Prospects and Implications for a GCC Common Currency - Dissertation Example

?Prospects for a GCC common currency: Implications of GCC currency union Background of the research problem In 2002, the euro was adopted as the first single currency of any unified monetary region worldwide. The euro was established by provision of the Maastricht Treaty in 1992. It is not commonly known, however, that some eleven years before this treaty, in 1981 the Gulf Cooperation Council formally articulated its objective to seek to establish a single, unified currency for the six member states in this region. Originally scheduled for adoption in 2010, the adoption date was postponed because of the destabilization caused by the intervening financial crisis and the economic recession. A new date has not been set, speculations setting it anywhere from two to ten years hence, which provides sufficient time and opportunity to assess the merits and the wisdom of the implementation of this course of action. One important consideration is the unit of value against which the new GCC currency will be pegged. Some speculate that the new currency will be backed by gold, consistent with the teachings in the Quran against riba (interest). It was not discounted, however, that the peg may be against the US dollar, at least initially (Daily Star, 15 Feb 2010). A proposal to use the International Monetary Fund (IMF) Special Drawing Rights (SDR), a theoretical currency used by the IMF for member states transacting with it, has been rejected. If the currency becomes a reality, four states – Saudi Arabia, Kuwait, Bahrain, and Qatar – have committed to adopting it as sole legal tender. Two other states – the UAE and Oman – have signified that they shall not join the currency union, although it may be conjectured that there is always a possibility that this may happen at a later date, when it shall be advantageous for them to do so. Host for the GCC central bank for the common currency is agreed to be situated in Riyadh, Saudi Arabia. Apparently, this is the reason the UAE has opted out of the monetary union; in 2004, the UAE was the first country to submit an application to host the GCC Central Bank, during arrangements for it to join the GCC monetary union. It is said that the UAE is not host to any GCC establishment, and its disappointment at not being chosen site of the GCC Central Bank may have led to its refusal to join the union (Gulf News, 20 May 2009). The adoption date was postponed beyond its initial deadline in 2010, due primarily to the negative repercussions of the financial crisis. There are, however, optimistic signs that the unification will push through. First is the halting of the issuance of loans to the public sector from the central banks of the four participating countries. Second is the continuing effort at converging government law and policy governing the financial sector (Emirates 24/7, 9 Mar 2010). The prospects of currency unification is of course not confined to the GCC. Precedent is the Euro, the European Union’s common currency which was adopted and has been in circulation since 2002, and administered by the independent European Central Bank situated in Frankfurt. There are, however, other proposed currency unification plans in other regions. The Amero is the theoretical legal tender of the proposed North American Currency Union (Canada, U.S. and Mexico), the Afro which is the proposed currency for the African Union, and the Asian Monetary Unit or the AMU, proposed to be adopted among ASEAN, China, Japan and South Korea. For sure, the experience of the establishment of the euro and the impending adoption of the GCC unified currency shall provide valuable input for future other efforts at currency unification. Objectives of the study The principal objective of the study is to explore the various issues and circumstances surrounding the establishment of the GCC single currency, and to arrive at an assessment as to its feasibility and the probable courses of action to ensure its success. The main objective of the study is supported by the following intermediate objectives: 1. To establish the factors that determine the success or failure of establishing a unified currency system; 2. To determine whether such factors are substantially determinative in the case of the GCC situation; 3. To make an assessment, based on the factors determined, whether or not the GCC may reasonably attain its objective of establishing a unified monetary union in the foreseeable future. Statement of the research problem The study aims to address the question: What are the prospects for the successful adoption of a single GCC currency, and what factors will determine its eventual success or failure? The research question adopts the position that the single currency proposition is intended for implementation in the next three to five years as per estimates, thus its assessment shall be based on the possibility that measures may be adopted in order to reasonably attain the single currency regime in the next five years. If it should conclude in the contrary (i.e. failure), this does not signify that unification is not possible, but simply that it is not likely in the foreseeable future. Research sub-problems In order to arrive at a satisfactory solution to the general research problem, the following questions shall serve as guide questions to which answers shall be sought: 1. What are the advantages and disadvantages of a single GCC currency? 