OCCASIONAL PAPER SERIESOCCASIONAL PAPER SERIES NO. 31 / JUNE 2005 REGIONAL MONETARY INTEGRATION IN...

OCCAS IONAL PAPER SER IESNO. 31 / JUNE 2005

REGIONAL MONETARY INTEGRATION IN THE MEMBER STATES OF THE GULF COOPERATIONCOUNCIL

by Michael Sturm and Nikolaus Siegfried

In 2005 all ECB publications will feature

a motif taken from the

€50 banknote.

OCCAS IONAL PAPER S ER I E SNO. 31 / J UNE 2005

This paper can be downloaded without charge from http://www.ecb.int or from the social Science Research Network

electronic library at http://ssrn.com/abstract_id=752091.

1 The authors are grateful to Christofer Burger and Raquel Torres-Ruiz, who provided valuable research assistance. We thankPierre van der Haegen, Georges Pineau, Pierre Petit, Francesco Mazzaferro, Christian Thimann and Adalbert Winkler for

suggestions that have improved the paper. We would also like to thank Corinna Freund, Anja Gaiser, Frank Moss, ChristianeNickel and Michel Stubbe for helpful comments. The views expressed in this paper do not necessarily reflect those of the

European Central Bank.2 DG-International and European Relations, European Central Bank, Postfach 16 03 19, 60066 Frankfurt am Main.

REGIONAL MONETARY INTEGRATION

IN THE MEMBER STATES OF THE

GULF COOPERATIONCOUNCIL 1

by Michael Sturm 2

and Nikolaus Siegfried 2

© European Central Bank, 2005

AddressKaiserstrasse 2960311 Frankfurt am MainGermany

Postal addressPostfach 16 03 1960066 Frankfurt am MainGermany

Telephone+49 69 1344 0

Websitehttp://www.ecb.int

Fax+49 69 1344 6000

Telex411 144 ecb d

All rights reserved. Reproduction foreducational and non-commercialpurposes is permitted provided thatthe source is acknowledged.

The views expressed in this paper donot necessarily reflect those of theEuropean Central Bank.

ISSN 1607-1484 (print)ISSN 1725-6534 (online)

3ECB

Occasional Paper No. 31June 2005

CONTENTSC O N T E N T SABSTRACT 4

EXECUTIVE SUMMARY 5

I INTRODUCTION 7

2 CHARACTERISTICS OF THE GCC MEMBERSTATES’ ECONOMIES 9

2.1 The GCC in the global economy 9

2.2 Similarities among and differencesbetween GCC economies 11

2.3 Key economic challenges 16

3 INSTITUTIONAL AND ECONOMICINTEGRATION IN THE GCC 23

3.1 Relevance of the broaderintegration process in the GCCfor monetary union 23

3.2 The institutional framework ofthe GCC 24

3.3 The process of economic integrationin the GCC 26

4 ECONOMIC CONVERGENCE OF GCCMEMBER STATES 32

4.1 Monetary convergence 33

4.2 Fiscal convergence 37

4.3 Structural convergence 39

5 SOME CONSIDERATIONS ONCONVERGENCE CRITERIA FOR THE GCC 44

5.1 The relevance of assessingeconomic convergence 45

5.2 The need for a policy consensus 46

5.3 Key policy choices regardingconvergence criteria: purpose,economic content and design 47

5.4 Multilateral surveillance ofconvergence criteria andinstitutional underpinnings 53

5.5 Appropriate fiscal criteria as aspecific challenge for the GCC 55

6 ISSUES RELATING TO THEESTABLISHMENT OF A SUPRANATIONALGCC MONETARY INSTITUTION 63

6.1 The need for a single monetary andexchange rate policy and centraliseddecision-making in a supranationalinstitution 63

6.2 Centralisation and decentralisationof the analysis, implementationand communication of monetaryand exchange rate policy 64

6.3 Overview of further key issuesto be considered in the design ofa GCC monetary institution 66

7 FINAL REMARKS 70

8 BIBLIOGRAPHY 72

EUROPEAN CENTRAL BANKOCCASIONAL PAPER SERIES 77

ABSTRACT

The Gulf Cooperation Council (GCC) plans tointroduce a single currency by 2010 in its sixmember states, Bahrain, Kuwait, Oman, Qatar,Saudi Arabia and the UAE. This paper focuseson selected macroeconomic and institutionalissues and key policy choices which are likelyto arise during the process of monetaryintegration. The main findings are that (i) asupranational GCC monetary institution isrequired to conduct a single monetary andexchange rate policy geared to economic,monetary and financial conditions in themonetary union as a whole; (ii) GCC memberstates have already achieved a remarkabledegree of monetary convergence, but fiscalconvergence remains a challenge and needs tobe supported by an appropriate fiscal policyframework; and (iii) there is currently a highdegree of structural convergence, although thisis expected to diminish in view of the processof diversification in GCC economies, whichcalls for adequate policy responses.

5ECB


EXECUTIVE SUMMARY

EXECUTIVE SUMMARY

The Gulf Cooperation Council (GCC) plans tointroduce a single currency by 2010 in its sixmember states, namely Bahrain, Kuwait,Oman, Qatar, Saudi Arabia and the UnitedArab Emirates (UAE). This paper focuses onselected macroeconomic and institutionalissues and key policy choices which are likelyto arise in the GCC’s process of monetaryintegration. It does not however assess thepotential benefits and costs of a GCC monetaryunion, given that the political decision has beentaken to introduce a single currency, and nordoes it analyse options for monetary andexchange rate policy in the GCC after a singlecurrency has been launched.

The main findings of the paper are that (i) asupranational GCC monetary institution isrequired to conduct a single monetary andexchange rate policy geared to economic,monetary and financial conditions in themonetary union as a whole; (ii) GCC memberstates have already achieved a remarkabledegree of monetary convergence, but fiscalconvergence remains a challenge and needs tobe supported by an appropriate fiscal policyframework; and (iii) there is currently a highdegree of structural convergence, although thisis expected to diminish in view of the processof diversification in GCC economies, whichcalls for adequate policy responses.

The objective of monetary union in the GCC isembedded in a broader economic integrationprocess, for which an ambitious, but consistentagenda has been set. Following the realisationof a free trade area and a customs union, thecompletion of a common market is scheduledfor 2007, prior to the introduction of a singlecurrency in 2010. A deepening of the so farrelatively low degree of economic integrationin the GCC would be helpful in order to reapthe potential benefits of a monetary union,supporting the case for a comprehensive andtimely implementation of the planned stagesof integration. Furthermore, GCC institutionsassisting the economic integration process,

which so far has followed a mainlyintergovernmental approach, might need to bestrengthened in view of the stages ofintegration ahead.

A GCC monetary union will necessarilyrequire a single and indivisible monetary andexchange rate policy. Given this principle ofindivisibility, monetary union is more than justa particularly tight exchange rate arrangement,and the mere coordination of national monetarypolicies is not sufficient to sustain a singlecurrency. A single monetary and exchangerate policy that is geared to the economic,monetary and financial conditions in the singlemonetary area as a whole can only be ensured ifit is conducted by a supranational monetaryinstitution. In particular, decision-making onmonetary and exchange rate policy has tobe centralised, while there are differentoptions with regard to the centralisationor decentralisation of the analysis,implementation and communication of a singlemonetary and exchange rate policy.

The analysis of monetary and fiscalconvergence in the GCC reveals a remarkabledegree of monetary convergence, withgenerally low inflation rates in all memberstates and short-term interest rates co-movingin a narrow range. This is due to the GCCcurrencies’ long-standing alignment with acommon external anchor, the US dollar, whichhas led to a very high degree of intra-GCCexchange rate stability that is all the morenoteworthy as it has prevailed in anenvironment of liberalised capital accounts.Fiscal convergence is less marked thanmonetary convergence and seems to constitutean important challenge for the GCC. As far ascan be discerned from available data, thebudget balance-to-GDP ratios as well as publicdebt levels vary significantly between memberstates.

While the current state of structuralconvergence of GCC member states does notseem to constitute an impediment to afunctioning monetary union, the high degree of

6ECBOccasional Paper No. 31June 2005

structural homogeneity cannot simply beextrapolated into the future. Given thedominant role of oil and gas in the GCCeconomies, their economic structures,dynamics and trade patterns are broadlysimilar, thus reducing the likeliness ofasymmetric shocks or the need to resort tonominal exchange rate adjustments. However,both the pace and direction of economicdiversification will probably differ in thefuture between GCC member states, and willthus reduce the structural similarities betweentheir economies. This process is likely to bereinforced by the very different time horizonsover which the oil and gas reserves of GCCmember states are expected to be exhausted,raising the possibility that a GCC monetaryunion might in the future comprise both majoroil and gas producing countries and non-oil/gasproducing countries. This stresses theimportance of strengthening adjustmentmechanisms other than the nominal exchangerate (such as factor mobility and priceflexibility) in order to cushion asymmetricshocks, the likelihood of which may increase inthe wake of ongoing diversification.

It would be helpful to monitor an appropriateset of monetary and fiscal convergence criteriain a framework of multilateral surveillancein order to entrench and further promoteeconomic convergence. Key policy choicesrefer to the purpose, economic content anddesign of such criteria. The criteria could provea useful information tool for assessing policies,and may serve as an anchor for expectations,although their role as a disciplining device forpolicies may remain limited due to theprevailing consensus in the GCC that theyshould not be selection criteria determiningmembership of the monetary union. It would besufficient for monetary criteria to function asentry criteria, while fiscal criteria could play auseful role both as entry criteria and aspermanent criteria, thereby serving as thefoundation for a set of permanent fiscal rules.Ensuring sustainable fiscal convergence onthe basis of sound public finances both inthe run-up to monetary union and after its

establishment is warranted, so as to avoid asituation in which undisciplined national fiscalpolicies undermine a stability-orientedmonetary framework and lead to undesirablespillover effects between member states. Whileseveral options for appropriate fiscal criteriaare conceivable, it is crucial that they take intoaccount the specifics of fiscal policy in oileconomies. For a meaningful monitoring andassessment of convergence criteria, and lateron for the conduct of an area-wide monetaryand exchange rate policy, the quality,availability and comparability of statisticaldata in GCC member states needs to beensured.

Finally, a strong and informed politicalcommitment to the objective of a GCC singlecurrency and a basic consensus on theorientation of a single monetary and exchangerate policy are key prerequisites forestablishing a sustainable monetary union in2010, taking into account the fact thatmonetary union inevitably entails the transferof monetary sovereignty from the national tothe supranational level.

7ECB


I INTRODUCTION

I INTRODUCTION

The European Union (EU) can look back on ahistory of more than 50 years of regionaleconomic and monetary integration. Integrationis far advanced, has been much discussed andanalysed, and has often become a point ofreference for other regions in the world, eventhough it is only one of many experiencesregarding regional economic integration.1 Thedebate about regional monetary integration andattempts to form regional currency blocs hasparticularly intensified since the successfulintroduction of the euro, which seems to have had a“demonstration effect” for other regions of theworld.

The Gulf Cooperation Council (GCC),comprising six member states on the Arabpeninsula (Bahrain, Kuwait, Oman, Qatar, SaudiArabia and the United Arab Emirates (UAE)) hasrecently made more definite plans for a regionalmonetary union, with the ultimate objective ofintroducing a single currency in GCC memberstates by 2010. Plans for monetary integration inthe GCC date back to the GCC’s UnifiedEconomic Agreement, which was ratified in1982, one year after the GCC was founded.However, concrete steps to approach thisobjective have only been taken over the last sixyears. In December 2000 the Supreme Councilof the GCC (Heads of State) mandated theCommittee of Monetary Agencies and CentralBank Governors and the Financial and EconomicCooperation Committee (Ministers of Finance)to draw up a working plan and a timetable toestablish a single currency. In spring 2001 theGCC governors and finance ministers decided toestablish a high-level technical working group inorder to study the requirements for a monetaryunion. Initial results were presented at the GCCSupreme Council meeting in Muscat inDecember 2001, where Heads of State agreed onthe following stages and timetable to establish amonetary union2:

– By the end of 2002, all national currenciesof GCC countries shall be pegged to the USdollar.

– By the end of 2005, the Committee forFinancial and Economic Cooperation(Ministers of Finance) and the Committeeof Monetary Agencies and Central BankGovernors shall agree on economicconvergence criteria, methods to calculatethem, the required levels of these criteria,and the manner in which to fulfil them.3

– Between 2005 and 2010, GCC countriesshall strive to fulfil the criteria.

– In January 2010, a single currency shall beintroduced.

The GCC’s planned monetary union isinteresting for a number of reasons. It seems tobe the most advanced initiative among variousattempts to achieve monetary integration inmany regions of the world, given the timetableand state of preparations. Moreover, the degreeof economic convergence, in particularmonetary convergence, that has already beenachieved is high compared to other regions. Ifrealised, the GCC monetary union would be thesecond most important supranational monetaryunion in the world in terms of GDP andpopulation, after the euro area. Furthermore, itis worth noting that this integration initiative istaking place in a region, the Middle East, whichhas up till now been characterised by a verylow degree of economic integration andfailed attempts to foster regional economicinteraction in an effective fashion, and whose

1 See ECB (2004).2 The Muscat summit also concluded a new Economic

Agreement replacing the 1982 agreement and forming thelegal basis for a monetary union. The new EconomicAgreement, Article 4, stipulates: “For the purpose ofachieving a monetary and economic union between MemberStates, including currency unif ication, Member States shallundertake, according to a specif ied timetable, to achieve therequirements of this union. These include the achievement of ahigh level of harmonization between Member States in alleconomic policies, especially f iscal and monetary policies,banking legislation, setting criteria to approximate rates ofeconomic performance related to f iscal and monetarystability, such as rates of budgetary def icit, indebtedness, andprice levels.”

3 The criteria are not intended to be selection criteria. Rather, itis intended that all GCC countries shall introduce a singlecurrency simultaneously.


economic performance has attractedconsiderable attention recently.4 Finally, theGCC monetary union project has so far notbeen widely covered in the economicliterature.5

Over the last few years the ECB has been incontact with monetary agencies and centralbanks in the region and with the GCCSecretariat General to discuss – as with otherregional groupings – potential lessons frommonetary integration in the EU to the extentthat these are relevant to the region. ThisOccasional Paper is based on an ECB staffstudy on several aspects of the GCC’smonetary integration process that wasconducted in this context. While the paper has aclear focus on monetary integration in theGCC, some of the aspects covered, relating forexample to convergence criteria and theestablishment of a supranational monetaryinstitution, are of broader interest for regionalmonetary integration processes in general andmay be of relevance for other regions in theworld that are currently considering monetaryintegration.

The paper is structured as follows: Chapters2-4 review the characteristics of the GCCmember states’ economies; take stock of theeconomic and institutional integrationachieved so far in the GCC; and analyse theeconomic convergence of GCC member states.Two key issues in the GCC’s monetaryintegration process are discussed in thefollowing chapters, namely policy choices withregard to convergence criteria (Chapter 5), andthe establishment of a supranational GCCmonetary institution (Chapter 6). Chapter 7concludes with some final remarks.

4 The low degree of economic integration is reflected in intra-regional trade, which accounts only for 8% of the total tradeof Middle Eastern and Northern African countries. Theeconomic performance of Arab countries compared to otheremerging market economies over recent decades has beenhighlighted, for example, by the UNDP Arab HumanDevelopment Report (2002).

5 So far, most publications have originated in the IMF. See forexample IMF (2003).

9ECB


2 CHARACTERISTICSOF THE GCC

MEMBER STATES’ECONOMIES

2 CHARACTERISTICS OF THE GCC MEMBERSTATES’ ECONOMIES

The six GCC member states, Bahrain, Kuwait,Oman, Qatar, Saudi Arabia and the UnitedArab Emirates, envisage completing theprocess of economic integration by enteringinto a monetary union. This project is based ona shared economic background, as well as on acommon language and history. Arabic is theofficial language across the entire Peninsula.Oil and gas remain the region’s most importantproducts, even though some countries havestarted to diversify their economies, focusingin particular on banking, trade and tourism. Alleconomies are important employers of foreignlabour, due to a shortage of human capital in theregion.

This chapter reviews the key features of the sixeconomies and the main economic challengesthat lie ahead and that have a potential bearingon monetary integration. Section 2.1 looks atthe GCC as a whole, putting it into perspectivewith other economic areas in the globaleconomy. Section 2.2 focuses on the internalstructure of the GCC from the perspective ofmajor similarities and differences between themember states. Finally, Section 2.3 isdedicated to the major challenges facing theGCC countries, namely diversification,privatisation and labour market reform.

The main conclusions of the chapter are asfollows: firstly, the six GCC member states areoverall largely similar in terms of economicstructures and face common challenges;secondly, most of their economies are largelybased on oil and gas, and are rather opentowards the rest of the world; thirdly, whileexports of oil and gas mainly go to Asia, aconsiderable proportion of imports stem fromthe EU; fourthly, in general, financial marketsin the region have not developed to a largeextent, as regulation and the strong focus on oiland gas have led investors, also from within theGCC, to prefer investment outside the region;and fifthly, all the economies need to diversifyaway from oil and gas, to decrease the size of

the government sector and to step up educationefforts and labour market reform. At the heartof these challenges lies the need to generatesufficiently high growth in the private non-oilsector to promote employment opportunitiesfor the young and rapidly growing population.

Notwithstanding these broad similarities, thereare also some considerable differences. Oil andgas endowment differs greatly betweencountries, and reserves will soon be exhaustedin some countries, and in the distant future inothers. Financial markets are developed in afew member states, but less so in others.Pressure on the labour market is less acutelyfelt in some countries, and diversificationefforts have not been equally successfuleverywhere. The effects of these differenceswill have to be taken into consideration whenenvisaging monetary union.

2.1 THE GCC IN THE GLOBAL ECONOMY

The GCC economy as a whole comprises 35million inhabitants and produces an aggregateGDP of about €376 billion (2004 figures). It istherefore comparable in population to Canada,with which it also shares the distinction ofbeing one of the least densely populated areasin the world. Total GDP is equivalent toroughly half the Canadian or half theaggregated Benelux output. The oil and gassector contributes more than one-third of GDPin the GCC. Other contributing sectors, albeitmuch smaller, are construction, tourism andbanking. Given the arid climate, agriculture isof negligible importance. Developments innominal GDP and export values are closelyrelated to energy prices, in accordance with thestrong focus on oil and gas in the economy.

2.1.1 OIL AND GASThe global importance of the GCC memberstates stems from the fact that the countriesjointly account for 42% of global oil reserves,and 23% of global natural gas reserves (seeChart 1).


The GCC’s strategic position in internationalenergy markets will even increase over the nextfew decades, as it currently produces relativelylittle oil and gas per year in relation to the sizeof its currently proven reserves. At presentoutput levels, which amount to 22% of globaloil and 6.5% of global gas production, theGCC’s reserves are being depleted two to threetimes more slowly than those of other regionsof the world.6 This suggests that at currentproduction levels, the GCC will be among onlya few remaining suppliers of fossil fuels in2050.

2.1.2 WEALTHIn per capita terms, GCC energy reserves arethe highest globally, and comfortably exceedthe ratios of the next countries on the list. Percapita oil reserves are more than five timeshigher than in Venezuela, over 30 times higherthan in Russia, and over 150 times higher thanin the United States (US). Per capita gasreserves in the GCC are moreover more thanfour times as high as in the country with thenext highest ratio, Iran. Adding oil and gasreserves as energy equivalents yields anaverage of over 26,500 barrels of oil for eachGCC national (see Chart 2), equivalent to avalue of about €880,000 at year-end prices(2003).

Income from the export of fossil fuels makesthe GCC the wealthiest region in the MiddleEast and comparable to some of the newlyindustrialised economies. Average incomeper capita in nominal terms amounts tosome €11,000 per year, which puts the regionalmost on a par with South Korea, a high-income country by World Bank definitions. Asignificant part of this income, about €4,000

6 Given that depletion projections depend on various factorsthat are diff icult to predict, such as the future state oftechnology and prices, they should be regarded as highlytentative.

Chart 1 Geographical distr ibution of global oi l and gas reserves

Source: BP Statistical Review of World Energy, 2004.

Oil Gas

Americas8%

UAE

Asia/Pacific

8%

Europe/FormerSoviet Union

36%

Qatar

Other Middle East22%

Americas14%

Europe/FormerSoviet Union

9%

Africa9%

Asia/Pacific4%

GCC42%

Kuwait

Oman

Other Middle East17%

Africa8%

GCC23%

BahrainOman

Kuwait

Qatar

Saudi Arabia UAE

Saudi Arabia

Chart 2 Per capita oi l and gas reserves inbarrels equivalent

Sources: BP Statistical Review of World Energy, 2004; CIAand United Nations Economic and Social Commission forWestern Asia (ESCWA).

5,000

10,000

0

15,000

20,000

25,000

30,000

5,000

10,000

0

15,000

20,000

25,000

30,000

per capita oil reserves in barrelsper capita gas reserves in barrel oil equivalent

GCC Iran Venezuela Norway Russia Kazakhstan Nigeria UnitedStates

11ECB




per capita, is directly generated from oil andgas revenues. The income distribution is moreuneven than in most other high-incomecountries. This gap is most marked betweennationals and non-nationals, because nationalsreceive higher wages than non-nationals. GCCcitizens hold large financial assets outside theGCC financial system.7

2.1.3 TRADEWith regard to international trade, the GCC is arather open economy, with the average ofexports and imports reaching 48% of GDP. Thetrade balance has displayed a surplus of 20% ofGDP on average over the last five years. Whileexporting mainly oil and gas, the GCC importsa high proportion of consumer and capitalgoods as a result of the arid climate conditionsand the low share of manufacturing.

Roughly one-third of imports come from theEU and more than a third from Asia, while only9% come from the US (see Chart 3). Exportsare more concentrated and the main exportmarkets for GCC oil are in Asia. Over 65% oftotal GCC exports are oil and oil products, andmore than half of total exports are destinedfor Asia, principally to Japan, South Korea,Singapore and China. The EU and US accountfor 11% and 12% of exports respectively.Trade between GCC members is fairly low,

accounting for just 5% of exports and 6%of imports. This is explained mainly by thesimilar factor endowment of the countries;however, trade barriers, which are to beeliminated as part of the integration process,may also have contributed to this low figure(see Chapter 3).

2.2 SIMILARITIES AMONG AND DIFFERENCESBETWEEN GCC ECONOMIES

In terms of population and aggregate output,Saudi Arabia is the largest of the six countries,comprising about 24 million inhabitants (about70% of the total GCC population) andaccounting for more than half of total GCCGDP. The other five countries are considerablysmaller: the second largest country, the UAE,is home to only 4.3 million people, or one-fifthof the Saudi population. The UAE producesroughly a fifth of total GCC GDP, less than halfthat of Saudi Arabia (see Chart 4).8

While Saudi Arabia has the largest overallweight in the GCC with regard to bothpopulation and total GDP, its income per capita

7 Bourland (2001) estimates these assets at €870 billion, i.e.over 230% of GDP. However, such estimates are subject togreat uncertainty.

8 Similarities and differences between GCC economies withregard to economic developments (such as inflation and f iscalpolicies) will be discussed in Chapter 4.

Chart 3 Export and import structures of the GCC

Source: International Monetary Fund (IMF) Direction of Trade Statistics (DOTS).Note: Data are for 2003.

Exports

Pakistan2%

Singapore5%

Thailand3%

China4%

Korea11%

India1%

Other GCC5%

Japan20%

US12%

EU11%

Other18%

Non-JapanAsia 34%

Imports

Singapore2%

Korea3%

Asiaundeclared

6%

Other17%

EU32%

US9%

Japan8%

Other GCC6%

China6%

India5%

Hong Kong2%

Non-JapanAsia 29%


is lower than in most of the other countries.GDP per capita in Qatar is three times higherthan in Saudi Arabia and even exceeds the euroarea average by some 10% in nominal terms.With a GDP per capita (in 2004) in nominalterms of about €27,000 and €17,600respectively, Qatar and the UAE are thewealthiest countries in the GCC. While theGDP per capita of Bahrain and Kuwait is lower,they are also high-income countries. Omanand Saudi Arabia (with a GDP per capitaabove €8,500) are upper middle-incomecountries, and are still far wealthier than the

majority of the other Arab Middle Easterncountries. Converted to purchasing powerparity (PPP) standards, the differences betweenGCC economies are less pronounced, althoughQatar’s GDP per capita remains more thantwice as high as Saudi Arabia’s, and almostequals the euro area average (see Chart 5).

2.2.1 OIL AND GAS ENDOWMENT BY COUNTRYSaudi Arabia accounts for more than half of allGCC oil reserves, while resources in the otherGCC countries are considerably lower, withBahrain in particular having only very limitednatural resources. Although possessingrelatively little oil, Qatar is home to the thirdlargest natural gas reserves worldwide afterRussia and Iran, and receives a considerableproportion of its income from gas. An examinationof reserves in per capita terms reveals largedifferences in both oil and gas wealth per capitabetween countries (see Chart 6). Oil reserves percapita are relatively low in Oman and Bahrain,and considerably higher in the other countries.Similarly, gas reserves are relatively small inOman, Saudi Arabia and Bahrain.

While these differences between countries arereflected in current production levels, resourcesare especially tight in Oman and Bahrain where,at current production levels, oil will run out

Chart 4 GCC basic economic indicators

Sources: IMF, ECB staff calculations.Note: Data are for 2004.

Saudi Arabia23.6

Qatar0.8

Kuwait2.6

Bahrain0.8UAE

4.3Oman

2.4

Saudi Arabia207.0

Qatar21.7

Kuwait42.4

Bahrain8.6UAE

76.5

Oman20.0

GDP in billion (Total: 376 bn EUR) Population in million (Total: 34.5 million)

Chart 5 Income per capita in individual GCCcountries and GCC average

(GDP per capita in thousands, EUR, PPP)

Sources: IMF, ECB staff calculations.Note: Data are for 2004.

0

5

10

15

20

25

0

5

10

15

20

25

EMU averageGCC averageincome per capita

Bahrain Kuwait Oman Qatar SaudiArabia

UAE

13ECB




during the next two decades. By contrast, oilreserves will last more than 100 years in Kuwaitand the UAE, which means that these countrieswill be the only producers of oil in the GCC in2100. Gas complements oil both in terms ofdrilling and revenues. With almost 15% of theworld’s natural gas reserves, Qatar’s gas will notbe exhausted within the next 800 years at currentproduction levels. It is the only country that maybe producing gas far into the next century atcurrent output levels (see Chart 7). At the other

extreme, Bahrain’s reserves will run out soonest,with an estimated lifetime of less than ten years.

The pressure to diversify differs between GCCcountries in line with the differences in energyreserves. GCC governments have started to aimat diversifying into other sectors, such astourism and services. Approaches have variedwidely, with the focus ranging from tourism tobanking and manufacturing (see Section 2.3.1).

Chart 6 Per capita oi l and gas reserves

Source: BP Statistical Review of World Energy, June 2004. Oil reserves in barrels and gas reserves in cubic metres per capita.

Chart 7 Projected deplet ion of reserves

(oil reserves in billion barrels; gas reserves in trillion cubic metres)

Source: BP Statistical Review of World Energy, June 2004.

