## _082808a — Executive Summary

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### Background and context
- GCC currencies pegged to the U.S. dollar in 2003 to maintain parity until the GCC Monetary Union in 2010; Kuwait returned to a currency basket in May 2007.
- Resource and macro structure:
  - GCC jointly account for over 40 percent of global oil reserves and 23 percent of natural gas reserves.
  - Oil and gas production contributes about one half of total GDP and three-fourths of total exports and annual government revenues.
  - Total GDP of the six GCC member countries in 2007 = $815 billion; average per capita income ≈ $22,000.
  - Inflation averaged 1.5 percent over the last three decades.
  - Fiscal and current account surpluses in 2007 amounted to 19 percent and 26 percent of GDP, respectively.
  - Non-nationals account for about two-thirds of employment and comprise about one-third of the total GCC population.
  - The common market was launched on January 1, 2008, providing GCC citizens equal treatment in a wide range of economic activities.

### Exchange rate regime alternatives considered
- Four main options analyzed:
  - Pegging to the U.S. dollar.
  - Managed floating.
  - Pegging to a currency basket.
  - Pegging to the export price of oil (PEP).
- Summary of trade-offs:
  - Dollar peg:
    - Reduces exchange rate and capital flow volatility from nominal shocks.
    - Provides a credible and easily understood anchor for monetary policy.
    - Simplifies trade and financial transactions, accounting and business planning.
    - Disadvantages: imports U.S. monetary policy; cannot defend against imported inflation; forces adjustment via inflation rather than the nominal exchange rate; may trigger price-wage spirals, low real interest rates, asset bubbles, and reduces real value of financial savings.
  - Managed floating:
    - Permits monetary policy to smooth business cycles and adjust to real shocks.
    - Requires structural and institutional readiness and a choice of nominal anchor; considered more of a longer-term option.
    - Limitations in GCC: weak interest rate transmission, underdeveloped domestic capital markets, thin FX markets, and risks of high exchange rate volatility given oil dependence and open capital accounts.
  - Basket peg:
    - Introduces flexibility and reduces adverse effects of swings among major currencies.
    - Retains anchor properties of a peg but may be less transparent and credible if weights/composition undisclosed.
    - Example: SDR peg would have reduced volatility of oil export receipts compared with the dollar peg.
  - Pegging to export price of oil (PEP):
    - Delivers automatic accommodation to terms-of-trade shocks.
    - Drawbacks: greater exchange rate volatility; questionable small-economy assumption (GCC sizeable in world output/exports); potential transmission of volatility to non-oil sectors; may dampen diversification incentives.

### Assessment and recommended near-term regime
- On balance, the dollar peg appears the most appropriate leading up to and likely in the short-run after establishment of the monetary union.
- Preconditions and contingencies:
  - If current inflationary pressures are temporary, the benefits of the dollar peg outweigh costs of switching regimes.
  - Authorities should reconsider options if:
    - inflation persists, and
    - there is a further sharp depreciation of the dollar against other major currencies.
  - If floating is not viable when reconsideration is needed, pegging to a common basket of currencies may become the more appropriate regime.
- If the monetary union is delayed, the 2003 commitment to pegging at given parities until 2010 may no longer be binding and individual countries could consider other regimes earlier.

### Institutional framework, readiness, and timeline for monetary union
- ECB provided draft Monetary Union Agreement (MUA) and statutes on the Gulf Monetary Council (GMC) and Gulf Central Bank (GCB).
- Expected transitional body: monetary council to be established in 2009.
- A set of five convergence criteria agreed in principle (inflation, interest rates, reserves, fiscal balance, public debt); at end-2007 GCC countries had met almost all criteria and exhibited a high degree of convergence on many macro indicators.
- Official target date for the launch remains 2010; Oman decided in February 2008 not to join; Kuwait moved to an undisclosed basket in May 2007 but reaffirmed commitment to join the union.
- Delays and incompleteness in harmonization and institution-building include:
  - monetary policy frameworks; payment and settlement systems; regulatory and supervisory structures; macroeconomic statistics; central bank functions; management of reserves and non-reserve assets.
- Fiscal priorities: common accounting framework and adequate budgetary procedures.
- Conclusion: "As a result, the 2010 deadline for the single GCC currency appears increasingly unachievable."

