Everyone’s watching the dollar

The GCC swings back to a stronger greenback

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United States currency policy concerns almost everyone: the Chinese, who hold some $876 billion in US treasury bills; the Middle East and North Africa, where nearly every nation’s currency is pegged to the dollar; and financial markets the world over. But only one of these concerned parties from around the globe is actually responsible for setting US currency policy: The US Federal Reserve (Fed).

Lately there has been speculation in global markets that a hike in the Fed funds rate is imminent — talk from which the Fed itself is remaining aloof. 

“The Federal Reserve Bank extended the low borrowing costs period after looking at the state of the economy and the [9.7 percent] unemployment rate,” said the chairman of the Federal Reserve Bank of Chicago, Charles Evans, to Executive at the 2010 Summit on Financial Literacy & Education in Chicago, Illinois, hosted by Visa.

Fed funds rate and inflation

Given the prevailing winds the economy is weathering, rates are likely to remain in the zero to 0.25 percent range — a world of zero interest-rate policy or “ZIRP” in Fed-speak — which the US has been in since December 2008.

Inflation, an appealing tool but no solution
Because it would lead to a higher nominal GDP while keeping the same level of debt, inflation can actually help temper the urgency of America’s debt-to-GDP ratio, likely to “balloon to more than 100 percent of GDP” by the end of 2020, as Fed chief Ben Bernanke told the US Congress’ Joint Economic Committee. But even if it were desirable to inflate in the short-term, such a policy would also harm the economy down the road. After monetizing the debt, returning to an acceptable level of inflation is not easy and might initiate a problematic economic spiral with downside risks of escalating the debt when the central bank raises interest rates (increasing debt interest payments), while slowing GDP growth.

“There isn’t much inflationary pressure [with inflation at 2.3 percent], hence we can afford that monetary policy,” indicated Evans. “However, if economic conditions change quickly, we will respond appropriately.”

The last time inflation was a major concern to the US economy was in the early 1980s; the Keynesian model, which predicted alarming inflation resulting from such a low Fed funds rate, is not in use today because demand has not yet rebounded, as the US moved from a consumer society to a savings one after the global economic crisis.

“Although the Fed added $1.5 trillion…to the economy by freeing up some money to the banks or through large-scale asset purchases, it did not trigger inflation, just as Chairman Ben Bernanke expected, because real estate prices went down, along with the stock market,” explained Yervant Demirjian, managing director and board member of Interaudi Bank in New York.

Inflation therefore remained contained as a result of a fall in prices, low consumption levels and limited economic growth. Nevertheless, markets currently expect an increase in inflationary pressure by September, along with a change in the state of the economy.

Backing the Benjamins 

In the 1980s, the dollar only regained its strength when inflation declined. But today, although it’s a ZIRP world, we have not attained the kind of inflationary pressure that could be bearish for the dollar.

Bearish euro
Various factors weigh on the euro, which reached a one-year low of 1.32 against the dollar on April 23. In addition to a restrictive European fiscal policy, the Greek debacle and its contagion effect on other European countries are also having an adverse effect on the euro. Greece asked the European Central Bank, the European Union and the International Monetary Fund to activate a bail-out as the five-year Greek credit-default swap spread reached a record high of 650 basis points on April 22, increasing borrowing costs and working against Greece’s efforts to reduce its budget deficit. Hence, the euro will probably not gain momentum in the short-term. According to Makram Abboud, managing director at Nomura Holdings in London, the euro even “appears overvalued… considering the macroeconomic situation of some EU members, or to a smaller extent, the European air travel disruption following Iceland’s volcano eruption… the airlines will possibly need a bail-out at a moment where governments are already over-leveraged.” This is in line with Morgan Stanley Research’s estimate of the euro dropping to 1.24 by year’s end, a lower forecast compared to other brokers.

First, the relative strengthening of the dollar stems from the diverse roles of the currency. It is not only a medium of exchange but, most importantly, a reserve currency, a safe haven through US Treasuries, a unit of account for commodities and trades, an anchor for pegging currencies and a carry trade currency (previously limited to the yen), given its low interest rates.

Secondly, economies in 2008 did not want to increase their US dollar exposure, placing a stronger interest in the euro and the British pound as oil prices and commodity prices were peaking. But this tend reversed at the end of 2009, when portfolios had to re-align their investment strategy and currency positions due to lower commodity prices and a more complex correlation between the dollar and oil prices (as opposed to a purely negative correlation). Finally, the US labor market is showing relative growth prospects and improving productivity, thus the overall market sentiment is positive toward the dollar.