141 2 3 4 5 6 7 8 9 10 11 12 13 141 2 3 4 5 6 7 8 9 10 11 12 13

Oil (1,000 barrels)

37.9

24.2

20.4

11.5

3.1 2.4 2.2 1.9 0.6 0.5 0.2 0.2

16.2

0.15

0

10

15

20

25

30

35

40

5

0

10

15

20

25

30

35

40

Gas (million cubic meters)

1.50

0.61

0.120.130.160.290.330.400.41

0.54

0.04

1.24

0.02

0,5

0

1

1,5

2

2,5

0,5

0

1

1,5

2

2,534.69

6 Venezuela 7 Oman 8 Norway 9 Iran10 Kazakhstan

6 Oman 7 Iran 8 Russia 9 Saudi Arabia10 Venezuela

1 Qatar2 UAE3 GCC4 Kuwait5 Norway

1 Kuwait2 UAE3 Qatar4 GCC5 Saudi Arabia

11 Russia12 Nigeria13 Bahrain14 United States

11 Kazakhstan12 Bahrain13 Nigeria14 United States

0

100

200

300

400

500

600

0

100

200

300

400

500

600

0

45403530252025201510

50

454035302520252015105

Projected Depletion of Oil Reserves Projected Depletion of Gas Reserves

Year of DepletionYear of Depletion

Bahrain 2011Oman 2022Qatar 2049Saudi Arabia 2077UAE 2110Kuwait 2121

Bahrain 2012Oman 2060Saudi Arabia 2112UAE 2139Kuwait 2191Qatar 2840

2011 2049 2012 2060


2.2.2 TRADE PATTERNS OF GCC MEMBERSTATES

While the GCC is overall rather open, theopenness of the individual economies varieswidely, ranging from 77% and 72% in Bahrainand the UAE respectively, to 35% in SaudiArabia.9 For the GCC as a whole, the EU is themost important provider of imports, with ashare of more than 30% of total imports. Withthe exception of the UAE, all countries receivethe largest percentage of their extra-regionalimports from the EU. By contrast, the shareof imports from the US is less than 10% oftotal GCC imports, or below one-sixth of thetotal imports of each individual country (seeTable 1).

On the export side, most of the prominentrecipients of GCC exports are located in Asia,with the exception of Saudi Arabia, which alsoexports a large share to the US. Intra-regional

trade is fairly limited. Except for Oman, nocountry exports more than 10% of its totalexports to other GCC members (see Table 2).However, this picture changes somewhat if welook at non-oil trade instead of total trade.Kuwait and Qatar exhibit the highest share ofintra-GCC non-oil exports among memberstates, exporting more thanhalf of their total non-oil exports (mostlychemicals) to other GCC countries. Overall,non-oil trade accounts for roughly one-third oftotal trade within the region.10

On the import side, intra-regional trade ismost important for Bahrain and Oman, whichreceive a considerable percentage of theirimports from the other Gulf states (Omanimports machinery mainly from the UAE,

Saudi TotalBahrain Kuwait Oman Qatar Arabia UAE GCC

Exports-to-GDP ratio (%) 83.9 54.8 56.2 72.0 45.9 79.1 55.8Destination of Exports 1)

Other GCC 5.9 1.5 10.6 4.8 4.8 5.1 4.9EU 3.7 10.4 2.2 2.1 15.7 7.6 10.7United States 3.6 11.9 3.3 1.7 20.7 2.2 11.7Japan 1.3 22.0 16.2 46.0 15.4 26.1 20.3Asia (excl. Japan) 8.1 49.2 59.4 36.6 32.1 31.4 34.2

Table 2 Destination of GCC exports (2003)

Sources: IMF DOTS and WEO.1 ) As a % of total exports.

Saudi TotalBahrain Kuwait Oman Qatar Arabia UAE GCC

Imports-to-GDP ratio (%) 69.9 38.9 37.7 38.9 23.6 64.7 34.9Source of Imports 1)

Other GCC 35.8 9.6 27.8 14.9 2.5 2.7 5.9EU 24.4 34.1 21.7 35.5 31.1 33.6 31.9United States 11.4 14.5 6.2 12.2 9.3 6.5 8.6Japan 7.8 10.1 17.1 10.5 7.6 6.7 8.0Asia (excl. Japan) 10.7 17.8 15.6 17.2 26.9 36.4 28.8

Table 1 Source of GCC imports (2003)

Sources: IMF DOTS and World Economic Outlook (WEO).1) As a % of total imports.

9 Openess is def ined here as the average of exports and importsper GDP.

10 See Jadresic (2002).

15ECB




while Bahrain imports predominantly oil andfuel products from Saudi Arabia). The othercountries receive less than 15% from the otherGCC member states.

2.2.3 FINANCIAL MARKETSThe GCC financial systems are still relativelysmall in most countries, but have developedover recent years. They are largely bank-based, although stock markets have recentlyexpanded. The banking sector is generallywell developed, profitable and efficient, inparticular compared with other Middle Easternand North African countries.11 Total GCCbanking assets amount to about 122% of GDP(2003), with Bahrain, where bank assets exceed800% of GDP, serving as a regional bankinghub.12 Due to interest rate ceilings in somecountries in the past, bank lending has focusedon the government sector rather than on thelocal private sector. Although cross-borderlending within the GCC has been permitted forseveral years, a genuine intra-regionalGCC banking market has not emerged (seeChapter 3). Besides bureaucratic obstacles tocross-border banking, expansion into otherGCC countries does not significantly improvediversification for banks, as all six economiesare largely based on oil and gas. In addition,one of the main driving forces for cross-borderexpansion, namely trade in goods and services,is at a low level, and has only recently becomemore dynamic.

Given that many economic activities are closelylinked to oil price changes, they also have animpact on banks’ balance sheets. Indeed, thegrowth of GCC banks’ balance sheets is correlatedwith oil price developments (see Chart 8). On theliability side, it is worth noting that, overall,GCC banks are well capitalised. Moreover,financial institutions have been obliged to complywith the Basel standards. In order to prepare for acommon financial area, regulation may requireharmonisation across countries and increasedcooperation between regulators across borders(see Chapters 3 and 6).

Capital markets in the GCC have only recentlyexpanded and significantly differ in sizebetween member states. In September 2004, thetotal stock market capitalisation of GCCcountries amounted to 113% of GDP, up from42% in 2002, reflecting the stock market boom inthe wake of high oil prices. Stock marketcapitalisation ranges from 51% of GDP in Omanto 171% and 175% of GDP in Kuwait and Qatar,respectively. Formal and sophisticated tradinginfrastructures have only been established overthe last decade in many countries, and most ofthe GCC stock exchanges still have considerablepotential for development. The Saudi ArabianMonetary Agency (SAMA) sponsors asophisticated computer-based stock tradingsystem, Tadawul.13 Qatar established the DSM(Doha Securities Market) in 1997, while theBahrain and Oman exchanges have been inoperation for several years. Bank assets exceedstock market capitalisation significantly in allcountries except Qatar and Saudi Arabia. Totalmarket capitalisation (measured by bank assetsplus stock market capitalisation to GDP) ishighest in Bahrain and Kuwait, while bankingand stock market capitalisation combinedare lowest in Saudi Arabia and in Oman (seeTable 3).

11 See Creane, Goyal, Mobarak and Sab (2004) and Berthélemyand Bentahar (2004).

12 However, over 80% of bank assets in Bahrain are located in theoffshore sector, which may only conduct banking activitieswith non-residents.

13 A capital market law that enforces complete disclosure bylisted companies was approved by Saudi Arabia’s Council ofMinisters on 15 June 2003.

Chart 8 Balance sheet growth of GCCcommercial banks and oi l pricedevelopments

Source: Arab Monetary Fund (AMF).

2

3

4

5

6

7

8

9

10

1992 1993 1994 1995 1996 1997 1998 1999 2000 20015

10

15

20

25

30

balance sheet growth % (left-hand scale)oil price (USD per barrel) (right-hand scale)


Unlike stock markets, secondary bond marketshave not developed at all. Bonds issued byentities located inside the GCC equal less than3% of GDP, around €13.3 billion. Most bondsare listed abroad, particularly in Luxembourg.Participation in the local capital markets islargely restricted to the local population. As aconsequence, inward portfolio investment hasbeen subdued.

A low degree of inward investment is alsoreflected in low rates of foreign directinvestment (FDI). The ratio of FDI stock toGDP is, at around 11% (2003), considerablylower than the world average of 23% orthe average for either developed countriesor developing countries (20% and 31%respectively). In addition to the low figures inabsolute terms, FDI flows have been highlyvolatile and closely linked to the oil price.After recording net FDI outflows for two yearsin 1999 and 2000, the GCC received positivenet FDI inflows of some €0.6 billion in 2001,€1 billion in 2002 and €5.9 billion in 2003.

2.3 KEY ECONOMIC CHALLENGES

The GCC economy faces three majorchallenges to economic development, namelyan increased need for diversification awayfrom oil and gas; privatisation in view ofthe large size of the government sector; andlabour market reform and education. The keyissue behind these challenges is generatingsustainable high growth in the private non-oil sector that can provide employmentopportunities for a young and rapidly growingpopulation.

2.3.1 DIVERSIFICATIONA main issue for the GCC economy is its strongorientation towards oil and gas, which makes ithighly dependent on price developments inglobal markets. While providing an importantsource of income, the strong reliance on oil hasalso proven to be a liability. Oil production haslifted the level of economic development andliving standards enormously in past decades,and the GCC countries went from beingessentially subsistence economies in the 1960sto extremely wealthy countries by 1980.However, following the decrease in oil pricesduring the early to mid-1980s, income per capitafell considerably and has stagnated or evendeclined slightly since then (see Chart 9). Thevirtual stagnation of per capita incomes over thepast 20 years is a major economic issue for theregion, and sets it apart from many otheremerging economies that by contrast witnesseda steady and often even rapid increase inincomes during the 1980s and 1990s.

SaudiBahrain Kuwait Oman Qatar Arabia UAE GCC

Bank assets/GDP 866 329 50 98 62 121 122Stock market capitalisation/GDP 163 171 51 175 126 96 113

Table 3 Financial sector indicators

(percentages)

Sources: IMF International Financial Statistics (IFS) and AMF.Note: Bank assets in 2003, stock market capitalisation in September 2004.

Chart 9 Average GCC GDP per capita

(1995 = 100)

Sources: World Bank World Development Indicators (WDI)database, ECB staff calculations.Note: Data for a limited number of years are not included forBahrain, Kuwait, Qatar and UAE due to lack of availability.

60

80

100

120

140

160

180

60

80

100

120

140

160

180

1970 1972 1974 1976 1978 1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002

17ECB




The high oil dependency of the GCC economyis reflected in the share of the oil and gas sectorin GDP, the share of oil revenues ingovernment revenues and the share of oilexports in overall exports (see Table 4).Calculations by the Arab Monetary Fund(AMF) suggest that the oil and gas sectorscontribute more than one-third of total GCCoutput. Taking into account the fact that over80% of public services are financed by oilrevenues, the share of GDP that dependsdirectly and indirectly on oil and gas revenuesexceeds 50% of the total.

Oil income contributes around 80% togovernment revenues, while oil exportsaccount for over two-thirds of total GCCexports. Only 10% of GDP is generated by

SaudiOil share in … GCC Bahrain Kuwait Oman Qatar Arabia UAE

GDP 1) 36.0 25.7 45.9 43.1 56.8 34.9 28.1Govt. revenue 2) 79.3 73.0 91.5 78.4 64.2 80.6 75.3Exports 3) 67.0 66.7 83.8 64.5 34.5 85.5 38.8

Table 4 Oi l dependency of the GCC and its member countries

Sources: AMF, national central banks, IMF, Institute of International Finance (IIF).1) Oil and gas sector’s share of GDP as a % in 2001.2) Oil revenue/total government revenue as a % (includes gas revenues for Bahrain) in 2000.3) Oil and oil products’ share of total exports as a % in 2004.

manufacturing, and just 4% by agriculture (seeChart 10).14

The high contribution from oil to GCCcountries’ overall exports and governmentrevenues implies that oil price volatilitytranslates into volatility in current accountbalances and government budget balances.Since there is no personal income tax or ageneral consumption or value-added tax in anyof the countries, the financial base of the GCCgovernments is particularly exposed to oilprice volatility (see Chart 11).

Chart 11 Inf luence of oi l exports on currentaccount and government budget

Sources: IMF, ECB staff aggregations for the GCC.

-15

-5

5

15

1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 200450

70

90

110

130

150

170

190

current account balance (% of GDP) (left-hand scale)general government balance (% of GDP) (left-hand scale)oil exports (billion USD) (right-hand scale)

14 This reflects the adverse climatic conditions in all sixcountries. Accordingly, the share of the urban populationexceeds 80% in each country, and is as high as 98% in Kuwait.

Chart 10 GDP shares by sector

(percentages)

Source: AMF.Note: Data are for 2001.

100

80

60

40

20

0

100

80

60

40

20

0GCC Bahrain Kuwait UAESaudi

ArabiaQatarOman

oil and gasgovernmentprivate servicesindustryagriculture


To reduce oil dependency, to enhance outputand efficiency in other sectors and to smootheconomic dynamics, diversification andprivatisation have been declared key economicpolicy priorities. Moreover, governments haverealised that neither the public sector nor the oilindustry alone will provide sufficient jobopportunities for their young and growing

populations. The development of the privatenon-oil sector is therefore seen as crucial toease labour market pressure.

The need for diversification is particularlystrong in Bahrain and Oman, whose oil reservesare limited and are expected to run out duringthe next two decades. Every GCC member state

Bahrain Kuwait

Oman Qatar

Saudi Arabia

Commodities

Manufacturing

Finance

Tourism

Commodities

Manufacturing

Finance

Tourism

Commodities

Manufacturing

Finance

Tourism

Commodities

Manufacturing

Finance

Tourism

Commodities

Manufacturing

Finance

Tourism

Commodities

Manufacturing

Finance

Tourism

United Arab Emirates

GCC average

Chart 12 Divers i f icat ion across GCC member states

Sources: ECB staff calculations on the basis of data from the AMF, the IMF, the World Tourism Organization and nationalauthorities.Note: The graphs give shares of the maximum of all six countries. “Tourism” refers to tourist arrivals per capita of nationalpopulation; “Commodities” is income from oil and gas per GDP; “Finance” is stock market capitalisation plus bank loans per GDP;and “Manufacturing” is the share of manufacturing in GDP.

19ECB




has made efforts to diversify and to privatise,including the opening up and liberalisation ofmarkets and the creation of an environmentmore conducive to FDI inflows. In this context,Saudi Arabia is currently applyingfor World Trade Organization (WTO)membership, while the other five GCCcountries are already members.

Using the percentage contribution of oil incometo GDP, government revenue and exports asrough measures of oil dependence, the successof diversification efforts varies between thecountries. Between 1986 and 1991, the exportshare of oil even rose, before stagnating around alevel of 65% after 1995. While Bahrain and theUAE in particular have been successful inreducing their oil dependence, in the other fourcountries it is considerably higher. The oil sharein exports has stagnated at levels around 80% oftotal exports in Kuwait and Saudi Arabia.

Chart 12 depicts the state of diversification inthe four most likely areas for generatingincome in the GCC countries, namelycommodities, manufacturing, finance andtourism.

These diversification results reveal thefollowing marked differences betweenindividual countries:

– Bahrain has established itself as a financialhub for the Gulf region and for the Arabworld, particularly in Islamic banking.Tourism, transport and related services areother areas in which the country is gainingground.

– The UAE has similarly diversified intotourism, manufacturing and transport,making it the only other country apart fromBahrain with a relatively low level of oildependency.

– Kuwait remains highly dependent oncommodities, while finance has developedrecently.

– Oman, despite having diversified intomanufacturing to a certain extent, is one ofthe countries where the need for structuralchange away from production of oil and gasis most pressing.

– Saudi Arabia is not focused completely oncommodities either, but generates 10% ofGDP in the manufacturing sector and isquite active in the construction sector. Theexploration of natural gas resources is seenas another important source ofdiversification, and an area for which SaudiArabia has great expectations.

– Qatar is even more focused on oilexploration, and is also developing largecapacities for the extraction of natural gas.A switch from oil to gas as the main sourceof export revenues would not completelysolve the problems related to the Gulfcountries’ role as primary commodityexporters. However, this move would stillreduce the effects of price volatility, asnatural gas prices tend to be less volatilethan spot prices on the oil market.

The differences in both endowment of oil andgas and in diversification efforts may induceconsiderable differences in the economicstructures across GCC countries. While todayall the GCC countries largely rely on energyexports, this can be expected to change to avarying degree over the coming decades, asdiscussed above. This development may makethe GCC economy more prone to asymmetricreactions to exogenous economic shocks (seeChapter 4).

2.3.2 PRIVATISATIONPrivatisation is seen as the key todiversification and greater economicefficiency. A major problem for GCCeconomies is their large government sectors, incombination with the high degree ofdependence of government budgets on oil andgas. Oil companies are nationalised, ensuringgovernment control of this vital sector.Government spending on large infrastructure


projects also strongly influences the non-oilsector of the Gulf economies. As this type ofspending typically varies with fluctuations inbudget balances and thus oil revenues, thevolatility of oil prices also has a major impacton the non-oil sector (see also Chapters 4 and5). Public sector companies are predominant inother key sectors such as telecommunications,energy and water supply, health and airtransport. Moving away from this dependencerequires intense privatisation efforts.Currently, government services contribute25% to GCC GDP and are the main source ofemployment for nationals. The result in mostcases is large administrations and a high shareof wage payments in government budgets.

While all governments have embarked on theprivatisation process, it is difficult to gauge thesuccess of these efforts. Large privatisationprojects, especially in public utilities, haveraised the private sector contribution to GDPover the last decade. However, the distinctionbetween the public and private sectors is notstraightforward, as it is sometimes difficult toattribute shareholder ownership clearly to thetwo sectors.

The opening of capital markets is anotheraspect of efficient privatisation that needsfurther development. Foreign investmentregulations have been changed considerably topermit foreigners to hold shares in GCCcompanies (see Chapter 3). However,restrictions on access to the stock exchangesand on majority holdings in GCC companies inseveral member states continue to prevent theallocation of international capital to the GCCmarket.

2.3.3 LABOUR MARKET REFORM ANDEDUCATION

High population growth has become anincreasing challenge for national governments,as it has been accompanied by risingunemployment, especially among the young.The GCC area has been characterised by one ofthe world’s highest rates of population growth(3.2% per year over the past decade), resultingin a very young population. In 2002, almost40% of the GCC population were below 15years of age.

Besides high birth rates among nationals,immigration has contributed to populationgrowth in some member states. The economiesof the GCC rely to an extraordinarily highextent on expatriate workers. An educationalmismatch of the local population has preventedGCC nationals from working in most industriesthat require higher education, especiallytechnical skills. Accordingly, high-skilledlabour is carried out to a considerable extent byexpatriates. Non-nationals (mostly fromSouth-East Asia or other Arab countries) alsoprovide a large part of the unskilled labour. Asa result, expatriates outnumber nationals in theworkforces of some GCC countries. The shareof nationals in the total population is only 65%,while the share in the workforce is even lower,as immigrant workers do not always bring theirfamilies (see Table 5).

Given high population growth and youngpopulations, young GCC nationals find itincreasingly difficult to obtain employment.While official unemployment figures do notexist for all countries, external sourcesestimate that unemployment in the GCC ranges

SaudiGCC average Bahrain Kuwait Oman Qatar Arabia UAE

65.1 60.0 33.4 77.3 26.3 74.6 24.3

Table 5 Shares of nationals in total population

(percentages)

Source: ESCWA.Note: Data refer to 2000.

21ECB




from 3% to 17%.15 The Arab HumanDevelopment Report 2002 indicates that thepopulation in the region will continue to growrapidly, exceeding 44 million by 2020, some140% of the current population.16 Thepopulations in Saudi Arabia and Oman areexpected to grow by around 60% within twodecades (i.e. between 2000 and 2020). Incombination with low oil resources, thepressure on the labour market is especiallystrong in Oman. While Bahrain’s populationwill also grow rapidly, the country seemssufficiently diversified to cope with runningout of gas.

GCC governments have attempted to addressthis challenge by initially reserving positionsin the public sector largely for nationals. Manynationals are employed in the services sector, alarge part of which is public. Services employover three-quarters of the active population,but only contribute 43% to GDP. Morerecently, quotas for nationals and stricter workpermit requirements for the employment ofexpatriates have increasingly been imposed inthe private sector as well.

This policy of regulation is complemented byefforts to enhance the education and training ofnationals. While the level of education has

15 Figures from United Nations (2002). Estimatedunemployment of the working-age national population in UAEis 2.6%, Bahrain 3.1%, Qatar 5.1%, Kuwait 7.1%, SaudiArabia 15.0% and Oman 17.2%.

16 United Nations (2002). Forecasts for growth in the period2000-2020 are: UAE 23%, Qatar 29%, Bahrain 30%, Kuwait30%, Saudi Arabia 61%, and Oman 63%. This corresponds toannual growth rates of between 1% and 2.5%.

Chart 13 Human Development Index andeducation sub-index

Sources: World Bank, ECB staff calculations.

Chart 14 Human Development Index andeducation sub-index in the GCC

Sources: World Bank, ECB staff calculations.

been raised considerably over recent years,there is still room for improvement in tertiaryeducation. Educational standards in the GCCcountries lag somewhat behind the worldaverage. The overall Human DevelopmentIndex (HDI) for the GCC compares favourablywith the world average (see Chart 13). Butwhile income and life expectancy in the GCCexceed the world average, the sub-index foreducation compares unfavourably not onlywith the high and middle-income countries, butalso with the world average. By contrast withthe GCC, the education sub-index exceeds theoverall HDI in both high-income and middle-income countries. The Arab states as a wholecomprise the only country group in which theeducation index lags behind the HDI. Indeed,this index is fairly similar across GCC membercountries (see Chart 14), and lags behind theHDI in every GCC country except Bahrain and(just) Qatar. In terms of adult literacy, none ofthe six countries matches the middle-incomecountry average of 89% of the population.

1.0

0.9

0.8

0.7

0.6

0.5

1.0

0.9

0.8

0.7

0.6

0.51 2 3 4 5 6 7 8 9 10 11 12

1 Norway2 “High income”3 OECD4 Chile

9 “Middle income” 10 World 11 Arab States 12 “Low income”

5 Libya6 GCC7 Venezuela8 Brazil

HDIeducation sub-index

0.9

0.8

0.7

0.6

0.5

1.0

0.9

0.8

0.7

0.6

0.5

1.0

Bahrain Kuwait UAE Qatar SaudiArabia

Oman GCC

HDIeducation sub-index


Education levels vary widely, and are mostadvanced in Bahrain, Qatar and Kuwait, whereenrolment rates at all levels of education ofover three-quarters compare well with thoseof middle-income countries. In the GCC as awhole, enrolment rates are on average lowerthan in the Arab world as a whole. Enrolmentrates in the range of 60% in Oman andSaudi Arabia indicate possible challengesregarding the development of labour marketqualifications in these countries. Thisgenerates a potentially problematic mixturewith population growth.

23ECB


3 INSTITUTIONALAND ECONOMIC

INTEGRATIONIN THE GCC

3 INSTITUTIONAL AND ECONOMICINTEGRATION IN THE GCC

This chapter – after highlighting the relevanceof the broader integration process for monetaryunion in the GCC – outlines the institutionalunderpinnings on which the GCC’s economicintegration project is based. It sets out the basiclegal texts of the GCC and describes the maindecision-making and implementing bodies.Furthermore, it summarises the development ofthe GCC’s economic integration project sinceits inception in 1981. The chapter also brieflystates the objectives of the process as set out inthe statutes and the principal economicagreements. It then provides a summaryassessment of progress made towards theseobjectives, using as a benchmark the so-calledfour freedoms – the free movement of goods,services, capital and natural persons.17

The key findings of this chapter are as follows.The project of monetary union in the GCC isnot an isolated act of integration, but isembedded in a comprehensive integrationproject, aimed at the creation of a commonmarket that would remove all barriers to themovement of goods, services, labour andcapital. While both the objectives andtimetable of economic integration in the GCCare ambitious and seem sufficient to underpin asustainable monetary union, the effectiveimplementation of the agreed objectives will beof paramount importance prior to the plannedintroduction of a single currency in 2010. Inaddition, with regard to areas such as capitalmarkets, some services sectors and possiblylabour mobility, the expected efficiency gainsof a common market (and monetary union) arelimited by the dominance of the public sector inGCC member states, which tends to bypass theallocation function of the market. The GCC hasdeveloped a broad range of institutions tosupport the economic integration process. Theinstitutional framework of the GCC has so farrelied heavily on an approach based oncomprehensive intergovernmental coordinationat the political and technical levels. While thisconstruction has its merits and appears to have

served its purpose well in the past, GCCinstitutions might need to be strengthened inthe light of integration steps ahead.

3.1 RELEVANCE OF THE BROADERINTEGRATION PROCESS IN THE GCC FORMONETARY UNION

As in any monetary union, the economicviability of the GCC’s project to introduce asingle currency crucially hinges on the degreeof economic integration among its members.The expected economic benefits of adopting asingle currency are associated with, amongother factors, reduced uncertainty, lowertransaction costs and the facilitation of cross-border trade and financial transactions. Inorder to reap these benefits fully, it is desirableto eliminate in the GCC, insofar as possible,non-monetary obstacles to integration.Moreover, a high degree of cross-border factormobility can also serve to mitigate theeconomic impact of asymmetric shocks and canthus contribute to the sustainability of themonetary union.

The project of GCC monetary union thereforeneeds to be embedded in a broader efforttowards comprehensive economic integration,which should ultimately aim to eliminate allbarriers to the movement of goods, services,labour and capital. A logical sequencing ofstages of integration is thereby warranted, withmonetary union ideally being established onlywhen economic integration has matured to anextent that lends credibility to the monetaryintegration project. The GCC’s schedule interms of economic integration – a fully fledgedfree trade area to be established via a customsunion in 2003, then the completion of acommon market in 2007, to be followed bymonetary union in 2010 as outlined below – isconsistent with this approach. The timing ofthis schedule is, however, ambitious. Thechallenge in the coming years will be toimplement the envisaged stages of integration

17 In the European context, these four freedoms were laid downas the hallmark of the establishment of the Single Market inthe Single European Act (signed in 1986).


effectively. This will require, judging fromthe European experience, political commitmentat the highest level, strong administrativecapacities and enhanced multilateralsurveillance.

3.2 THE INSTITUTIONAL FRAMEWORKOF THE GCC

3.2.1 LEGAL FOUNDATIONSThe six Heads of State of Bahrain, Kuwait,Oman, Qatar, Saudi Arabia and the UAEfounded the GCC by signing the “Charter of theCooperation Council” in Abu Dhabi in May1981. The Charter establishes the main bodiesof the GCC, namely the Supreme Council, theMinisterial Council and the Secretariat Generaland lays down their composition, theirfunctions and their mutual relations.18 InNovember 1981 GCC leaders signed the“Unified Economic Agreement”, whichreplaced previous bilateral agreements andstipulated in some detail the main objectivesand measures of economic cooperation. TheUnified Economic Agreement came into forcein January 1982 and remained the legal basisfor much of the GCC’s integration process untilit was replaced 20 years later by the new“Economic Agreement between the States ofthe Cooperation Council” concluded by theGCC Summit in Muscat in 2001. In addition tothese founding documents, the SupremeCouncil has over time adopted a number ofGCC laws and regulations.