### Inflation dynamics and pressures on the dollar peg
- Historically low inflation sustained by:
  - imported monetary discipline from the peg; open trade regime; labor market flexibility; prudent fiscal policy; benign global inflation.
- Recent pressures:
  - rising inflation in the last couple of years (partly from supply bottlenecks, housing, international prices of food, raw materials, equipment);
  - depreciation of the U.S. dollar against other major currencies;
  - divergence in business cycles between the GCC and the United States highlighting the cost of an imported monetary policy.
- These developments "have raised questions about whether the peg to the dollar remains appropriate."

### Empirical observations and country experiences
- Peg preference among oil exporters:
  - Of 26 countries with oil exports > 50 percent of total exports, 18 (including GCC and CEMAC members) have conventional fixed pegs; examples include Brunei (currency board) and Ecuador (dollarized).
- Kuwait (May 2007 move to undisclosed basket) observed impacts:
  - By July 21, 2008 the KD had appreciated by 8.2 percent.
  - KIBOR cut from 5.19 percent to 4.13 percent within days in May 2007 and subsequently to a level lower than the one month LIBOR rate.
  - Credit growth: annual growth accelerated from about 25 percent in January 2007 to about 34 percent in July and August and to 36 percent by December.
  - Inflation reached 11.4 percent y/y in April 2008.
  - Currency speculation, strong demand for KD, capital inflows, and increased liquidity were observed.
- Managed floats in other oil exporters (Algeria, Kazakhstan, Russia) improved growth and inflation performance post-exit from pegs, but exits were often disorderly and associated with crises; exchange flexibility in practice showed high coefficients of variation (Kazak tenge = 21; Russian ruble = 10).

### Policy implications and preparatory steps
- If maintaining a peg (dollar or basket):
  - Accept imported monetary policy and limited domestic rate autonomy.
  - Use fiscal policy and macroprudential measures to contain domestic demand and credit growth.
  - Expect slower real exchange rate adjustment via inflation, with associated risks to savings and asset prices.
- If moving toward greater flexibility or adopting a basket:
  - Build central bank institutional capacity: improve measurement of inflation, develop inflation forecasting capacity, develop instruments to manage liquidity, strengthen transparency and central bank independence.
  - Develop deep and liquid foreign exchange markets and hedging instruments.
  - Define clear intervention rules and strengthen fiscal-monetary coordination.
  - Consider disclosure of basket composition and weights to reduce speculative and informational risks.
- If considering pegging to the export price of oil (PEP):
  - Recognize limitations: GCC not a small economy; oil price may not be exogenous; greater volatility and potential adverse effects on diversification and fiscal balances.
  - PEP requires high transparency and credibility and may transmit volatility to non-oil sectors.

### Transitional scenarios and adjustments at monetary union
- If inflation and current account surpluses are temporary:
  - They will likely decline by the monetary union date; maintaining the current peg would be optimal so the common central bank inherits a well-functioning anchor.
- If inflation and surpluses persist:
  - Move to greater flexibility via a basket peg is advisable; peg to a common disclosed basket could shield markets from dollar movements.
  - Feasibility depends on prior progress in institutional infrastructure and market-based operations.
- If parities are out of line with fundamentals at union formation:
  - The GCC could retain the dollar peg but effect a one-off coordinated parity adjustment (revaluation) at establishment of the common currency.
  - Revaluation costs: immediate valuation losses on large official foreign assets; reduced international competitiveness for diversification efforts; sharply lower fiscal revenues in domestic currency; adverse balance-sheet impacts on governments and banks.
  - Announcing adjustments could spur speculative inflows and deposit transfers (experience after Kuwait’s move).
  - Need for credible communications strategy and careful timing.

