Persian Gulf Arab states may not keep dollar

In early July, the Central Bank of the United Arab Emirates announced that the country would drop its 30-year peg to the dollar by June 2009, linking instead the national currency, the dirham, to a basket of currencies which would include the dollar and the euro. Some experts claim that the move would lead to the fast appreciation of the dirham against the dollar.


The UAE is one of the world's main holders of dollar-denominated assets. However, the dollar has gone down by 33% against the euro since 2003, severely devaluing currencies of the six states of the Persian Gulf Cooperation Council (PGCC) -Saudi Arabia, the United Arab Emirates, Qatar, Kuwait, Bahrain and Oman- even as oil prices reach record levels. Inflation, meanwhile, has surged to double digits in all Persian Gulf Arab countries, except Bahrain.
Inflation in the UAE, the second-largest Arab economy, surged to 11.1% in 2007 from 9.3% because the weak dollar and high global food prices led to more expensive imports. With its monetary policy tied to the United States, the UAE has fixed price limits on basic foods and building materials in an attempt to control prices, Bloomberg has reported. The UAE's oil-rich economy expanded 16.5% to 190 billion dollars in 2007, which is equivalent to 1.3% of the size of the US economy, according to data compiled by Bloomberg.

The National newspaper, owned by the ruling family of Abu Dhabi, reported on July 6 that the UAE will call on all six Persian Gulf Cooperation Council member states to de-peg their currencies from the US dollar to curb inflation. However, the UAE will not be the only country to scrap its peg to the US currency. Kuwait put an end to its 5-year dollar peg in May 2007 in favor of a basket of currencies. Since then, the uwaiti dinar has appreciated more than 8%; the country's inflation is lower than that of other PGCC states, mainly because it can freely determine its own interest rate policy.


Qatar has reduced its exposure to the dollar by approximately 60%, distributing its reserves between the US dollar (40%), euro (40%) and a basket of other currencies such as the yen, the sterling pound etc (20%).
The problem at hand is also influenced by social factors. In recent months, many of the Persian Gulf Arab countries, which depend on Asian foreign labor to man their rapidly growing economies, have experienced strikes as foreigners are demanding higher wages due to the devaluation of local currency. PGCC governments fear that if they do not take rapid measures crises will evolve.


All Persian Gulf economies seek to reduce their exposure to the weak US dollar. PGCC central bank governors are expected to meet in September to finalize a draft of the Single Currency Agreement, a framework that would let them set up a monetary union by 2010. If an agreement is reached, PGCC economy ministers and eventually heads of state will need to deal with the issue in December.
China and Russia have also been gradually shifting their foreign currency reserves from the dollar to the euro. The Russian Central Bank expects that the US dollar portion of its reserves will fall to 45%. Iran has gone even further, conducting euro oil deals in response to US pressure on the country.


Given the poor performance of the US economy, and the weakness of the dollar against all major currencies, new measures to reduce the exposure to the dollar are widely expected.
The most likely scenario will be that Persian Gulf countries will switch to a currency basket, thus enabling their financial institutions to invest in assets denominated in other currencies. However, a significant reduction in US dollar exposure by these countries and also by China might prove to be devastating for the US economy.