3.2.2 GCC INSTITUTIONSThe institutional framework of the GCC todaycomprises three main pillars, namely theintergovernmental decision-making andconsultative bodies with the Supreme Counciland the Ministerial Council at its core, theSecretariat General as the major supranationalinstitution, and a number of specialisedregional agencies.19

Intergovernmental bodiesThe Supreme Council is the GCC’s highestauthority and main decision-making body. It iscomposed of the Heads of State of the member

states, and its presidency is rotated annually.The Supreme Council’s main tasks are toprovide policy direction, review reports andrecommendations submitted by subsidiarybodies and to appoint the Secretary General ofthe GCC. Resolutions are passed on the basisof unanimity for substantive matters, and bysimple majority for procedural matters. TheSupreme Council meets twice a year (onceformally and once informally), with the optionof extraordinary sessions at the request ofindividual member states.20

The Ministerial Council is composed ofForeign Ministers or other ministers asdelegated by member states. It proposespolicies and prepares recommendations,studies and projects in all fields. Like theSupreme Council, resolutions are passed on thebasis of unanimity for substantive matters andby majority for procedural matters. TheMinisterial Council meets every three months,with the option of extraordinary sessions at therequest of member states. At the ministeriallevel, a number of specialised committees havealso been established, of which the mostimportant in respect of economic integration isthe Committee for Financial and EconomicCooperation, which is composed of theMinisters of Finance and Economics. These

18 The Rules of Procedure for the Supreme Council, theMinisterial Council and the Commission for the Settlement ofDisputes were also approved in May 1981.

19 Among these institutions, only the Supreme Council (alongwith its Dispute Settlement Commission), the MinisterialCouncil and the Secretariat General were established by the1981 GCC Charter. Since then, numerous intergovernmentalcommittees and sub-committees have been established atvarious off icial and working levels; the Secretariat Generalhas been extended and assigned new responsibilities; andcommon agencies have been established to provide technicaland research services to the region.

20 The Charter of the GCC also provides for a Commission forthe Settlement of Disputes, which is attached to the SupremeCouncil. The Commission is formed on an ad hoc basis foreach case. The Commission looks into the case and submits its(non-binding) recommendations to the Supreme Council.However, this provision has not been invoked since thefounding of the GCC. In addition, in 1997 the ConsultativeCommission for the Supreme Council was established toprovide advice on any subject referred to it by the SupremeCouncil. It comprises 30 members, with seats equallydistributed among the six member countries.

25ECB




ministerial committees are similar to theMinisterial Council in their workingprocedures, as they prepare studies and submitrecommendations to the Supreme Councilthrough the Ministerial Council. They in turnmandate various sub-committees to conductstudies, draft proposals and coordinate nationalpolicies at a technical level.

As a rule, the various intergovernmental bodiesmay pass binding and non-binding decisionsonly at their level and in their field ofjurisdiction. While the Supreme Council’sdecisions are to be applied through decreesissued at least at the level of the memberstates’ councils of ministers, the ministerialcommittees may approve common rules withinthe executive jurisdiction of the respectiveministers. Central bank cooperation in the GCCtakes place within the Monetary Agencies andCentral Bank Governors’ Committee, whichmeets twice a year and reports to theCommittee for Financial and EconomicCooperation, and its sub-committees, whichinclude the Banking Supervision Committee,the Payment Systems Committee, theMonetary Union Committee and the TrainingCommittee.

The GCC Secretariat GeneralThe Secretariat General is the GCC institutionwith the most pronounced supranationalcharacter (see Box for its functions andinteraction with the intergovernmental bodies).In contrast to the above-mentioned bodies, theSecretariat General does not consist ofrepresentatives of the member states, as itsmandate, according to the GCC Charter, is towork independently and for the common interestof the members. It is located in Riyadh with astaff of approximately 400, and is headed by theSecretary General, who serves a three-year term,renewable only once. The Secretary Generalnominates the Assistant Secretaries General,who are appointed by the Ministerial Council forrenewable three-year terms. The SecretariatGeneral is composed of six Directorates(Political Affairs, Economic Affairs, MilitaryAffairs, Environmental and Human Resources,Legal Affairs and Financial and AdministrativeAffairs) and an Information Centre. The newmonetary union unit, which the SupremeCouncil decided to establish at its 2002 sessionin Doha, has also been attached to the SecretariatGeneral. This will increase the number of staffworking on monetary affairs at the SecretariatGeneral.

Box

FUNCTIONS OF THE GCC SECRETARIAT GENERAL AND ITS INTERACTION WITHINTERGOVERNMENTAL BODIES

The Secretariat General is not only in charge of the administrative preparation and follow-up ofthe meetings of the intergovernmental bodies, but also prepares studies and reports on issuesrelated to the cooperation objectives, follows up the member states’ implementation of GCCresolutions and recommendations, and drafts resolutions and common legislation. Itsrepresentatives participate in the consultations of the various specialised committees.Moreover, the Secretariat General acts as the common representative of the GCC in someinternational fora, such as the Financial Action Task Force on Money Laundering in Paris.There is also a GCC Permanent Mission to the European Commission in Brussels. A new taskwas assigned to the Secretariat General in Article 27 of the 2001 Economic Agreement, namelythe settlement of disputes concerning the implementation of the Agreement and the ratifieddecisions based on it, including claims raised by private parties. In such cases, the SecretariatGeneral will try to reach a harmonious solution between the parties, or will refer the matter tothe GCC Commercial Arbitration Center or a newly formed judicial body.


Specialised agenciesGCC member states have also set up a numberof specialised agencies, such as theStandardization and Metrology Organization forGCC Countries ,21 the GCC CommercialArbitration Center ,22 and the Patent Office.23

While dealing with widely different substantivematters, these agencies share similar governancestructures: each agency is headed by a board ofdirectors composed of representatives of themember states, and has a permanent technicalstaff. Through a number of Supreme Councilresolutions and implementing nationallegislation, the decisions of these agencies,namely arbitration rulings, patent grants and theissuance of Gulf standards, have been accordeddirectly binding status in all GCC memberstates.

3.3 THE PROCESS OF ECONOMICINTEGRATION IN THE GCC

3.3.1 OBJECTIVES AND HISTORIC EVOLUTIONOF THE INTEGRATION PROCESS

The Charter of the GCC lays down the basicobjectives of the GCC as follows:

– to effect coordination, integration andinterconnection between member states inall fields in order to achieve unity betweenthem;

– to deepen and strengthen relations, linksand areas of cooperation now prevailingbetween their peoples in various fields;

– to formulate similar regulations in variousfields, including economic and financialaffairs, commerce, customs andcommunications, education and culture,social and health affairs, information andtourism and legislative and administrativeaffairs;

– to stimulate scientific and technologicalprogress in various fields;

– to establish scientific research;

– to establish joint ventures and encouragecooperation by the private sector.

The interaction between the Secretariat General and the various intergovernmental bodies inthe process of GCC legislation can serve to illustrate the relationship between these twomajor pillars of the GCC institutional framework. In some cases, the Supreme Council candecide to harmonise national legislation in a specific field and then mandates the SecretariatGeneral to draft a new GCC law/regulation. The competent branches of the SecretariatGeneral study the existing national legislation and draft the common legal text incooperation with experts from the member states. The draft is then presented to thespecialised sub-committees of the Council for review. These committees can requestmodifications according to the wishes of the member states or decide to recommend itsadoption by the Ministerial Council or the Supreme Council. Finally, the MinisterialCouncil or the Supreme Council decides whether to adopt the legislation and whether toaccord it binding or exemplary character. Legislation has to be ratified by the relevantnational bodies of member states, but this tends to be no obstacle given the consensus-drivenapproach to adopting legislation at the GCC level.

21 The Standardization and Metrology Organization wasestablished in 1982 to def ine common product standards andmeasures. As most of the other GCC members at the time didnot have national standards off ices, the Saudi ArabianStandards Organization was entrusted with the operation ofthis agency until 2001, when the GCC Heads of State decidedto set up an independent common standards organisation.

22 The decision to set up the Commercial Arbitration Center inBahrain was taken in 1993 with the adoption of its charter bythe Supreme Council. The Center was declared fullyoperational in 1995.

23 The Patent Off ice is the youngest agency in the GCC and islocated in Riyadh. The Supreme Council approved its statutein 1992, and the Off ice became operational in 1998. ByOctober 2002 it had granted some 30 Gulf patents.

27ECB




These objectives were further spelt out in the1982 “Unified Economic Agreement”, whichlaid down the principles of a GCC free tradearea, the free cross-border movement of GCCcitizens, and the coordination of banking,financial and monetary policies. Over thefollowing two decades the integration processsaw periods not only of impressive progress butalso of stagnation. While the implementationof the free trade area began in 1983 and the firstservices sectors were opened to GCC citizensas early as 1986, it took more than ten yearsafter the initial deliberations in the MinisterialCouncil in 1989 to agree on a common externaltariff. In the late 1990s, however, theintegration process gained new momentum,culminating in the ratification of the new“Economic Agreement between the States ofthe Cooperation Council” at the MuscatSummit in 2001, which replaced the UnifiedEconomic Agreement. The new document setsambitious targets for the next stage of theintegration process, drawing up a road map forthe creation of a fully integrated common

market and the preparation of a monetaryunion. Table 6 presents the evolution of theintegration project as reflected in these twoagreements.

In 2001 the Supreme Council agreed on atimetable for the implementation of some of theenvisaged stages of integration. This timetablecalls for the implementation of the customsunion in January 2003; the establishment ofimplementation guidelines, includingconvergence criteria, for the monetary union by2005; the completion of the common market by2007; and, finally, the adoption of the singlecurrency by 2010.

Given this sequence, the process of economicand monetary integration in the GCC is designedto follow an incremental approach, as it isintended that monetary union shall beestablished only after considerable groundworkin terms of economic integration has been laid.The scope of the GCC’s economic integrationobjectives as laid out in the new Economic

Table 6 Integration object ives la id down in the economic agreements of 1982 and 2001

Unified Economic Agreement (1982) Economic Agreement (2001)

Trade in goods – Specifies operational principles for the – Specifies operational principles for the customs union,free trade area, including rules of origin including a common external tariff and the single entry

point principle– Provides for the subsequent creation of – Lays down principles for the common market, including the

a customs union harmonisation of all product standards

Trade in services – Makes an implicit reference – Common Market of the Gulf to include national treatment in(exercise of economic activity) the field of services

Movement – Calls for coordination of financial and – Common Market of the Gulf to include national treatment ofof capital banking policies GCC capital

– National treatment to be accorded to investments owned byGCC nationals

– Calls for complete integration of financial markets andharmonisation of relevant regulations

Movement – Assures freedom of movement, work and – Extends the scope of national treatment to include explicitly:of persons residence – employment in both the governmental and the private sector

– National treatment for GCC nationals – exercise of professions and all economic activitiesregarding ownership, inheritance and – real estate and equity ownershipbequests, exercise of economic activity – social insurance and pensions, education, health and

– social services

Monetary – Commitment to coordinate monetary – Envisages a timetable for the implementation ofintegration policies monetary union

– The prospect of monetary union is – Commitment to harmonise all relevant economic policiesmentioned – Calls for the establishment of convergence criteria


Agreement is remarkable and goes beyond mostother regional integration schemes worldwide.The agreed measures address the most crucialareas of policy coordination and harmonisation,and appear to be mutually consistent andcomplementary. The challenge for the GCC inthe coming years will be the comprehensive andtimely implementation of the envisaged stagesof integration.

3.3.2 THE CURRENT STATE OF ECONOMICINTEGRATION

Free movement of goodsOn 1 January 2003, a GCC customs unionfinally came into effect with the enactment of acommon external tariff, a unified customs codeand the single entry point principle. This can beregarded as an important landmark in theGCC’s efforts to promote the free movement ofgoods and to foster trade integration among itsmember states. While the low degree of tradeintegration achieved so far within the GCC (seeChapter 2) may largely be explained by thesimilar factor endowment of member states(i.e. oil and gas), continuing regulatory barriersalso seem to have contributed to low levels ofintra-regional trade. Thus, an effort to teardown these barriers and to foster tradeintegration is required, in particular withregard to non-oil trade.

Given that national tariff levels differedsubstantially (in 1999 the simple mean tariffwas 12.6% in Saudi Arabia, compared with4.8% in Oman), agreement on a customs unionwas a considerable achievement. The fact thatin 2001, after a decade of discussion, GCCHeads of State finally agreed on a tariff levelclose to that of its most liberal members (5% onall tariff lines except tobacco products (100%)and exempted products) was therefore a displayof their commitment to the integration project.In the same year they also adopted a unifiedcustoms code and a binding schedule for theintroduction of the customs union, and inDecember 2002 a set of implementationprovisions was approved, including a list ofduty-exempt products (417 tariff lines).

The single entry point principle adopted in thecontext of the customs union implies that allcustoms procedures and duty payments forgoods imported from outside the GCC arefinalised at the first point of entry, irrespectiveof the final destination. In addition,domestically produced goods no longer requirea certificate of origin in order to benefit fromduty-free treatment in other GCC countries.24

Besides some transitory difficulties in theimplementation of the customs union, whichcan be regarded as “teething problems”, anumber of trade barriers still remain in place inaccordance with the agreed rules. Theimplementation measures provide for a three-year transition period, during which internalcustoms procedures are to be rolled backgradually. However, even in the final stage,beginning in 2006, intra-GCC border measuresare set to remain, albeit limited to inspectionsfor prohibited and restricted goods and animaland plant quarantine measures. In order toeventually eliminate the need for borderinspections and reap the full benefits ofintegration, further efforts may therefore bewarranted in terms of adopting common healthstandards and solving the problem ofprohibited goods through internal rather thanborder measures.

In institutional terms, the Customs UnionCommittee, which is composed of nationalcustoms directors and reports to the Committeefor Financial and Economic Cooperation, isresponsible for monitoring and steering theimplementation of the newly establishedcustoms union. Thus, the customs unionfollows the same intergovernmental approach

24 The latter is a crucial point with regard to the free movementof goods in the GCC. A free trade area had already beenestablished in the GCC in 1983, allowing for the duty-freemovement of goods produced in any of the member states.However, imported goods still had to undergo customsprocedures when crossing internal borders. Moreover, sinceGCC producers had to meet a 40% minimum domestic contentrule if they wanted to benef it from duty-free treatment,burdensome procedures had to be followed to establish thenational origin of manufactured goods. To overcome theseinherent limitations and allow the free circulation of goods, apolitical step had to be taken, namely to agree a commonexternal tariff schedule and to create a customs union.

29ECB




that characterises the integration process in theGCC in general. This may however pose achallenge for the future, as the establishment ofa customs union essentially forces memberstates to pursue common policies, rather thansimply to coordinate their national policies, onthe most important aspects of trade policy, inparticular external tariffs. There areindications that it will not be easy to deal withsuch matters smoothly in such a consensus-based intergovernmental framework in theabsence of an effective dispute settlementmechanism or a supranational body with theright to make authoritative interpretations.

Moreover, the free movement of goods remainsincomplete even in a customs union, unlessnational product and production standards aresufficiently harmonised or mutuallyrecognised.25 GCC Heads of State were clearlyaware of the importance of harmonisedstandards when they decided in 2001, as acomplementary measure to the creation of thecustoms union, to upgrade the GulfStandardization and Metrology Organizationfrom a branch of the Saudi Arabian StandardsOrganization to an independent agency. Inaddition, the implementing provisions for thecustoms union establish the principle of mutualrecognition of national standards. TheEuropean experience suggests that, pending theeventual complete harmonisation of nationalstandards, the success of the common marketwill crucially depend on the implementation ofthe principle of mutual standard recognition.

Free movement of servicesThe free movement of services in the GCCseems to be less advanced than the freemovement of goods, although in the case ofservices, an assessment is more complicated.From a purely economic point of view, trade inservices is analogous to trade in goods.However, legal barriers to trade in services aremuch harder to assess or indeed to eliminatethan barriers to trade in goods. Whereas thelatter are essentially a matter of customs

regulations and product standards, the formerare usually deeply entrenched in nationallegislation. A brief glance at various areas ofthe implementation of the common market inthe GCC reveals a highly heterogeneouspicture across countries and sectors. Forinstance, while traffic legislation in a givencountry might already have been adapted toallow drivers to obtain insurance in anotherGCC country, its commercial law might stillnot allow foreign accountancy firms to operateon its soil.

However, a few horizontal issues point to theoverall degree of integration in the field ofservices. Major determinants of the freedom oftrade in services are the freedoms of movementof capital and of natural persons, as manybusiness models require either consumers orproducers to cross a border (supply modes 2and 4 under the General Agreement on Trade inServices (GATS)), or require the commercialpresence of the supplier (supply mode 3), andtherefore some capital investment. A relativelyhigh level of integration has been achieved interms of movement of capital as well as people(these aspects are discussed in more detailin the following two sub-sections). Theimplementation of the common market is, bycontrast, still incomplete with respect to lawsof incorporation and of commercial realestate ownership, which are essential for cross-border commercial presence. Similarly, therecognition of professional skills and diplomasand the principle of equal tax treatment havenot yet been fully accomplished. The former isnot only important to foster the free movementof services, but also to increase labour mobilityin general.

25 As most GCC member states have only established nationalstandardisation authorities relatively recently and in the pastrelied in many cases on foreign (mainly British) standards, thedifferences in national standards among GCC states should berelatively limited. Another favourable factor in this respectwas the creation in 1983 of the Gulf Standardization andMetrology Organization, which has since its creation issuedmore than 1,700 Gulf standards.


While there seems to be a strong commitmentto eliminate such barriers over time, GCCcountries might not be able to reap the benefitsof free movement of services due to anotherlimiting factor: the prevalence of monopoliesand public entities in the services sector. Incountries where water, for instance, is providedfree of charge, there is little opportunity forefficiency gains to be achieved by allowingcompanies from other GCC countries tocompete. While privatisation efforts are alsounderway in the services sector at the nationallevel in all GCC member states, there seems tobe some scope for further action in this regardat the GCC level.

Free movement of capitalGCC member states share a tradition ofrelatively liberal capital accounts. However, anumber of regulatory and structural factorshave limited cross-border capital mobility, andthere seems to be a commitment in the GCC toeliminate these regulatory barriers. Living upto this commitment and enhancing capitalmobility with the objective of achieving thefull integration of GCC financial and bankingmarkets is particularly important in view of theplans for monetary union.

The factors that have impeded intra-GCCcapital flows include restrictions on foreignownership of equity and real estate, regulatorybarriers to cross-country banking operations,and underdeveloped capital markets (seeChapter 2). In recent years, many GCCgovernments have given higher priority toattracting private investment, and in particularFDI, as a vehicle of economic diversification.It is in this context that Article 5 of the 2001Economic Agreement calls for the creation ofan “investment climate characterised bystability and transparency”, including thecomplete integration of capital markets in theregion. To achieve this goal, member statescommitted themselves to harmonising theirregulations regarding investment, bankingand financial markets, to eliminating alldiscriminatory regulations regarding thetrading and ownership of assets, and thereby

effectively to removing all barriers to cross-border banking services and investment.

The number of banks operating across GCCcountries is still very limited,26 although allmember countries allow in principle theestablishment of banks from other GCCcountries on their territory. This may be due tothe fact that the equal treatment principle hasnot yet been implemented completely innational banking and commercial legislation.Furthermore, while basic harmonisation hasbeen achieved, legislation in the areas ofbanking regulation and supervision continuesto display differences across countries,complicating the establishment of cross-borderbranches by GCC banks. In addition to theregulatory environment, which is set to beimproved by implementing the provisions ofthe Economic Agreement, some structuralbarriers to the integration of banking systemsdeserve attention, such as the low level of intra-GCC trade. Further trade integration, asrecently observed with the increase in intra-GCC trade, will be an important source ofdemand for cross-border financial services.This points to the need to follow a trulycomprehensive approach with regard to theimplementation of the common market, as the“four freedoms” are intrinsically linked to eachother.

With regard to capital markets, the mostprominent restriction to capital mobility in thepast was the requirement in all GCC countriesof majority national ownership in allcorporations. This is now being abandoned orreplaced by the principle of majority ownershipby GCC nationals. In some countries, shareownership in certain sectors, such as finance, isstill restricted to nationals. In 2002, 28% ofGCC joint stock companies were covered bysuch provisions. Apart from these restrictions,stock markets seem to be freely accessible toGCC investors, and a number of cross-listingagreements between stock exchanges nowprovide national companies with access to

26 Bahrain is an exception in this respect due to its role as anoffshore financial centre.

31ECB




GCC capital.27 However, up till now thenumber of cross-listed stocks and their share inmarket capitalisation appears to be very small.

In addition, the high proportion of publiclyowned companies in the GCC economies has sofar limited the potential for gains from cross-border capital mobility. By analogy with whathas been noted with regard to the liberalisationof services, there is a strong case for steppingup privatisation efforts in order to benefit fullyfrom the efficiency gains that the commonmarket and, to an even greater extent, themonetary union entail.

Free movement of natural personsThe free movement of natural persons is fairlyadvanced for GCC nationals. However,expatriates are not covered by the integrationendeavours in this area. Given the large shareof expatriates in the population and, inparticular, in the workforce, this may limit theoverall economic gains from the completion ofthe common market.

By and large, GCC nationals are free to travel toall member states without having to obtain avisa, and, in most cases, even without a passport.They largely enjoy equal treatment regardingemployment in the private sector, and areentitled to temporary and permanent residence.Implementation of the national treatmentprinciple is also relatively advanced with respectto personal real estate ownership, employmentin the private sector, education, health and socialservices and the exercise of most professions(except those included in a negative list). At thesame time, equal treatment is still not fullyensured in other areas such as employment in thepublic sector and access to social insurance andpension schemes. However, efforts continue tobe made to implement the principle of GulfCitizenship in these areas, as well as to reach fullmutual recognition of diplomas and certificatesof qualification.

As a result, the number of GCC citizens whohave obtained a licence to conduct economicactivity in other member states remains

extremely low. Only in the UAE does theirnumber exceed 0.1% of the total population.Similarly, only around 0.15% of GCC citizensown real estate in another GCC country.

The free movement of non-nationals betweenGCC countries is not explicitly a subject of theintegration objectives as set out in theEconomic Agreement. Some countries grantexpatriate residents of other GCC statespreferential visa treatment, and there seem tobe plans to introduce a common GCC visa forforeign businesspeople. As long as there is nocommon visa or residence permit for expatriateworkers, however, labour mobility will notapply to a significant proportion of the labourforce in GCC countries. Given the importanceof expatriate labour in the private sector inGCC countries, this may represent animpediment to economic integration,especially in the areas of trade in services(which often involves the movement of naturalpersons) and cross-border transport. It alsoraises the issue whether the overall degree oflabour mobility is compromised, which canplay an important stabilising role in a monetaryunion in the event of asymmetric shocks.However, in this context it has to be taken intoaccount that even in the absence of freemigration of expatriates between GCC memberstates, overall labour mobility remains high,given the ability to adjust swiftly the overallnumber of expatriate workers in a countrywhen, for instance, it faces the consequences ofan asymmetric shock.

27 No information was available on private bond markets;however, these are of marginal importance in the GCCcountries.


4 ECONOMIC CONVERGENCE OF GCCMEMBER STATES

When analysing economic convergence, acrude distinction can be made betweenmonetary, fiscal and structural convergence.Monetary convergence refers to variablesmainly determined by monetary policy, suchas inflation, interest rates and exchangerates, whereas fiscal convergence refers toindicators such as budget deficits and debtlevels, which are strongly influenced by fiscalpolicy. Structural convergence is not asstraightforward to assess in quantitative terms,and refers mainly to an increasing similarity ineconomic structures and economic dynamics.This is relevant for a monetary union, as itreduces the probability and severity that agroup of countries’ economies will be hit byasymmetric shocks. Given that economicdynamics will never be identical and that someasymmetric shocks will always remain, thecapability to cope with such shocks is also ofrelevance. There are a wide range of indicatorsthat can provide information on structuralconvergence. The most commonly used arevariables such as income levels, GDP growthcycles and the sectoral structure of theeconomy, which can provide hints to assess thisaspect.

This chapter reviews the state of monetary,fiscal and structural convergence among GCCmember states. When looking at the overallpicture concerning the convergence of GCCeconomies, the following features stand out:

(i) The degree of monetary convergence amongGCC economies with low and similar inflationrates, co-moving interest rates and low interestrate differentials and stable exchange rates isremarkable, and exceeds the convergenceachieved in this field by euro area countries in acomparable period prior to the introduction ofthe euro in 1999. In particular, the degree ofexchange rate stability for almost two decadesis noteworthy, all the more so in anenvironment of relatively free capital flows.

(ii) Fiscal convergence is less marked thanmonetary convergence in GCC economies.While government revenues and expenditureand the budget balance tend to move in paralleldue to the dependency of public finances on oilrevenues, the level of deficits/surpluses variessignificantly between countries. In somecountries, high and persistent fiscal deficitshave become the norm until recently and haveled to a build-up of public debt, the level ofwhich also seems to vary significantly betweenGCC member states. An in-depth assessment ofthis would require enhanced transparency ofdata.

(iii) Concerning structural convergence,neither the pattern of growth cycles, nor thedifferences in GDP per capita between memberstates, nor the economic structure of memberstates provide an argument against furthermonetary integration and the introduction of asingle currency. Growth cycles tend to berelatively synchronised due to the role of oil inthe economy. Differences in GDP per capita aresignificant, but not more so than in the euroarea, and as such seem to form no impedimentto a functioning monetary union. Economicstructures are broadly similar, thus reducingthe likelihood of asymmetric shocks and theneed to resort to exchange rate adjustments.

(iv) An important qualification has to be maderegarding the possible future development ofeconomic structures. The high degree ofstructural homogeneity cannot be extrapolatedinto the future, as progress in diversificationefforts might reduce the structural similaritiesof the GCC economies. If some countriesdiversify more successfully and faster thanothers (i.e. if the differences in the degree of oildependency widen significantly betweencountries), or if diversification takes adifferent path in individual GCC countries,then the likelihood of asymmetric shocks mayincrease. Thus, by achieving the reasonablekey policy objective of economicdiversification in the GCC, which could evenbe supported by a single currency, the potentialmacroeconomic costs associated with a

33ECB


4 ECONOMIC CONVERGENCE

OF GCCMEMBER STATES

monetary union might increase, particularly asit is conceivable that a GCC monetary unioncould in the future comprise both highly oil/gasdependent countries and non-oil/gas dependentcountries. However, this point should not beseen as a prima facie argument againstmonetary union in the GCC. Rather, it points tothe increasing importance of the economies’ability to deal with shocks using tools otherthan nominal exchange rate adjustments, in theevent that asymmetric shocks become morelikely in the wake of ongoing diversificationafter monetary union. This lends furthersupport to efforts to liberalise product marketsand to enhance labour market flexibility andlabour mobility in GCC economies.

4.1 MONETARY CONVERGENCE

This section analyses monetary convergence inGCC member states, focusing on inflationrates, interest rates and exchange rate stability.

