06-09-2009, 11:48 PM
Central banks reaffirm the terms for setting up of single currency in 2010 Ability to meet economic criteria depends largely on oil prices; FX volatility in the region to increase over time.
The six members of the Gulf Cooperation Council (GCC; consisting of Bahrain, Kuwait, Oman, Qatar, Saudi Arabia and the United Arab Emirates (UAE)) took a step closer to monetary union last week as central bankers agreed the text associated with fiscal and monetary targets agreed in March.
Given the imperative of job creation in the region, there is an increasing realisation of the need for the region to become a more attractive investment site for both small and medium enterprises and larger companies. The key is to make it easier and cheaper to set up companies and then allow them to operate efficiently.
In this regard, much work remains to be done. In its recently released report - Doing Business in 2006 Creating Jobs - the World Bank ranked countries according to how easy it is to do business. Out of the four GCC countries that are ranked, Saudi Arabia is best positioned at 38th out of the 155 countries surveyed (Kuwait is 47th, Oman 51st and the UAE 69th).
In terms of starting a business, the GCC countries are comparable to East Asia. The number of days to set up a business averages 47, compared to East Asia's 51. Meanwhile, it still costs almost 40% of per capita Gross National Income to set up a business versus 41.7% for East Asia. However, there is considerable scope for improvement with OECD averages of 19 days and 6.5%, respectively.
Given the lack of an advantage in a business environment context versus East Asia, the issue of size becomes increasingly important. For larger companies in particular, there is a need for new investments to show their ability to become economically significant. In recent times, China and India have been dominating the headlines in terms of attracting foreign direct investment. This is partly due to their ability to produce things more cheaply than other countries, but as important is the attractiveness of the local market.
The size of the economy can be considered a proxy for the general size of opportunity facing the corporate sector. In 2004, China's GDP was USD 1,649bn. For India, it was USD 692bn. The largest GCC economy is Saudi Arabia at USD 251bn. For the GCC as a whole, it was almost USD 450bn.
An economically united and efficient GCC is clearly a more interesting proposition for larger companies than each individual economy, especially given the impediments to trade evident within the region. This is why trade relations within the GCC have been a core focus of late.
The natural extension of this trend for increased integration is to introduce a common currency in order to further facilitate trade between the different countries. On Wednesday, Bahrain central bank chief Rasheed al-Maraj reiterated that the region's central bankers had agreed to pursue monetary union in a similar fashion to the rules used in Europe. These rules still have to be formally signed off by the countries' rulers, after which it is envisaged that countries will need to comply by 2007 before monetary union is achieved in 2010.
In line with the Maastricht criteria, the requirements for entry are that a country's budget deficit is less than 3% of GDP and the public sector debt is less than 60% of GDP. In addition, each country will be required to have currency reserves in excess of four months of imports. On the monetary front, inflation must not exceed the weighted average of the six countries' inflation rates by more than 2%, while interest rates must not exceed the average of the lowest three countries by more than 2%.
Given high oil prices, it will surprise few that all six countries are expected to comply with the fiscal, debt and FX reserve criteria by the end of 2005. Indeed, as of 2004 data, only two countries failed to meet the criteria. First, Saudi Arabia failed to meet the public sector to GDP ratio criterion. However, strong oil prices in 2005 will boost government revenues, allowing the Saudi government to pay down its debt while also boosting the level of nominal GDP, pushing this ratio down. Second, Bahrain fell marginally below the FX reserve requirement threshold, but this is also likely to be resolved by high energy prices.
Of course, whether these countries can sustainably meet these criteria is a different issue. While the economies have been diversified somewhat, less progress has been made on diversifying the source of government revenues. Therefore, if oil prices were to slump dramatically, then budget deficits may once again rear their ugly heads and jeopardise compliance.
One option being pursued by the UAE is to implement a value-added tax in order to improve the country's resilience to lower oil prices. Such a policy response across the rest of the GCC would be welcome. However, even without this response all would not be lost under such a scenario. In March, a senior GCC official suggested there is scope for flexibility should low oil prices induce a temporary increase in the budget deficit.
As the situation stands currently, our analysis suggests that the break-even oil price, as far as the budget deficit is concerned, varies from as low as USD 10 per barrel (pb) in Kuwait to USD 28pb in Saudi Arabia. For Saudi Arabia to record a 3% budget deficit as a percentage of GDP, we estimate oil prices would have to fall to USD 24pb or below. While this is not inconceivable in the event that we see a sharp slowdown in global economic activity, it is not expected to happen either this year or next as oil supply conditions remain relatively tight.