2. What are the conditions prevailing presently in the GCC quest for unification? 3. What are the requisite conditions that must still be fulfilled before unification becomes possible? 4. What courses of action are open to the GCC leadership to attain their objective of a unified currency regime? Answers to the preceding questions are expected to lead to a suitable conclusion to the overall research question posed by the study. Significance of the study The findings of this study are deemed important in that they provide insight that may be brought to light on the process of currency unification. Such insights would be valuable from an academic standpoint, because to date there has been only one successful occasion – the adoption of the euro – when such unification has successfully been concluded, and in the bigger picture it is still a work-in-progress with the continuing expansion of the European Union. The findings may likewise provide additional inputs for policy makers in the countries aiming to unify their currency, as well as countries intending to join existing currency unions. The study provides a useful opportunity to integrate in a practical exercise principles of international economics, finance, and monetary theory. This research promises to constitute a useful addition to the existing pool of academic literature on monetary policy and currency theory. Review of related literature The Viability of a Unified GCC Currency Before considering aspect of transition from one currency regime to another, some studies delved into the possibilities that currency unification can be successfully undertaken. Qader and Shotar (2005) addressed the question by determining whether or not the countries intending to adopt the currency will be able to adopt a unified economic policy, which necessitates examining if the differences and similarities among the economic structures of the GCC countries are suitable for convergence. The study found that the existing difference render highly unlikely that economic policy integration will be achievable in the near future (contemplating at that time the 2010 deadline set by the GCC). Espinoza, Prasad and Williams (2010) sought the same determination with a different research strategy. The extent of regional financial integration was assessed by determining the degree of convergence in the countries’ financial markets and macroeconomic indicators. Money market integrations was assessed by determining interest rate convergence via both beta and sigma convergence, and found this to be present. The degree of equity market integration was evaluated by conducting an analysis of cross-listed stocks (rather than examining the co-movements of stock indexes) and assessed the relative magnitude of transaction costs in equity markets. Arbitrage opportunities were found to exist more or less persistently at the 1% level, indicating that barriers to the free movement of capital in the Gulf are still a significant factor. The main reason for the sluggish movement of prices of cross-listed stocks is that days on which the cross-listed stocks trade are relatively infrequent, but other than this, price differentials are quickly resolved and the markets show relative efficiency and integration (Espinosa, Prasad & Williams, 2010). Overall, there is sufficient evidence that the financial markets of the GCC countries are sufficiently integrated and converged to support a single currency system. Using a different methodology, an earlier study arrived at findings contrary to the Espinoza, et al. study. The theory of an optimum currency for the region was also the topic of study by Benbouziane, Benhabib & Benamar (2008). Its purpose was to determine if the six GCC countries satisfied certain preconditions for the creation of an optimum currency area: i.e., similarity in economic structures with exposure to symmetric shocks, the existence of open economies, the condition of being well-diversified, and possessing a high degree of factor mobility. The study employed econometric techniques such as vector autoregression (VAR) and multivariate threshold autoregression (MVTAR) modelling. Based on the symmetry in their response to external shocks, the study determined that the GCC countries are best split into two sub-groups, the first consisting of UAE, Oman and Bahrain, and the second consisting of Saudi Arabia, Qatar and Kuwait. Implied in the findings is that the GCC is still far from attaining the preconditions necessary for establishment of an optimal currency area. Actions that must first be taken include the elimination of domestic and cross-border distortions that hamper trade and foreign investments, the coordination of national policies to ensure macroeconomic stability, the deepening of regional integration and development of a robust non-oil economy, coupled with extensive political integration (Benbouziane, Benhabib & Benamar, 2008). The Benbouziane, et al. study is itself countered by a policy paper delivered by Al-Jasser and Al-Hamidy (Vice Governor and Director General of the Research