Exchange Rate Policy in the Gulf States - Literature review Example

Introduction It has been argued that with the beginning of 21st century, there are many important changes taking places within the sphere of monetarypolicy and foreign exchange regime management. Countries are increasingly finding it difficult to manage their foreign exchange rates and as such are employing new and different exchange rate regimes than the ones being used for years. Countries in the Middle Eastern Region specially those belonging to the Gulf States have since long been pursuing the policy of pegging their exchange rates with the US dollar. This has mostly been done because most of the countries are oil rich and earn their revenue in dollars which is the currency of international settlements. However, recently, due to shocks in oil prices, many Gulf States have been pursued to adapt to the flexible exchange rate regimes because of rising inflationary pressures as well as bringing in more structural reforms into such economies in order to improve their long term sustainability. (Times, 2007). Further, many analysts are also indicating the recent movements in the oil price as one of the most critical reasons for bringing in the changes into the exchange rate regimes in GCC countries as most of the OPEC members believe that the mismanagement of US economy and weakening dollar against major currencies of the world is a cause of concerns as revenues continue to dwindle despite maintaining adequate supply in the market. (Feldman, 2008). This research paper will attempt to study and analyze the policy options available to various States in Gulf to address the current exchange rate dilemma being faced by them. Exchange Rate Regimes There are different foreign exchange regimes which are followed by the countries across the world. However, a historical understanding of the process would further add up to the overall understanding of the issue. The issues of choosing a fixed exchange rate regime or floating exchange regime is one of the oldest debated policy issues which both public policy makers as well as monetary policy makers encounter with. Both the systems have their own merits and de-merits and both the regimes and combination of both as one can be beneficial under certain economic conditions. Thus the choice of having different exchange rate regimes largely depend upon the multitude of factors which combine produced the economic environment most conducive for such an exchange rate regime. The following section will discuss some of the exchange rate regimes besides discussing which exchange regime may be beneficial under what sorts of conditions. The Gold Exchange Standards The more modified form of the gold exchange standards was put in place during 1927 mostly due to the increase in the output of world’s gold. The exchange rates were fixed against the gold due to its increasing convertibility as well as willingness of most central banks to hold interest bearing foreign exchange securities as an alternative to the overall gold. (Ghosh, Gulde, & Wolf, 2003) Under this regime, the monetary system of the economies were based on paper notes that were commonly convertible into certain fixed quantitites of gold. The Bretton Woods System Due to great depression in US, the economic system was shattered as the economy fell into continuous decline. The Bretton Woods agreement was an effort to bail out US from the recession and putting back the economic system of the world on its feet. It was during this meeting that it was decided that the exchange rates of most of the world’s currencies will be fixed or pegged against the dollar in order to arrest the deflation as well as other destabilizations into the values of the currency. Any gaps arising due to devaluation or other economic pressures would have to be settled through IMF which was created in order to support the countries with deficits. Most of the countries at that time decided to peg their currencies against US dollar and hence the dollar emerged as the currency of the world. (Ghosh, Gulde, & Wolf, 2003). Post Bretton Woods System This was an era which started around 1970s when it was strongly felt that the Bretton Woods system of fixed exchange rate regimes is a failed system and as such the exchange rates shall be free floating and shall be determined by the market forces of supply and demand. Accordingly, a new system of exchange rate regimes was proposed which advocated the use of floating exchange rate regimes. The currency crisis in most of the Asian countries was also largely seen as failure of the fixed exchange rate regimes, and as such it was advocated that a new system of free float shall be introduced in order to curb the impacts of economic shocks. Present Scenario The present situation indicates that there are mostly three exchange rate regimes are in place. Most of the countries are following the managed float system in which government occasionally intervenes to correct the imbalances in the market and as such exchange rates are determined by the forces of demand and supply in the market. Further, few