GCC rides greenback

From a pure trading perspective within the Gulf Cooperation Council’s dollar-pegged economies, goods imported in currencies other than dollars became more expensive as the dollar weakened in the last five years.

But today, the relatively resurgent greenback – with a 5 percent to 6 percent increase year-to-date against the euro and British pound – translates positively because imports of, for example, European goods and services, as well as workforces, become cheaper. Meanwhile the main GCC exports, oil and gas, are denominated in dollars the world over (except for Iran,) meaning that despite the fact that they will be more expensive for consumers, they will be more expensive everywhere they shop, so there is no loss of competitive advantage.

Where things are not so rosy is in areas with an increasingly diversified economy that have exports paid in a cheaper currency, or non-oil economies such as Dubai. The Emirate will see a decrease in both real estate buyers and tourists whose home currency is not dollars and a stronger dollar will reduce competitiveness.

 Economically, the GCC was growing so fast in 2007 and 2008 that the double-digit growth, along with the increase in commodity prices and the cheap dollar, fueled an “oil bubble” and created uncomfortable levels of inflation. Qatar and the United Arab Emirates even reached consumer price index inflation levels of 15 percent and 12.3 percent respectively in 2008.

“Problems started to occur because the GCC was compelled to follow relatively low Fed funds rates while meanwhile, inflation was skyrocketing,” said Florence Eid, founder and chief executive officer of Arabia Monitor research and advisory firm. “Whereas in 2009, the Gulf entered a deflationary period, today the dollar peg — coupled with current low interest rates — is no longer a drawback for the GCC economy.”

These things are all cyclical of course, and they will change again,” she added. 

However, the relative strengthening of the dollar against the euro has two major economic advantages. It is, first, an effective tool for inflation stabilization in the Gulf area, which, as mentioned above, is extremely important for the state of the economy. Furthermore, it eliminated concerns surrounding the dollar peg.

“GCC countries, with 95 percent of assets in dollars, would have suffered from de-pegging from a weak dollar, running high risks of weakening their own currencies even further,” said Makram Abboud, managing director at Nomura Holdings in London. “Now with a stronger dollar that discussion [of de-pegging] has gone away.”

On the monetary front, the peg to the dollar “implies that, by design, the GCC interbank rates should not diverge,” as stated by an IMF paper on regional financial integration. Consequently, the region responded fast to Fed discount rate cuts as GCC central banks also reduced their borrowing rates, with cuts of 250 basis points in Bahrain and 175 basis points in Saudi Arabia. Such monetary policy is a useful tool to push demand, along with pumping money into local banks, encouraging citizens to borrow again, while governments continued to spend in key areas such as infrastructure.

In Saudi Arabia, the 2010 budget will likely reach $144 billion, and “even though main growth drivers in the Gulf are government expenditures [highly related to the level of oil prices], all things being equal, an appreciation of the US currency will tend to improve local purchasing power, fueling consumer demand and investment with a positive impact on growth” said Michel Cordahi, head of Capital Markets at Gazprombank Invest (MENA).

JP Morgan effective exchange rate indices

Thus, a stronger dollar will, overall, improve economic conditions already facilitated by monetary policies and will directly lead to a rebound in consumption, fostering a positive economic spiral. Such assumptions led the International Monetary Fund to forecast a real gross domestic product growth of 4.5 percent in the MENA region for 2010, doubling 2009 growth.

Some warning signs

However dollar bullish one may be in the short-to-medium term, the situation is perhaps less that of a stronger dollar than a cheaper Euro, all the more since the dollar has weakened against most emerging market currencies in the last six months. Moreover, “with a US deficit worsened by the healthcare bill, a high level of federal debt and a renminbi [yuan] revaluation likely to redirect capital inflows to Asia and cause sells on the USD, the dollar might lose its temporary bullish tone,” forecasts Stefan Teufer, coverage director at Deutsche Bank.

True, Bernanke’s Fed has saved the US economy from a depression, sparing a global financial Armageddon in the world’s interconnected economies, but the GCC should neither be blinded by what may be a short-term resurgence in the greenback, nor neglect monitoring closely their inflationary pressure.

Even if they are committed to the dollar peg, central banks should be cautious when aligning their monetary policies to future Fed hikes, especially for countries that have not reached their desired inflation rates, or if an interest rate hike would risk a relapse into a credit crunch. In the short term, it may be a wise idea to count their lucky stars — or dollars.