4.1.1 INFLATIONThe GCC countries have been characterised byrelatively low inflation rates over the past twodecades, and inflation rates have also tendedto move broadly in parallel betweencountries during this period. Inflation hasrarely exceeded 5%, which was the case only in

a few countries in exceptional years. Thisperiod of a high degree of price stability haslasted since the mid-1980s, but was precededby significantly higher inflation rates in the1970s when, as a result of the oil boom,inflation rates reached double-digit levelsbefore starting to stabilise around 1980 (seeChart 15).

The average inflation rate over the last twodecades has been highest in the UAE (3.7%)and lowest in Saudi Arabia and Oman (0%).The difference between the highest and lowestinflation rates in GCC countries seems to havegradually narrowed and to have become lessvolatile over the past 10 years, pointing toincreased convergence (see Chart 16). Over thepast two years, average inflation in theGCC has somewhat increased to reach 2.1% 28

in 2004 owing to recent oil price peaks, withinflation ranging from 0.8% in Oman to 3.5%in Qatar.

Turning to country-specific developments,inflation rates were temporarily higher afterthe 1990 Iraqi invasion of Kuwait in severalGCC countries, most notably in Kuwait itself in

28 Unweighted average.

Chart 15 Inf lat ion in GCC member states

(annual percentage changes)

Sources: IMF WEO and IFS.

Chart 16 Dif ference between highest andlowest inf lat ion rate in GCC member states

(percentage points)

Sources: IMF WEO and IFS.

0

2

4

6

8

10

0

2

4

6

8

10

1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002 2004-4

-2

0

2

4

6

8

10

12

-4

-2

0

2

4

6

8

10

12

Bahrain KuwaitSaudi Arabia

OmanQatar U. A. E

1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002 2004


view of the reconstruction of the country. Qatarexhibited relatively high inflation rates in themid-1990s due to dynamic growth in the naturalgas sector. In addition, inflation rates in the UAEwere persistently higher than in other GCCcountries in the late 1980s and the first half of the1990s. However, this development does notseem to have been driven by significantlydivergent economic developments or monetarypolicy, and, despite a real appreciation of thecurrency, does not seem to have led to a loss ofcompetitiveness of UAE exports.

In conclusion, the high degree of inflationconvergence of GCC member states at lowlevels of inflation over the past 20 years isremarkable. The major factor explaining thepersistently low inflation rates is the (at leastde facto) continued peg of the currencies to theUS dollar (see sub-section 4.1.3). The GCCcountries’ choice of an external anchor formonetary policy has obviously been credibleand served them well in the past to anchorinflation expectations and to import monetarystability from the anchor economy. Anotherfactor that seems to have contributed to lowinflation rates has been the relatively low levelof central bank credit to governments in GCCcountries. Unlike in some other Middle Eastcountries, GCC member states did notextensively use monetary policy to

accommodate budget deficits. This wasfacilitated by accumulated foreign assets,which they could resort to in times of budgetarystrain, for instance in periods of low oil prices.Moreover, the low level of inflation achievedin all GCC member states in the last 20 yearspoints to a shared policy preference for pricestability, which also seems to enjoy supportamong the respective populations.

4.1.2 INTEREST RATESOver the past 20 years, interest rates in GCCmember states have co-moved in similarranges. The high degree of interest rateconvergence reflects the inflation convergenceand the degree of exchange rate stability amongGCC member states, resulting from their long-standing orientation towards the US dollar.Hence, interest rates have tended to move inline with US interest rates (see Chart 17). Thespread between GCC and US interest rates isgenerally low and reflects the credibility of theexchange rate peg. The spread tends to beinfluenced by oil price developments, inparticular in the case of Saudi Arabia, wherefalling oil prices normally lead to a spreadwidening (see Chart 18).

It should be noted that the Gulf region isgenerally characterised by short-term creditrelations. Therefore, long-term interest rates,

Chart 17 Interest rates in GCC memberstates

(3-month deposit rate, percentages)

Sources: IMF IFS, and national sources for UAE.1) Certif icates of deposit interest rates.

Chart 18 Interest rate spreads SaudiArabia – USA and oi l prices

Source: Bloomberg.

-0.4

-0.2

0.0

0.2

0.4

0.6

0.8

1988 1990 1992 1994 1996 1998 2000 2002 20040

5

10

15

20

25

30

35

40

KSA–US interest rate spread (in percentage points)(left-hand scale)oil price (USD per barrel; Europe DTD Brent) (right-hand scale)

02468

1012141618

024681012141618

1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002 2004

BahrainKuwaitSaudi ArabiaOman

QatarUAEUSA (memorandum) 1)

35ECB



OF GCCMEMBER STATES

for instance for ten-year bonds, do not exist ona comparable basis. The analysis of interestrate convergence must thus focus on short terminterest rates, for which a three-month depositrate is chosen here in view of data availabilityand comparability.

Specific developments can be observed forKuwait in the early 1990s connected to thesituation after the Iraqi invasion; for Oman inthe second half of the 1990s due to interest rateregulations; and for Qatar, whose interest ratewas fixed until 1991 but, once it was allowed tofluctuate, moved in line with the interest ratesof the other GCC countries. In the last decadethe spread between the highest and the lowestrate was highest in 1993 with 4.1 percentagepoints (7.1% in Kuwait versus 3.0% inBahrain), and lowest in 1995 with 0.8percentage point (6.5% in Kuwait versus 5.7%in Bahrain).

4.1.3 EXCHANGE RATESThe degree of nominal exchange rate stabilityamong GCC currencies in the past two decadesis remarkable and probably unparalleled in theworld economy. It reflects the long-standingcommon orientation of GCC countries’exchange rate policies towards the US dollar(see Chart 19). The orientation of GCC

countries’ exchange rate policies towards acommon external anchor has not only limitedintra-GCC currency fluctuations, but has alsosignificantly contributed to the convergence ofinflation and interest rates, as described in theprevious sections.

Since the beginning of 2003 all GCC currencieshave been both de jure and de facto pegged tothe US dollar as part of the GCC’s road map tointroduce a single currency. The peg is aconventional peg according to the IMFclassification and, with the exception of theKuwaiti dinar, there is no horizontal bandaround the rate at which the currencies arepegged to the US dollar. The Kuwaiti dinarfluctuates in a band of ± 3.5% around thecentral rate. As a result of the common USdollar peg, there are no exchange ratefluctuations between five of the GCCcurrencies, and only limited fluctuationsbetween those five and the Kuwaiti dinar.

The transition to a common US dollar peg withthe aim of further enhancing exchange ratestability among GCC currencies and bringingtheir exchange rate regimes formally into linein view of the planned monetary union did notrequire any major modifications to the GCCcountries’ long-standing exchange rateregimes, with the exception to a limited extentof Kuwait. In fact, the exchange rate regimes ofGCC countries had already shown a highdegree of homogeneity for an extended period.The Omani riyal has been de facto peggedto the US dollar since 1973; the Bahraini dinar,the Qatari riyal and the UAE dirham since1980; and the Saudi riyal since 1986.Notwithstanding the de facto peg to the USdollar, until the beginning of 2003 Bahrain,Qatar, Saudi Arabia and the UAE had dejure29 pegged their currencies to the SpecialDrawing Rights (SDR) currency basket, witha fluctuation band of ± 7.25% in the cases ofBahrain, Qatar and the UAE. Oman was the

29 As notif ied to the IMF in the Annual Reports on ExchangeRate Arrangements and Exchange Restrictions.

Chart 19 Exchange rates against USD for theGCC member states

(national currencies per USD, 1966-2004)

Source: IMF IFS.

0.25

0.30

0.35

0.40

0.45

0.50

1968 1972 1976 1980 1984 1988 1992 1996 2000 20043.03.23.43.63.84.04.24.44.64.85.0

Oman (left-hand scale)Bahrain (left-hand scale)Saudi Arabia (right-hand scale)UAE (right-hand scale)Qatar (right-hand scale)Kuwait (left-hand scale)


only GCC country which also had a de jure USdollar peg. Thus the transition to a common USdollar peg in early 2003 meant only anadjustment of the de jure exchange rate regimeto the long-standing de facto regime.

Kuwait’s exchange rate regime differedslightly from those of the other five GCCmember states. Until the beginning of 2003 theKuwaiti dinar was pegged to a basket ofcurrencies of the country’s main trading andfinancial partners. The composition of thebasket was not disclosed, but obviously the USdollar had a dominant weight, as only minorfluctuations occurred vis-à-vis the US dollar,and as a result, exchange rate fluctuations vis-à-vis the other five GCC currencies were alsovery limited. Nevertheless, the limitedexchange rate flexibility enjoyed by Kuwait inthe past explains the fact that under the presentcommon US dollar peg, the Kuwaiti dinar is theonly currency which is granted a narrowfluctuation band.

The last major adjustments of parities vis-à-visthe US dollar, and thus among the five GCCcurrencies pegged to the US dollar, took placein 1986 (in Oman and Saudi Arabia), while theparities of Bahrain, Qatar and the UAE haveremained largely unchanged since 1979.30

Accordingly, there has been almost completeexchange rate stability among five of the sixGCC currencies over the last 18 years. In thelast decade, the fluctuations of the Kuwaitidinar did not exceed ± 3.5% vis-à-vis either theUS dollar or the other five GCC currencies.

With regard to real exchange ratedevelopments, higher inflation rates haveinduced an appreciation of the real effectiveexchange rates of the Kuwaiti dinar, the Qataririyal and the UAE dirham over the last decade.Interestingly, although the real appreciation issignificant, in particular for the UAE dirham,this has not resulted in a loss ofcompetitiveness or a rising current accountdeficit and, subsequently, in pressure on thenominal exchange rate, as standard economictheory would suggest. This may be explained

by stronger productivity growth in the UAE,which is more advanced in its degree ofdiversification (see Chapter 2). However, thedominance of oil in foreign trade may also bepart of the explanation, as the price of anddemand for oil is not influenced by domesticprice developments.

Exchange rate stability among the GCCcountries is all the more remarkable as it hasevolved in an environment of relatively opencapital accounts, and thus cannot be explainedby foreign exchange restrictions. Moreover,this exchange rate stability has withstoodvarious instances of severe economic andpolitical turbulence, such as large oil pricefluctuations, crises in various emerging marketeconomies with a global impact, the 1990/1991Gulf War following the Iraqi invasion ofKuwait, and most recently the militaryintervention in Iraq in 2003.

This stability can be explained by three mainfactors: (i) the similarity of economicstructures of GCC member states, notably therole of oil in their economies, which reducesthe potential for asymmetric shocks and thusthe need to resort to exchange rate adjustments;(ii) economic policies in GCC member states,which have largely been consistent with theexchange rate pegs and have not underminedtheir credibility; and (iii) the accumulation ofsignificant foreign exchange reserves by GCCmember states, which have underpinned thecredibility of the peg and deterred speculativeattacks. Such attacks occasionally occur,mainly in the wake of low oil prices, and tendprimarily to target the Saudi riyal, as it exhibitsby far the most liquid foreign exchange marketamong GCC currencies. Past attacks have ledto a temporary widening of interest rate spreadsvis-à-vis the US and to interventions in theforeign exchange markets to defend the peg. Noformal arrangement exists among GCCmonetary agencies and central banks to supporteach others’ currencies when the exchange rate

30 A very small adjustment of the UAE dirham took place in1997.

37ECB



OF GCCMEMBER STATES

peg is under strain. However, it is widelyacknowledged that monetary agencies andcentral banks would be able to coordinatesupport informally on an ad hoc basis if deemednecessary.

The US dollar orientation of the GCCcountries’ exchange rate policies is explainedby the fact that oil revenues, which constitutetheir main income flow from exports, are pricedin US dollars. The US dollar pegs thus serve theaim of stabilising export revenues, and, giventhe prominent role of oil revenues in GCCmember states’ budgets, fiscal revenues aswell. The repercussion of these US dollarpegs is that the GCC countries’ terms oftrade are to a considerable extent exposed tofluctuations in the US dollar vis-à-vis othermajor currencies, given their foreign tradepatterns (see Chapter 2).

4.2 FISCAL CONVERGENCE

Fiscal convergence is examined here on thebasis of deficit-to-GDP ratios and debt-to-GDPratios in order to provide a cursory overview ofthe fiscal situation.31

4.2.1 BUDGET DEFICITSWhile GCC budget balance-to-GDP ratios tendto exhibit a considerable degree of co-movement, significant differences regardingthe level of deficits/surpluses remain (seeChart 20).

Three major periods can be distinguishedwithin the past three decades. In the 1970s,following the dramatic increases in oil prices,GCC budgets exhibited surpluses which werein some cases massive in relation to GDP. Theearly 1980s marked the transition to deficits,which remained the norm until the late 1990s.Most recently, fiscal revenues havesignificantly increased due to the pick-up in oilprices, and budget balances have moved intosurplus again. However, the magnitude of thebudget balance-to-GDP ratios differedbetween GCC member states, with SaudiArabia exhibiting the highest annual average

deficit (-8.8% of GDP) in the period 1985-2004, and Oman the lowest (-0.1% of GDP).Unsurprisingly, the budget balances arestrongly influenced by oil price developments,and thus show a significant degree of co-movement (see Chart 21). However, country-specific developments leading to a divergencefrom the general trend can be identified, suchas the high Kuwaiti deficit in the early 1990sdue to the reconstruction effort following theIraqi invasion.

The underlying components of the budgetdeficits – government revenue and expenditure– also exhibit a high degree of co-movement,although to a slightly different extent. Revenuegrowth tends to be highly correlated in all GCCmember states, due to the high dependency ofgovernment budgets on oil as the major sourceof revenue. Thus revenue in all GCC countriesincreases sharply in times of high oil prices,and decreases when oil prices fall. Governmentexpenditure growth tends to follow closelyrevenue growth and thus oil prices;accordingly, spending cycles of GCC memberstates are also correlated, although to a slightlysmaller extent than revenues, with Kuwait inthe early 1990s being the major outlier.

31 This does not imply that these would be appropriate f iscalconvergence criteria in the GCC context in view of the role ofoil in budget revenues (see Chapter 5, Section 5 on the issue off iscal convergence criteria in the GCC).

Chart 20 Budget balances in GCC memberstates

(as a percentage of GDP)

Source: IMF WEO.

-50-40-30-20-10

010203040

-50-40-30-20-10010203040

1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002 2004

UAESaudi ArabiaQatar

BahrainOmanKuwait


Government spending is mainly driven byrevenue and thus tends to be pro-cyclical.32 Asa result of the large inflow of oil revenues in the1970s, GCC member states launched largedevelopment projects and introduced far-reaching schemes for welfare spending andsubsidies, thereby sharply raising the level ofgovernment spending. Once revenues declined,it proved difficult to reduce spending, leadingto two decades of deficits since the early 1980s.

4.2.2 PUBLIC DEBTBased on available data, the ratio of total publicgross debt to GDP in GCC countries seems tovary significantly and reflects different paths

of fiscal policies pursued over the past twodecades. Saudi Arabia, with a debt-to-GDPratio of over 80%, has accumulated by farthe largest public debt burden among theGCC countries, while the UAE exhibits thelowest debt ratio, at below 10% of GDP (seeChart 22).33 Recently, gross debt levels havetended to decline. Several GCC countries haveused high budgetary revenues as a result of highoil prices to reduce public debt significantly,notably Saudi Arabia.

Chart 21 Oi l pr ice and budget def ic its in GCC member states

Sources: IMF WEO and Bloomberg.

oil price (USD per barrel) (left-hand scale)budget balance (% of GDP) (right-hand scale)

Bahrain

05

1015202530354045

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

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

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

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

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

-10-8-6-4-2024681012

Kuwait

05

1015202530354045

-60-50-40-30-20-10010203040

Saudi Arabia

05

1015202530354045

-12-10-8-6-4-20246810

Oman

05

1015202530354045

-10

-5

0

5

10

15

Qatar

05

1015202530354045

-12-10-8-6-4-202468

United Arab Emirates

05

1015202530354045

-15

-10

-5

0

5

10

15

20

32 See Fasano and Wang (2002), who provide empirical evidencethat government spending in GCC countries follows revenues.

33 The latest available and comparable data for all six GCCcountries refer to 2002.

39ECB



OF GCCMEMBER STATES

Data on public debt in GCC countries have to beinterpreted with great caution, however.Different sources point to very different levels ofdebt, and the net position of the public sector inparticular remains unclear, as several GCCcountries have reportedly accumulated largeforeign assets which are not disclosed.Furthermore, it is difficult to gauge theappropriate delineation of the public sector. Forinstance, in Saudi Arabia, a large proportion ofpublic debt is owed to public social securityinstitutions. Given the importance of the publicdebt level for the sustainability of publicfinances, an improvement in data availabilityand quality as well as a comparable,comprehensive and concise delineation of whatconstitutes public debt in GCC member statesseems indispensable for a meaningfulassessment of fiscal convergence.

4.3 STRUCTURAL CONVERGENCE

This section examines structural convergencewith a view to the likeliness of asymmetricshocks and the availability of adjustmentmechanisms, focusing on sectoral structures,trade patterns, labour markets, GDP growthand GDP per capita.

4.3.1 ASYMMETRIC SHOCKS AND ADJUSTMENTMECHANISMS IN THE CONTEXT OFMONETARY UNION

A key precondition for a viable monetary unionis the existence of economic structures in theprospective member states that allow for a

smooth conduct of a single monetary policy.The macroeconomic cost of relinquishingnational monetary policy in the context of acurrency union depends on a) the frequency andseverity with which member states are exposedto asymmetric shocks, and b) the adjustmentmechanisms available to mitigate the impact ofsuch shocks, given that adjustments in nationalmonetary policies and nominal exchangerates are impossible.34 The most importantmechanisms that can facilitate this adjustmentprocess are domestic price flexibility and, inparticular, wage flexibility, cross-border factormobility and fiscal and financial integration.Where asymmetric shocks are rare or can easilybe mitigated or dispersed among memberstates, a single monetary policy focused on theaggregated macroeconomic situation of thecurrency area should not present significantproblems for any particular region. Bycontrast, in the presence of shocks thatpersistently affect some but not all memberstates, it might be difficult to devise a singlemonetary policy that is appropriate for all.

The past record of economic convergence canshed some light on the similarities anddifferences of economic structures in themember states that may either facilitate orimpede a single monetary policy. Certaineconomic features, such as the degree ofsimilarity in the sectoral structure, the degreeof trade integration, labour market flexibility,per capita income levels, the co-movement ofGDP growth cycles and exchange rate stability,can provide indicators of the frequency andseverity with which GCC member states havebeen hit by asymmetric shocks in the past, andof their ability to cope with such shocks.

4.3.2 SECTORAL STRUCTURESAs pointed out in Chapter 2, the sectoralstructures of GCC economies exhibit a highdegree of similarity owing to their commondependency on oil, and to a lesser extent onnatural gas as well. The oil and gas sector

Chart 22 Total government gross debt ofGCC member states

(as a percentage of GDP, 2002)

Source: IMF estimates.

0

20

40

60

80

100

0

20

40

60

80

100

Bahrain Kuwait Oman Qatar Saudi Arabia

UAE

34 For an overview of the literature on optimum currency area(OCA) theory, see Mongelli (2002).


accounts for more than one-third of GDP in theGCC as a whole, and, except for Bahrain, is thelargest sector in the economy, ranging fromroughly a quarter in Bahrain to almost 60% inQatar (see Chart 10, Chapter 2).

The similarity in sectoral structures reduces theGCC economies’ susceptibility to asymmetricshocks. In this context, it is worth recalling theGCC economies’ extraordinary record ofexchange rate stability. The structural featuresof the GCC economies (most notably the factthat the competitiveness of their external sectoris independent of domestic price and wagedevelopments, and that oil price changesconstitute symmetric shocks in view of theirshared oil dependency) have enabled memberstates to pursue such policies without incurringsignificant costs in terms of employment orinflation. The stability of nominal exchangerates can thus be understood as an indicationthat the GCC economies (i) have not beensubjected to frequent and severe asymmetricshocks, given their similar economic structure,and (ii) have so far been able to cope with thefew shocks they have faced, such as theinvasion of Kuwait, without having to resort tonominal exchange rate adjustments or to makeuse of their monetary autonomy.

The differences in the economic structures ofGCC countries may, however, increase in thefuture in the course of further economicdiversification. While all GCC countries have

declared that diversification and the reductionof their dependency on oil is a major goal ofeconomic policy, the pace and direction ofdiversification may differ from country tocountry. In particular, the pace ofdiversification could be influenced by the factthat some GCC countries face the exhaustion oftheir oil reserves at current levels of productionduring the next two decades (i.e. Bahrain andOman, see Chapter 2, sub-sections 2.2.1 and2.3.1), while others, like Kuwait, the UAE andSaudi Arabia, will not run out of oil reserves fora much longer period. Therefore, it is notunreasonable to assume that the economicstructures of GCC countries will be moreheterogeneous in 20 to 30 years’ time than theyare today. The increasing heterogeneity mayfoster economic integration and intra-GCCtrade. At the same time, price flexibility inproduct and factor markets will become anincreasingly important alternative adjustmenttool, once the option of nominal exchange rateadjustments has been relinquished. In the samevein, a well-designed system of intra-GCCfiscal transfers could potentially contribute tosmoothing adjustments to asymmetric shocksand to enhancing the cohesion of the monetaryunion. The development of such adjustmentmechanisms will determine whether, in thelong term, the GCC, when exposed to morefrequent asymmetric shocks, will be in aposition to make smooth adjustments under asingle monetary policy, or will find itself in amore problematic situation in which

Adjustment

Risk ofmechanisms

asymmetric shocks Not developed Developed

Low unproblematic: unproblematic:asymmetric shocks are rare, therefore no asymmetric shocks are rare and can be absorbedimminent need for developed adjustment without endangering the cohesion of the monetarymechanisms; union; GCC today

High problematic: unproblematic:asymmetric shocks may put the sustainability asymmetric shocks may occur, but can be absorbedof the monetary union at risk. without endangering monetary union. GCC 2030? GCC 2030?

Table 7 Asymmetric shocks and adjustment mechanisms as future chal lenges to the GCCmonetary union

41ECB



OF GCCMEMBER STATES

adjustment mechanisms are underdeveloped,which may challenge the sustainability of themonetary union (see Table 7).

4.3.3 TRADE PATTERNSThe level of trade integration in the GCCis relatively low when looking at overallexports (5% intra-GCC exports, see Chapter 2,Table 2). However, this is due to the dominanceof oil in GCC exports. The share of intra-GCCtrade increases to roughly one-third when onlynon-oil exports are taken into account,although this share is still significantlylower than the Chart for intra-trade in, forexample, the EU or the North American FreeTrade Agreement (NAFTA) (62% and 55%respectively). While the share of intra-GCC trade remains relatively low, it hassignificantly increased over the past decade,pointing to a process of trade integration whichhas been facilitated by the efforts undertakenby the GCC to eliminate barriers to intra-regional trade (see Chapter 3).35 In terms of thedirection of trade, GCC countries tend toexhibit a relatively homogeneous pattern, withAsia as the major export destination andEurope as the dominant source of imports (seeChapter 2, Tables 1 and 2).

4.3.4 LABOUR MARKETSLabour markets in the GCC, althoughfragmented between nationals and expatriates,appear to exhibit a considerable degree offlexibility thanks in particular to the high shareof expatriate workers, whose number can beadjusted in response to demand shocks.Typically, nationals of GCC countries providethe bulk of the labour force employed in thepublic sector, which tends to exhibit manyrigidities, while expatriates are employedmainly in the private sector, which is highlyflexible. This flexibility might be reduced,however, in the course of ongoing efforts toincrease the participation of nationals inprivate sector labour markets and to reduce thereliance on expatriates. As national employeesmay enjoy greater bargaining power than theexpatriates that currently dominate the privatesector labour force, it could be expected that

their increasing participation in labour marketswould give rise to institutional arrangementsentailing a higher degree of wage rigidity andjob protection. Therefore, it will be a policychallenge to ensure that the process of“nationalisation” of the labour force in theprivate sector is not accompanied by areduction in the flexibility that currentlyprevails. To promote stability in the context ofmonetary union, the cross-border mobility of(national and expatriate) labour will becomemore important as an adjustment mechanism inthe future. By comparison with other regionalintegration projects, the high degree of culturaland linguistic homogeneity in the GCC, inparticular of nationals, should greatly facilitatethe achievement of labour mobility, whichwould be enhanced by the removal of theremaining legal obstacles to the free movementof natural persons (see Chapter 3).

35 The overall impact of trade integration on economicconvergence is theoretically ambiguous. While strong tradelinks can serve to transmit and thereby moderate asymmetricshocks, they may also promote regional specialisation, andthereby potentially increase the risk of asymmetric shocks.

Chart 23 Real GDP growth in GCC memberstates


Source: IMF WEO.

-30

-20

-10

0

10

20

30

40

-30

-40 -40

-50 -50

-20

-10

0

10

20

30

40

50 50

60 60

Bahrain Saudi Arabia Qatar

KuwaitOmanUAE

1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002 2004


4.3.5 GDP GROWTHGDP growth rates in the GCC countries tend tobe volatile and show some correlation over thepast three decades (see Chart 23). The growthperformance of GCC member states depends toa great extent on oil, and the importance of theoil sector in their economies explains wellthe volatility in and a certain degree ofsynchronisation of their business cycles. Largeoil price fluctuations can be interpreted assymmetric shocks to GCC economies.

The 1970s and early 1980s were characterisedby very high GDP growth following the twolarge increases in oil prices in 1973 and 1979,while growth rates since the early 1980s havebeen significantly lower. The most significantdeviation from the general growth cycle ofGCC countries can be observed for Kuwait inthe early 1990s due to the Iraqi invasion and thesubsequent reconstruction, which in economicterms can be seen as an asymmetric shockaffecting one GCC member state in particular.Another asymmetric development discerniblefrom these data is the rapid development of thenatural gas sector in Qatar in the mid-1990s.Furthermore, GDP growth in Bahrain tends tobe less cyclical than in other GCC memberstates, reflecting the country’s lowerdependence on oil. Looking at levels of growthover the longer term, in the period 1980-2004

Oman, which was the country with the lowestGDP per capita at the outset (see next section),recorded the fastest GDP growth, with anannual average increase of 6.1%. Saudi Arabia,by contrast, exhibited the lowest averagegrowth (1.7%). Over the last decade, Qatar wasthe fastest growing GCC economy with annualgrowth averaging 9.1%, while Kuwaitfollowed by Saudi Arabia had the lowestgrowth rates (2.1% and 2.3% respectively).

Although the difference between the highestand the lowest growth rates among GCCeconomies tends to be high, it has beendeclining over the last two decades, with onenotable interruption in the early 1990s due tothe volatility of growth in Kuwait in the wakeof the Iraqi invasion (see Chart 24).

Naturally, growth in the non-oil sector of GCCmember states is less correlated than total GDPgrowth, and the differences between countriesregarding the level of non-oil sector growthalso seem to be significant (see Chart 25).36

In particular, non-oil growth in the UAEwas consistently high throughout the 1990s,making the UAE the most diversified economyin the GCC besides Bahrain (see Chapter 2).

36 Based on available data for four GCC countries.

Chart 24 Dif ference between highest andlowest real GDP growth rate of GCC memberstates(percentage points)

Source: IMF WEO.

0

10

20

30

40

50

60

0

10

20

30

40

50

60

1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002 2004

Chart 25 Real growth of the non-oi l privatesector in GCC member states


Source: GCC member states.