countries are still following fixed or pegged exchange rate regimes under which the local currency is pegged to US dollar, mostly. Most of the Gulf countries have still pegged system in place as their currencies are fixed against the US dollar. Exchange Rate Regimes in Gulf Countries Gulf States are those States, which have a long history of pegging their currency against the dollar as most of them are oil producing countries and dollar being the international currency, offer them many flexibilities as well as breadth in terms of managing their exchange rate in international market. Saudi Arabia has the system in place since 1960s with slight variations being made into the adjustment of exchange rates. Similarly, countries like Kuwait, Qatar, Bahrain, UAE has also pegged their currencies with the US dollars with pre-determined margins to allow the currency to move within a certain range. The system has been in place for quite long time. However, there are renewed calls from both the experts as well as the GCC countries themselves to review the system. Recent Issues The current performance of US dollar against the major currencies of the world is really worrisome for most of the policy makers in the region as continuous weak performance of the dollar as an international currency has forced countries like Kuwait to change their exchange rate regimes in order to better manage its exchange rate. One of the strongest arguments against de-pegging the major GCC currencies against the dollar is the fact that weak dollar coupled with increasing oil prices have increased the inflation in the region and as such the pegged system is not helping most of the countries to manage inflation. Since most of the GCC countries rely on expats as major source of human resource. Therefore, increase in costs for them is forcing them to leave the countries because they are unable to save. (Rutledge, 2005). There are other issues related with this problem also such as rapid growth of most of the countries, increasing oil prices, especially before the current credit crisis as well as the tight fixation of exchange rates is causing the policy makers to look for other ways to manage the economy. GCC countries combine produce almost 2/3rd of the oil output of the world and with the last rally of price increase in oil, revenues surged. However, with it, the domestic inflation also increased too which is forcing policy makers to make some structural changes into the exchange rate management of the economies. Considering the above situation, there are many policy alternatives which are being contemplated including pegging the currency with the Euro as well as changing the exchange rate regime from fixed to floating. Further, it has also been contemplating that the price of oil shall be pegged in the basket of the currencies against which the GCC currencies are pegged. (Frankel, 2008). It is also argued that the free floating system may be introduced into the States. However, given the empirical weaknesses of the floating exchange rate regime and its benefits to the small open economies; economists like Frankel are not supporting such an idea. Conclusion There are various exchange rate regimes in place which are being used by different countries under different economic environment. Most of the Gulf States have in place the pegged or fixed exchange rate regimes under which the local currencies are pegged against the US dollar. This practice has been in place since years. However, slight variations have been made to it. The recent performance of US dollar in the international market specially its slide against major currencies such as EURO and increasing oil prices have increased the inflationary pressures on Gulf Countries. The supposedly uncontrolled inflation is forcing expats to leave the country as the overall cost of living has greatly increased. Considering this situation, many policy makers and economists are now considering the shifting the exchange rate regimes to other regimes such as floating exchange rate regimes in order to give a breathing space to the GCC economies. Bibliography 1. Feldman, N. (2008). Exchange Rate Policies in the Gulf: A New Challenge to American Preeminence? Retrieved Feb 23, 2009, from Institute for National Securities Studies: http://www.canadafreepress.com/index.php/article/2380 2. Frankel, J. (2008). UAE & Other Gulf Countries Urged to Switch Currency Peg from the Dollar to a Basket That Includes Oil. Retrieved Feb 24, 2009, from VOX: http://www.voxeu.org/index.php?q=node/1381 3. Ghosh, A. R., Gulde, A.-M., & Wolf, H. C. (2003). Exchange Rate Regimes. New York: MIT Press. 4. Rutledge, E. (2005). Pleasure of high oil prices brings pain of inflation to Gulf countries. Retrieved Feb 24, 2009, from The Daily Star: http://www.gulftalent.com/home/Pleasure-of-high-oil-prices-brings-pain-of-inflation-to-Gulf-count-Press-26.html 5. Times, K. (2007, October 24). Gulf States urged to move beyond fear of floating. Retrieved Feb 23, 2009, from http://www.menafn.com: http://www.menafn.com/qn_news_story_s.asp?StoryId=1093171171 Read More