Kuwait's foreign minister, Sheikh Mohammed Al-Sabah, said that

    the GCC's common currency might be linked to basket of currencies other than one

    currency. He said that to the Kuwaiti Parliament showing that there is a possibility

    that the new currency might not be pegged to the US Dollar. On the other hand,

    Youssef Kamal, the Finance Minister of Qatar said that Qatar is satisfied with thevalue of its riyal currency and sees no need to change its peg to the dollar (Reuters,

    2007). He was wondering about the reason of pegging his currency to a basket of

    currency when he have 100% of his exports are sold for US Dollars in Washington,

    quoted Qatari daily Gulf Times, 2007. He also said that he has a comparative

    advantage over products that are not pegged to the US Dollar. An economist was

    talking to Sheikh Hamad Al-Thani the Ruler of Qatar, he was discussing the issue of

    major oil producers, and he said that they should be more willing to discuss theviability of linking their currencies to the US Dollar. Going forward, if you have a

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    structurally weak US Dollar, policymakers will have to look at different options, said

    Monika Malek (Reuters, 2007). According to MENAFN, the GCC common currency

    might be pegged to the US Dollar in the first place then they might consider ditching

    the dollar peg to a basket of currencies that is dominated by the US Dollar

    (MENAFN, 2009).

    However, a note that was published by The Dubai International Financial

    Centre stated that the new currency of the GCC should be pegged to a basket of

    currencies from the beginning. The study argues that pegging the new currency to a

    basket of currencies will allow the Gulf Central Bank to have more flexibility in

    monetary policies. The note suggested that the basket should be compromised of four

    major currencies and the weight of each currency in the basket should be based on the

    trade, the output, and inflation inter-linkages. So, the US Dollar might weight 45% of

    the basket, 30% Euro, 20% Japanese yen, and 5% of the British pound (The exchange

    rate regime of the GCC monetary union, 2008).

    The Optimal Exchange rate regime

    Since the IMF is leading economies towards more flexible regimes which is

    floating the currency to supply and demand forces in the international market; so that,

    as it is seen in table 2 and table 3, countries are moving towards a more flexible

    exchange rate regime.

    According to IMFs, instead of the fact that a fixed exchange rate regime

    provides some credibility instead of the flexibility that would be assured by the

    flexible exchange rate regime, the IMF research department assured that the tradeoff

    between credibility and flexibility depends on the general orientation of the country or

    the monetary union as well. The IMF recommends that a flexible exchange rate

    regime would be more beneficial for a country when the political costs of exchangerate adjustments exceed the benefit (Caramazza et al, 1998).

    If the GCCs exchange rate system of the unified Gulf currency was left to be

    determined through market forces or let the exchange rate proposed in accordance

    with the forces of supply and demand this would expose the region to shocks affecting

    the monetary stability of the GCC countries and increase the likelihood of speculative

    attacks, which could result in the worst threat to Union project. Especially for a region

    that is affected violently by external attacks. It would be more prefer not to be floating

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    the new unified Gulf currency, or at least in the early stages of the production process

    so as not to exposing the region to stability shocks.

    On the other hand, Alan Greenspan, former Chairman of the Board of

    Governors of Federal Reserve in the ninth session of Jeddah Economic Conference,

    said that adopting the most flexible exchange rate regime would extensively relieve

    the inflation rates within the region in the short term and erase it entirely in the long

    term (Abdelaziz, 2008).

    Yet, IMF argues that the free-floating system or the exchange rate system

    against the crude-oil price would be inappropriate because of its negative effect on the

    other sectors of the economy; although, the positive advantages of a hedge against

    shocks of foreign trade (Ministry of Finance, 2010).

    Table 1: Export Concentration Indices for GCC Countries

    Table 2: Exchange Rate Arrangements as of December 31, 1997

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    Flexibility Limited vis--vis a Single Currency or

    Group of Currencies

    More Flexible

    Single currency1 Cooperative arrangements2 Other managed floating Independently floating

    Bahrain5

    Qatar5

    Saudi Arabia5

    United Arab Emirates

    Austria

    Belgium

    Denmark

    Finland

    France

    Germany

    Ireland

    Italy

    Luxembourg

    Netherlands

    Portugal

    Spain

    Algeria

    Belarus

    Brazil4

    Cambodia4

    Chile4,7

    China, Peoples Rep. of

    Colombia9

    Costa Rica

    Croatia

    Dominican Republic 4

    Ecuador4,12

    Egypt4

    El Salvador

    Georgia

    Greece

    Honduras4,12

    Hungary15

    Indonesia

    Iran, Islamic Rep. of4

    Israel14

    Kazakhstan

    Kyrgyz Republic

    Lao P.D.R.

