Moral Hazard in a Single Currency Union, the Case of GCC - Essay Example

Majid Al Shamsi Majid Al Shamsi Topic: GCC Moral Hazard in a single Currency Union, the case of GCC A currency union, also referred to as monetary union, refers to a situation where two or more countries use a similar currency without need fully having any other consolidation such as the monetary or economic union. There are three kinds of currency unions i.e. formal, formal but with common policy and informal union. Informal currency union refers to the one-sided espousal of foreign currency while formal currency union refers to the embracing a foreign currency on merit of multilateral or bilateral concurrence with the offering authority. Formal with a common policy refers to an institution established by a number of states with a mutual offering authority for the currency and monetary policy (Cohenen, 2012). Over the past few decades there has been observed a developing importance in currency fusions and monetary consolidations. This impression of exchange regions dates back to the Mundell’s Optimum Currency Areas. He asserts that “ if the world can be divided into regions within each of which there is a factor mobility and between which there is factor immobility, then each of these regions should have a separate currency that fluctuates relative to all other currencies” (Mundell, 1961, pp.56). The mobility of the inputs should act as the adjusting instrument if any region experiences asymmetric shock. In the absence of these inputs, the overseas exchange rate elasticity is not anticipated to execute the stabilization role assigned to it while the changing unemployment rates and inflation in the diverse areas would dominate. There has been various monetary unions in the various continents i.e. in Africa there has been the West African states who came together to share a common CFA franc currency, there also has been the multilateral Monetary Area to use the South African Rand. In Europe, there has been the European Union who uses the Euro as the common currency. There are other currency unions which have been proposed in other parts of the world i.e the East African Corporation that is scheduled to kick start by 2015, the West African Monetary Zone and the Gulf Corporation Council that is targeted to start within 2013 to 2020. These unions across the different nations have been faced with various challenges and most of them have flopped rendering a single currency impossible within the member states. Most of these unions also collapse due to some asymmetrical penchants and preferences that the union brings to the different states where one country may be favored than the other. Due to this unfavorableness, some countries opt to be out of the union (Cohenen, 2012). The Gulf Cooperation Council (GCC) is an economic and political union of the Arab countries which border the Persian Gulf (Laabas & Limam, 2002, pp. 10). The six member countries of the GCC proposed that the union would develop to a confederation from a regional block due the Iranian pressure and control and due to the Arab democratic instability in the region. The Persian Gulf region has several fast growing economies in the world due to the natural gas and oil revenues. The plan for economic agreement between the member states of GCC dates back in 1981 and the ratification of the endorsement in 1982. The progress towards the single currency union had been slow over the first decade and later in 2001, it gained speed which culminated to the endorsement of a new economic agreement ((Laabas & Limam, 2002, pp. 59). According to a research by Darrat and Al-Shamsi to experiment consolidation of GCC member states’ GDPs, inflation rates, monetary bases and exchange rates, it was wrapped up that the GCC member states are simpatico to institute a single currency union but the only factor that hampers this is the socio-political factors that are prevalent in the Persian gulf region (Darrat and Al-Shamsi, 2005, pp. 67). The main objectives of Gulf Cooperation Union were to develop standardized regulation in the several areas such as trade, economy, finance, tourism, customs and administration, set up joint ventures and to adopt a similar currency. Numerous studies have tried establishing if the GCC states are prepared to come up with a single currency union established on the economic resemblances and general cultural and social environments. According to a research by Laabas and Limam (2002) GCC states have so far not matched up the pre-requisite of developing a currency unification because the GCC countries are all oil dependant, have little or less trade among themselves, are deficient in synchronization of their business phases and lack intersection of the macroeconomic essentials (Laabas & Limam, 2002, pp. 45). This assessment was based on the comprehensive Purchasing Power Parity. The introduction of a Gulf Cooperation Council will call for the establishment of a Central bank, a common GCC exchange rate regime and a single GCC monetary policy. The decision on the type of currency exchange regime to adopt is one of the major economic policies unfinished for the GCC states. Should these states decide on adopting the US dollar, or to