Gulf currency pegs

Textbook theory certainly backs the trade. By choosing to have their currencies pegged to the dollar, the Gulf Cooperation Council states (Saudi Arabia, Kuwait, Bahrain, Qatar, United Arab Emirates and Oman) surrendered the tool of interest rates to control inflation. Monetary policy, instead, has to mirror the country to which the currency is pegged - in this case the US. Enforced monetary discipline and steady currencies often serve developing economies well. For the GCC, where the main export, oil, is dollar denominated, it made particular sense.

But a combination of events is putting these pegs under strain. A falling dollar, record oil prices and higher food and housing costs are all causing inflation to tick up. At the same time, a slowing US economy has resulted in a 75 basis point reduction in US rates since the summer, just when the GCC needs tighter, not looser, monetary policy. In addition, underdeveloped local bond markets have made it difficult for central banks to soak up liquidity by borrowing locals' excess cash. This also helps explain why money supply growth and equity markets are surging.

This week, the governor of the UAE's central bank twice questioned the existing currency regime. Such talk is counterproductive, as anything but silence can lead to self-fulfilling speculation. Even so, a blanket punt that the remaining GCC states will follow Kuwait's move to a more flexible peg is no sure thing. The US will resist a further blow to sentiment against the dollar. It is also arguable that the region's export base is not yet diversified enough. Finally, a drop in oil prices might cool inflation for long enough that a currency union moves back up the agenda, the GCC's ultimate goal.