### Exchange rate assessment and REER findings (Box 5)
- REER assessment:
  - GCC REERs appear undervalued; the 2003–07 terms-of-trade shock likely appreciated the equilibrium REER.
  - Panel-based estimates using CGER variables show average deviation of actual REER from estimated equilibrium REER ranged from 3 percent in Kuwait to 13 percent in Saudi Arabia.
  - Recent inflation increases should narrow the gap between actual REER and equilibrium REER.
- Macrobalance approach:
  - Current accounts are presently above medium-term norms, implying some undervaluation.
  - Current account surpluses expected to narrow as government spending and investment-related imports rise.
  - GCC current account balances determined mostly by fiscal policy and only to a limited extent by the exchange rate.

### Key data points and indicators (selected figures from IMF staff estimates)
- GCC nominal GDP (2007) = 815.2 (In billions of U.S. dollars)
- Saudi Arabia nominal GDP (2007) = 381.9 (In billions of U.S. dollars)
- GCC current account balance (2007) = 210.4 (In billions of U.S. dollars)
- Saudi Arabia current account balance (2007) = 95.8 (In billions of U.S. dollars)
- GCC consumer price inflation (2007, year average) = 6.3 percent
- Qatar consumer price inflation (2007, year average) = 13.8 percent
- GCC gross official reserves (2007) = 420.1 (In billions of U.S. dollars)
- Saudi Arabia gross official reserves (2007) = 305.3 (In billions of U.S. dollars)
- Average deviation of actual REER from estimated equilibrium REER: Kuwait = 3 percent; Saudi Arabia = 13 percent.
- Saudi Arabia illustrative annuity assumptions:
  - Reserves = 264 billion barrels; Recovery rate = 78 percent; Depletion by 2085; Real GDP growth rate = 3.5 percent; Discount rate = 8 percent.
- Kuwait depegging outcomes:
  - KD appreciated by 8.2 percent by July 21, 2008.
  - KIBOR cut from 5.19 percent to 4.13 percent within a few days in May 2007.
  - Credit growth accelerated from about 25 percent (January 2007) to about 34 percent (July/August 2007) and to 36 percent by December 2007.
  - Inflation reached 11.4 percent y/y in April 2008.

### Conclusions (extract)
- Both retaining the fixed exchange rate regime initially and introducing more exchange rate flexibility in the medium term are plausible.
- The dollar peg seems to be the best option leading up to and possibly in the short-run after establishment of the monetary union in the near future.
- Authorities should reconsider options if inflation persists and there is further sharp depreciation of the dollar against other major currencies.
- If the monetary union is delayed, the 2003 commitment to pegging at given parities until 2010 would no longer hold and other options could be examined.
- The longstanding de facto peg to the U.S. dollar has contributed to a strong track record of macroeconomic stability.

*Source: IMF staff chapter content from the provided PDF content unit.*

### Executive Summary ......................................................................................................

### EXECUTIVE SUMMARY

### Background and context
- 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.
- Kuwait returned to pegging to a currency basket in May 2007.
- The GCC jointly account for over 40 percent of global oil reserves and 23 percent of natural gas reserves.
- Oil and gas production contributes about one half of total GDP and three-fourths of total exports and annual government revenues.
- The total GDP of the six GCC member countries in 2007 was $815 billion, with an average per capita income of about $22,000.
- Inflation has averaged 1.5 percent over the last three decades.
- With oil prices rising sharply since 2003, the GCC countries recorded fiscal and current account surpluses in 2007 amounting to 19 percent and 26 percent of GDP, respectively.
- Non-nationals account for about two-thirds of employment and comprise about one-third of the total GCC population.
- The common market was launched on January 1, 2008, providing GCC citizens equal treatment in a wide range of economic activities.

### General considerations in choosing an exchange rate regime
- The standard criterion is macroeconomic and financial stability in the face of real or nominal shocks.
- The exchange rate regime should ideally:
  - yield external and internal stability,
  - preserve monetary credibility and international competitiveness,
  - reduce balance sheet risks and transaction costs.
- Application to the GCC must account for:
  - the dominant influence of the oil sector in GDP, exports, and government revenue;
  - the labor market structure (heavy reliance on imported labor and flexible nominal wages);
  - the ability of these countries to pursue domestic goals of inflation and growth if they had monetary policy independence.