a hoop of currencies where the U.S dollar and the Euro have a large ratio or to allow the currency float dependent on the potential exchange market interferences? Each decision will have its own advantages and disadvantages. As a forward-thinking study, this paper will construct a weighted average of the Gross Domestic Product and the price level in the member states of GCC. An emergent unanimity among the economists is that emerging and growing economies should think about stiffly fixed exchange rate or an entirely floating exchange regime. The function of a monetary policy may be trammeled since a majority of the growing economies are deficient in a well developed financial market and liquid financial instruments (Zind, 1999, p. 341). It has been argued that the benefits from the believability of connecting a local currency to an international backbone can be greater than the benefits that accrue when the Single Currency Union adopts the floating exchange regime. It has been argued that states that specialize in the production and exportation of agricultural goods or minerals can gain from pegging their currencies to the price of their exports. Under the Peg Export Price (PEP) suggestion, countries that endured a declining world oil market in 1990’s would have undergone through depreciation automatically which would have promoted exports (Zind, 1999, p. 341). The Peg Export Price can at the same time fork out automatic accommodation to terms-of-trade shocks, while helping those states uphold the credibleness of pegging their currencies to the normal anchor like the dollar or other arrangements. There are other policy considerations to consider in deciding on a currency peg for the GCC. These considerations include the impacts of the exchange rate unpredictability on the financial markets, the reliability of the monetary and exchange policy position and the transaction expenses that arise from the exchange rate unpredictability. These considerations prevail external stability and competitiveness. When the GCC conditions for setting up the a successful GCC monetary policy is compared to the already existent monetary unions, such as the Euro zone and the CFA franc zone, there is need for the GCC members to put up an institutional union structure such as a decentralized central bank and financial crises system, and also to establish some essential quantitative yardsticks. An examination of the financial integration of the GCC stock markets reveals that the markets have a numerous long-run relationships (Darrat and Al-Shamsi, 2005, pp. 87). However, in the short term dynamics, there are restricted causative relationships in the GCC stock markets. This paper also focuses on the optimality of affiliating the proposed GCC coinage to The United States dollar or to a collection of other currencies with a whippier exchange rate regime. We will examine the roles that terms of trade shocks, regional shocks and global shocks play in impacting on the Gross Domestic Products of the GCC member states. Regional shocks are considered to be the same as the domestic shocks since the weighted average Gross Domestic Product of the GCC is given by the regional GDP of the member states (Zind, 1999, p.341). The real Gross Domestic Product and the Consumer price index will be considered in the investigation of the extent of the influence of real oil price, the domestic shocks and the United States or European shocks on the GDP of the GCC member states (Darrat and Al-Shamsi, 2005, pp. 90). Through our research we will also be in a position to answer various questions such as to what degree do the GCC member states influence the real oil prices or to what magnitude are the countries affected by the real oil prices? We will also be in a position to know whether the GCC business phase is related to the United States and the Euro business cycles such that a monetary policy adopted by these countries would be a right move for the GCC single currency union. Several criteria can be employed in analyzing the appropriateness of a common monetary agreement. This includes the balance between the fundamental macroeconomic impacts, openness, fiscal redeployment strategies, factor mobility and real wage litheness. The GCC economies are reasonably integrated in terms of trade and economic structure. Most of the GCC states GDP is greatly supported by the Oil prospects and there is need for diversification. Falling oil prices can wield pressure on the local currencies, thus making the new proposed single currency susceptible to evolutions in the world oil markets. Continuation Instability in the region and pressure from Iran necessitated the formation of this union. The pursuant gulf region is extremely endowed with gas and oil revenues. This makes the region one of the fastest developing regions in the world, (Mundell, 1961, pp.56). This economic and political pact proposal dates back to 1981. The GCC union was ratified in the year 1982. However, the plans and efforts towards the currency integration have been extremely slow. However, the single currency initiative among the member states of GCC gained momentum in the year 2001, (Goyal, 2004, p.29). This led to signing of a new economic agreement. The