0

2

4

6

8

10

12

14

0

2

4

6

8

10

12

14

1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002

BahrainKuwaitSaudi ArabiaUAE.

43ECB



OF GCCMEMBER STATES

4.3.6 GDP PER CAPITADifferences in GDP per capita in PPP termsbetween GCC member states are significant,but are smaller than those that exist in the euroarea. GDP per capita growth has been subduedover the past two decades, and differences inGDP per capita have somewhat declined overthis period (see Chart 26).

GDP per capita rose steeply following the 1973oil price increase and reached a peak in mostGCC countries in around 1980, after the secondoil price hike. It declined in the early 1980s andbroadly stagnated or only slightly increasedover the following decade in most countries.The most marked developments over the pastdecade have been the significant growth inGDP per capita in Qatar due to the developmentof the gas sector combined with relatively lowpopulation growth, the decline and recovery inGDP per capita in Kuwait in the early 1990s,and Oman’s steady catching-up process. Thefact that GDP per capita has stagnated in manyGCC countries over an extended period showsthat real GDP growth was not sufficient to raiseper capita income levels in view of theprevailing high population growth.

Differences in GDP per capita between GCCmember states, which were most pronounced

Chart 26 GDP per capita (PPP) in GCCmember states

(in USD)

Source: IMF WEO.

around 1980, when the GDP per capita of thepoorest member state (Oman) was only about20% of that of the wealthiest in PPP terms(Qatar), remain significant. These differencesdecreased in the first half of the 1980s andthen remained broadly stable before wideningonce again as a result of recent dynamicdevelopment in Qatar. In 2004 Saudi Arabiaand Kuwait had the lowest GDP per capita inPPP terms of the GCC countries, correspondingto around 44% and 52% respectively of thehighest GDP per capita in Qatar. Althoughlarge, the differences in GDP per capitabetween GCC member states are, in fact,smaller than those found in the euro area.37

Large differences in GDP per capita within amonetary union may be relevant if, forexample, they result in a catching-up process,which in turn may lead to structural differencesin inflation rates via the Balassa-Samuelsoneffect, implying higher inflation rates in thecatching-up countries. While increases inproductivity in trading sectors may prevent adirect loss of competitiveness, wage increasescan spill over into the non-trading sectors andhave an indirect bearing on competitiveness.However, GDP per capita differences and theirdevelopment in the GCC are not primarilydriven by productivity, but rather by oil sectordevelopments, e.g. production increases. Thissuggests that GDP per capita differences andthe Balassa-Samuelson effect are of lessrelevance in the GCC context.

37 For example, in 2004 GDP per capita in Greece was 31.6% ofGDP per capita in Luxembourg (in PPP terms).

0

5,000

10,000

15,000

20,000

25,000

30,000

35,000

0

5,000

10,000

15,000

20,000

25,000

30,000

35,000

BahrainSaudi ArabiaQatar

KuwaitOmanUAE

1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002 2004


5 SOME CONSIDERATIONS ONCONVERGENCE CRITERIA FOR THE GCC

Decision-makers in the GCC will face somefundamental policy choices prior to theintroduction of a single currency, in particularconcerning the design and implementation ofconvergence criteria. Therefore, afterdemonstrating the relevance of assessingeconomic convergence and the need for a basicpolicy consensus, this chapter discussesconceptual issues arising in the design ofconvergence criteria which are relevant beyondthe concrete case of the GCC. Furthermore, therole of multilateral surveillance is highlightedas a tool for pursuing convergence both in therun-up to monetary union and after theintroduction of a single currency. Given theirparticular relevance in the GCC, fiscalconvergence criteria and the specifics applyingto the GCC context are dealt with in a finalsection.

The main findings can be summarised asfollows:

(i) Given the relevance of assessingeconomic convergence and in particularthe need for a policy consensus, the GCCmay benefit from a well-defined set ofcriteria that capture monetary and fiscalconvergence. These criteria should bemonitored in an effective framework ofmultilateral surveillance. Monetarycriteria are sufficient to function as entrycriteria, while fiscal criteria could play auseful role both as entry criteria and aspermanent criteria, providing thefoundation for a set of fiscal rules andpolicy coordination. The criteria willfunction as a useful information tool forassessing policies, and may additionallyserve as an anchor for expectations.However, their role as a discipliningdevice for policies may remain limited,since there is consensus in the GCC thatthey shall not represent selection criteriadetermining which countries are allowedto join the envisaged monetary union.

(ii) Monetary criteria could serve a slightlydifferent purpose in the GCC than in theEuropean context prior to the introductionof the euro. This is due to the high degreeof monetary convergence alreadyachieved among GCC member states.Monetary convergence criteria would thusnot require a major shift in policies toachieve compliance, as was the case inseveral EU Member States in the 1990s.There is no need for disinflation, andexchange rate parities have been stable fortwo decades. The monetary convergencecriteria would therefore not be a newlyintroduced anchor for policies andexpectations, or a disciplining device, butrather a tool to check whether the highdegree of monetary convergence achievedin the past has been maintained in the run-up to monetary union (a “lock-in” ofmonetary convergence).

(iii) Designing appropriate fiscal criteriaconstitutes a challenge for GCC countries.This is due partly to the much lower degreeof fiscal convergence achieved so farcompared with the monetary sphere, andpartly to the specific nature of thebudgetary situation in GCC countries as aresult of their heavy reliance on oilrevenues, which poses both short-termchallenges stemming from the volatilityand unpredictability of oil prices, andlong-term challenges in view of theexhaustibility of oil reserves and the needfor asset accumulation to ensure fiscalsustainability. Any fiscal framework willface the unavoidable trade-off betweentransparency and simplicity on the onehand, and economic optimalityconsiderations and the desire for country-specific tailor-made solutions on theother.

(iv) In general, when designing convergencecriteria, a reference period for theirassessment that is meaningful in view ofthe sustainability of convergence needs tobe defined. The thresholds need be chosen

45ECB


5 SOMECONSIDERATIONS

ON CONVERGENCECRITERIA

FOR THE GCC

so that they are both reasonable andplausible in the specific circumstances ofthe region, although it should beacknowledged that these necessarilyinvolve some degree of arbitrariness. Thetrade-off between the scope forinterpretation and political discretion onthe one hand and the credibility of thecriteria on the other also needs to be takeninto account. Finally, the quality andavailability of statistical data must besufficient to allow meaningful cross-country comparisons in the GCC.

5.1 THE RELEVANCE OF ASSESSINGECONOMIC CONVERGENCE

As with any monetary union, monetary unionand the introduction of a single currency38 inthe GCC necessarily require a single andindivisible monetary and exchange rate policy.Given this indivisibility principle, monetaryunion is more than just a particularly tightexchange rate arrangement, and a merecoordination of national monetary policies isnot sufficient to sustain a single currency. Asingle monetary and exchange rate policy hasto be geared to economic, monetary andfinancial conditions in the single monetary areaas whole. This, first and foremost, implies(i) that the participating member states have toagree on the basic orientation of monetary andexchange rate policy, and (ii) that memberstates are deprived of monetary and exchangerate policy as an adjustment tool to copewith divergent economic developments, forexample in the event of an asymmetric shock.

These basic implications of a monetary unionpoint to the role of economic convergence bothduring the process of monetary integrationprior to the introduction of a single currencyand afterwards. The level of economicconvergence achieved between countriesprovides some indications as to whether thefollowing three prerequisites for a successfulmonetary union are in place:

– a consensus on the role and objectives ofmonetary policy and the exchange rateregime;

– a shared commitment to fiscal policies thatat least do not contradict these objectives;and

– economic structures that allow for thesmooth conduct of a single monetarypolicy.

Hence, there is a case for closely monitoringand thoroughly assessing the degree ofeconomic convergence prior to the introductionof a single currency, and in particular thesustainability of convergence, as it is essentialto achieve convergence not only at a specificpoint in time, but on a sustainable basis.39 Inorder to monitor and assess economicconvergence, appropriate criteria need to bedefined.

In terms of the distinction between monetary,fiscal and structural convergence outlined inthe previous chapter, it is important to note thata high degree of monetary convergence is infact achieved by the establishment of amonetary union. The irrevocable fixing ofexchange rates and thus the elimination of anyexchange rate fluctuations betweenparticipating countries is the constitutiveelement of a monetary union. Once a singlemonetary policy is being conducted, the scopefor differences in inflation rates and interestrates is also limited, although these variablesare influenced by a variety of other factors,such as national fiscal policies and wagepolicies. Thus, the monitoring of monetary

38 Monetary union does not necessarily require the introductionof a single currency. As the GCC has decided not only toestablish a monetary union but also to introduce a singlecurrency, the terms “establishment of monetary union” and“introduction of a single currency” are used synonymously inthis paper, and the pros and cons of taking the latter step aftera monetary union has been established are not discussed.

39 In the EU the concept of sustainable convergence is enshrinedin the Treaty establishing the European Community (Article121) with respect to EMU, and was emphasised in theconvergence reports of the European Monetary Institute(EMI) between 1995 and 1998 in the run-up to the introductionof the euro.


convergence is of prime importance prior to theestablishment of monetary union, in particularto assess the direction of monetary policy andthe underlying degree of policy consensus,although this motive becomes less relevantonce the monetary union has been established.

In contrast, the monitoring and assessment offiscal convergence is essential both before andafter the introduction of a single currency iffiscal policy is not substantially centralised inthe monetary union. In a monetary union inwhich fiscal policy remains a nationalprerogative and national fiscal policiesdetermine the fiscal stance in the union as awhole in the absence of a large,macroeconomically dominant budget, as iscurrently the case in the euro area and is alsolikely to be the case in a GCC monetary union,there is a strong case for both (i) fiscalconvergence in the run-up to the establishmentof monetary union, and (ii) a framework forpermanent fiscal policy coordinationunderpinned by appropriate fiscal rules afterthe monetary union has come into effect.

In a similar vein, while the introduction of asingle currency can be expected to encouragethe integration of goods, services and factormarkets, it by no means guarantees a sufficientdegree of structural convergence. Rather, ahigh degree of multilateral surveillance andcoordination in many areas of economic policyis required even after the implementation ofmonetary union in order to ensure a level ofstructural convergence that supports thesmooth conduct of a single monetary policy.

5.2 THE NEED FOR A POLICY CONSENSUS

An important prerequisite for a sustainablemonetary union is sufficient consensus on thebasic orientation of monetary policy, and oneconomic policy in general. In particular,consensus on the role and tasks of monetarypolicy – in particular in the central bankingcommunity, but also among other economicpolicymakers and among the wider public – isessential for the smooth functioning and

credibility of a monetary union.40 Crucialquestions in this context include the following.Should price stability be the primary objectiveof monetary policy, or should this objective beon an equal footing with other potentialobjectives? Should monetary policy be mediumterm-oriented or used to fine-tune theeconomy? Is there a trade-off between pricestability and growth in the medium and longterm? What is the preferred status of the centralbank? What should be the main features of theexchange rate regime of the single currency? Inthe absence of a basic consensus on suchfundamental monetary issues, diverging policypreferences and views on the functioning of theeconomy may lead to conflicts over theorientation of a single monetary policy and maypossibly undermine the cohesion of a monetaryunion. Economic convergence betweencountries points to similar policy preferencesand views about the functioning of theeconomy, and thus to a lower potential forconflict once the monetary union has beenestablished. In the EU, such a consensus hasevolved over the last two decades, based on,among other things, the conviction that pricestability should be the primary objective ofmonetary policy, that monetary policy shouldnot be used to fine-tune the economy, that pricestability is the best contribution that monetarypolicy can make to economic growth andemployment, that there is no trade-off betweenprice stability and growth in the medium andlong term and, lastly, that price stability is bestachieved by an independent central bank.

In the GCC, there seems to be a sharedpreference for price stability, as reflected in thelow inflation rates over the past two decades.The main question on which policymakers in theGCC will have to reach a consensus is likely tobe the exchange rate regime of a single currency.Up till now, all GCC member states have chosento peg their currencies to an external anchor and,in so doing, have achieved a remarkable degreeof macroeconomic stability. However, there

40 See Blackburn and Christensen (1989) on the role of policyconsensus in the credibility of monetary policy.

47ECB




FOR THE GCC

might be considerations in the context of theintroduction of a single currency to modify theexternal anchor or to move to a more flexibleexchange rate regime, thus allowing moreautonomy for a domestically oriented monetarypolicy. Whichever path is chosen, many of theother institutional and policy decisions to betaken ahead of the launch of the GCC singlecurrency may depend to some extent on thechoice of exchange rate regime for the futuresingle currency. Therefore, reaching a broadconsensus in the GCC on this fundamentalorientation of monetary and exchange ratepolicy before the monetary union is establishedwould help to avoid possible conflicts later on.41

Another matter of importance is the need toreach a consensus among member states onsome basic aspects of fiscal policy, given thatundisciplined fiscal policies may clash with astability-oriented monetary policy. This is truefor the interaction of fiscal and monetarypolicy in general. Moreover, under the specificcircumstances of a fiscally decentralisedmonetary union, national fiscal policies maycause significant spillover effects in othermembers of the monetary union and in theunion as a whole.42 National fiscal policieshave, for example, an impact on commoneconomic variables such as interest rates, theinflation rate and the exchange rate, andthrough these variables on other members ofthe union.43 The impact will tend to be thegreater the larger a member state is relative tothe other members of the union, implying thatthe issue will become potentially moreimportant if large asymmetries exist in theeconomic sizes of member states, as is the casein the GCC. Thus, undisciplined fiscal policiesin the member states of a monetary union mayignite severe conflicts within the union. Whilesound fiscal policies are beneficial in generalfor the economic performance of a country andshould thus be pursued irrespective ofmembership of a monetary union, the case forfiscal discipline underpinned by commonlyagreed rules becomes even stronger in thecontext of such a union. It also has to be takeninto account that in a monetary union there may

be greater incentives to run excessive deficitsin member states, as the negative effects ofsuch deficits can be externalised.44

5.3 KEY POLICY CHOICES REGARDINGCONVERGENCE CRITERIA: PURPOSE,ECONOMIC CONTENT AND DESIGN

An effective monitoring and assessment ofeconomic convergence requires a set ofconvergence criteria to be defined which thecountries participating in the process ofmonetary integration must in turn meet, andwhich can be considered appropriate in thespecific economic context of the region.45

When defining convergence criteria, decision-makers in the GCC face a number offundamental policy choices with regard tothree basic aspects (see Table 8): (i) thepurpose of convergence criteria must beclarified (i.e. what role they are to play in themonetary integration process); (ii) theireconomic content must be decided (i.e. theunderlying set of economic variables and thusthe policy areas that are to be covered); and(iii) choices have to be made concerning thespecific design of the criteria. The three aspectsare intrinsically linked: the purpose and

41 The issue of the appropriate monetary and exchange ratepolicy in the GCC after the launch of the single currency fallsoutside the scope of this paper and hence is not addressed.

42 See ECB (2003) and Detken, Gaspar, Winkler (2004).43 Excessive government def icits will tend to increase union-

wide interest rates if the single monetary policy is notaccommodating, thereby potentially reducing growth in theunion (and possibly leading to pressure on the central bank toloosen monetary policy). If the single monetary policyaccommodates an excessive def icit in one or more memberstates, this will result ceteris paribus in higher inflation ratesfor the union as a whole. Thus, irrespective of the reaction ofthe single monetary policy to an excessive def icit in a memberstate, the latter tends to lead to a welfare loss for the othermembers. If a member state defaults as a result ofaccumulated excessive def icits, this may put pressure on othergovernments to bail out the country in question in view of thethreat of contagion and systemic risk.

44 The economic literature is inconclusive on this point,however. There is a different strand of thought that implies theopposite, i.e. that monetary union may foster f iscal disciplinein member states because, for example, the option ofmonetising public debt is more diff icult to realise. For anoverview of the arguments regarding the incentives for f iscalpolicy in a monetary union, see Sturm (1997).

45 See Bini-Smaghi, Padoa-Schioppa and Papadia (1993) for anoverview of the discussion on convergence criteria in the run-up to the Maastricht Treaty.


economic content of criteria, for example, to alarge extent influence the design, while thedesign determines the objectives that can beachieved with such indicators, as discussed inthe following sections.

5.3.1 PURPOSE OF CONVERGENCE CRITERIAConvergence criteria can, in principle, serve as– an information tool,– an anchor for policies and expectations, and

as– a disciplining device.

In serving these purposes, they may function asan important instrument that can providecredibility to the GCC monetary integrationproject. The extent to which convergence criteriamay fulfil some or all three functions largelydepends on how they are designed, applied,sanctioned and embedded in an institutionalframework. These issues are discussed in moredetail in the sections below. The role ofconvergence criteria tends to be strongest if theyserve as a disciplining device for policies, andweakest if they serve as a mere information toolto assess policies. In the latter case it might bemore appropriate to speak of convergencebenchmarks rather than criteria. The potentialimpact of the criteria on the convergence processcan be expected to correlate with theconsequences a country faces in the event of non-compliance, as this determines the incentives togear policies towards fulfilling the criteria. Thisimplies that appropriate sanctions have to be partof an institutional framework aimed atdisciplining policies effectively.

Furthermore, the time horizon over whichcertain criteria should be met plays an important

role in determining the convergence process.The European experience with Economic andMonetary Union (EMU) suggests that thecombination of a clearly defined set ofconvergence criteria plus a binding timetable forthe introduction of a single currency can be astrong instrument for fostering economicconvergence. The GCC already has a deadlinefor the end point of the process of monetaryintegration with the decision taken by theSupreme Council in Muscat to introduce a singlecurrency in 2010. A decision has also been takento define convergence criteria by 2005 and tostrive to meet these criteria between 2005 and2010. Thus, the decision on the basic approach tobe followed by the GCC to promote economicconvergence has been taken by combiningconvergence criteria with a timetable which, inview of the European experience, represents apromising way to entrench and fosterconvergence. The major difference to the EU isthat the GCC does not intend the criteria to beselection criteria, which raises questions withregard to, for example, incentives forcompliance (see sub-section 5.3.3).

5.3.2 ECONOMIC CONTENT OF CONVERGENCECRITERIA

With regard to the set of economic variablesunderlying convergence criteria, a basicdistinction can be made between monetary,fiscal and structural convergence criteria,whereby monetary criteria concern indicatorsdetermined mainly by monetary policy, fiscalcriteria concern indicators strongly influencedby fiscal policy, and structural criteria relate tothe probability and severity of asymmetricshocks and the ability to cope with them (seeChapter 4). Whether monetary, fiscal or

Purpose Economic content Design

Key policy choices – information tool – monetary criteria – entry criteria vs. permanent criteria– anchor for policies and – fiscal criteria – selection criteria vs. indicative

expectations – structural criteria targets– disciplining device – further issues (reference period,

thresholds, scope for interpretation, etc.)

Table 8 Key pol icy choices regarding convergence cr iter ia

49ECB




FOR THE GCC

structural criteria are more appropriate for theGCC in order to achieve a convergence processdepends largely on the focus and on the timehorizon to be observed.

If the focus is primarily on policy convergence,in particular in the area of monetary and fiscalpolicies, and if a short to medium-term timehorizon is to be captured, an emphasis onmonetary and fiscal criteria is warranted.Accordingly, if convergence criteria primarilyserve the purpose of indicating whether asufficient degree of convergence in the area ofmonetary and fiscal policy has been achieved inorder to enable a transition to a single monetarypolicy and to subject fiscal policy to commonlyagreed rules, then this purpose is best served bycriteria that refer to monetary and fiscalvariables. Such criteria can also assist in theassessment of whether a sufficient consensuson the basic orientation of these policies existsas a crucial prerequisite for avoiding tensionsand conflicts in a monetary union.46

If however the focus is primarily on structuralconvergence over a longer time horizon, thenstructural criteria may be appropriate.Accordingly, if convergence criteria primarilyserve the purpose of answering the question ofwhether a group of countries exhibit asufficient degree of structural similarity toform a successful monetary union (i.e. whetheron the basis of the optimum currency area(OCA) theory the establishment of a monetaryunion is advisable), a focus on structuralcriteria may be warranted.

Thus, the choice regarding the underlyingeconomic variables in terms of monetary, fiscaland structural convergence largely depends onthe kind of information policymakers in theGCC want to extract by monitoring andassessing the criteria. Given the interaction ofmonetary, fiscal and structural variables in theeconomy, some criteria may capturedevelopments in more than one sphere. Forinstance, a criterion concerning exchange ratestability, although clearly a monetary criterion,may also be a useful structural indicator to

assist in examining whether economies havebeen hit by asymmetric shocks and whetheradjustment mechanisms other than nominalexchange rate adjustments are in place.

At the same time, monetary and fiscal criteriaon the one hand and structural criteria on theother tend to differ with regard to (i) the degreeto which they can be influenced by theauthorities’ policies, and (ii) the time horizonover which major variations of the underlyingeconomic variables may occur. While thedevelopment of monetary or fiscal variablessuch as the inflation rate or the budget deficitdepend to a large extent on the course taken bymonetary and fiscal policymakers, structuralvariables such as the sectoral structure of theeconomy, trade patterns, labour marketfeatures or growth cycles are largely beyondthe authorities’ immediate control. They areinfluenced by various domestic and externalfactors and by the decisions of a variety ofprivate and official agents. This also largelyexplains the different time horizons over whichmonetary and fiscal variables on the one handand structural variables on the other can beinfluenced. While monetary and fiscal datausually reflect a shift in the respective policiesrelatively quickly, the effects of policiesdesigned to, for example, enhance growth orreduce unemployment, or to foster structuralchange or trade integration, typically takelonger to show.47 The key features of monetary,fiscal and structural convergence criteria aresummarised in Table 9 below.

46 See Corden (1993) on the role of stability preferences in theformation of monetary unions.

47 Moreover, structural variables are of less concern in thecontext of a monetary union if price stability is the primaryobjective of monetary policy, and if monetary policy isconsidered to be neutral in the medium and long term withregard to its real effects. While this does not imply that suchvariables are irrelevant, structural features of the economy,such as the synchronisation of business cycles, would deservemore attention if monetary policy is assigned the task of f ine-tuning the economy and influencing real variables such asgrowth and employment. The fact that the former view ofmonetary policy is part of the policy consensus upon which theMaastricht Treaty (as the monetary constitution of the euroarea) was built explains to a large extent why only monetaryand f iscal convergence criteria were incorporated into theEuropean Community (EC) Treaty.


In the context of the GCC, the political decisionto introduce a single currency has been taken.Thus, the function of convergence criteria isnot to determine whether GCC countriesshould form a monetary union, or indeedwhether they can be regarded as an OCA. Thisunderstanding is reinforced by the GCCmember states’ intention to design the criterianot as selection criteria, and to start monetaryunion with all member states (see sub-section5.3.3 below, second indent, on issues arising inthis context). The time frame for theconvergence process has also been determinedby setting 2010 as the date for the introductionof a single currency, and 2005 as the point intime when member states shall begin to striveto fulfil the convergence criteria. In view ofthis framework and the above considerations, afocus on monetary and fiscal criteria tends to bethe most appropriate approach for the GCC’scurrent deliberations on the design ofconvergence criteria. Regarding structuralconvergence, the difficulties in formulatingmeaningful criteria in quantitative terms mayalso justify some caution in designing andusing such criteria. Nevertheless, it isadvisable that structural convergence and theunderlying features of the economies aresubject to a multilateral surveillance process(see Section 5.4).

5.3.3 ISSUES RELATING TO THE DESIGN OFCONVERGENCE CRITERIA

Basic issues concerning the design ofconvergence criteria in the GCC are the timehorizon over which they are applied, i.e.whether they are entry criteria or permanentcriteria, and whether the criteria are designedas selection criteria for participation in themonetary union or as mere indicative targets.

– Entry versus permanent convergence criteriaConvergence criteria can be designed as mereentry criteria. Thus, they have to be met at aspecific point in time or throughout a referenceperiod prior to the creation of a monetary unionto provide a basis for deciding whether themonetary union should be established or whichcountries should participate. After themonetary union has been established, suchcriteria naturally cease to be relevant.

In addition to being just entry criteria,convergence criteria can also serve as an anchorfor policies after the establishment of amonetary union, to be fulfilled by member stateson a permanent basis. As previously pointed out,the act of establishing a monetary union ensuresa high degree of monetary convergence, butfiscal convergence is not permanently secured ina union if fiscal policies remain a nationalprerogative, even though a high degree of fiscalconvergence may have been achieved prior tothe introduction of a single currency. Thus, thepermanent risk exists that national fiscal

Monetary criteria Fiscal criteria Structural criteria

Primary purpose assess direction of policy, assess direction of policy, assess structural features of thepolicy consensus policy consensus economy, OCA compatibility

Responsiveness to high high lowpolicy decisions

Time horizon for short/medium term short/medium term long termchanges in underlyingvariables

Quantification easy easy difficult

Relevant time prior to monetary union prior to and during prior to and duringfor application monetary union monetary union

Table 9 Key features of monetary, f iscal and structural convergence cr iter ia

51ECB




FOR THE GCC

policies may undermine a stability-orientedsingle monetary policy if fiscal policies areunrestrained by fiscal rules or a policycoordination mechanism. Against thisbackground, there is a case for designingmonetary criteria as pure entry criteria formonetary union, while at the same time usingfiscal criteria as both entry criteria andpermanent criteria. The latter may continue toserve as a disciplining device once the monetaryunion has been established. The discipliningeffect of the criteria depends to a large extent onthe sanctions which countries face in the eventof non-compliance. Potentially the strongestsanction for failing to meet the entry criteria isnon-admittance to the union, provided the entrycriteria are designed as selection criteria. Thissanction is no longer available once a countryhas joined a monetary union,48 implying thatalternative ways and possible sanctions toensure continued compliance with the criterianeed to be considered.

– Selection criteria versus indicative targetsConvergence criteria can be designed asselection criteria with the aim of helping todetermine which countries are suitable to forma monetary union. They can also serve thepurpose of determining when countries that didnot take part in the first round of membershipcan subsequently join the union. Alternatively,convergence criteria can serve as mereindicative targets to be achieved by memberstates. In this case, their function is restrictedto being a tool that provides information on thedevelopment of certain economic indicatorsdeemed relevant for monetary union on asystematic and comparable basis, with thecriteria serving as benchmarks.

Selection criteria obviously provide a strongerincentive for compliance, as the potentialsanction in the case of non-compliance isdenial of access to the monetary union. This is apotentially strong sanction. The non-admittance to a “club”, the membership ofwhich is considered to be attractive, due to afailure to fulfil the entry criteria may entailhigh economic and reputational costs for the

authorities.49 Accordingly, the discipliningeffect of selection criteria on monetary andfiscal policies can be regarded as high, and thusthey may also serve as an effective anchor forexpectations. This presupposes that the criteriaare credible, i.e. there is an expectation thatthey will actually be implemented as selectioncriteria and that their role in the decision-making process will not be diluted for politicalreasons. The European experience suggeststhat the Maastricht criteria, which weredesigned as selection criteria, were indeedeffective as a disciplining device and as ananchor for policies and expectations.