### Alternative exchange rate regimes considered
- Four main options analyzed: pegging to the U.S. dollar, managed floating, pegging to a currency basket, pegging to the export price of oil (PEP).
- Characteristics and trade-offs highlighted:
  - Dollar peg:
    - Reduces volatility in the exchange rate and in capital flows that could result from nominal shocks (such as continuing geopolitical risks and oil price volatility unrelated to fundamentals).
    - Provides a credible and easily understood anchor for monetary policy.
    - Simplifies trade and financial transactions, accounting and business planning.
  - Managed floating:
    - Allows use of monetary policy as a stabilization tool and better adjustment to real shocks.
    - Requires structural and institutional readiness and the selection of a nominal anchor—hence considered more of a longer-term option.
  - Basket peg:
    - Introduces some flexibility and reduces adverse effects of swings among values of major currencies.
    - Would not yield monetary independence and may be less easily understood and hence potentially less able to anchor expectations.
  - Pegging to the export price of oil (PEP):
    - Delivers automatic accommodation to terms-of-trade shocks.
    - Could transmit significant volatility to other sectors of the economy.

### Assessment and recommendation
- On balance, of the four main options—pegging to the U.S. dollar, managed floating, pegging to a basket, or pegging to the export price of oil—the dollar peg seems at this stage to be the most appropriate, leading up to and likely also in the short-run after the establishment of the monetary union.
- If current inflationary pressures are temporary in nature, the benefits of the dollar peg outweigh the costs of changing to another exchange rate regime.
- Authorities would need to reconsider options if:
  - inflation persists, and
  - there is a further sharp depreciation of the dollar against other major currencies.
- In such circumstances, as floating is not at this stage a viable option, pegging to a common basket of currencies may turn out to be the more appropriate exchange rate regime.
- The 2003 commitment to pegging at given parities was based on the GCC monetary union being established in 2010, with the exchange rate regime to be decided then; if the monetary union is postponed, that commitment may no longer be binding and other exchange rate regime options could be considered earlier by individual GCC member countries.

*Source: EXECUTIVE SUMMARY (IMF staff paper)._082808a - Executive Summary*

### 10.      The European Central Bank (ECB) has provided the GCC with a draft

### 10.      The European Central Bank (ECB) has provided the GCC with a draft

### Establishment, institutional framework, and convergence criteria
- The ECB has provided the GCC with a draft Monetary Union Agreement (MUA) and statutes on the Gulf Monetary Council (GMC) and the Gulf Central Bank (GCB).
- It is expected that a monetary council will be established in 2009 to serve as a transition body in preparation for the single currency and the GCC Central Bank.
- A set of five convergence criteria (on inflation, interest rates, reserves, fiscal balance, and public debt), similar to those in the run-up to the European Monetary Union (EMU), has been agreed in principle.
- Although they are not preconditions for entry, at end-2007 the GCC countries had met almost all of the convergence criteria and exhibited a high degree of convergence on many macroeconomic indicators (Figure 3).
- Inflation convergence, which had been lagging, is being achieved as inflation across the GCC (except in Bahrain) rose to similar rates, though "at a level that is obviously too high from the standpoint of macroeconomic stability."

### Timeline, membership decisions, and readiness for a single currency
- The official target date for the launch of the monetary union remains 2010.
- Oman decided in February 2008 that it would not join the monetary union.
- In May 2007, Kuwait moved from the dollar peg to an undisclosed currency basket, but reaffirmed its commitment to join the union.
- Delays have occurred in establishing harmonized systems and in institution-building.
- Areas not yet fully harmonized or agreed include:
  - monetary policy frameworks;
  - payment and settlement systems;
  - regulatory and supervisory structures;
  - macroeconomic statistics;
  - other specific central bank functions;
  - management of reserves and non-reserve assets.
- On the fiscal side, setting up a common accounting framework and adequate budgetary procedures are high priorities.
- Conclusion: "As a result, the 2010 deadline for the single GCC currency appears increasingly unachievable."

