Wealthy nations in Gulf rethink peg to dollar

The Wall Street Journal

For many years, oil-rich Persian Gulf states have pegged their currencies to the dollar. Now that link is stoking a bad bout of inflation in their red-hot economies and putting policy makers in a dilemma: Break the dollar peg and risk undermining the U.S. currency, or keep it and face growing local discontent.

The dollar peg has "served the economy ... very well in the past," said Sultan Nasser al-Suweidi, the governor of the United Arab Emirates' central bank, last week. "However, we have reached a crossroads."

Because countries such as the UAE, Saudi Arabia and Qatar sit on large reserves of U.S. dollars, their decisions will have repercussions beyond their borders. If they move away from their strict dollar pegs - perhaps following Kuwait, which earlier this year switched to a basket of currencies - it could undermine demand for dollars and encourage others to diversify their holdings. Many nations have already created sovereign wealth funds to invest their holdings in a broader array of assets.

The Persian Gulf nations originally tied their currencies to the dollar to stabilize their revenue from oil, which is traded in dollars. Also, some nations had little central-banking expertise and found it easier to tie their monetary policy to that of the Federal Reserve in Washington.

Now, however, the Fed is cutting rates to prop up the slowing U.S. economy and forestall damage from the U.S. housing downturn. That's precisely the wrong prescription for economies trying to tame galloping growth, such as those in the Persian Gulf.

The peg isn't finished yet, particularly in Saudi Arabia, which maintains a close relationship with Washington. During the summit of the Organization of Petroleum Exporting Countries in Riyadh over the weekend, Venezuela and Iran pushed to mention concerns about the dollar in the meeting's final statement. Saudi Arabian Foreign Minister Saud al-Faisal rejected the effort, saying such a move could have a damaging impact on the U.S. currency.

Officials in Saudi Arabia, the region's largest economy, have said they will not break the peg between their currency, the riyal, and the dollar. However, the country has other options. It could revalue its currency at a slightly stronger level, much as China did in 2005, but still link it to the dollar.

A key date in the debate will come in early December, when heads of state of the Gulf Cooperation Council, a loose regional economic bloc, meet in Doha, Qatar. Currency issues will be high on the agenda.

Investors are betting that some change is coming. Contracts that allow investors to lock in exchange rates a year from now reflect expectations that both the UAE dirham and the Saudi riyal will strengthen somewhat. Bank deposits in the UAE have swelled, as local and foreign investors buy dirhams at the current rate and bet on a revaluation.

The countries of the Persian Gulf are struggling with the impact of their own good fortune as rising oil prices bring a windfall. Normally, when the price of a country's major export rises, that pumps up the local currency, which helps restrain inflation.

Instead, much the opposite has happened. As the price of oil has skyrocketed in recent years, Gulf currencies tied to the dollar have fallen relative to other currencies such as the euro and British pound, making many of their imports more expensive.

The UAE and Qatar have suffered some of the worst inflation, as the oil gusher has triggered a building boom. In Qatar, inflation hit 11.8 percent last year, and the International Monetary Fund estimates it will average 12 percent this year. This week, officials in Doha, the capital, raised taxi fares by a third.

Both countries depend on an army of guest workers from South Asia and elsewhere, who send much of their income to their families back home. As costs go up, these workers are spending more of their salary on basic goods and have less to send. What's more, the falling dollar erodes the value of the Gulf currencies against the workers' home currencies, meaning their remittances don't go as far.

In Dubai, which is part of the UAE, thousands of workers have staged sometimes-violent protests at construction sites, protesting their decreased buying power. The UAE government is now mulling a minimum wage. Construction and contracting companies worry that will boost their costs, and some executives have spoken out in favor of revaluing the dirham.

In September, Imran Sheikh, 27 years old, moved to Doha, the Qatari capital, after landing a job working the night shift at a reception desk in one of the city's new apartment towers. Since then, prices for the basics - food, clothing and taxi fare - have marched higher. He makes about 2,000 Qatari riyal, or about $550, a month. As the cost of living creeps up, he's sending less cash home to his family in Mumbai, India, and that cash buys fewer Indian rupees.

"The prices are going up," he says. And because of the dollar, "the salaries are smaller."

Saudi Arabia, too, is struggling with inflation pressures, and unlike other Gulf countries, it has a large and comparatively poor population. Inflation touched 4.9 percent in September, the highest level in at least a decade. Last month, King Abdullah summoned the interior minister and provincial governors to account for the rising prices. And for the first time in 27 years, Saudi authorities increased the amount banks must hold in reserve in an attempt to limit the money coursing through the economy.

The challenges faced by the countries of the Persian Gulf resonate in places as disparate as China, which ties its yuan closely to the dollar, Ecuador, where dollars serve as the official currency, and Ukraine, which maintains a de facto dollar peg.

The Gulf is "the front line at the moment, but the pressures are much broader," says Simon Derrick, chief currency strategist at Bank of New York Mellon Corp. These countries share "one consistent factor, which is they've pegged themselves to a falling currency."

Countries in the Persian Gulf have several options. Kuwait chose in May to link its currency, the dinar, to a basket of currencies. Though the exact weighting of the basket isn't disclosed, experts say the dollar still accounts for a considerable portion. Since the move, the dinar has strengthened about 5 percent versus the dollar.

Another option would be to maintain the peg to the dollar, but at a new level reflecting the strength of the local currency. A third choice would be to permit the currency to float freely, but that is unlikely because the Persian Gulf nations aren't eager to allow volatile swings in their currencies.