    Macedonia, formerYugoslav Rep.of

    Malaysia

    Maldives

    Mauritius

    Nicaragua

    Norway

    Pakistan4

    Poland14

    Russian

    Federation

    Singapore

    Slovenia

    Sri Lanka

    Sudan4

    Suriname

    Tunisia

    Turkey

    Turkmenistan4

    Ukraine

    Uruguay

    Uzbekistan4

    Venezuela8

    Vietnam

    Afghanistan, Islamic

    State of4

    Albania

    Armenia

    Australia

    Azerbaijan

    Bolivia

    Bulgaria

    Canada

    Eritrea

    Ethiopia

    Gambia, The

    Ghana

    Guatemala

    Guinea

    Guyana

    Haiti

    India

    Jamaica

    Japan

    Kenya Republic

    Korea

    Lebanon

    LiberiaMadagascar

    Malawi

    Mauritania

    Mexico

    Moldova

    Mongolia

    Mozambique

    New Zealand

    Papua New Guinea

    Paraguay

    Peru

    Philippines

    Romania

    Rwanda

    So Tom and

    Prncipe4

    Sierra Leone

    Somalia

    South Africa

    Sweden

    Switzerland

    Tajikistan, Rep. of4

    Tanzania

    Trinidad and Tobago

    Uganda

    United KingdomUnited States

    Yemen, Rep. of

    Zare4

    Zambia4

    Zimbabwe1In all countries listed in this column, the U.S. dollar was the currency against which exchange rates showed limited flexibility.

    2This category consists of countries participating in the exchange rate mechanism (ERM) of the European Monetary System (EMS). In each case, the exchange rate

    is maintained within a margin of 15 percent around the bilateral central rates against other participating currencies, with the exception of Germany and the

    Netherlands, in which case the exchange rate i s maintained within a margin of 2.25 percent.

    3The exchange rate is maintained within margins of 47 percent.

    4Member maintained exchange arrangement involving more than one market. The arrangement shown is that maintained in the major market. For Zare, note that

    the official name was changed to Democratic Republic of the Congo on May 17, 1997.

    5Exchange rates are determined on the basis of a f ixed relationship to the SDR, within margins of up to 7.25 percent. However, because of the maintenance of a

    relatively stable relationship with the U.S. dollar, these margins are not always observed.

    6The exchange rate, which is pegged to the European currency unit (ECU), is maintained within margins of 2.25 percent.

    7The exchange rate is maintained within margins of 12.5 percent on either side of a weighted composite of the currencies of the main trading areas. The exchange

    arrangement involves more than one market.

    8The exchange rate is maintained within margins of 7.5 percent.

    9The exchange rate is maintained within margins of 7 percent.

    10The exchange rate is maintained within margins of 6 percent.

    11Country uses peg currency as legal tender.

    12The exchange rate is maintained within margins of 5 percent.

    13The exchange rate is maintained within margins of 3 percent.

    14The exchange rate is maintained within margins of 7 percent with regard to the currency basket.

    15The exchange rate is maintained within margins of 2.25 percent with regard to the currency basket.

    Table 3: Exchange Rate Arrangements as of December 31, 1997

    Source: Caramazza et al, 1998

    Country/Region Bahrain Kuwait/1 Oman Qatar /1 Saudi Arabia UAE/1

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    Share of GCC GDP (%) 2.5 10.2 3.3 6.7 56.6 20.7

    Real GDPby Sectors

    (%)

    Non-oil 84.2 65.5 52.8 42.4 44.1 77.4

    Oil 15.7 34.5 28.0 57.6 32.7 22.6

    Government 0.1 n/a 19.2 n/a 23.2 n/a

    % of Oil In Total Gov. Revenues 15.7 34.5 28.0 57.6 32.7 22.6

    Exports/GDP (%) 79.1 60.5 71.6 63.8 51.2 n/a

    Imports/GDP (%) 63.6 34.3 40.3 23.7 20.3 n/a

    Notes:1/ Non-oil sector includes the government sector.2/ In % of total exports3/ In % of total imports within

    Table 3: Exchange Selected Macroeconomic Indicators for the GCC countries (1998-2003)

    Sources: IMF DOT, Monetary Agencies and central banks.