union aimed at having a monetary union by 2010. This was supposed to make economic integration happen with ease. The move had many potential benefits, (Darrat and Al-Shamsi, 2005, pp. 90). However, this meant that they would have to lose the exchange rate mechanism together with their monetary policy. The major aim of the GCC union is to come up, and develop a standardized approach in terms of tourism, economy, single joint currency, trade and administration. There have been many studies that aimed at establishing the readiness of the member states of the GCC with regard to a single currency. A research by Laabas and Limam (2002) shows the fact that most of these states depend on oil makes it hard for them to integrate. This is because they do not have diversified trade activities happening between them. For the integration to be effective, there are fundamentals that must be addressed, (Goyal, 2004, p.29). These include the ability of the member states to do trade and come up with joint monetary policy that encourage cross border trade. Economist unanimously agrees that emerging economies should think about the issue of stiffly fixed exchange rates. Most of the growing economies have weak measures when it comes to interacting with a well developed market and liquid financial instruments, (Mundell, 1961, pp.56). It has been argued that the benefits from the believability of connecting a local currency to an international backbone can be greater than the benefits that accrue when the Single Currency Union adopts the floating exchange regime. The member states would have to adopt new policy mechanisms. This called for a thorough look into the preconditions for setting the union, (Thorpe, 2008, p.9). The aim was to maximize the benefits of the GCC to member states. An economic study into the analysis of the GCC indicates that the exchange rates of the member states are closely related. Using a generalized purchasing power test, the study revealed that the members of the GCC share the stochastic trend. This indicates that if the union is established, it can lead to growth and expansion of industries. This is not withstanding the current inadequacy in diversification, (Laabas & Limam, 2002, pp. 45). This expansion was tipped to lead to intra-industry trade. The study also shows that the unions would lead to unification or even convergence of economic structures. This means that the economic policies and the business trends would must to be synchronized, (Thorpe, 2008, p.9). A research conducted in 2004 highlighted some of the costs and merits of GCC countries monetary union. The study looked at a group of aspects in order to come up with some of the observations. These aspects include: flexibility, financial services, convergence, investment, employment and stability. Structural convergence was not a threat to the formation or even sustenance of the GCC union. According to the study, fiscal policies were a challenge because their coordination was poor. The budget balances were tremendously affected by oil contribution to the government revenues. Oil price fluctuations and volatility meant that there were many disparities to public debts, levels of surplus and debts among the members of GCC union, (Laabas & Limam, 2002, pp. 45). The study concluded that the member states of the GCC would have to face and pay some economic price for the joint monetary union initiative to become a success. According to IMF, proper and professional implementation of the GCC currency union would enhance economic policy efficiency. It would also develop and consolidate the regional integration. Another outstanding and notable point is that the union would develop and enhance its non-oil economy, (Darrat and Al-Shamsi, 2005, pp. 90). However, the report argued that integration should be viewed in a wider and broader perspective. This is because currency union is only a single component of regional integration. Pegging against the dollar for the GCC union would not have a remarkably different impact. This is because the GCC economies heavily rely on oil production. This means that the already existing policies and practices with regard to a peg against the dollar would retain the same impact as that of pegging against a basket, (Sturm & Siegfried, 2005, p.69). There is an enormous need for the GCC union states to diversify their economies. This would make them more flexible in terms of their exchange rates. Stability in exchange rates means that the trade in the GCC union would be impacted positively. This in turn, would lead to growth in terms of investment. A currency union would mean greater economic and regional integration. However, the volume of trade may not pick as fast as expected due to currency fluctuations. Besides, currency fluctuations can easily lead to increased cost in international transactions. This is a substantial risk and ultimately affects the volume of trade. Reducing variations in terms of exchange rate can lead to increased trade. This is an observation of empirical studies observations. Integration of capital markets and external relations would be promoted by liquidity for the regional currency. In case of a dominant member in the bloc’s monetary policy, then the