Convergence criteria that have been designedas mere indicative targets, while being ahelpful information tool, will tend to have amore limited effect on disciplining policies,and thus will also tend to be less effective as ananchor for policies and expectations. Peerpressure will be the only available instrumentto foster convergence and to press for thefulfilment of the criteria. While peer pressuremay potentially be strong, its effectiveness indisciplining policies is likely to fall short ofthat of the potential sanction imposed on acountry that does not comply with the selectioncriteria.

The GCC does not intend to designconvergence criteria as selection criteria.Rather, there is a political consensus toestablish a monetary union in 2010 comprisingall six member states. Given this intention, theauthorities face the challenge of fosteringconvergence in the absence of strongincentives to comply with the criteria,particularly if this might involve unpopulardecisions in the area of fiscal policy. Sufficientpeer pressure among the authorities will becrucial to ensure that countries make a seriouseffort to meet the criteria and to prevent the

48 Notwithstanding the theoretical possibility of exclusion fromthe union, which would be such a draconian measure that it canbe ruled out as a feasible sanction.

49 The economic costs can, for example, take the form of higherinterest rates, pressure on the exchange rate or a change in thegeneral market perception of a country once it has off iciallyfailed a convergence test.


criteria from suffering a lack of credibility.GCC countries may, in any case, face asituation prior to 2010 in which it becomesclear that not all member states will fulfil thecriteria for the introduction of a singlecurrency. They will then have to decidewhether to postpone the transition to monetaryunion until the criteria are fulfilled by allcountries, or to introduce the single currencyaccording to schedule despite some countries’non-compliance with the criteria.

– Further issues related to the design ofconvergence criteria

Reference periodAs pointed out above, particular attention shouldbe paid to the sustainability of economicconvergence with a view to the establishment ofa GCC monetary union. Such an emphasis onsustainability can be reflected in the design ofconvergence criteria, in particular of entrycriteria. The concept of sustainability requiresthe reference period for assessment of thecompliance with the criteria to be not too short.Looking, for instance, only at a single year priorto the introduction of a single currency wouldhardly be sufficient to come to any meaningfulconclusion regarding sustainability, and mayeven lead to undesirable policy reactions. In thecase of fiscal criteria, the choice of a shortreference period may lead to a fiscal tighteningtargeted only at the budget balance in thereference period, for example through the use ofone-off measures to bring down budget deficits.This, however, would not improve the fiscalposition in the medium term – indeed, it couldeven worsen it.50 In the same vein, in respect ofmonetary criteria, a short reference period mayencourage a sudden tightening of policies tobring down inflation in the period concerned,entailing a high cost in terms of output loss,without representing a sustained stabilisationeffort. In order to avoid such counterproductivebehaviour and to provide an appropriate view ofsustainability, the development of theunderlying indicators should be observed over alonger period, preferably throughout a businesscycle.

ThresholdsIn the design of any convergence criterion,thresholds, or reference values, have to bechosen to decide at what point the criterion isconsidered to be fulfilled, as well as todetermine when it has not been fulfilled.Theory cannot generally help with regard to theoptimal reference value for a certain criterion.There is, for instance, no way to reliably definean optimal rate of inflation or to determine areference value above which a budget deficitcan in itself be regarded as excessive, or abovewhich a debt level can be regarded asunsustainable. Thus, any choice of thresholdnecessarily involves a certain degree ofarbitrariness. This unavoidable arbitrariness is,however, not an argument against usingconvergence criteria in principle. Rather, itpoints to the need to find thresholds which arereasonable and plausible under the specificcircumstances of a country/region, and whichare mutually consistent within a set of criteria.

This point can be illustrated by the 3% of GDPreference value for budget deficits in the EU.This threshold, which indicates whether or not abudget deficit should be regarded as excessive,was derived from the average public debt-to-GDP ratio of around 60% in the then 12 EUMember States at the time when the MaastrichtTreaty was concluded in 1991. Given certainassumptions regarding real GDP growth andinflation, a deficit of 3% of GDP stabilises a debtlevel of 60% of GDP.51 Moreover, a deficit

50 The EMI’s 1998 Convergence Report quantified the effects oftemporary fiscal measures taken by EU countries in order toreduce their budget deficits in the crucial reference year 1997 atbetween 0.1 and 1 percentage point of GDP, with the levelvarying according to the country. In view of these incentives ofa short reference period, the Treaty calls for the sustainability ofconvergence to be assessed prior to the adoption of the euro.

51 A debt-to-GDP ratio of 60% is stable at a budget def icit of 3%of GDP and a nominal growth rate of 5%. The assumption of anominal growth rate of 5% was derived from an estimate of 3%trend growth for the EU in the early 1990s and an inflationnorm of 2%. The change in the debt-to-GDP ratio (Db) isapproximately a function of the budget def icit (d) the nominalgrowth rate (n) and the initial debt-to-GDP ratio (b): Db = d - nb.Therefore, given the underlying assumption for growth, adebt-to-GDP ratio which is higher than 60% will decline to60% over time if budget def icits do not exceed 3% of GDP,while a debt-to-GDP ratio of less than 60% will rise to 60% ifbudget def icits stay at 3% of GDP. Consequently, debt-to-GDPratios will converge at the 60% level.

53ECB




FOR THE GCC

ceiling of 3% of GDP in EU countries leavesenough room for the automatic stabilisers towork in a recession without breaking the ceiling,if the budget is balanced or in surplus over themedium term.52 This is the basic rationale behindthe EU’s Stability and Growth Pact as aframework for fiscal policy. Thus, the 3% ofGDP threshold can be considered to bereasonable, although it cannot be argued from atheoretical point of view that a deficit of forinstance 3.2% is excessive, whereas a deficit of2.8% is not – or, indeed, that 60% of GDP is theoptimal level of public debt. Nevertheless, athreshold has to be chosen and, for it to have adisciplining effect, mechanisms to enforcecompliance must be in place.53 The inevitabledegree of arbitrariness involved in any thresholdfor convergence criteria can therefore not beused in itself as an argument against such criteriaor mechanisms to enforce them, as long as theyseem reasonably plausible.

Scope for interpretation and political discretionWhen designing convergence criteria in theGCC, it has to be decided to what extent theyshould be open to interpretation, leavingpolicymakers some discretion in decidingwhether or not the criteria have been fulfilledor not. A certain degree of discretion may bewarranted to avoid too mechanistic anapplication of the convergence criteria, whichmay not allow for due consideration of theoverall picture, in particular in view of thearbitrariness necessarily involved in the choiceof thresholds, or developments that extendbeyond the reference period. However, it has tobe acknowledged that there is a trade-offbetween such discretion for policymakers inthe application of the criteria and theircredibility. The more room is left for a politicalinterpretation of the convergence criteria, theless effective they are as an anchor for policiesand expectations and as a disciplining device.

Availability, reliability and comparability ofstatistical dataAn absolutely crucial issue for GCCconvergence criteria is the quality of thestatistical data on which the monitoring and

assessment of the criteria are based. First, datafor all indicators used must be available in atimely manner. Second, the data have to besufficiently reliable (i.e. the need for majorrevisions later on should be avoided), althoughthere may be a trade-off between the timelydelivery and the reliability of data. Third, datamust be comparable between member states, asotherwise no meaningful conclusions can bedrawn from the criteria, and comparisons mayeven be misleading. The European experienceshows that even in countries with a generallysound data basis, a major effort is neededto meet the statistical requirements formonetary union, in particular regarding datacomparability.54 The current state of dataavailability, reliability and comparability inthe GCC suggests that further effort is neededin GCC countries to meet the statisticalrequirements for a meaningful assessment ofconvergence criteria – in particular in the fiscalarea – and the operation of a monetary union.

5.4 MULTILATERAL SURVEILLANCE OFCONVERGENCE CRITERIA ANDINSTITUTIONAL UNDERPINNINGS

The monitoring and assessment of convergencecriteria needs frequent and effectivemultilateral surveillance, which in turnrequires suitable institutions and fora to

52 See Buti, Franco and Ongena (1997).53 The rationale for using reference values for convergence

criteria, despite some unavoidable arbitrariness, can becompared to the rationale behind a speed limit on roads. Fewwill doubt that a speed limit is a useful and necessary tool tocontrol traff ic and to avoid accidents. However, there is notheoretical or empirical case to limit speed to a specif icthreshold. The 50 km/h speed limit imposed in cities in mostEuropean countries, for example, is completely arbitrary, andit could indeed be argued that 40 km/h or 60 km/h would dojust as well. No one could plausibly argue that driving 60 km/his always and on any inner-city road endangering traff ic,whereas 40 km/h is always safe. However, the 50 km/h valuecan be seen as broadly reasonable. By contrast, a limit of 10km/h would obviously choke traff ic, and 100 km/h wouldrepresent no effective restriction at all, making themunreasonable choices. It is also logical that despite thearbitrariness of any concrete speed limit, violations have toresult in sanctions, and that exceptions must be made underspecial circumstances, e.g. for ambulances/the f ire brigade.

54 See EMI (1996a) on the statistical requirements for monetaryunion in the EU.


exchange information and discuss the relevanteconomic developments and policies. Prior tomonetary union and the establishment of asupranational monetary authority, it is crucialthat the national central banks participating inthe monetary integration process closelycooperate and develop intensive workingrelationships as well as an institutionalisedframework for the exchange of information andfor policy discussions. The need for closeinteraction between central banks applies notonly to Governors but also to seniormanagement and experts. In the Europeancontext, the Committee of Governors ofEuropean Community (EC) central banks,which was established in 1964 (including itssubstructures and secretariat), was decisive inlaying the groundwork for European monetaryintegration. It was the core body for monetarycooperation and policy dialogue and wasinstrumental in developing a policy consensus,and formed the nucleus of later Europeanmonetary institutions (the European MonetaryInstitute (EMI), founded in 1994, andsubsequently the European System of CentralBanks (ESCB) and the Eurosystem in 1998,with the ECB at its core).

As well as having the necessary institutions inplace for central bank cooperation, it is crucialto establish appropriate institutions and forafor the exchange of views and policydiscussions among finance ministers andsenior finance ministry officials. In theEuropean context, the EU Council of Ministersof Economic Affairs and Finance (ECOFIN)(and, since the introduction of the euro, theEurogroup) is the platform for suchinteraction.55 Furthermore, given the widenumber of issues in a process of monetaryintegration (and later on in a monetary union)that are of mutual interest to central banks andfinance ministries, appropriate institutions fora confidential exchange of views betweencentral banks and finance ministries are ofgreat importance. In the EU, the role of aplatform for an exchange of views betweenhigh-level representatives of central banks andfinance ministries is primarily fulfilled by the

Monetary Committee and, since theintroduction of the euro, by the Economic andFinancial Committee (EFC).

The necessary structures for central bankcooperation can be replaced by a supranationalmonetary authority, at the latest when thesingle currency is introduced (see Chapter 6).The institutions for cooperation betweenfinance ministries and for an exchange of viewsbetween finance ministries and central bankshave an important role to play in the run-up tomonetary union in monitoring the convergenceprocess, but must also remain in place, andmight even have to be strengthened, after theintroduction of a single currency.

With regard to the institutional underpinningsof multilateral surveillance, a key issue relatesto enforcement mechanisms in case nationalpolicies deviate from commonly agreedconvergence criteria. Peer pressure is animportant instrument for disciplining nationalpolicies, and for ensuring that nationalpolicymakers refrain from actions which maybe detrimental to objectives pursued at thecommunity level. Peer pressure can bereinforced by public pressure (“name andshame”). This requires the process ofmultilateral surveillance to be transparent tothe public, as well as the commonly agreedconvergence criteria. This is a precondition forthe public to be able to monitor the complianceof national policies with the supranationalcommunity’s interests. Apart from peerpressure, further enforcement mechanisms maybe contemplated to ensure compliance withcommonly agreed objectives, rules andstandards, such as fines. If such financial orlegal sanctions are deemed useful, it is crucialto clarify the exact nature of a sanction, thecircumstances under which it would beimposed, and the process leading to theimposition of a specific sanction.

55 See ECB (2001) for an overview of the economic policyframework of EMU.

55ECB




FOR THE GCC

In the context of the GCC, the nucleus forappropriate institutions to be assigned the taskof multilateral surveillance and policycoordination is already in place. TheCommittee of Governors of MonetaryAgencies and Central Banks is, with itssubstructures, the natural body to supervisemonetary and exchange rate policies in the run-up to a GCC monetary union and the necessaryharmonisation of legislation on bankingsupervision and financial markets, given theresponsibility of GCC monetary agencies andcentral banks for banking supervision and theoversight of financial markets in the respectivemember states. The task of monitoring andcoordinating national fiscal policies and otherareas of economic policy where surveillanceand coordination is required would naturallyfall to the Committee for Financial andEconomic Cooperation, which is composed ofministers of finance and economics.

So far there is no permanently establishedinstitution comparable to the EU’s EFC thatwould allow senior central bank and financeministry officials from all GCC member statesto exchange views on issues of mutual interest.The GCC’s Technical Committee, which wasformed in 2001 to prepare for monetary unionat the technical level, is a forum which bringstogether officials from central banks andfinance ministries of GCC member states, andcompetent officials from the GCC SecretariatGeneral. Given this composition, it couldprovide a forum for an exchange of viewsbetween central banks and finance ministrieson all monetary and financial issues in the run-up to monetary union, including surveillance ofthe convergence process and policycoordination. Furthermore, it seems sensiblethat such a Committee should be transformedinto a permanent forum after the establishmentof monetary union, which would then includerepresentatives of a new supranationalmonetary authority.

For multilateral surveillance to be effective, itis also essential to have sufficient staff at thesupranational level to prepare the meetings of

the competent bodies and to conduct thenecessary background analytical work, such asanalysing economic developments in memberstates and, in particular, monitoring budgetarypolicies. Assigning the staff involved in thiswork to a supranational institution at the GCClevel is crucial to guarantee that analysis andassessments are conducted from the angle ofthe Council as a whole and not impeded bynational points of view. Simply entrusting staffworking for the national authorities with thesetasks and trying to foster cooperation incommittees and working groups may not besufficient to ensure that the necessarysupranational perspective is given dueconsideration.

5.5 APPROPRIATE FISCAL CRITERIA AS ASPECIFIC CHALLENGE FOR THE GCC

As pointed out in Section 5.2, fiscalconvergence on the basis of sound publicfinances prior to monetary union is a keyindicator of a country’s willingness and abilityto implement disciplined fiscal policies, andthus will allow tentative conclusions regardingthe sustainability of fiscal convergence afterthe introduction of a single currency in theGCC. Defining appropriate criteria for fiscalpolicy is thus crucial for assessing fiscalconvergence based on sound public finances. Abinding framework regarding fiscal policymight not only be beneficial in the run-up toGCC monetary union, but may prove to be evenmore important once the union has beenestablished. This could secure permanent fiscalconvergence with the objective of preventingpotential conflicts between national fiscalpolicies and a single monetary policy, as wellas any negative spillovers between memberstates of the union. Designing appropriatefiscal criteria is a specific challenge for theGCC as (i) in contrast to the monetary sphere,fiscal convergence among member states is lesspronounced (Chapter 4); and (ii) the oildependence of government budgets incombination with the volatility of oil revenueshas to be taken into account.


Against this background, general reflections onfiscal convergence criteria and fiscal rules witha view to a supranational monetary union mustbe complemented by a clear acknowledgementof the specific challenges for fiscal policy in oileconomies such as those of the GCC, as well astheir implications with regard to potentialfiscal convergence criteria.

5.5.1 GENERAL REFLECTIONS ON FISCALCONVERGENCE CRITERIA/FISCAL RULES

The case for fiscal rules in general, or, morespecifically, for fiscal convergence criteria inthe context of a supranational monetary union56,is primarily based on political economyconsiderations. Governments tend to have atendency to finance public expenditure via debtissuance to a greater extent than is warrantedfrom a purely economic point of view.57 Thisleaning towards excessive public deficits is dueto the intertemporal redistribution involved indeficit financing, which shifts part of the fiscalburden from present to future generations. Alarge body of economic literature providestheoretical and empirical evidence for this biasin favour of deficit financing.58 Most of thisliterature concerns countries with democraticpolitical systems, where elections, and theefforts of competing parties to win electoralsupport through expenditure-enhancing orrevenue-reducing fiscal measures, are thedriving force behind the deficit bias. Much lessis known about the political economy withregard to public deficits in political systemswhere there are no elections, or where electionsare not the ultimate source of political power andlegitimacy. While this topic is not analysed herein detail, there is sufficient evidence, not leastfrom GCC countries over the past two decades,to suggest that persistent and high fiscal deficitsand an accumulation of public debt are by nomeans phenomena confined to Western-styledemocratic political systems. As persistentdeficits lead to an accumulation of public debt,the deficit bias is intrinsically linked to the issueof debt sustainability.59

Fiscal rules can be seen as a tool to contain thedeficit bias of governments by limiting their

discretion with regard to specific parameters offiscal policy. They can act as a commitmentdevice to prevent short-sighted politicalconsiderations leading to excessive spendingand deficits. Thus, there is a general case forthe adoption of fiscal rules to limit the scope fordiscretion with regard to fiscal policy even inthe absence of a monetary integration process.This case is enhanced in the specificcircumstances of a supranational monetaryunion as envisaged by the GCC, where fiscalpolicy remains the prerogative of memberstates, as undisciplined national fiscal policiesmay impede a stability-oriented singlemonetary policy and have negative spillovereffects on the other members of the union.Against this background, fiscal rules constitutean institutionalised coordination mechanismintended to oblige countries to act responsiblywith regard to the impact of their fiscal stanceon area-wide economic variables.

A number of requirements for fiscal rules havebeen formulated:60

56 The term “fiscal rule” is used synonymously here with “f iscalconvergence criteria”, as the latter, particularly if they arepermanent criteria in a monetary union, have the same effectand fulf il similar functions as f iscal rules in a purely nationalcontext.

57 Financing public investment, tax smoothing and smoothingbusiness cycles are the major normative arguments proposedby economic theory in favour of budget def icits.

58 The seminal contribution on the def icit bias from a politicaleconomy point of view is that of Buchanan and Wagner (1977).Later literature has increasingly looked at specif ic features ofdemocratic systems that are particularly conducive toexcessive def icits, such as individual election systems and thedegree of political polarisation, etc. (see, for instance,Roubini and Sachs (1989), Grilli, Masciandaro and Tabellini(1991), Corsetti and Roubini (1993) and Alesina and Perotti(1995)). For a recent overview of the literature, seeSchuknecht (2004).

59 See Chalk and Hemming (2000) for concepts in debtsustainability and an overview of the issues involved.

60 See Kopits and Symansky (1998), who provide acomprehensive overview of fiscal policy rules and the majorpolicy issues involved. This overview, as well as thedeliberations in this section, are limited to quantitative rules –i.e. rules constraining one or several parameters of f iscalpolicy. As an alternative or complement to such quantitativerules, procedural and institutional rules may also help tofoster f iscal discipline. Such procedural and institutionalrules are for example often implemented to enhance thecontrol of the treasury over the budgetary process or tostrengthen the role of the Minister of Finance within thegovernment.

57ECB




FOR THE GCC

– A fiscal rule should be well defined withregard to the indicators to be constrained,the institutional coverage and potentialescape clauses.

– A fiscal rule has to be transparent,including accounting, forecasting andinstitutional arrangements.

– A fiscal rule should be adequate withrespect to the specified proximate goal.

– If there is a set of fiscal or othermacroeconomic rules, these rules have to bemutually consistent.

– A fiscal rule should be simple andunderstood by policymakers and the widerpublic.

– A fiscal rule should be sufficiently flexibleto accommodate exogenous shocks beyondthe control of the authorities.

– A fiscal rule should be enforceable andshould clarify the consequences of non-compliance.

The extent to which these requirements are metwill determine the overall credibility of thefiscal rule and its disciplining effects on fiscalpolicy. There are however some inevitabletrade-offs between the different requirements,most notably between simplicity andtransparency on the one hand, and flexibility onthe other. The more flexibly a rule is designedin order to accommodate for specific situations(i.e. the more room for interpretation anddiscretion is left open to policymakers – forinstance, via wide and open escape clauses),the less simple and transparent and, ultimately,the less credible the rule tends to be.61 From apolitical economy point of view, simplicityand transparency stand out as the mostcrucial attributes to be fulfilled by an effectivefiscal policy rule.62 However, there is alsoa case for flexibility in order, for instance,to accommodate business cycles, which isreinforced under the particular circumstance of

a monetary union. As member states aredeprived of using monetary policy and nominalexchange rate adjustments as a policy tool toaccommodate asymmetric shocks, fiscal policyis one of the few tools left in their hands tocounter such shocks. A temporary increase inthe deficit may therefore be warranted to limitthe fallout from a negative demand shockhitting a member state.

Furthermore, it has to be decided in a monetaryunion how far a single rule should be applied toall member states, or how far the rule itself orits application should be differentiatedaccording to specific features of the publicfinances in individual countries. A single “onesize fits all” rule, such as the same deficit-to-GDP ratio threshold for all member states, isclearly preferable from the point of view ofsimplicity and transparency, whereas a moredifferentiated approach may have economicmerit in view of different fiscal positions andfeatures. In the GCC context, for example, theissue arises of whether the same rule can beapplied to countries whose oil reserves willbecome exhausted over very different timehorizons. The design of a rule which is assimple and transparent as possible andsufficiently flexible at the same time iscertainly one of the crucial challenges facingpolicymakers in the GCC in view of theinevitable trade-off.

61 This trade-off between credibility and flexibility is not one-dimensional, however. An extremely rigid rule leaving noflexibility at all, such as one stipulating that a balanced budgetmust be maintained under any circumstances, would clearlyalso lack credibility.

62 Buchanan and Wagner (1977) postulate that: “First of all, it[the f iscal rule] must be relatively simple and straightforward,capable of being understood by members of the public. Highlysophisticated rules that might be fully understood only by aneconomists’ priesthood can hardly qualify on this accountalone. Secondly, an effective rule must be capable of offeringclear criteria of adherence and for violation. Both thepoliticians and the public must be able readily to discern whenthe rule is being broken.” Kopits and Symansky also identifytransparency as the most outstanding requirement of a usefulf iscal rule. Schuknecht (2004) makes the point that clarity andsimplicity of f iscal rules are particularly important in asupranational context, in which formal enforcement is limitedand the ability of the public and f inancial markets to monitorcompliance with the rules is even more important than in anational context.


Apart from fiscal rules addressing deficits,debt or expenditure, placing an explicitobligation on national governments not to baileach other out in the event of financial distressin a member state may contribute to fiscaldiscipline in a monetary union. Such a “no-bailout” clause would have to stipulate thatparticipating countries (and the supranationalunion) will not be held responsible for thepublic debt of any government should fundingdifficulties manifest themselves.63 If a bailoutamong members of the monetary union isexplicitly ruled out, this will tend to enhancefiscal discipline and avoid moral hazardproblems. It has sometimes been argued that acredible no-bailout clause in combination withan independent central bank might be asufficient institutional provision to ensurefiscal discipline in a monetary union throughmarket mechanisms.64 According to this view,unsound fiscal policies would result in highernational risk premia which, in the absence ofexchange rate risk in a monetary union and inthe presence of a credible no-bail out clause,would reflect the credit risk. Such risk premiawould discourage deviation from fiscaldiscipline by individual governments andprovide them with incentives to conductsustainable policies. While such marketdiscipline may definitely be helpful, it seemsimprudent to rely entirely on this mechanism toensure fiscal discipline. First, it is uncertainwhether financial markets are always in aposition to fully assess the country-specificcredit risk, and thus whether risk premia areappropriate. Second, a no-bailout clause maynot be fully credible in the eyes of the market,depending on the perceived political cohesionof a monetary union, and thus risk premiadifferentiation may remain limited. Third, evenif the risk premia are appropriate and the no-bailout clause is credible, it is far from certainthat governments will react to increasing riskpremia by reducing deficits, in particular ifthey have a short time horizon and facesignificant political pressure, such as anupcoming election. Thus a no-bailout clause isan additional tool to foster fiscal discipline, butshould not be relied upon entirely. Such a

provision may be useful as a complement tofiscal rules directly addressing deficits, debt orexpenditure, but cannot substitute them.

5.5.2 FISCAL POLICY CHALLENGES IN OILECONOMIES AND IMPLICATIONS FOR GCCCONVERGENCE CRITERIA

Fiscal policy in oil-producing countries facesspecific challenges related to the fact that oilrevenues are exhaustible, volatile, uncertainand largely originate from abroad.65 Thechallenges will tend to be greater the larger theshare of oil revenues is in the government’soverall revenues and the larger the oil sector isin the economy. Given the dominance of oil inthe GCC’s economies and public revenues, it isobvious that the specific features of oilrevenues must be taken into account in thedesign of any fiscal rule/convergence criteriafor these countries. The specific features of oilrevenues pose challenges in both the long andthe short term.

In the long term the challenge stems fromthe exhaustibility of oil reserves and concernsthe complex issues of sustainability andintergenerational resource allocation. To avoida sharp adjustment of fiscal policy once oilreserves are exhausted, and to secure nationalwealth for future generations, oil-producingcountries have to accumulate financial assetsduring the periods in which they produce oil.After the end of oil production, the revenuesfrom these assets can be used to replace oilincome and to maintain levels of expenditure.Oil wealth is thus gradually transformed intofinancial wealth, leaving the country’s overall

63 The EC Treaty contains such a no-bailout clause in Article103, which stipulates that “The Community shall not be liablefor or assume the commitments of central governments,regional or local or other public authorities, other bodiesgoverned by public law, or public undertakings of any MemberState […]. A Member State shall not be liable for or assume thecommitments of central governments, regional or local orother public authorities, other bodies governed by public law,or public undertakings of another Member State […].”

64 See for example Bishop, Damrau and Miller (1989) in thecontext of the establishment of EMU.

65 See Barnett and Ossowski (2002). The followingconsiderations are mainly based on their comprehensiveoverview and analysis of operational aspects of f iscal policyin oil-producing countries.

59ECB




FOR THE GCC

wealth unchanged and preserving it for futuregenerations. Intuitively, this reasoning isstraightforward and makes a strong case forpersistent overall fiscal surpluses toaccumulate assets.66 However, the challenge ofderiving concrete policy conclusions from thisway of reasoning and making them operationalmust not be underestimated. For example,estimating the oil wealth of a country, definedas the present discounted value of futureoil revenues, is surrounded by significantuncertainty regarding the underlyingassumptions, which supports a generallyconservative approach to fiscal policy.67

Uncertainty also prevails regarding the role ofthe government’s capital expenditure inpreserving overall wealth. In principle, it couldbe argued that capital expenditure and theaccumulation of physical assets could at leastpartially represent an alternative to theaccumulation of financial assets, therebyreducing the need for persistent fiscalsurpluses. However, the uncertaintiessurrounding the effects of capital expenditureon productivity, future output and governmentrevenues, and the well-known difficulties indistinguishing between capital expenditure andcurrent expenditure, are too great to draw anyclear-cut conclusions.68

The short-term challenge for fiscal policy inoil-producing countries stems from thevolatility and unpredictability of oil prices.Public finances are dependent on a volatilevariable that is largely beyond the authorities’control. This poses a challenge to bothmacroeconomic management and fiscalplanning. The volatility of oil prices, and hencegovernment revenues, tends to contribute to apro-cyclical pattern of government expenditureand abrupt changes in government spending,which may translate into macroeconomicvolatility and reduced growth prospects.Thus, there is a case for smoothing publicexpenditure in oil-producing countries, whichis further reinforced by the other potentialfiscal costs of volatile expenditure policies.69

In general, the planning of a fiscal stance bytargeting a particular level of the overall

budget balance is rendered difficult by oil pricevolatility.

