IMF Executive Board Discusses Paper on GCC Monetary Union: Choice of Exchange Rate RegimePublic Information Notice (PIN) No. 08/144
November 25, 2008
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On October 27, 2008, the Executive Board of the International Monetary Fund (IMF) discussed a paper on GCC Monetary Union: Choice of Exchange Rate Regime.
One of the critical decisions in the formation of a monetary union is the choice of an appropriate exchange rate regime for the single currency. The member countries of the Gulf Cooperation Council (GCC) agreed in 2003 to peg their currencies to the U.S. dollar and to maintain the parity until the establishment of the GCC Monetary Union in 2010. A decision on the exchange rate regime for the single GCC currency would be made then. Although the choice of the U.S. dollar peg as the external anchor for monetary policy served the countries of the GCC well for many years in maintaining macroeconomic stability, rising inflationary pressures in the last two to three years, the continuing depreciation of the U.S. dollar against major currencies, and differing economic cycles and policy needs to that of the anchor country (the United States) have raised questions about whether the peg to the dollar remains appropriate, and therefore would be appropriate for the GCC Monetary Union.
Against this background, staff prepared for the Executive Board a paper outlining the pros and cons of some exchange rate regimes that could be considered for the GCC Monetary Union. The standard criterion for determining the optimal exchange rate regime is macroeconomic and financial stability in the face of real or nominal shocks. Ideally, the exchange rate regime chosen should yield external and internal stability, preserve monetary credibility and international competitiveness, and reduce balance sheet risks and transaction costs. In applying these criteria to the GCC, however, it is necessary to take account of: the dominant influence of the oil sector in GDP, exports, and government revenue; the labor market structure; and the ability of these countries to pursue domestic goals of inflation and growth if they had monetary policy independence.
Executive Board Assessment
Executive Directors welcomed the opportunity to have a preliminary exchange of views on the choice of the exchange rate regime for the planned monetary union by GCC countries. Directors considered the staff paper to have provided a rigorous analytical framework, while highlighting the likely challenges in the transition to the union, and offering a balanced assessment of alternative exchange rate regimes.
Directors agreed that analysis of the appropriate exchange rate regime should consider costs and benefits in a medium-term framework, and incorporate country-specific circumstances—including the dominance of the oil sector, the labor market structure, the institutional capacity to conduct monetary policy, and development of financial markets. The economic criteria for determining the appropriate exchange rate regime should include: external and internal stability, international competitiveness, policy credibility, transactions costs, and the nature of shocks. Directors welcomed the pragmatic application of these criteria to the GCC countries and the recognition that the exchange rate regime is only one element of the overall policy framework and as such should not be assessed in isolation. Directors stressed that, while short-term factors would continue to be relevant in the run up to the monetary union, the determination of the appropriate exchange rate regime will depend on economic developments at the time of establishment of the monetary union. In addition, the choice of the exchange rate regime should be guided by forward-looking considerations and longer-term objectives.
The costs and benefits of four exchange rate regimes—single currency (U.S. dollar) peg; managed float; basket peg; and pegging to the export price of oil—were explored. Directors remarked that the current U.S. dollar peg has served GCC countries well on balance. Continuation of the peg to the U.S. dollar would offer several advantages, including established credibility through a well-understood nominal anchor and lower transactions costs. In the face of the recent significant volatility in oil prices, the U.S. dollar peg has contributed to macroeconomic stability. Nonetheless, Directors observed that questions about its suitability have arisen over the past two years, owing to higher inflation among GCC countries, depreciation of the U.S. dollar against major currencies, and desynchronized business cycles coupled with reductions in U.S. policy interest rates. In this context, the role played by supply-side bottlenecks and temporary factors will require continued monitoring. The prudent conduct of fiscal policy—the main macroeconomic instrument—would be crucial for achieving external and internal balance.
Directors noted that a managed float could allow greater monetary independence to control inflation and facilitate real exchange rate adjustment to real shocks. Many Directors viewed a more flexible exchange rate regime as a longer-term possibility. These Directors believed that additional exchange rate flexibility could be warranted as the GCC economies become less dependent on oil and more heterogeneous over time, and if the business cycles of GCC countries and the United States continue to diverge. On the other hand, greater exchange rate volatility could increase costs related to international transactions. It would also require the establishment of a credible central bank with effective monetary instruments and harmonized regulation and supervision in GCC financial markets. In this regard, several Directors noted the contribution that could be made by technical assistance from the Fund and the European Central Bank (ECB).
Directors agreed that a basket peg of major currencies could provide an intermediate exchange rate regime that introduces some flexibility in the exchange rate and reduces the adverse effects of swings in the value of major currencies. However, a basket peg might be less easily understood and provide a less secure nominal anchor than a single currency peg. The experience of Kuwait with its basket peg, which was adopted in May 2007, was considered highly germane but too short-lived as yet to yield definitive conclusions. From a longer-term perspective, some Directors saw increasing merits in favor of a basket peg, particularly comprising the U.S. dollar and the Euro.
Directors generally agreed with the staff paper that an exchange rate peg to the international price of oil has important drawbacks, as it would pass through automatically fluctuations in oil prices to the non-oil sectors. Moreover, given the importance of GCC oil production for international oil prices, this peg might not provide a firm nominal anchor.
Directors asked staff to continue to examine this key topic. Several Directors suggested that a more multilateral perspective be adopted, taking into account possible spillover effects of the GCC's choice of exchange rate regime on the global economy, and implications for reserve currencies, oil prices, global external imbalances, and expatriate labor in the GCC.
Directors observed that much has changed in the global economy since this paper was prepared, noting in particular the halving of oil prices, the strengthening in the U.S. dollar, and the global downturn. Therefore, Directors were of the view that the choice of the exchange rate regime for the GCC monetary union would need to be determined in light of economic conditions and prospects prevailing at the time the currency union is established. Many Directors agreed with staff that achieving monetary union by 2010 would be a challenge. Several Directors stressed the importance of creating the proper institutional infrastructure for launching a currency union. Directors encouraged staff to continue to support the efforts of the GCC countries toward their monetary union, including by producing analytical papers.