member can gain credibility from the group affiliation. Currency unions promote policy integration and coordination, (Rashid, 2012, p.18). This is vital for the success of the trade in a bloc. Increase in price transparency creates a stable business atmosphere. This means that there will be increment in financial services. This shall happen through various aspects: increased trade, unifying the bond and facilitating the equity market. One of the aims of regional trade, currency and economic integration is increasing cross-border trade and investment. This automatically leads to economic diversification. This calls for policies that facilities fiscal discipline among the union. Therefore, formation of GCC’s union would lead to a stronger and more influential voice in the global market and specifically in the external relationships, (Laabas & Limam, 2002, pp. 45). The biggest cost of the single currency integration tends to revolve around the issue of loss of exchange rates. This is coupled with the fear of absence of independent monetary policy among the member states of the GCC union, (Kamar & Bakardzhieva, 2006, p.11). This is of particular concern given the unstable nature of the Persian Gulf economies. The new integration policy should address these fears and facilitate risk sharing and address the fiscal transfers. Without a unified policy that reduces the cost of integration and specially considers the countries which are suffering from the shocks and instability, some member states might become motivated to leave the GCC union, (Darrat and Al-Shamsi, 2005, pp. 90). Changeover costs are also expected to affect the single currency initiative in the GCC and the cost of switching to a new system which shall include institutions for a new currency. This shall call for construction of new financial institutions and different local monetary policies. Remaining with a fixed exchange rate might prove to be risky in the long term. Fixed exchange rates are not substantially sustainable in the context of the global trade. Free capital and smooth flow leads to more balanced payments, (Sturm & Siegfried, 2005, p.69). The disparities in the exchange rates fluctuations are easily addressed with the exchange rates are flexible. This paper seeks to shed more light on the rationale for having a common currency of the GCC. Key aspects that are considered include the synchronization of business cycles among the member states in the Gulf region, (Sturm & Siegfried, 2005, p.69). It is clear that there is little business activity among the Persian Gulf states. Smaller economies stand a better chance of benefitting from having a unified currency. Higher interregional l trade means more benefits arising from risk reduction and lower transition costs. Flexible prices mean that the economies in the region have a better capacity of absorbing the economic shocks. The costs of adjustment shall be lower compared to a fixed price case. A similar production structure means that countries can adopt a unified approach in terms of dealing with the economic shocks, (Rashid, 2012, p.18). This is because they can easily adopt a symmetrical approach. Deeper integration and trade cooperation can lead to increased concentration of industries in the members of the union. However, in such cases, the effects of shocks tend to be region specific. As at now the plans for a unified currency among the embers states of the GCC states have been happening for almost 30 years now. In the realization of what is happening in the European economic zone, experts are beginning to wonder whether is it vital to have a single currency among the, member states of the GCC union. There have been disputes with regard to the location of the GCC central bank, (Darrat and Al-Shamsi, 2005, pp. 90). This led to the withdrawal of the united Arabs emirates in the single currency initiative of the GCC. Already, the initative has lost a lot of momentum, (Kamar & Bakardzhieva, 2006, p.11). Oman has indicated it does not intend to join the common currency immediately. Supporting the single currency among the six member states has been significantly reducing. A suitable casing point has been Europe where the euro has been substantially devalued. This is because of the Greece bailout plan, (Zind, 1999, p.341). The Dubai debt situation is a point of concern, and if the six member states want to unite, the need to pay attention to the realities that is taking shape in Europe. This has necessitated a research to help look into the future of the GCC union in the wake of the emerging crises of the European Union experience. Most of the previous researches had not factored these present day realities. Methodology When researching in this field, the best approach was to use both the qualitative and quantitative research. This research method is one of the most exploited methods of research by other writers. It also is known are triangular or mixed method of research. One of the biggest merits of the triangular method is that the data collected from one method complements the data collected in the other method. This means that comprehensive opinions are obtained by the research for quality analysis. Secondary sources. This included engaging