Several countries which derive substantialexport and fiscal revenue from oil (or other non-renewable resources) have set up stabilisationand savings funds to deal with both the long-termand short-term challenges for fiscal policy. Thesavings function of such funds is meant toaddress the long-term issue of intergenerationalequity and fiscal sustainability by accumulatingassets, while the stabilisation function addressesthe short-term issues of fiscal planning andmacroeconomic stability by absorbing andinjecting revenue from/into the budget.70 More

66 See Alier and Kaufman (1999) who, based on an extension ofthe non-stochastic overlapping generation model, make thecase for persistent f iscal surpluses in an economy with non-renewable resources on intergenerational equity grounds.

67 There is uncertainty about the future path of oil prices, aboutoil reserves, and about the costs of extracting them. In the longrun, an extreme case to be considered could be technicalinnovations largely replacing oil as a primary energy source,or signif icantly enhancing eff iciency in the use of oil, whichwould greatly reduce the value of oil reserves or even makethem obsolete. Given such uncertainties, prudence in thedesign of f iscal policies is important, in particular from thepoint of view of long-term considerations. See, for instance,Bjerkholt (2003), who suggests a very conservative approach(a “bird-in-the-hand rule”) to counter the uncertainty of acountry’s oil wealth by limiting non-oil def icits to the returnon accumulated assets.

68 Instead of classifying capital expenditure as productivespending, whose effect on future revenues is indeed highlyuncertain and may therefore not theoretically underpin itsdef icit f inancing, capital expenditure may also be regarded asmore akin to spending on durable consumption. According tothis view, governments undertake capital spending notbecause capital is productive, but because government capitalprovides social benef its for many years. Barnett and Ossowski(2002) suggest that this view of capital spending may providea rationale for higher non-oil def icits.

69 During a period of rapidly rising expenditure, for example,these costs involve a reduction in the quality and eff iciency ofspending due to constraints in the administrative capacity orthe realisation of projects with little marginal value added anddiff iculties in containing and streamlining expenditurefollowing an expansion. In periods of rapidly decliningexpenditure, moreover, viable investment projects may beinterrupted.

70 See Fasano (2000) and Davis, Ossowski, Daniel and Barnett(2001) for a review of experiences with oil stabilisation andsavings funds. The latter stress that such funds, while posing anumber of problems in themselves, are not a substitute forexplicit f iscal policy decisions and a f iscal rule both tosmooth expenditure and to ensure long-term f iscalsustainability. Therefore, this section focuses on f iscal rules,rather than discussing whether, in addition to a rule, theestablishment of stabilisation and savings funds would bewarranted.


recently, it has been suggested that theunpredictability of oil prices and revenuesshould be dealt with by using market instrumentsto hedge oil market risks.71

In a monetary union among oil-producingcountries, as is the case with the GCC, both theshort-term and long-term challenges for fiscalpolicy need to be addressed through fiscalrules. The specific arguments for fiscal rules ina supranational monetary union as identifiedabove – avoiding negative spillovers and thepotential impediment of a single monetarypolicy – are relevant even in the short term, andnot only over a longer time horizon. At thesame time, it is obvious that any ruleaddressing short-term issues must becompatible with long-term sustainability. Afiscal rule which may be sufficient to containpressures from deficits in the short term, butwould nevertheless lead to deteriorating publicfinances in the long term, would not beplausible from the point of view ofsustainability.

The specific challenges for fiscal policy in oil-dominated economies have implications for thechoice of the appropriate fiscal indicators thathave to be taken into account in the design ofconvergence criteria. For instance, in the GCCcontext the overall nominal deficit, andaccordingly also the deficit-to-GDP ratio, hasto be interpreted with even greater caution thanin industrialised economies, and cannot beconsidered a reliable indicator of the course offiscal policy.72 In a period of rising oil prices,for example, the deficit-to-GDP ratio maydecline in spite of expansionary fiscal policiesfeaturing expenditure increases or a reductionin non-oil revenue. Higher oil revenues (andthus higher oil GDP) would mask the fiscalexpansion. Conversely, in a period of fallingoil prices, the deficit-to-GDP ratio may rise inspite of budgetary consolidation in the form ofexpenditure reductions and an increase in non-oil revenue. An assessment of the underlyingfiscal policy stance on the basis of the overalldeficit could therefore be misleading. As thedebt-to-GDP ratio is strongly influenced by the

overall deficit as well as by the impact of oilprices on GDP, this indicator is also affected byoil price developments, which may obscure theeffects of the underlying course of fiscal policyon the debt level. Thus, the two fiscalindicators laid down in the Maastricht Treaty,while providing important information, cannotbe deemed sufficient to monitor and assessfiscal developments in the GCC member states.Accordingly, basing quantitative targets/reference values on an unqualified deficit-to-GDP ratio would be highly problematic, andcould even exacerbate and institutionallyenshrine a major problem of public finances inoil economies, namely pro-cyclical behaviour.

Oil price-related deficit-to-GDP ratioRelating the overall balance-to-GDP ratio tospecific oil price levels might point a way outof this dilemma. Such a link could beestablished by identifying a reference range forthe overall balance-to-GDP ratio to beachieved if the oil price is within a specifiedreference range or close to a specified referenceprice. In view of the long-term considerationsof fiscal sustainability in oil-producingeconomies as outlined above, the target overallbalance-to-GDP ratio under “normal” oil priceconditions should be positive to allow for therequired accumulation of assets. Accordingly,a common reference oil price or a reference oilprice range would also need to be defined. Thiscould for instance be a long-term equilibriumoil price derived from past developments. If theoil price is below the specified reference range,budget balance-to-GDP ratios below thetargeted reference range could be tolerated.Conversely, if the oil price is above thespecified reference range, budget balance-to-GDP ratios above the reference range would beexpected.

71 See Daniel (2001), who acknowledges, however, that theinstitutional framework for such markets is not yet fullydeveloped and that it does not represent a solution for large oilproducers.

72 In GCC countries, developed tax systems and unemploymentinsurance schemes do not exist so far. Therefore automaticstabilisers do not at present play a role in GCC economies, andaccordingly do not deserve specif ic attention, unless theirimpact on the overall balance increases in the process ofeconomic diversif ication.

61ECB




FOR THE GCC

An oil price-related overall budget balance-to-GDP ratio would be a relatively simple andtransparent indicator and would at the sametime eliminate the main weakness in oileconomies of an unqualified overall balance-to-GDP ratio. Nevertheless, several caveatshave to be taken into account:

– It is difficult to identify an appropriatereference range for the overall balance-to-GDP ratio that is consistent with an oil pricereference range. In the same vein, definingand agreeing an appropriate commonreference oil price or even a reference rangefor oil prices is not a simple task given thesignificant uncertainties surrounding oilprice developments. Thus, the frameworkmay have to be reviewed frequently, inparticular when developments in oilmarkets change rapidly.

– Oil revenues not only depend on oil prices,but also on production levels. Therefore,the overall balance-to-GDP ratio is not onlyinfluenced by oil price fluctuations, butalso by variations in oil production in acountry. This could be taken into accountwhen assessing the development of theoverall balance-to-GDP ratio, but would atthe same time make interpretation morecomplex and thus reduce the indicator’sappeal.

– If automatic stabilisers were to develop inthe process of economic diversification,their impact on the overall balance wouldhave to be taken into account.

The primary non-oil balance/non-oilGDP ratioAlternatively, an indicator which insulates thebudget balance from oil price developments isthe non-oil deficit/surplus. This is defined asgovernment revenue excluding oil revenueminus government expenditure, from whichoil-related expenditure is deducted (assumingsuch expenditure exists, is significant and canbe clearly delineated). The non-oil deficit is notaffected by changes in oil revenues resulting

from movements in oil prices (or in oilproduction), but is influenced by variations inexpenditure or in non-oil revenues. Therefore,it could be an indicator of the underlying courseof fiscal policy in oil-producing countries.Information may for instance be extracted fromyear-on-year percentage changes in the non-oildeficit. The non-oil deficit-to-GDP ratio is alsoan important source of information, but withone crucial caveat. Total GDP movements inoil-producing countries are usually heavilyinfluenced by oil price developments (andvariations in oil production). The non-oildeficit-to-GDP ratio may therefore decline,signalling a consolidation effort, even thoughexpenditure has been increased or non-oilrevenue lowered. Such a decline in the non-oildeficit-to-GDP ratio may be triggered by asignificant increase in total GDP due to anincrease in oil GDP following an oil price hike.This could mask the relaxation of fiscal policy,and thus may send a misleading signal. It maytherefore be preferable to look at the non-oildeficit/non-oil GDP ratio to obtain informationon the course of fiscal policy, and to comparefiscal developments in different countries.Furthermore, if a stock of debt or financialassets exist and generate interest payments orrevenues, the primary non-oil balance/non-oilGDP is a more refined indicator of fiscal policyto determine whether or not a fiscalconsolidation or expansion has taken place.The primary non-oil balance is then moreappropriate, as declining interest payments orrising asset revenues could for example mask afiscal relaxation.73

73 See Barnett and Ossowski (2002). They illustrate, using theexample of a hypothetical oil-producing country, how theoverall balance and the non-oil balance and their respectiveratios vis-à-vis total GDP and non-oil GDP react in the eventof a stylised oil price variation. Barnett and Ossowski alsogive reasons why the primary non-oil balance is the mostappropriate indicator of f iscal policy from the long-termperspective of sustainability and intergenerational equity. Inprinciple, these issues boil down to choosing a primary non-oil def icit that is consistent with f iscal sustainability.


Notwithstanding the benefits of this indicatoroutlined above, some caveats also have to betaken into account:

– It is far from easy to identify an appropriatereference level for the (primary) non-oilbalance/non-oil GDP ratio, and at the outsetdefining a realistic path to achieve thatlevel.

– The share of non-oil revenues in the budgetsof GCC countries is small. A sub-balanceexcluding oil revenues (and oil GDP) maybe seen as a highly “artificial” indicator,given the importance of oil in GCCeconomies. Furthermore, the non-oildeficit/non-oil GDP ratio is inevitably high,and the disclosure of such a high deficitratio may have unwarranted effects from apsychological and confidence point ofview. In this context, it would be necessaryto explain that this is primarily a technical,auxiliary measure to capture thediscretionary fiscal impulse.

– It might be technically difficult todifferentiate non-oil revenues from oilrevenues, and oil GDP from non-oil GDP ina meaningful way. However, it should bekept in mind that in industrialisedcountries, cyclically adjusted deficits servea similar purpose as the non-oil balance inoil-dominated economies. They are aimedat insulating the overall deficit measurefrom purely cyclical influences andindicating the underlying fiscal policystance. Calculating cyclically adjusteddeficits is complex and entails a high degreeof methodological uncertainty, butnevertheless does serve the useful purposeof assisting in the interpretation of overalldeficit developments. In a similar vein, itmay be useful to make an effort to overcomepossible difficulties in deriving ameaningful non-oil balance.

Combining several indicatorsA fiscal framework in the GCC could also bebased on more than one indicator, in particular

given the intricacy of fiscal policy in oileconomies. For instance, developments in anoil-price-related overall balance-to-GDP ratioas outlined above could be combined with andcross-checked by the primary non-oil balance.Thus, the framework would not rely on just oneindicator, thereby reducing the uncertaintieswhich may appear, for instance, with regard tothe calculation of the primary non-oil balance/non-oil GDP ratio or in interpreting oil-price-related developments in the overall balance. Afurther element could be a close monitoring ofand target for debt (asset)-to-GDP ratios.Identifying a target for this indicator and a pathto achieve the target could be beneficial, giventhe importance of debt (asset)-to-GDP ratiosfor the long-term sustainability of fiscal policyin GCC countries.

The advantage of the explicit use of acombination of indicators is that fiscaldevelopments can be cross-checked before anyconclusions are drawn regarding the stance offiscal policy. However, this advantage comesat the expense of simplicity and transparency,pointing to the inevitable trade-off mentionedabove. Furthermore, the consistency ofquantitative targets and reference values, if setfor more than one indicator, must be ensured.

63ECB


6 ISSUESRELATING TO THE

ESTABLISHMENT OFA SUPRANATIONAL

GCC MONETARYINSTITUTION

6 ISSUES RELATING TO THEESTABLISHMENT OF A SUPRANATIONALGCC MONETARY INSTITUTION

There are several key institutional issues thathave to be addressed prior to the introduction ofa single currency in the GCC. The first sectionof this chapter briefly explains that monetaryunion requires a single monetary and exchangerate policy, which has to be underpinned by asupranational monetary institution at the GCClevel. The following section discussespotential degrees of centralisation/decentralisation in such an institution withregard to crucial aspects of monetarypolicymaking. The final section reviews anumber of further key issues which have to betaken into account in the design of a GCCmonetary institution.

The main finding of this chapter is that a singleGCC currency inevitably requires theestablishment of a supranational monetaryinstitution, in which decision-making on asingle monetary and exchange rate policy iscentralised. As far as other crucial aspects ofmonetary policymaking – analysis,implementation and communication – areconcerned, a division of labour between thesupranational institution and the nationalmonetary agencies and central banks ispossible, while taking into account certainrequirements regarding centralisation in theseareas as well.

6.1 THE NEED FOR A SINGLE MONETARY ANDEXCHANGE RATE POLICY ANDCENTRALISED DECISION-MAKING IN ASUPRANATIONAL INSTITUTION

A GCC monetary union with a single currencyrequires a single monetary policy and a singleexchange rate policy. A mere coordination ofnational monetary policies by national centralbanks is not sufficient to sustain a monetaryunion with a single currency, given theindivisibility of monetary policy and the factthat a monetary union is more than just a tightexchange rate arrangement. A single monetary

policy must be guided by economic, monetaryand financial conditions in the monetary unionas a whole. This implies that decisions onmonetary policy will be based on objectives forthe monetary union as a whole and on data forthe single currency area, such as the averageinflation rate, and that they will be reflected ina single set of interest rates that influence asingle money market. A single monetary policycannot address national or regionaldevelopments. If economic developments inone member state diverge from the unionaverage, such divergent developments have tobe addressed by policies that remain in thecompetence of national governments, such asfiscal policy or structural policies.

The requirement of a single monetary policyhas far-reaching consequences for theinstitutional framework in which monetarypolicy is formulated and implemented.Conceptually it is important to distinguishbetween four crucial dimensions of monetarypolicymaking: the analysis of economic,monetary and financial developments as a basisfor monetary policy decisions, the decision-making itself, the implementation of monetarypolicy decisions, and their communication tothe public. Monetary policy decisions have tobe centralised at the supranational level, whichrequires the establishment of a supranationaldecision-making framework. Supranationalityimplies that in such a decision-making body,members act in their personal capacity ratherthan as representatives of their respectivemember states. By contrast, the analysis,implementation and communication ofmonetary policy leave some room fordecentralisation, and the appropriate degree ofcentralisation/decentralisation has to beidentified in view of regional circumstances.Accordingly, the key issues arising for theGCC regarding the institutional design of themonetary policy framework are (i) theappropriate format for taking supranationalmonetary policy decisions in a centralisedframework, plus the shape of the supranationalmonetary institution; and (ii) its relationshipwith national monetary authorities, including


the degree of centralisation/decentralisation inmonetary policy analysis, implementation andcommunication.

While there are different options with regard tothe composition of the decision-making bodyconcerning the level at which its members areappointed – i.e. the supranational or nationallevel – a single GCC monetary policy willinevitably require centralised decision-makingin a supranational body. An effectiveinstitutional framework for monetary policymust permit swift decision-taking ifcircumstances so require. Such decisions mayhave to be taken by majority vote if unanimitycannot be reached. The search for a broadconsensus has its merits in decision-making onmonetary policy, and thus the decision-makingprocess may, in essence, be consensus-driven.However, it is crucial that formal proceduresare in place in order to reach timely andefficient decisions in situations which wouldotherwise result in deadlock. It would thereforenot be appropriate for monetary policydecisions to require unanimity. This implies awillingness to accept majority decisions thatgoes considerably beyond the typicalintergovernmental approach to integration.

Therefore, a GCC monetary union and theestablishment of a supranational monetaryinstitution will require a significant transfer ofnational sovereignty to the supranational levelin the area of central banking, notwithstandingthe variety of approaches that can be followedconcerning the division of labour between asupranational monetary institution and nationalcentral banks in other areas, such as the analysis,implementation and communication ofmonetary and exchange rate policy (see nextsection). This implies that full monetaryintegration – with the ultimate goal ofintroducing and managing a single currency –cannot be achieved and sustained effectively bya purely intergovernmental approach tointegration, in which national monetaryauthorities still have the ultimate say on theformulation of policies.

6.2 CENTRALISATION ANDDECENTRALISATION OF THE ANALYSIS,IMPLEMENTATION AND COMMUNICATIONOF MONETARY AND EXCHANGE RATEPOLICY

The degree of centralisation or decentralisationin the design of a future GCC monetaryinstitution is discussed here in relation to thosecrucial dimensions of monetary policymakingto which differing degrees of centralisation/decentralisation can be applied: analysis,implementation and communication.

6.2.1 ANALYSISMonetary policy decisions have to be based onthorough economic, monetary and financialanalysis. The degree of centralisation/decentralisation corresponds to the role of thesupranational monetary institution in providinganalysis for the members of the decision-makingbody to prepare the ground for monetary policydecisions. A policy geared to the requirementsof the monetary union as a whole can only bedevised if decision-makers are provided withthorough analysis focusing on the singlecurrency area as a whole. This cannot beachieved without a coherent source of analysis.A coherent view of the single currency arearequires a “bird’s eye view” and is more thanpurely a compilation and addition of analyses ofnational developments. Such a bird’s eye viewfree from national bias requires a supranationalmonetary institution that is entrusted with theanalysis of union-wide developments andendowed with the necessary resources. At thesame time, a complementary, decentralisedprovision of some analysis may entail benefits,including, for instance, competition betweenseveral centres of competence, a variety ofdifferent analytical perspectives and a betterunderstanding at the national level of localdevelopments and circumstances, which isparticularly valuable in a supranationalmonetary union in which there is significantheterogeneity between member states.

65ECB





6.2.2 IMPLEMENTATIONMonetary policy decisions can be implementedeither by the supranational monetaryinstitution alone or by the national centralbanks, or there can be a division of labourbetween them regarding different aspects ofpolicy implementation. The greater the role ofthe national central banks in policyimplementation, the higher the degree ofdecentralisation. The scope for decentralisedimplementation is however limited by theinevitable requirement of having a singlemoney market with identical liquidityconditions throughout the monetary area. Thisimplies that monetary operations are executedon uniform terms and conditions in all memberstates of the monetary union. This uniformityof monetary operations and thereby thesingleness of the money market must beensured by clear instructions on monetaryoperations from the supranational level.

6.2.3 COMMUNICATIONAs with policy implementation, the task ofcommunicating monetary policy to publicauthorities, financial markets and the generalpublic can be assigned to the supranationalmonetary authority alone, or shared betweenthe supranational and national levels, or left tothe latter. In any case, it is crucial to ensure thata coherent and consistent policy message issent throughout the single currency area,avoiding conflicting signals from differentnational central banks and theirrepresentatives. The need to ensure theconsistency of policy messages has to bebalanced by comparative advantages at thenational level with regard to communication.Notably, national central banks tend to becloser to their respective publics and thereforecould contribute to an effectivecommunication.

In a GCC-wide monetary framework, theappropriate degree of centralisation/decentralisation would also depend to someextent on the type of monetary and exchangerate policy the GCC intends to pursue once thesingle currency has been introduced. A fixed

exchange rate peg as an external anchor formonetary policy, for instance, is lessdemanding, in particular with regard to theanalysis and communication of monetarypolicy, than an autonomous monetary policywith an internal anchor. Accordingly, if it isintended to peg the new GCC single currency tothe US dollar (or any other currency), and thusto continue the exchange rate regime in placeprior to monetary union, a more decentralisedinstitutional framework would be conceivable.Nevertheless, even in such a case, the minimuminstitutional requirements for a functioningsingle currency would have to be met from thebeginning of monetary union by sufficientlycentralising competencies in a newsupranational institution. In particular, theinstitutional centralisation of decision-makingis inevitable. The historical experience withhighly decentralised central banks, which havetypically undergone some centralisationprocess in the course of their history, quiteclearly points to the potential problems ofoverly decentralised frameworks in the area ofmonetary policy.74

Two specific aspects of the GCC facilitate theinstitutional design of a supranationalmonetary institution as compared with the EU,for example. First, the relatively small numberof monetary agencies and central banks doesnot pose a problem regarding the potential sizeof a decision-making body even if it were tocomprise, for instance, all six Governors of theGCC monetary agencies and central banks plusan approximately equal number of membersappointed in a supranational context.Similarly, cooperation among only sixmonetary agencies and central banks can beimplemented relatively easily. Second, the factthat the GCC member states share a common

74 Past examples of such highly decentralised central banks arethe early Federal Reserve System in the US, from itsestablishment in 1913 until the Banking Act of 1935, and theFederal Republic of Germany’s Bank deutscher Länder (Bankof German Federal States). The latter was the predecessor ofthe Bundesbank, which was not established until 1957, eightyears after the foundation of the Federal Republic. SeeMeltzer (2003) and Goodfriend (1999) on the history of theearly Federal Reserve System, and Buchheim (1998) on theBank deutscher Länder.


language will greatly facilitate thecommunication of a single monetary policy,making it easier for the supranational monetaryauthority to directly communicate with therespective publics.

6.3 OVERVIEW OF FURTHER KEY ISSUES TOBE CONSIDERED IN THE DESIGN OF A GCCMONETARY INSTITUTION

A number of additional issues have to beaddressed regarding the institutional design ofa new GCC monetary institution. Thefollowing list is far from exhaustive, but aimsto highlight key issues.

6.3.1 MANDATEIt is crucial that a GCC supranational monetaryinstitution is provided with a clear,unambiguous mandate that clarifies theprimary objective of the institution, and avoidsthe institution being overburdened withobjectives which it either cannot sufficientlyaccomplish with the tools at the disposal of acentral bank, or which may at times beconflicting.75 Furthermore, the mandates of themonetary agencies and central banks of GCCmember states need to be compatible with thatof the supranational institution to avoiddiffering mandates becoming a source ofconfusion and friction.

6.3.2 INDEPENDENCEBoth central bank practice and academicresearch provide ample evidence that centralbank independence is essential for monetarystability.76 Against this background, a trendtowards granting central banks independencefrom political authorities can be observedworldwide in recent decades.77 The decision onthe degree of independence granted to thecentral bank is ultimately a political one to betaken by the relevant authorities in the GCC,against the background of their historicexperience and their political systems. A broadconsensus on the status of a GCC monetaryinstitution and its relations with politicalauthorities at the GCC level and the nationallevel prior to the establishment of a monetary

union would reduce the risk of conflicts lateron. Furthermore, the agreed level ofindependence is to be granted to all centralbanks in order to provide monetary stability,and to avoid institutional incompatibilitiesbetween a supranational institution andnational monetary agencies and central banks.

6.3.3 PROVISIONS ON MONETARY FINANCINGThe prohibition on monetary financing preventspublic bodies from funding themselves in apotentially inflationary, non-market-orientedmanner.78 As a central bank can only be trulyindependent if it cannot be obliged to extendcredit to the government, this may be referred toas “economic independence”. Given thatprovisions with regard to monetary financingcurrently differ between GCC monetaryagencies and central banks, these would have tobe harmonised.

6.3.4 LEGAL ISSUES CONCERNING THEORGANISATIONAL STRUCTURE

A number of legal issues have to be addressedconcerning the organisational structure of aGCC monetary institution, including (i) thetasks of the supranational institution (whichwould have to be clearly defined and delineated

75 The ECB’s mandate, which singles out one overridingobjective, to maintain price stability, is an example that isclear and unambiguous in this respect. Art. 105 of the Treatystipulates: “The primary objective of the ESCB shall be tomaintain price stability. Without prejudice to the objective ofprice stability, the ESCB shall support the general economicpolicies in the Community with a view to contributing to theachievement of the objectives of the Community […]”.

76 See for example Parkin (1987), Grilli, Masciandaro andTabellini (1991), and Alesina and Summers (1993).

77 The predecessor of the ECB, the EMI, established a number ofcriteria against which the concept of central bankindependence can be assessed in concrete terms. Thesecriteria apply to functional independence, institutionalindependence, personal independence and f inancialindependence. See EMI (1996b).

78 To prevent the ECB or national central banks extending creditto the government, which would undermine their ability toachieve the primary objective of price stability, Article 101 ofthe Treaty stipulates: “Overdraft facilities or any type ofcredit facility with the ECB or with the central banks ofMember States […] in favour of Community institutions orbodies, central governments, regional, local or other publicauthorities, other bodies governed by public law, or publicundertakings of Member States shall be prohibited, as shallthe purchase directly from them by the ECB or national centralbanks of debt instruments.”

67ECB





from those of the national central banks); (ii) theownership of the supranational institution(whether it is owned by the national centralbanks or vice versa, or whether another option isavailable); (iii) the determination of theinstitution’s budget (whether the supranationalinstitution’s budget is determined by thenational central banks, or it has control over thebudgets of the national central banks); and(iv) the legal personality of the supranationalinstitution. However, the answer to thesequestions does to a great extent depend onthe preferred degree of centralisation/decentralisation as outlined above, as well as thelegal traditions in the region.

6.3.5 DISTRIBUTION OF SEIGNIORAGEA decision has to be taken on how to distributethe seigniorage generated by the performanceof the monetary policy function. The twoprincipal options are (i) to assign revenue to thesupranational level (assuming a single legalissuer of the currency), or (ii) to distribute it tonational monetary agencies and central banksaccording to a key that would have to be agreedby member states (assuming the nationalmonetary agencies and central banks are toremain legal issuers of the single currency).Any provision in this regard may haveredistributive effects between member statesand could affect their national budgets.

6.3.6 MONETARY POLICY INSTRUMENTS ANDPROCEDURES

A single monetary policy requires monetarypolicy operations to be executed on uniformterms and conditions in all member states of themonetary union. Therefore, GCC member stateshave to agree on a common set of monetarypolicy instruments and procedures, whichtogether would form the operational frameworkof the GCC monetary institution. It is crucialthat these instruments are designed and agreedupon prior to the start of monetary union, toensure that they can be applied smoothly fromday one of the single currency. While there hasbeen a general trend in GCC countries awayfrom direct and towards indirect, market-basedinstruments, differences between monetary

policy instruments applied by the GCCmonetary agencies and central banks still exist.A starting point for work on a common set ofmonetary policy instruments could be athorough review of instruments used by GCCmonetary agencies and central banks today,including an assessment of experiences madewith different instruments so far.

