Middle East Council Meeting This Weekend: How Could This Affect the US Dollar?

US Dollar Vulnerable in the Middle East – Why Oil Shouldn’t Be Your Only Concern

On December 3 and 4, the Gulf Cooperation Council – which counts Saudi Arabia, Bahrain, Kuwait, the UAE, Qatar, and Oman as members – will meet for the Doha Summit, and this meeting will be watched very carefully as the council is expected to discuss breaking their respective currencies from the US dollar peg. With the greenback trading near record lows, countries like the UAE and Qatar are grappling with rapidly growing import price inflation and accelerated expansion as oil revenues rocket higher. In fact, during the second quarter of this year, the Qatar Central Bank reported that inflation hit 12.8 percent. Meanwhile, the US Federal Reserve has reduced the federal funds rate by 75bp since September and the markets continue to price in additional cuts. Clearly, the synergies between the US and Persian Gulf countries have lessened quite a bit, making US monetary policy and more importantly, the US dollar, an uncomfortable fit for many GCC members. As a result, there is little reason to doubt that moving away from a dollar peg will be discussed at the Doha Summit, but what are their options and how will it affect the US dollar?

Pegging to a Basket of Currencies – Most Likely Scenario

Persian Gulf countries like the UAE, Qatar, and Saudi Arabia have a few choices when it comes to shifting their respective currencies from the dollar peg, but they will likely want to go with a method that has been tried and tested by one of the other GCC member countries: Kuwait. In May, Kuwait shifted their currency, the dinar, from a dollar peg to a basket of currencies. While the exact weighting has not been disclosed, the basket likely remains heavily weighted in the greenback, with the remaining portions in the currencies of some of their major trading partners, including Europe, the UK, and Japan. Since the shift, the Kuwaiti dinar has appreciated approximately 5 percent, indicating that a move to a currency basket is a very feasible option.

In the short-term, the announcement of a shift to a currency basket by any of the other GCC members would be detrimental to the greenback, as it would suggest that the country would start to diversify central bank reserves away from the dollar and into assets denominated in the currencies of the basket. There is significant capital at stake, as Saudi Arabia’s foreign currency reserves rose 26 percent in September from last year to $259 billion, while the UAE's reserves surged a whopping 65 percent in June from a year earlier to $43 billion. Furthermore, the risks of a sharp knee-jerk sell-off in the greenback would be exacerbated if a group of GCC members announced that they would all de-peg from the dollar, given the increased reserve diversification prospects.

A One-Off Revaluation – Another Possible Action

Another option that some of the GCC members may consider is a one-off revaluation, which would maintain the dollar peg, but at a level that reflects an appreciation of the local currency. This is similar to what China did with the yuan in July 2005, when the currency was allowed to appreciate 2.1 percent within a single day. The primary reaction of the greenback was seen as a 2.7 percent drop against the Japanese yen, but the sell-off of the dollar also followed through to a lesser degree of approximately 1 percent against the Euro and British Pound. However, the price action did not carry over into the long term, as the prevailing trends of the pairs eventually took over within a few days. If one or more GCC members chose to implement a one-off revaluation, we would likely see similar results where the US dollar would drop against the majors, though the sharpest moves would likely be against the Euro and British Pound. Nevertheless, with central bank foreign exchange reserves likely to go untouched for the time being, the sentiment may wane rather quickly.

A Free Float - The Road Less Traveled

A daring move on the part of the Persian Gulf nations would be to allow their respective currencies to float freely. However, given the implications of the wild volatility that would ensue, this option is highly unlikely. With their main source of government revenues – oil – priced in dollars, the GCC countries have an interest in having their national currencies tied to the greenback in some way, shape, or form.

Not to Be Forgotten…What About the Far East?

China is the most crucial variable in the discussion of reserve diversification. The People’s Bank of China said that foreign exchange reserves totaled $1.434 trillion at the end of September, up 45.1 from a year earlier and by far the largest in the world. While China does not disclose the weightings of their holdings, it is widely speculated that most of the reserves are held in US dollar denominated debt, such as US Treasuries, with the remainder denominated in Euros and other currencies, including the Japanese yen and Korean won. Any investor would question putting all of their eggs in one basket, so why would China be any different? With the risks of a recession looming large for the US economy and dragging the US dollar to record lows, it’s no wonder countries like China are weighing their options. As a result, the greenback remains in danger from a supply and demand standpoint as the central banks of China and the Persian Gulf countries could decide to hedge their bets by the billions and move funds away from the United States into European assets.

Written by Terri Belkas, Currency Analyst

DailyFX

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