the unified monetary policy makers books, journals and drafters of the fiscal policies articles. The secondary sources include the IMF report of the GCC union and the public debt policies of the GCC member countries and considering the Europe debt crises situation Questionnaires: The aim was be to get a wide range of opinions. Questionnaires were designed, to collect fundamental aspects of the GCC union and its future. The questionnaires were 6 in number. Some of the questions in the questionnaire required state officials from the key member states to describe their understanding of the GCC union. They also required them to state their biggest expectations and how to proceed with the GCC union initiative. Interviews: Up to 6 financial advisers/experts were interviewed using a method known as the structured interview method. Each member state produced a financial expert. The participants were assured that the information would be treated with confidence. Data collection and analysis: Descriptive statistics were used to analyze the collected data. This involved content analysis. This is because the validity and applicability of data in qualitative research depends on how carefully the instruments have been constructed. This helped in ensuring that what is supposed to be measured by the instruments was accurately obtained. Integrity of the research: The integrity of the research depended on both the analytical and ethical adequacy. This means that there was voluntary participation from the respondents, data was well protected, and the purpose of the research was made clear and that the participants were assured of an opportunity to see and read that research report. Time scale Preliminary preparations of the research took one week. This involved preparing the research team and giving the team data collection skills. The research activity took 2 month. This involved giving the questionnaire and conducting interviews with the targeted number of respondents. Data collection took 4 weeks Data analysis shall take 1 week In total, the entire project took 3 and1/2 months. Data analysis: All the six member states expressed their intention to strengthen the GCC union. 60 per cent of the member states said that all the member states stand a chance of benefitting immensely while 30 per cent were cautious. One of them did not have an opinion. 20 per cent said that they were not for the idea of a single currency in the next five years. 90 per cent of the respondent said that the European crises had given them a new insight and hence the caution. 10 per cent said the crises did not have any impact in them.40 per cent of the respondents were contented with the current progress but called for more efforts. 70 per cent of the respondents thought the progress can be faster if there is better coordination. 45 per cent thought that they future of GCC is going to be more challenges than it was previously. Hypothesis: The success of GCC largely depends of the political and economic will. This needs to be coupled by strong policies to make the union sustainable and prosperous. Key findings 1. The analysis of data and the integration aspects showed that there is an intention for the member states to unite. However, the fears of uncertainty have made it hard to unite. 2. Little business activity among member states, having oil as the most common asset among the six member states and differences of how to conduct the single currency plan has threatened the GCC initiative. 3. Instability in the region makes it hard for the GCC countries to use a common trade language. 4. The idea of the exchange rates is still contentious. The agreement on whether to use fix or flexible exchange rates need to be resolved. Recommendations The first step to regional integration is political and economic will. The member states of GCC need to be more intentional. The regional integration of the GCC countries is key for their grown and relevance in the global market. The GCC countries have no choice but to diversify their economics. The European crises should not be used to slow down the unification of a currency. However, cautionary measures should be taken to avoid the same from happening in the GCC countries. Natural resource centered exports are not always helpful in terms of international or regional trade. This calls for exploitation of other resources that shall cause the value to trade to grow. Monetary union whose currency is pegged on the dollar is likely to maintain volatility in the GCC block. Works Cited Darrat, Ali; Al-Shamsi, Fatima .2003. “On the Path to Integration in the Gulf Region: Are the Gulf Economies Sufficiently Compatible?" Laabas B. and Limam I. 2002. “Are GCC Countries Ready for Currency Union?” Kuwait-Arab Planning Institute. Mundel, Robert A. 1961. “A Theory of Optimum Currency Areas” reprinted in Blejer, Mario et. al. (1997) “Optimum Currency Areas: New Analytical and Policy Developments” IMF. Zind, R. (1999, December). Income determination in the GCC member states. OPEC Review: Energy Economics & Related Issues, 23(4), 341. Retrieved March 31, 2012, from Business Source Premier Database. Cohen B.J .2012. "Monetary Unions." Economic History. Web. 29 Mar. 2012. Cited at : Read More