### Inflation dynamics, sources of monetary discipline, and challenges to the dollar peg
- Until recently, relatively low inflation rates in the GCC region were sustained by:
  - the imported monetary discipline embodied in the pegged exchange rate regime;
  - the open trade regime;
  - flexibility of the labor market;
  - prudent fiscal policy;
  - benign global inflationary conditions.
- Openness ensured availability of goods and services at internationally competitive prices.
- Labor market flexibility—mainly due to the inflow of foreign workers—limited the impact of domestic demand on prices in the nontradable sector, though the inflow of skilled foreign labor recently contributed to property price increases.
- Investing oil surpluses outside the domestic financial system (accumulation of foreign assets) and efforts to control the non-oil fiscal deficit helped contain monetary expansion.
- Recent pressures:
  - rising inflationary pressures in the last couple of years;
  - depreciation of the U.S. dollar against other major currencies;
  - a monetary policy tied to that of the United States, where the Federal Reserve’s recent interest rate policy has highlighted divergence in business cycles between the GCC and the United States.
- These developments "have raised questions about whether the peg to the dollar remains appropriate."

### Criteria for selecting exchange rate regimes and GCC structural considerations
- Theoretical criteria for an optimal exchange rate regime emphasize macroeconomic and financial stability in the face of real or nominal shocks.
- Desired outcomes of a regime include: external stability, internal stability (low inflation), balance sheet stability, international competitiveness, credibility of monetary policy, and low transaction costs.
- Trade-offs and political-economy considerations are likely in choosing the regime.
- The argument for alternatives to the dollar peg rests on potential for better achievement of low inflation through monetary policy independence, but:
  - effectiveness depends on the monetary transmission mechanism;
  - in GCC countries the interest rate transmission mechanism is weak due to absence of domestic capital markets, shallow credit markets, and limited role of interest rates;
  - exchange rate channel impact on inflation is limited where expenditure switching between traded and nontraded goods is limited and administrative price controls exist.
- Structural features that shape regime choice:
  - dominance of the oil sector in GDP, exports, and government revenue (Figures 5 and 6);
  - differing hydrocarbon endowments across countries, with Bahrain and Oman accelerating non-oil sector development while in all GCC countries except Oman and Bahrain hydrocarbons will continue to play a major role for a very long time.
- As diversification proceeds, "greater exchange rate flexibility may be warranted" to support competitiveness in non-oil tradables.
- Nationalization efforts that increase costs of employing expatriate workers could reduce labor market flexibility and constrain adjustment to terms-of-trade shocks.
- External financial assets have been mainly in U.S. dollars but "may also become progressively more diversified," reducing attractiveness of the dollar peg over time.
- With increased capital mobility, trade openness, and FDI, a more flexible exchange rate regime could provide another tool for adjusting to shocks and managing oil-price related volatility.

### Historical context and official stance
- GCC member countries officially pegged their national currencies to the U.S. dollar as of January 1, 2003, to advance monetary integration.
- At that time, except for Kuwait, countries were already pegged to the U.S. dollar; the decision aimed to maintain stability and strengthen confidence and to enter the monetary union at those parities.
- Under the peg, GCC countries have pursued policies consistent with exchange rate pegs, including appropriate fiscal policies and flexible labor and product markets.
- GCC members have accumulated significant foreign exchange reserves, supporting the peg's credibility and discouraging speculation.
- Governments remain open to choices for the exchange rate arrangement under the planned GCC currency union; the ultimate choice will depend on member preferences and economic and political considerations.