6.3.7 FOREIGN EXCHANGE RESERVESAn agreement has to be reached about controlover and management of foreign exchangereserves. Reserves can be transferred eithertotally or partially to the supranationalinstitution, or left in the hands of the nationalcentral banks. The extent to which reserves aretransferred to the GCC monetary institution orleft with the national central banks will mainlydepend on the desired degree of centralisation/decentralisation as described above, inparticular with regard to policy implementation.If, for instance, the supranational monetaryinstitution is assigned the task of executinginterventions on the foreign exchange market, itmight be preferable for it to command part of thereserves directly. While the question of whomanages and administers foreign exchangereserves is of a more technical nature, it is ofgreat importance that the GCC monetaryinstitution and its decision-making body haveeffective control over the use of foreignexchange reserves if they remain with thenational central banks, and that thesupranational institution is in a position toinfluence large foreign exchange transactionsundertaken by other public bodies in the memberstates, which might impact the single exchangerate policy. Only by exercising effective controlover the use of reserves of all member states canthe supranational institution pursue a coherentexchange rate policy and prevent transactions byindividual national central banks or other publicbodies contravening its exchange rate policy.

6.3.8 PAYMENT SYSTEMSMonetary union requires the provision of safeand reliable monetary area-wide mechanismsfor the settlement of payments and securitiestransactions in the single currency. The


existence of such mechanisms is a crucialprecondition for a smooth execution of a singlemonetary policy by ensuring that liquidityconditions are identical throughout themonetary union. In this context, a well-functioning area-wide payment systemoffering settlement in central bank money isnecessary in order to guarantee the singlenessof the money market. Area-wideinfrastructures for the handling of large-valueand retail payments and securities transactionsare vital not only for the overall efficiency ofthe economic system, but also because theyfacilitate economic and financial integration ina more general sense. A first step towardsdeveloping the necessary infrastructures couldbe to define the requirements to be compliedwith by these infrastructures and to conduct athorough review of the payment and securitiessettlement systems currently in place for thehandling of transactions within and betweenGCC member states.

6.3.9 STATISTICSThe need for high quality statistics has alreadybeen highlighted in the context of thediscussion on convergence criteria in the run-up to a monetary union (see Chapter 5). Incontrast to the statistical work required in thecontext of the convergence process, whichfocuses mainly on the availability, reliabilityand comparability of national data in order toreview economic convergence, the statisticalwork in view of the single monetary policy tobe conducted after the single currency has beenintroduced should be geared towards theprovision of area-wide statistics. The conductof a single monetary policy requires theavailability of a rather wide range of statisticscovering the monetary union as a singleeconomy, in particular in the areas of the priceindex, economic developments, money andbanking, interest rates, exchange rates, balanceof payments, and the international investmentposition and financial accounts statistics. Stepstowards the harmonisation of concepts and thepreparation of appropriate aggregation andconsolidation methods have to be taken in goodtime prior to the start of monetary union. Their

implementation in all prospective participatingcountries has to start sufficiently far inadvance, as it generally involves a significantlead time.

6.3.10 BANKING AND FINANCIAL MARKETREGULATION AND SUPERVISION

Integrated banking and financial markets arecrucial in a monetary union in order to reap thefull benefits of a single currency and tofacilitate the smooth conduct of a singlemonetary policy. The European experiencesuggests that the full integration of banking andfinancial markets does not followautomatically from the introduction of a singlecurrency, but has to be spurred on by furtheraction based on explicit political decisions. Asa minimum requirement for a monetary union,GCC member states need a common set ofharmonised legislation on banking andfinancial market regulation. Furthermore, theyhave to find solutions to ensure effectivesupervision of cross-border financial groups ina monetary union. It has to be decided whetherthe model for banking supervision in the GCCwould necessarily be the same as theinstitutional model to be envisaged formonetary policy, or whether a differentinstitutional set-up is preferable.

In the area of banking and financial marketsupervision, three issues have to be addressedin principle in the context of the GCC monetaryunion: (i) whether supervision should beassigned to the national level or the GCC level;(ii) whether supervision should be the task ofcentral banks or specific supervisoryinstitutions; and (iii) whether one institutionshould be assigned comprehensive supervisoryauthority over banks and financial markets, orwhether there should be specialisedsupervisory institutions for different financialsectors.

If supervision basically remains a nationaltask, it has to be ensured that effective fora andmechanisms of information exchange andcoordination of supervisors in all financialsectors are established. Such arrangements

69ECB





would be necessary to ensure adequateconvergence of supervisory practices and toaddress issues which may impact on thefinancial stability of the single currency area asa whole. Turning to the role of central banks inbanking supervision, there seems to be a casefor strong involvement in the GCC context as(i) all GCC monetary agencies and centralbanks are responsible for banking supervision,and (ii) financial intermediation in the GCC ismainly conducted via banks, with financialmarkets only playing a secondary role to date.Given the expertise of GCC monetary agenciesand central banks in banking supervision, itwould seem natural for a GCC monetaryinstitution to play a significant role in thecoordination of banking and financial marketsupervision at the GCC level. In addition,strong involvement on the part of central banksand monetary agencies would acknowledgetheir specific expertise in the area of financialstability.

6.3.11 INTERNATIONAL REPRESENTATIONAn issue to be addressed prior to theestablishment of monetary union is therepresentation of the single currency area at theinternational level, in particular inorganisations and fora dealing with monetary,financial and economic issues, such as the IMF,the G20 (of which Saudi Arabia is a member),and, in the specific case of the GCC countries,the AMF. The respective roles of a GCCmonetary institution, the Committee forFinancial and Economic Cooperation (and itsChairman) and the GCC Secretariat General inrepresenting the monetary union at theinternational level would have to be clarified. Ithas to be taken into account in this context thatthe statutes of international organisationsusually foresee the membership of nationstates. The appropriate representation of asupranational monetary union, which iswarranted by the nature of the monetary,financial and economic issues dealt with in therespective institutions, may therefore requirespecial arrangements.79

6.3.12 TIMING AND SEQUENCING OF THEESTABLISHMENT OF A GCC MONETARYINSTITUTION

A supranational GCC monetary institution willhave to be fully operational as from the day onwhich the single currency is introduced.Therefore it is crucial to take into account thelead times required to set up the institution,including, for instance, the analytical agendathat has to be addressed and testing theoperational framework. The Europeanexperience suggests that the preparation formonetary union and the ultimate set-up of asupranational central bank are greatlyfacilitated if a predecessor institution, such asthe EMI in the case of the EU, is set up early onin the process of monetary integration. Apredecessor institution can serve as theinstitutional nucleus out of which thesupranational central bank evolves, and play acentral role in the analytical and technicalpreparation for the monetary union. Forinstance, a predecessor institution could takethe lead in making preparations for the issuanceof new banknotes, an area which requirescareful consideration and sufficient lead times.It can also help to address any credibilityconcerns, which could arise if thesupranational institution faced the task ofbuilding itself up from scratch (possibly havingto overcome difficulties on the way) beforebeing put in charge of conducting the singlemonetary and exchange rate policy.

79 An example of such an arrangement is the ECB observer at theIMF, who, for instance, participates in meetings of the IMFExecutive Board concerning Article IV consultations with EUMember States and candidate countries and in a number ofmeetings concerned with global economic and financialdevelopments.


7 FINAL REMARKS

This paper has looked at key economic andinstitutional aspects of the envisaged GCCmonetary union. Introducing a single currencyin the member states of the GCC is an objectivewhich is supported by the region’s commonhistory and language, the relative homogeneityof its political systems and traditions and, mostimportantly, the similarity of economicstructures among the member states. Despitedifferences between member states, thesestructures remain largely dominated by theproduction of oil and gas. In their endeavour toachieve a single currency by 2010, GCCcountries can also build on a considerabledegree of monetary convergence over recentdecades, which is reflected in a high degree ofexchange rate stability, generally low inflationrates and co-moving interest rates. The processof monetary integration is embedded in acomprehensive project for economicintegration which, after the establishment of afree trade area and a customs union in 2003,aims at the completion of a common market by2007. However, it has to be borne in mind thatso far the level of economic integration (asreflected in the level of intra-GCC trade, forexample) has been relatively limited. Besideslegal and regulatory barriers to closerintegration, which should be eliminated in thecourse of the integration process, the similarfactor endowment of the region represents astructural factor that limits economicintegration.

Against this background, the macroeconomiccosts of introducing a single currency in termsof relinquishing autonomous monetary andexchange rate policies seem to be limited. Thisview is supported by the fact that GCC memberstates in recent decades have not had to resort tothis adjustment instrument to deal with theconsequences of asymmetric shocks. At thesame time, the economic benefits of a monetaryunion in terms of the elimination of transactioncosts could be less significant than in the euroarea for instance, as intra-regional integrationin the GCC is relatively low, and exchange rate

risks seem to be small under the presentcircumstances. Notwithstanding the latter,however, a monetary union could result insignificant gains, for example in the area offinancial markets, where a single currencycould spur the development of more liquid anddeeper financial markets. In the same vein, asingle currency could facilitate non-oil tradebetween GCC member states and therebyfurther the objective of policymakers in theregion to diversify their economies. Finally,monetary union could be the catalyst for thedesign of a multilateral, stability-orientedmacroeconomic framework for GCC memberstates, which maintains monetary stability andpromotes the fiscal discipline that is necessaryto underpin monetary stability and to ensurefiscal sustainability in the long term.

The analysis in this paper has pointed to somekey issues that have to be addressed by the GCCin order to lay the groundwork for a credibleand sustainable monetary union:

– Deepened economic integration wouldincrease the potential benefits andminimise the costs of the envisaged singlecurrency. While the agenda that has beenset in this regard by the GCC seems to becomprehensive and well-sequenced, theeffective and smooth implementation of theplanned stages of integration will be key tounderpinning a monetary union.Furthermore, the integration process mayhave to be accompanied by a strengtheningof supranational GCC institutions to theextent that it requires not only thecoordination of national policies, but alsothe pursuit of common policies.

– Prior to monetary union, the GCC faces thechallenge of designing an appropriate set ofconvergence criteria, taking into accountthe specific situation of the region and theinevitable policy choices involved inestablishing such criteria. Monetarycriteria could be used to monitor whetherthe high degree of monetary convergencealready achieved by GCC member states is

71ECB


7 FINALREMARKS

maintained up to the introduction of thesingle currency. Fiscal criteria would becrucial in fostering fiscal convergenceamong member states on the basis of soundpublic finances, where significantdifferences still exist. They would have totake into account the specifics of fiscalpolicy in oil economies. Fiscal convergencehas to be ensured via a permanentframework for fiscal policy even after thesingle currency has been introduced. Such aframework is necessary to preventundisciplined national fiscal policies fromundermining a stability-oriented monetarypolicy and having unwarranted spillovereffects between member states. For ameaningful monitoring and assessment ofconvergence criteria, GCC member stateswill have to improve further their statisticaldata.

– The similarity of economic structures in theGCC, which is based on the dominance ofoil and gas and which in the past reduced therisk of asymmetric shocks and the need toresort to nominal exchange rateadjustments, may diminish in the future, asthe pace and direction of economicdiversification is likely to differ amongmember states. As a result, GCC countriesmight become more prone to asymmetricshocks. To absorb such shocks in amonetary union, alternative adjustmentmechanisms need to be in place, which is astrong argument in favour of economicreforms aimed at enhancing price flexibilityin product and factor markets in the GCC, inparticular in the labour market.

– As monetary union requires a singlemonetary and exchange rate policy, theGCC has to establish a supranationalmonetary institution to formulate andconduct such a policy. While differentmodels could be envisaged for the divisionof labour between such a supranationalcentral bank and the national central banksand monetary agencies, decision-making onmonetary and exchange rate policy has to be

centralised at the new institution. Thesingle monetary policy has to be geared toeconomic, monetary and financialconditions in the monetary union as awhole, which requires that thesupranational central bank also commandsufficient analytical resources. Such acentral bank has to be fully operational fromday one of monetary union, requiring timelypreparation.

Overarching these issues is the need for: (i) abroad consensus in the GCC on the basicorientation of monetary and exchange ratepolicy and other key areas of economic policy,in particular fiscal policy; and (ii) politicalcommitment to the economic integrationprocess in general, and the monetary unionproject in particular. Policy consensus iscrucial to avoid tensions once the singlecurrency has been introduced as well as tounderpin the credibility and sustainability ofthe monetary union. The political commitmentto the process has to be strong andunambiguous at the highest political level inorder to overcome obstacles or deadlock on theway to monetary union. At the same time, thepolitical commitment has to be an informedcommitment that fully takes into account theinevitable implications of monetary union. Inparticular, monetary union ultimately results inthe transfer of sovereignty from the national tothe supranational level in monetary affairs and,to some extent, needs to be accompanied byconstraints for government budgets, which areareas widely regarded as being at the core ofnational sovereignty.


8 BIBLIOGRAPHY

Al-Ahli (2003), Market Review & Outlook, Vol. 12, No 11, National Commercial Bank, 11 April.

Al-Awad, M. (1999), “Real Interest Rate Linkages in the GCC Countries”, Journal of EconomicIntegration, Vol. 14, No 3, pp. 363-381.

Alesina, A. and L. Summers (1993), “Central Bank Independence and MacroeconomicPerformance: Some Comparative Evidence”, Journal of Money, Credit and Banking, Vol. 25,No 2, pp. 151-162.

Alesina, A. and R. Perotti (1995), “The Political Economy of Budget Deficits”, IMF Staff Papers,Vol. 42, No 1, pp. 1-31.

Alier, M. and M. Kaufman (1999), “Nonrenewable Resources: A Case for Persistent FiscalSurpluses”, IMF Working Paper, No 99/44, Washington, D.C.

Arab Monetary Fund, Statistics, Economic Indicators, available at www.amf.org.ae

Barnett, S. A. and R. J. Ossowski (2002), “Operational Aspects of Fiscal Policy in Oil-producingCountries”, IMF Working Paper, No 02/177, Washington, D.C.

Berthélemy, J.-C. and N. Bentahar (2004), “Financial Reforms and Development in ArabCountries”, mimeo.

Bini-Smaghi, L., T. Padoa-Schioppa and F. Papadia (1993), “The Policy History of the MaastrichtTreaty: The Transition to the Final Stage of EMU”, The Monetary Future of Europe, CEPR,London.

Bishop, G., D. Damrau and M. Miller (1989), 1992 and Beyond – Market Discipline Can Work inthe EC Monetary Union, London: Salomon Brothers.

Bjerkholt, O. (2003), “Fiscal Rule Suggestions for Economies with Non-renewable Resources”,paper presented at the IMF/World Bank Conference on Rules-based Fiscal Policy in EmergingMarket Economies, Oaxaca, 14-16 February 2002.

Blackburn, K. and M. Christensen (1989), “Monetary Policy and Policy Credibility: Theories andEvidence”, in M. Parkin (ed.), The Theory of Inflation, Brookfield, VT: Edward Elgar,pp. 547-591.

Bourland, B. (2001), “GCC: Outward Investment Flows, Inward Investment Needs”, paperpresented at “The Middle East in London” conference, SOAS, London, 27 June 2001.

Buchheim, C. (1998), “Die Errichtung der Bank deutscher Länder und die Währungsreform inWestdeutschland”, Fünfzig Jahre Deutsche Mark – Notenbank und Währung in Deutschlandseit 1948, Munich: Deutsche Bundesbank, pp. 91-138.

Buiter, W. (2003), “How to Reform the Stability and Growth Pact”, Central Banking, Vol. XIII,No 3, February 2003, pp. 49-58.

73ECB


8 BIBLIOGRAPHY

Buchanan, J. M. and R. E. Wagner (1977), Democracy in Deficit – The Political Legacy of LordKeynes, New York: Academic Press.

Buti, M., D. Franco and H. Ongena (1997), “Budgetary Policies during Recessions: RetrospectiveApplication of the ‘Stability and Growth Pact’ to the Post-war Period”, European CommissionEconomic Papers, No 121, Brussels.

Chalk, N. (1998), “Fiscal Sustainability with Non-renewable Resources”, IMF Working Paper,No 98/26, Washington, D.C.

Chalk, N. and R. Hemming (2000), “Assessing Fiscal Sustainability in Theory and Practice”, IMFWorking Paper, No 00/81, Washington, D.C.

Corden, W. M. (1993), “European Monetary Union: The Intellectual Pre-history”, in TheMonetary Future of Europe, CEPR, London.

Corsetti, G. and N. Roubini (1992), “Tax Smoothing Discretion versus Balanced Budget Rules inthe Presence of Politically Motivated Deficits: The Design of Optimal Fiscal Rules for Europeafter 1992”, CEPR Discussion Paper, No 682, London.

Creane, S., R. Goyal, M. Mobarak and R. Sab (2004), “Financial Sector Development in theMiddle East and Northern Africa”, IMF Working Paper, No 04/201, Washington D.C.

Daniel, J. A. (2001), “Hedging Government Oil Price Risk”, IMF Working Paper, No 01/185,Washington, D.C.

Davis, J., R. J. Ossowski, J. A. Daniel and S. A. Barnett (2001), “Stabilization and Savings Fundsfor Nonrenewable Resources. Experience and Fiscal Policy Implications”, IMF OccasionalPaper, No 205, Washington, D.C.

Detken, C., V. Gaspar and B. Winkler (2004), “On Prosperity and Posterity – The Need for FiscalDiscipline in a Monetary Union”, ECB Working Paper, No 420, Frankfurt am Main.

DIW and IWH (2002), “Eine andere Meinung zum Europäischen Stabilitäts- und Wachs-tumspakt”, in “Die Lage der Weltwirtschaft und der deutschen Wirtschaft im Herbst 2002,Gemeinschaftsgutachten der Arbeitsgemeinschaft deutscher wirtschafts-wissenschaftlicherForschungsinstitute”, DIW Wochenbericht, No 43/2002, Berlin, pp. 752-756.

Dorrucci, E., S. Firpo, M. Fratzscher and F. Mongelli (2002), “European Integration: WhatLessons for Other Regions? The Case of Latin America”, ECB Working Paper, No 185,Frankfurt am Main.

Eifert, B., A. Gelb and N. Borje Tallroth (2002), “The Political Economy of Fiscal Policy andEconomic Management in Oil Exporting Countries”, World Bank Policy Research Paper,WPS 2899, Washington, D.C.

Engel, E. and R. Valdes (2000), “Optimal Fiscal Strategy for Oil Exporting Countries”, IMFWorking Paper, No 00/118, Washington, D.C.


European Central Bank (1999), “The Implementation of the Stability and Growth Pact”, MonthlyBulletin, May, Frankfurt am Main.

European Central Bank (2001), “The Economic Policy Framework in EMU”, Monthly Bulletin,November, Frankfurt am Main.

European Central Bank (2003), “The Relationship between Monetary Policy and Fiscal Policiesin the Euro Area”, Monthly Bulletin, February, Frankfurt am Main.

European Central Bank (2004), “Economic Integration in Selected Regions outside the EuropeanUnion”, Monthly Bulletin, October, Frankfurt am Main.

European Community (1989a), Report on Economic and Monetary Union in the EuropeanCommunity, Committee for the Study of Economic and Monetary Union, Luxembourg.

European Community (1989b), Collection of Papers Submitted to the Committee for the Study ofEconomic and Monetary Union, Committee for the Study of Economic and Monetary Union,Luxembourg.

European Monetary Institute (1996a), The Statistical Requirements for Monetary Union,Frankfurt am Main.

European Monetary Institute (1996b), Progress towards Convergence 1996, Frankfurt am Main.

European Monetary Institute (1998), Convergence Report, Frankfurt am Main.

Fasano, U. (2000), “Review of the Experience with Oil Stabilization and Savings Funds inSelected Countries”, IMF Working Paper, No 00/112, Washington, D.C.

Fasano, U. and Q. Wang (2001), “Fiscal Expenditure Policy and Non-oil Economic Growth:Evidence from GCC Countries”, IMF Working Paper, No 01/195, Washington, D.C.

Fasano, U. and Q. Wang (2002), “Testing the Relationship between Government Spending andRevenue: Evidence from GCC Countries”, IMF Working Paper, No 02/201, Washington, D.C.

Fasano, U. and Z. Iqbal (2002), “Common Currency”, Finance and Development, 39 (4),Washington, D.C.: IMF.

Fasano, U. et al. (2003), “Monetary Union among Member Countries of the Gulf CooperationCouncil”, IMF Occasional Paper, No 223, Washington, D.C.

Goodfriend, M. (1999), “The Role of a Regional Bank in a System of Central Banks”, FederalReserve of Richmond Working Paper, No 99-4, Richmond.

Grilli, V., D. Masciandaro and G. Tabellini (1991), “Political and Monetary Institutions andPublic Financial Policies in the Industrial Countries”, Economic Policy: A European Forum,6 (2), pp. 341-392.

75ECB


8 BIBLIOGRAPHY

International Monetary Fund (various years), Annual Report on Exchange Rate Arrangementsand Exchange Rate Restrictions, Washington, D.C.

Jadresic, E. (2002), “On a Common Currency for the GCC Countries”, IMF Policy DiscussionPaper, No 02/12, Washington, D.C.

Kopits, G. and S. Symansky (1998), “Fiscal Policy Rules”, IMF Occasional Paper, No 162,Washington, D.C.

Laabas, B. and I. Limam (2002), “Are GCC Countries Ready for Currency Union?”, ArabPlanning Institute Working Paper, No 0203, Kuwait City.

Liuksila, C., A. Garcia and S. Bassett (1994), “Fiscal Policy Sustainability in Oil-producingCountries”, IMF Working Paper, No 94/137, Washington, D.C.

Meltzer, A. (2003), A History of the Federal Reserve, Chicago: University of Chicago Press.

Mongelli, F. (2002), “‘New’ Views on the Optimum Currency Area Theory: What Is EMU TellingUs?”, ECB Working Paper, No 138, Frankfurt am Main.

Parkin, M. (1987), “Domestic Monetary Institutions and Deficits”, in J. M. Buchanan,C. K. Rowley and R. D. Tollison (eds), Deficits, New York: Basil Blackwell, pp. 310-337.

Roubini, N. and J. D. Sachs (1989), “Political and Economic Determinants of Budget Deficits inthe Industrial Democracies”, European Economic Review, No 33, pp. 903-933.

Schuknecht, L. (2004), “EU Fiscal Rules – Issues and Lessons from Political Economy”, ECBWorking Paper, No 421, Frankfurt am Main.

Sturm, M. (1997), Budgetdisziplin in der Europäischen Wirtschafts- und Währungsunion –Ursachen übermäßiger Defizite und Wege zu ihrer Begrenzung, Frankfurt am Main: PeterLang Verlag.

United Nations (2002), Arab Human Development Report 2002, United Nations DevelopmentProgramme, New York.

77ECB


EUROPEANCENTRAL BANK

OCCASIONAL PAPERSERIES

EUROPEAN CENTRAL BANKOCCASIONAL PAPER SERIES

1 “The impact of the euro on money and bond markets” by J. Santillán, M. Bayle andC. Thygesen, July 2000.

2 “The effective exchange rates of the euro” by L. Buldorini, S. Makrydakis and C. Thimann,February 2002.

3 “Estimating the trend of M3 income velocity underlying the reference value for monetarygrowth” by C. Brand, D. Gerdesmeier and B. Roffia, May 2002.

4 “Labour force developments in the euro area since the 1980s” by V. Genre andR. Gómez-Salvador, July 2002.

5 “The evolution of clearing and central counterparty services for exchange-tradedderivatives in the United States and Europe: a comparison” by D. Russo,T. L. Hart and A. Schönenberger, September 2002.

6 “Banking integration in the euro area” by I. Cabral, F. Dierick and J. Vesala,December 2002.

7 “Economic relations with regions neighbouring the euro area in the ‘Euro Time Zone’” byF. Mazzaferro, A. Mehl, M. Sturm, C. Thimann and A. Winkler, December 2002.

8 “An introduction to the ECB’s survey of professional forecasters” by J. A. Garcia,September 2003.

9 “Fiscal adjustment in 1991-2002: stylised facts and policy implications” by M. G. Briotti,February 2004.

10 “The acceding countries’ strategies towards ERM II and the adoption of the euro:an analytical review” by a staff team led by P. Backé and C. Thimann and includingO. Arratibel, O. Calvo-Gonzalez, A. Mehl and C. Nerlich, February 2004.

11 “Official dollarisation/euroisation: motives, features and policy implications of currentcases” by A. Winkler, F. Mazzaferro, C. Nerlich and C. Thimann, February 2004.

12 “Understanding the impact of the external dimension on the euro area: trade, capital flows andother international macroeconomic linkages“ by R. Anderton, F. di Mauro and F. Moneta,March 2004.

13 “Fair value accounting and financial stability” by a staff team led by A. Enria and includingL. Cappiello, F. Dierick, S. Grittini, A. Maddaloni, P. Molitor, F. Pires and P. Poloni,April 2004.

14 “Measuring Financial Integration in the Euro Area” by L. Baele, A. Ferrando, P. Hördahl,E. Krylova, C. Monnet, April 2004.


15 “Quality adjustment of European price statistics and the role for hedonics” by H. Ahnert andG. Kenny, May 2004.

16 “Market dynamics associated with credit ratings: a literature review” by F. Gonzalez, F. Haas,R. Johannes, M. Persson, L. Toledo, R. Violi, M. Wieland and C. Zins, June 2004.

17 “Corporate ‘Excesses’ and financial market dynamics” by A. Maddaloni and D. Pain, July 2004.

18 “The international role of the euro: evidence from bonds issued by non-euro area residents” byA. Geis, A. Mehl and S. Wredenborg, July 2004.

19 “Sectoral specialisation in the EU a macroeconomic perspective” by MPC task force of theESCB, July 2004.

20 “The supervision of mixed financial services groups in Europe” by F. Dierick, August 2004.

21 “Governance of securities clearing and settlement systems” by D. Russo, T. Hart,M. C. Malaguti and C. Papathanassiou, October 2004.

22 “Assessing potential output growth in the euro area: a growth accounting perspective”by A. Musso and T. Westermann, January 2005.

23 “The bank lending survey for the euro area” by J. Berg, A. van Rixtel, A. Ferrando,G. de Bondt and S. Scopel, February 2005.

24 “Wage diversity in the euro area: an overview of labour cost differentials acrossindustries” by V. Genre, D. Momferatou and G. Mourre, February 2005.

25 “Government debt management in the euro area: recent theoretical developments and changesin practices” by G. Wolswijk and J. de Haan, March 2005.

26 “The analysis of banking sector health using macro-prudential indicators” by L. Mörttinen,P. Poloni, P. Sandars and J. Vesala, March 2005.

27 “The EU budget – how much scope for institutional reform?” by H. Enderlein, J. Lindner,O. Calvo-Gonzalez, R. Ritter, April 2005.

28 “Reforms in selected EU network industries” by R. Martin, M. Roma, I. Vansteenkiste,April 2005.

29 “Wealth and asset price effects on economic activity”, by F. Altissimo, E. Georgiou,T. Sastre, M. T. Valderrama, G. Sterne, M. Stocker, M. Weth, K. Whelan, A. Willman,June 2005.

30 “Competitiveness and the export performance of the euro area”, by a Task Force of theMonetary Policy Committee of the European System of Central Banks, June 2005.

31 “Regional monetary integration in the member states of the Gulf Cooperation Council”by M. Sturm and N. Siegfried, June 2005.

Date post:	23-Apr-2020
Category:	Documents
Upload:	others
View:	3 times
Download:	0 times

OCCASIONAL PAPER SERIESOCCASIONAL PAPER SERIES NO. 31 / JUNE 2005 REGIONAL MONETARY INTEGRATION IN...

Documents