and Statistics Department, respectively, of the Saudi Arabian Monetary Agency), under the auspices of the Bank of International Settlements (BIS). The paper stressed the great potential that the GCC countries would be able to become a viable unified currency area, underscoring the fact that the establishment of a single currency has been one of the principal goals formally declared from the time the GCC was established in 1981. Other factors support the rationale of a single currency for the GCC, such as their contiguous geographical area, similarities in history, culture and economic characteristics, and their common high dependence on the export of oil. Imports and exports are generally unhampered by tariffs, capital movements to and from these economies are unrestricted, their currencies are fully convertible and there are no taxes or subsidies for the purchase or sale of foreign exchange. Most importantly, the exchange rates of these six countries have for a long time been well coordinated, with cross rates exhibiting stability. Steps have already been taken by these countries towards increased integration of financial and economic systems. (1) Cross-border movement of national goods, labor and capital are completely free. (2) They have adopted a common tariff and harmonised customs administration and procedures. (3) Steps have been instituted to resolve cross-border trade disputes and agreed to accord to each other’s individuals and corporations national treatment for tax. (4) Land ownership has been liberalised for each other’s nationals for the purposes of business as well as for building a second home. (5) Measures have been taken to motivate foreign direct investment and intraregional capital flows, harmonise investment codes, and stock exchange regulations, interlink electricity grids and develop a common gas grid. (6) Unified bank supervision procedures have been adopted in order to hasten the integration of financial systems, as well as allowing their banks to open branches in each other’s jurisdictions. Al-Omran (2010) undertook the same objective in his study, although from the viewpoint of being already situated in the time the unification was planned to have taken place. The study made use of five determinants in this determination: diversified economy, openness, factor mobility, policies integration, and other intangibles such as political will and resolve of the countries to effect unification. The study determined that rather than effect integration in 2010, the GCC should allocate at least two more years to institute the proper reforms and policy integration, and to resolve the political issues that could challenge the stability of the prospective union’s early stages (Al-Omran, 2010). Exchange Rate Regime and Currency Peg The choice of exchange rate regime for the unified GCC currency is a topic of intense research and discussion, because of its importance in the feasibility of establishing the single currency. According to Khan and his staff team at the IMF (2008), the GCC countries had decided in 2003 to peg their currencies to the U.S. collar and maintain parity, pending the new currency’s circulation (originally scheduled for 2010). To continue the US dollar peg with the new currency would have been the reasonable choice; however, the U.S. subprime crisis and economic meltdown had sent the dollar into a downward spiral and inflation rising, leading policy makers worldwide to reconsider the stability of the dollar as principal international currency. It is generally believed that the last financial crisis has rendered the US tender no longer meets the requisites of an anchor currency, namely external and internal stability, ability to preserve monetary credibility and international competitiveness, and viability of reducing balance sheet risks and transaction costs (Khan, et al., 2008). For this reason, the GCC policy makers are considering three other options: managed floating, pegging to a basket of currencies (similar to the IMF’s SDR), or pegging to the export price of oil. After consideration, however, it has been found that the other options to the dollar peg do not offer a greater stability than the former. Furthermore, the greater flexibility of the basket peg requires a number of key reforms which are too complex and costly to undertake for the uncertainty offered by this option. Also, to peg the value of the currency on the export price of oil could likewise prove just as destabilizing, because of the volatility of the proposed anchor. In the final analysis, the dollar peg still seems the most feasible option at the moment, because it allows for the reduction of volatility in the region, provides a credible and easily understood value on which to base monetary policy, and greatly simplifies international trade and financial transactions and the attendant accounting and business planning. In the long term and if inflationary pressures do not ease, it may be viable to gradually move to a more flexible regime, but in the short term the dollar peg still has more advantages than disadvantages (Khan, et al., 2008). Many studies confirmed the findings of Khan, et al., but many others also found to the contrary. One such study dealing on the choice of exchange rate regimes