### Assessment of the single currency peg option
- Arguments in favor of continuing the dollar peg under the monetary union:
  - Macroeconomic conditions have been stable for the last two decades, even during dollar fluctuations.
  - Over the long run, cyclical synchronicity between the GCC and the United States has been increasing (Box 1), despite recent divergence.
  - The peg has helped avoid nominal shocks from geopolitical risks and could remain valuable given continued geopolitical risks.
  - The dollar peg provides a credible and easily understood anchor for monetary policy and has anchored inflationary expectations at low levels.
  - Forward markets continue to reflect confidence in the dollar peg despite a recent uptick in inflation.
  - The peg is easy to administer and does not require institutions needed for an independent monetary policy, which would have to be built and made credible.
  - Given a weak monetary transmission mechanism, a peg rather than a float is a realistic option for the first years of a GCC monetary union.
- Additional benefits:
  - Simplifies trade and financial transactions, accounting, business planning, and monetary coordination among members.
  - Exchange rate risk is easily hedged through U.S. dollar markets.
  - Fixed cross-rates benefit intra-GCC transactions by removing exchange rate risk.
  - Labor market flexibility can support competitiveness under a fixed regime due to relatively elastic supply of labor (mostly unskilled) from low-income countries and flexible application of nationalization policies to avoid shortages.
- Empirical observation: Pegged regimes are preferred by major oil exporters:
  - Of the 26 countries whose oil exports account for over 50 percent of total exports, 18 (including the GCC countries and members of CEMAC) have conventional fixed pegs.
  - Examples: Brunei (a currency board) and Ecuador (a dollarized economy) also use pegs.
  - Algeria, Kazakhstan, and Russia have managed floats with contained volatility; Mexico and Norway (less reliance on oil) have relatively free-floating currencies.
- Rationale: When foreign exchange receipts are predominantly from a volatile dominant export commodity, operating a free foreign exchange market is relatively more difficult, particularly if supporting institutions are not well developed.

*Source: IMF staff text (chapter section provided in the PDF content).*

### 26.      The familiarity of GCC authorities and private economic agents with the

### 26.      The familiarity of GCC authorities and private economic agents with the

### A. Dollar peg — rationale and disadvantages
- Rationale for retaining the dollar peg:
  - "The familiarity of GCC authorities and private economic agents with the U.S. dollar peg" and "similar preferences the GCC countries have shown for a fixed exchange rate" argue for maintaining the current arrangement after the planned monetary union.
  - "In 2003 GCC member countries opted to fix their bilateral parities and to peg their currencies to the dollar in the run up to GCC Monetary Union in 2010 to benefit from the greater certainty about the parities at which they would enter the monetary union."
  - "Keeping the single GCC currency peg to the dollar would leave the public and policymakers on already familiar grounds."

- Disadvantages of the dollar peg:
  - "It imports a monetary policy from the United States, which at times may not be appropriate for local needs."
  - "With an open capital account, the dollar peg requires the GCC countries to follow U.S. interest rate policy, which has the potential to result in policies unsuited to the needs of their business cycles."
  - Where divergences are temporary, non-interest-rate tools would be required: "fiscal policy, and to a lesser extent quantitative credit restrictions and tighter prudential regulations, would need to be used to curb aggregate demand and credit expansion."
  - "The peg also means that GCC countries cannot defend against imported inflation."
  - "The peg forces adjustment of the real exchange rate to a new equilibrium to go through inflation rather than the nominal exchange rate. Adjustment through inflation is slower ... and may trigger price-wage spirals, generate low real interest rates, and increase the risk of asset bubbles as investors switch into real estate and equity assets."
  - "It also reduces the real value of financial savings."

### B. Managed floating — potential benefits and limits
- Advantages of letting the single GCC currency float:
  - "Letting the single GCC currency float against other currencies would have the advantage of being able to use monetary policy to smooth business cycles."
  - "A more flexible exchange rate regime would also allow the countries to absorb large adverse real shocks more easily than a fixed exchange rate regime."
  - As economies diversify: "flexibility of the exchange rate would become more desirable."

