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Kuwait has switched the dinar’s exchange rate mechanism to a basket of currencies, dropping a peg to the tumbling US dollar that was adopted in 2003 and throwing into disarray plans for a single currency in the Gulf region.
Kuwait was still committed to the monetary union, the central bank governor maintained, but the dollar’s slide over the past two years had forced it to break ranks with fellow Gulf oil producers to contain inflation.
Kuwait also revalued its dinar, allowing the currency to appreciate 0.37 per cent against the dollar after months of market pressure on the exchange rate. The new rate set by the central bank is $0.28806 compared with $0.28914.
Kuwait, which was named as the top candidate for a revaluation in a Reuters poll of analysts in March, has blamed rising inflation on the falling dollar, which tumbled to a record low against the euro in April. At the end of the first quarter inflation stood at 5.15 per cent.
Meanwhile, five other members of the Gulf Cooperation Council (GCC) will likely not follow Kuwait in revaluing their currencies, the bloc’s secretary-general said although there is intense speculation that the UAE also might follow suit.
The sharp fall of the dollar against other leading international currencies has eroded the buying power of GCC currencies and rebooted the revaluation debate.
The greenback fell more than six per cent this year versus the euro and other currencies, fanning further inflation fears in the Gulf. The Indian rupee jumped to a near nine-year high to Rs40 a dollar. The dollar-pegged Bahraini dinar also eroded substantially against the rupee since the beginning of 2007.
Dollar woes are hurting residents in Bahrain and elsewhere in the Gulf as the local currency no longer buys what it used to. While Bahraini nationals and expatriates alike are facing the heat of the rising cost of living, the large foreign population faces the risk of losing a significant share of earnings because of inflation and currency volatility.
Because of a combination of the falling buying power of the dinar and appreciating currencies of their home countries, expatriates are incurring huge losses.
Bahrain has ruled out revaluation, although its currency according to market analysts is the most undervalued. But the question remains how long can Bahrain hold on if one by one other GCC states too drop the dollar peg.
Among the most common arguments against currency appreciation is that it hurts exports. If the dinar appreciates, it takes more units of a foreign currency to buy a dinar, thus Bahrain-made goods become more expensive to the rest of the world and its exports fall.
Another view against currency appreciation is its impact on remittances, repatriated profits and foreign direct investment (FDI). Bahrain nationals working abroad and its investments abroad make profits that once repatriated to the country will buy fewer dinars. FDI could get hurt if, for example, it takes more euros to buy a dinar to be invested in Bahrain.
On the other hand, as the dinar appreciates it takes fewer dinars to buy a given unit of a foreign currency, thus goods made in the rest of the world become cheaper to Bahrain and imports increase. Also, dinar appreciation could help lessen the inflationary pressure that has eroded real wages in the country in the last few years. The appreciation of the dinar would also benefit consumers because as consumer goods produced elsewhere become cheaper to Bahrain, the inflationary pressure in Bahrain could fall.
It is true that the appreciation of the dinar will raise the cost of investing in Bahrain, but if expected returns on investment remain attractive, FDI will still flow into the country.
Turning to the UAE, the source of the inflationary pressure has been the rapid increase in investment spending, especially in the real estate, which in turn creates higher personal income. Since consumption is a positive function of income, consumption spending is also high. That rapid increase in investment has been assigned mainly to the extra revenue made by the sale of oil at current prices. This shows in the country’s large current account balance.
However, the International Monetary Fund thinks otherwise. Mohsin Khan, director for the IMF Middle East and Central Asia, contends the UAE and other GCC countries do not face the effect of imported inflation despite most of their imports coming from non-dollar zones.
Why is it that Saudi Arabia and Oman are not hit where the rate of inflation is as low as three and 3.4 per cent respectively compared with 10 per cent in the Emirates and 12 per cent in Qatar. “Inflation is not coming from depreciation of the dollar and a consequent higher import cost. Most of it is coming from domestic capacity constraints,” he says.
According to Khan the gains from revaluation will be small. The cost GCC would incur is that they lose the perception of currency stability.
However, Khan says inflation rates in the GCC — where GDP would grow at a slightly slower pace in 2007 as oil prices and output drop — should ease in 2007 amid a cooling in real-estate prices.
“We believe inflation will slow down in both the UAE and Qatar, but any declines will be slight. We initially expected inflation to drop more, but now we believe it will only drop slightly,” he says.
Inflation in the UAE is expected to fall to 8 per cent this year from 10 per cent in 2006. Price growth in Qatar will fall by 1.8 per cent to 10 per cent over the same period. Growth is still very strong in both countries, which is maintaining inflation rates up, but it’s gradually decreasing, according to the IMF.
Maintaining that increased spending is fuelling inflation, he says inflation for all the Gulf states combined would fall to 4.3 per cent in 2007 as more supply of housing becomes available in the UAE and Qatar, which had the Gulf’s highest inflation in 2006.
There appears no sure-fire one-way to address inflation and erosion of currency value. Governments and companies cannot halt economic development, just because spending is fuelling inflation. But efforts can be made to see that spending is done in productive sectors, export-oriented industries are set up, measures initiated to avoid overcapacity and real wage losses are compensated. Above all it would do the GCC a world of good if surpluses from oil are used to build basic industries rather than rely on high-cost imports for everything.
Talking Business with
K S Sreekumar
sreekumar@tradearabia.net