    Table 4: Directions of GCC countries exports

    Sources: IMF DOT, Monetary Agencies and central banks.

    Table 5: Middle East and North Africa: Financial Development Ranking

    Sources: (Creane et al., 2003)

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    Table 6: Determinants of Exchange Rate Regime Choices

    Source: (Jrgen et al., 2005)

    Results and Discussion

    It is shown in table 6 that is the determinants of exchange rate regime choices

    that was took from the Jurgens paper The choice of exchange rate regime: An

    empirical analysis for transition economies are seven. However, in this region, that is

    the GCC countries most of these data are not available, so that, we would not be able

    to apply the empirical analysis on the data of the GCC region. Yet, we would try to

    analyze it using the available data.

    First of all, OCA fundamentals measurements would be applied to the GCC

    region as a single bloc. The higher the degree of Economic openness suggests the

    fixed regime. As we all know the GCC region is considered to be a very open

    economy, however, the output in this economy is not affected by the fluctuations of

    other international currencies such as the US Dollar and the Euro as much as it is

    affected by the terms-of-trade (Aleisa et al. 2007). So this wouldnt be as effective as

    much. Another indicator is the geographical concentration of trade. The more

    concentrated the trade, the more fixed exchange rate the economy should adopt. GCC

    countries have some geographical concentration of trade as it is shown in table 4(IMF,

    2008). So, fixed interest rate would be better in that case. In addition, the higher the

    degree of the concentration of the commodities he more flexible exchange rate regime

    recommended. As it is known that GCC region has a 66% commodity concentration,

    so this would go for the flexible exchange rate regime (IMF, 2008). Furthermore,

    large economic size goes with the flexible exchange rate regime, so as we deal with

    the GCC as a single bloc, it would be considered a large sized economy. Also, the

    higher the level of financial development the more flexible exchange rate regime

    would be recommended, and as it is shown in table 5, all GCC countries considered to

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    have high financial development (Creane et al., 2003) So that, flexible exchange rate

    regime would be appreciated in that case. To know which exchange rate regime

    would be more effective according to these measurements of OCA fundamentals we

    would divide them into two sides and tick right on the more effective regime and then

    compare contrast between the two regimes.

    Determinant Flexible FixedHigh Degree of Economic Openness High Trade concentration : Commodities High Trade concentration : Geographical High Level of Economic Development Large Economic Size High Level of Financial Development

    Table 7: Measuring the Determinants of exchanged rate regime of the GCC

    According to table 7, the measurements would nominate the flexible exchange

    rate regime to be applied on the GCC common currency as the GCC region as a bloc

    is a very large, open economy that has to stand by its own and self-correct itself other

    than pegging its currency to another currency that could affect it negatively and limits

    its control on its currency.

    Conclusion

    It is yet to be determined when exactly the GCCs common currency will be

    launched. At present it looks like the GCC could miss the initial 2010 deadline by at

    least two years. The implications of the common currency for the US Dollar are

    mixed. On one hand, if the GCC pegs the common currency to the Dollar, the

    common currency could generate Dollar demand, and held to restore faith in the

    Dollar. On the other hand, if the GCC moves away from the Dollar the implications

    for the Dollar in the global marketplace will be much less than favorable.

    Analysts are of the opinion that the new currency of the GCC should be

    pegged to a basket of currencies from the beginning. By pegging the new currency to

    a basket of currencies the Gulf Central Bank will have more flexibility in monetary

    policies. The basket could comprise of major currencies and the weight of each

    currency in the basket should be based on the trade, the output, and inflation inter-

    linkages. However, depending on the experience of the EU, I see that floating could

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    be a better solution from the begging as long as inflation is not very high in the region

    and the IMF recommendations to most of the countries to float their currencies in

    order to live the real economic situation and be more independent on themselves and

    realize their own economic situation.

    References

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    Abdelaziz, Omar. (2008). Greenspan turns the table calling for lifting the gulf

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    Fisk, Robert. "The demise of the dollar: In a graphic illustration of the new world

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    Kenen, P. B. (1969), .The Theory of Optimum Currency Areas: An Eclectic View. in

    R.A.Mundel and A. K. Swoboda, Monetary Problems of the International

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    "Kuwait to keep currency basket peg: CBK ."Arab Times (2010): 3. Web. 25 May

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