On the monetary front, two countries failed to meet the criteria in 2004. Bahrain was marginally above the inflation threshold, while Qatar had by far the highest inflation rate of the region. Looking forward, inflation differentials are expected to remain wide between GCC countries and with all the currencies pegged to the USD, it is difficult to see how this can be sustainably addressed.
However, we need to recognise that all of the above analysis may be irrelevant. The EMU process in Europe showed us all that such projects are as much political as they are economic. Therefore, the possibility of the criteria being fudged, if necessary, cannot be ruled out.
Where does this leave us as far as the outlook for financial market developments is concerned? For the time being, there are more questions than answers with regards to the proposed 2010 currency union. For instance, the authorities have yet to state clearly exactly what the exchange rate arrangement will be with currencies outside of the GCC.
Some officials appear to favour a continuation of the USD peg. Other officials have indicated a floating currency may provide the GCC countries with significant benefits. We concur as such an arrangement would allow the authorities to either denominate oil sales in the new local currency or even a portfolio of foreign currencies, rather than be attached to a still structurally weak USD. This should ensure greater stability in terms of the region's spending power in international markets.
Therefore, our favoured route is for the new GCC currency to be floating, possibly with reference to a trade-weighted basket of currencies. However, for a region used to a USD peg, and thus stability, this may prove to be a step too far, at least initially.
What is clear is that the historical confidence in currency pegs versus the USD is likely to diminish until further clarity is provided. This could have significant implications for hedging behaviour in the region. In the UAE, for example, most companies hedge their dirham interest rate exposure using the US dollar swap curve as it is a slightly cheaper way to hedge. However, as the possibility of greater exchange rate volatility looms, this becomes more risky as companies become more exposed to the currency mismatch of such behaviour.
Also, with inflation in the region generally higher than that in the US, it would make sense for the divergence in US and regional interest rates to widen over time. Of course, it is tempting to continue to hedge in USDs as 2010 is still a long way off. However, this has to be balanced by the fact that the markets will likely move well before that date depending on market expectations of what form the new exchange rate mechanism will take. Therefore, over time, we expect local currency hedging instruments to become increasingly important and liquid.
http//www.ameinfo.com/67925.html
The six members of the Gulf Cooperation Council (GCC; consisting of Bahrain, Kuwait, Oman, Qatar, Saudi Arabia and the United Arab Emirates (UAE)) took a step closer to monetary union last week as central bankers agreed the text associated with fiscal and monetary targets agreed in March.
Given the imperative of job creation in the region, there is an increasing realisation of the need for the region to become a more attractive investment site for both small and medium enterprises and larger companies. The key is to make it easier and cheaper to set up companies and then allow them to operate efficiently.
In this regard, much work remains to be done. In its recently released report - Doing Business in 2006 Creating Jobs - the World Bank ranked countries according to how easy it is to do business. Out of the four GCC countries that are ranked, Saudi Arabia is best positioned at 38th out of the 155 countries surveyed (Kuwait is 47th, Oman 51st and the UAE 69th).
In terms of starting a business, the GCC countries are comparable to East Asia. The number of days to set up a business averages 47, compared to East Asia's 51. Meanwhile, it still costs almost 40% of per capita Gross National Income to set up a business versus 41.7% for East Asia. However, there is considerable scope for improvement with OECD averages of 19 days and 6.5%, respectively.
Given the lack of an advantage in a business environment context versus East Asia, the issue of size becomes increasingly important. For larger companies in particular, there is a need for new investments to show their ability to become economically significant. In recent times, China and India have been dominating the headlines in terms of attracting foreign direct investment. This is partly due to their ability to produce things more cheaply than other countries, but as important is the attractiveness of the local market.
The size of the economy can be considered a proxy for the general size of opportunity facing the corporate sector. In 2004, China's GDP was USD 1,649bn. For India, it was USD 692bn. The largest GCC economy is Saudi Arabia at USD 251bn. For the GCC as a whole, it was almost USD 450bn.
An economically united and efficient GCC is clearly a more interesting proposition for larger companies than each individual economy, especially given the impediments to trade evident within the region. This is why trade relations within the GCC have been a core focus of late.