- Limitations given current GCC structural characteristics:
  - "It is questionable whether active monetary and exchange rate policies would achieve domestic and external stability."
  - The interest rate channel may be ineffective: "economic agents’ decisions are highly insensitive to changes in the interest rate."
  - "Corporate sector investment and spending decisions ... depend to a large extent on actual and projected government spending, limiting the role of the interest rate. Thus, fiscal policy has to bear the burden of smoothing the effect of shocks on domestic activity."
  - "The exchange rate channel is weak because of the lack of sensitivity of exports to changes in the exchange rate."

- Choice of nominal anchor under a float:
  - Inflation targeting requirements: "good understanding of the inflationary process", "sophisticated market-based monetary operations", "central bank independence", "transparency of policy".
  - New GCC central bank: "would be untested, and likely to take some time to develop these institutional requirements."
  - Monetary targeting requirements: "a stable and predictable money demand function", "development of instruments and adequate forecasting ability."
  - Given ongoing structural changes: "the stability of the money demand function is uncertain."
  - To adopt an alternative anchor to the exchange rate, GCC countries would need to: "improve the measurement of inflation, develop inflation forecasting capacity and instruments to manage liquidity, and enhance communication strategies."

- Risks with floating given open capital accounts and oil dependence:
  - "There are also risks of high exchange rate volatility associated with a floating regime."
  - Drivers of volatility: "open capital account", "dominance of oil as the main export commodity", "inherent difficulty of distinguishing between temporary and permanent terms-of-trade shocks", "thin foreign exchange markets dominated by a relatively small number of agents."
  - "Large swings in oil prices could lead to volatile exchange rates, which could lead to larger fluctuations in non-oil output and higher and more volatile inflation, or the central bank would need to intervene heavily."
  - Empirical insight: "greater nominal exchange rate volatility is associated with greater real exchange rate volatility (Taylor, 2002)."

- Simulation evidence for Saudi Arabia:
  - Simulation setup: "price of oil in Riyals is kept constant ... by $/Riyal fluctuations that offset any $-oil price changes."
  - Findings:
    - "Even with perfectly stabilized fiscal revenues in Riyals (allowing perfect expenditure planning), changes in oil prices induce massive swings in the $/Riyal rate that may be beyond the capacity of the financial system to handle."
    - "The large relative price volatility would make investment planning in the non-oil sector extremely difficult."

### C. Basket peg — trade-offs and country experience
- Potential benefits of a basket peg:
  - "Adopting a basket peg may be a useful way to introduce some flexibility in the exchange rate."
  - "With a basket peg, the main anchor properties of an exchange rate peg could be retained, while at the same time gaining some adaptability to the adverse effects of swings among the values of the major reserve currencies."
  - Example: "With oil priced in U.S. dollars, volatility in the price of oil is reflected, under a dollar peg, directly in volatility in oil export receipts. Under an SDR peg, for example, the volatility of oil export receipts would have been much less than it was under the dollar peg (Figure 9)."
  - "The volatility of the nominal effective exchange rate would be reduced, benefiting external trade, investment, and balance sheet stability."
  - "In the short run, a basket peg can help contain imported inflation by sheltering the exchange rate against cross-rate movements such as the recent dollar slide."

- Drawbacks of basket pegs:
  - "Basket pegs may however reduce the microeconomic and informational benefits of maintaining constant one bilateral exchange rate relevant for price comparisons and economic transactions."
  - "They tend to be less transparent, more difficult to explain to the public, and less credible than single pegs, especially when the currency weights are not known."
  - "A failure to disclose the relative weights and composition of the currencies used in the basket could complicate the assessment of exchange rate risk and lead to unanticipated behavior."
  - Empirical example: "In Kuwait, speculation after the move to an undisclosed basket resulted in strong demand for the dinar, large capital inflows, and an increase in liquidity."

- Selected non-GCC oil exporters’ experience under managed float (Box 2):
  - Cases: Algeria, Kazakhstan, Russia — "growth and inflation performance improved significantly after exiting the peg", but exits were "disorderly" and associated with crises.
  - Exchange flexibility in practice: "coefficients of variation of daily percentage changes of the Kazak tenge and Russian ruble were 21 and 10 respectively" — "comparable ... to those of other oil exporters with de facto fixed exchange rates such as Iran, Nigeria, and Venezuela."
  - Policy lessons for orderly transition: develop deep and liquid FX markets; define central bank intervention role in managing oil receipts; build capacity of market participants and supervisory agencies; coordinate monetary and fiscal authorities; develop medium-term expenditure frameworks.