was conducted by Aleisa and Hammoudeh (2005). It conducted its determination by observing the external shocks and how these impacted on the countries of the GCC. It found that the drivers of output movements in the GCC as a bloc consist of domestic shocks in both the near and long term, and shocks emanating from the U.S. dollar and the euro zones exert smaller, less significant impacts, suggesting that the GCC domestic conditions are relatively (though not entirely) de-linked from the external market. Weak correlations were found to exist between the GCC and those two zones, suggesting that the GCC bloc would be better off with a currency peg based on a basket of currencies as an intermediate measure, on the way to establishing a more flexible exchange rate regime (Aleisa and Hammoudeh, 2005). Methodology The research methodology encompasses both qualitative and quantitative treatment of secondary data. The research strategy shall employ the descriptive approach and combine qualitative analysis of economic and financial policies of the four member states (Qatar, Saudi Arabia, Kuwait, and Bahrain) with correlational studies on macroeconomic and financial indicators that may include interest rates, inflation rates, and stock indices. The purpose is to determine the level of integration of the economies and monetary systems of the four countries that shall participate in the single currency regime. The data are to be sourced from institutional databases of the IMF, World Bank, the Bank of International Settlements (BIS) and official government websites. Academic research papers shall be referred to as a source of secondary qualitative data to describe efforts conducted so far in the determination of the research topic. News accounts from news agencies of credible standing shall be referred to for timelines and events concerning the GCC single currency process. From the foregoing academic literature, conflicting assessments have been made depending upon the macroeconomic and financial indicators employed and the manner in which the quantitative assessment were conducted. For this reason, additional investigation shall be conducted during the course of this research, in order to arrive at a suitable model consistent with existing established theory that may best answer the objectives of this paper. This undertaking is indicated in the succeeding table that embodies the work schedule for the research project. Work schedule Activity Purpose Time Date Initial research To ascertain data availability Hypothesis formulation Variable selection from available data and determination of statistical test from literature review Data gathering & hypothesis testing Collation of qualitative and quantitative data and the conduct of quantitative analysis Data analysis Integration of qualitative and quantitative data and determination of findings Writing the preliminary draft Writing the text and formatting the tables in the initial manuscript Consultation Assessment of completed preliminary version of the study Writing the final draft Inclusion of revisions and formatting of the final draft of the study Presentation and submission Compliance with research requirement Proposed References Al-Jasser, M & Al-Hamidy, A 2004 A common currency area for the Gulf region. Bank of International Settlements, BIS Papers No. 17, pp. 116-120 Al-Omran, A 2010 Towards a Common GCC Currency: Are the GCC Countries Ready? Amerian University of Kuwait, 25 May 2010 Aleisa, E A & Hammoudeh, S 2005 “A Common Currency Peg in the GCC Area: the Optimal Choice of Exchange Rate Regime.” Journal of Economic Literature. International Monetary Fund research paper. Anon. 2002 “Gulf States to Adopt a Single Currency?” Middle East, May 2002, Issue 323, p23 Anon. 2009 “Single currency union takes a step forward.” Middle East, Jul 2009, Issue 402, p9 Benbouziane, M; Benhabib, A; & Benamar, A 2008 “Could GCC countries achieve an optimal currency area?” Journal of Economic Literature. International Monetary Fund research paper. Daily Star, The 2010 “Riyadh defends dollar as key reserve currency.” The Daily Star Regional. 15 February 2010. Accessed 20 March 2011 from http://www.dailystar.com.lb/article.asp?edition_id=10&categ_id=3&article_id=111750#axzz1HI5So5V4 Espinoza, R; Prasad, A; & Williams, O 2010 Regional Financial Integration in the GCC. IMF Working Paper. Middle East and Central Asia Department. April 2010. Khan, M; Tahari, A; Ananthakrishnan, P; Enders, K; Hasan, M; Leon, G; & William, O 2008 The GCC Monetary Union – Choice of Exchange Rate Regime. International Monetary Fund, Middle East and Central Asia Department. Qader, K S S & Shotar, M M 2005 “Economic Policies and the Possibilities of Unified GCC Currency”, Studies in Business and Economics, vol. 12 no. 2 pp. 81-89. Siddiqi, Moin A. 2001 “The GCC Moves Towards a Single Currency.” Middle East, Apr 2001, Issue 311, p35 Siddiqi, M 2007 “GCC single currency faces a bumpy road.” Middle East, May 2007, Issue 378, p50-52 Smith, P A 2009 “Will the GCC finally dump the Dollar?” Middle East, Oct 2009, Issue 404, p55-59 WAM 2009 “UAE to skip GCC Monetary Union,” Gulf News, 20 May 2009. Accessed 20 March 2011 from http://gulfnews.com/business/banking/uae-to-skip-gcc-monetary-union-agreement-1.469 Read More