The natural extension of this trend for increased integration is to introduce a common currency in order to further facilitate trade between the different countries. On Wednesday, Bahrain central bank chief Rasheed al-Maraj reiterated that the region's central bankers had agreed to pursue monetary union in a similar fashion to the rules used in Europe. These rules still have to be formally signed off by the countries' rulers, after which it is envisaged that countries will need to comply by 2007 before monetary union is achieved in 2010.
In line with the Maastricht criteria, the requirements for entry are that a country's budget deficit is less than 3% of GDP and the public sector debt is less than 60% of GDP. In addition, each country will be required to have currency reserves in excess of four months of imports. On the monetary front, inflation must not exceed the weighted average of the six countries' inflation rates by more than 2%, while interest rates must not exceed the average of the lowest three countries by more than 2%.
Given high oil prices, it will surprise few that all six countries are expected to comply with the fiscal, debt and FX reserve criteria by the end of 2005. Indeed, as of 2004 data, only two countries failed to meet the criteria. First, Saudi Arabia failed to meet the public sector to GDP ratio criterion. However, strong oil prices in 2005 will boost government revenues, allowing the Saudi government to pay down its debt while also boosting the level of nominal GDP, pushing this ratio down. Second, Bahrain fell marginally below the FX reserve requirement threshold, but this is also likely to be resolved by high energy prices.
Of course, whether these countries can sustainably meet these criteria is a different issue. While the economies have been diversified somewhat, less progress has been made on diversifying the source of government revenues. Therefore, if oil prices were to slump dramatically, then budget deficits may once again rear their ugly heads and jeopardise compliance.
One option being pursued by the UAE is to implement a value-added tax in order to improve the country's resilience to lower oil prices. Such a policy response across the rest of the GCC would be welcome. However, even without this response all would not be lost under such a scenario. In March, a senior GCC official suggested there is scope for flexibility should low oil prices induce a temporary increase in the budget deficit.
As the situation stands currently, our analysis suggests that the break-even oil price, as far as the budget deficit is concerned, varies from as low as USD 10 per barrel (pb) in Kuwait to USD 28pb in Saudi Arabia. For Saudi Arabia to record a 3% budget deficit as a percentage of GDP, we estimate oil prices would have to fall to USD 24pb or below. While this is not inconceivable in the event that we see a sharp slowdown in global economic activity, it is not expected to happen either this year or next as oil supply conditions remain relatively tight.
On the monetary front, two countries failed to meet the criteria in 2004. Bahrain was marginally above the inflation threshold, while Qatar had by far the highest inflation rate of the region. Looking forward, inflation differentials are expected to remain wide between GCC countries and with all the currencies pegged to the USD, it is difficult to see how this can be sustainably addressed.
However, we need to recognise that all of the above analysis may be irrelevant. The EMU process in Europe showed us all that such projects are as much political as they are economic. Therefore, the possibility of the criteria being fudged, if necessary, cannot be ruled out.
Where does this leave us as far as the outlook for financial market developments is concerned? For the time being, there are more questions than answers with regards to the proposed 2010 currency union. For instance, the authorities have yet to state clearly exactly what the exchange rate arrangement will be with currencies outside of the GCC.
Some officials appear to favour a continuation of the USD peg. Other officials have indicated a floating currency may provide the GCC countries with significant benefits. We concur as such an arrangement would allow the authorities to either denominate oil sales in the new local currency or even a portfolio of foreign currencies, rather than be attached to a still structurally weak USD. This should ensure greater stability in terms of the region's spending power in international markets.
Therefore, our favoured route is for the new GCC currency to be floating, possibly with reference to a trade-weighted basket of currencies. However, for a region used to a USD peg, and thus stability, this may prove to be a step too far, at least initially.
What is clear is that the historical confidence in currency pegs versus the USD is likely to diminish until further clarity is provided. This could have significant implications for hedging behaviour in the region. In the UAE, for example, most companies hedge their dirham interest rate exposure using the US dollar swap curve as it is a slightly cheaper way to hedge. However, as the possibility of greater exchange rate volatility looms, this becomes more risky as companies become more exposed to the currency mismatch of such behaviour.
Also, with inflation in the region generally higher than that in the US, it would make sense for the divergence in US and regional interest rates to widen over time. Of course, it is tempting to continue to hedge in USDs as 2010 is still a long way off. However, this has to be balanced by the fact that the markets will likely move well before that date depending on market expectations of what form the new exchange rate mechanism will take. Therefore, over time, we expect local currency hedging instruments to become increasingly important and liquid.
http//www.ameinfo.com/67925.html