- Kuwait’s move to an undisclosed basket (Box 3) — key facts and observed impacts:
  - "On May 2007, Kuwait abandoned the Kuwaiti dinar (KD) peg to the U.S. dollar in favor of a peg to an undisclosed currency basket."
  - By July 21, 2008 "the KD had appreciated by 8.2 percent."
  - The new system required a more active monetary policy and prompted "currency speculation before and after the move ... resulting in a strong demand for the KD, capital inflows, and large increases in the KD liquidity."
  - Central Bank of Kuwait actions: "dampen capital inflow at the time of depegging by driving down the KD interbank rate (KIBOR) to 4.13 percent from 5.19 percent within a few days in May 2007, and since then to a level lower than the one month LIBOR rate."
  - Credit growth: "annual growth rate accelerating from about 25 percent in January 2007 to about 34 percent in July and August and to 36 percent by December."
  - Banks’ responses included "closing their open position in foreign currency in 2007 ... in part through foreign borrowing."
  - Inflation outcome: "Inflationary pressures accelerated toward the end of 2007 and in early 2008, with inflation reaching 11.4 percent y/y in April 2008."
  - Comparative note: "While inflation in Kuwait was close to that in Saudi Arabia (which remained pegged) in early 2007, it became slightly higher."

### Policy implications and preparatory steps highlighted
- If maintaining a peg (dollar or basket):
  - Expect imported monetary policy and limited domestic rate autonomy.
  - Use fiscal policy and macroprudential measures to manage domestic demand and credit growth.
  - Recognize slower real exchange rate adjustment via inflation and the associated risks to savings and asset prices.

- If moving toward greater flexibility or a basket:
  - Develop central bank institutional capacity before adopting inflation targeting: measurement, forecasting, liquidity management, transparency, and independence.
  - Develop deep and liquid foreign exchange markets and hedging instruments.
  - Define clear intervention rules and coordination between fiscal and monetary authorities.
  - Consider disclosure of basket composition and weights to reduce speculative and informational risks.

*Italic: IMF staff analysis and country simulations contained in the provided chapter excerpt.*

### 35.      Pegging to a basket of currencies, however, rules out active monetary policy,

### 35.      Pegging to a basket of currencies, however, rules out active monetary policy,

### Implications of pegging to a basket of currencies
- Pegging to a basket rules out active monetary policy much as a single currency peg does.
- Under capital convertibility, interest rates would have to follow a “basket” of interest rates.
- This arrangement will reduce the likelihood for a recurrence of the actual extreme de-synchronization between monetary policy needs in the GCC and the anchor currency.
- The central bank would have to actively manage foreign exchange operations and foreign exchange risk.
- Relatively low levels of financial intermediation and breadth of financial instruments would limit the scope and effectiveness of these operations (see Roger and others, 2008).
- Pegging to a basket would not fully address:
  - management of oil price volatility, and
  - the rise in liquidity from high oil prices.
- A basket that included the price of oil (see Section D on pegging to the export price of oil) would mirror the relatively higher volatility of oil prices (Figure 10).

- Empirical/numerical note in text:
  - In the case of Saudi Arabia, a peg to the SDR would have raised current domestic interest rates by only 1 percentage point (as of July 2008).

- Figure/series referenced:
  - Figure 10. Volatility of Oil Price, U.S. Dollar, and the Euro
    - Series cover Jan. 1, 2008–July 2, 2008 and Jan. 1, 2008–June 27, 2008 for crude oil price (U.S. dollar per barrel).
    - Panels include SDR to the Euro, SDR to the U.S. dollar (5-day standard deviation), and Oil Price (5-day standard deviation, RHS).

### Option: transparent basket of U.S. dollar and the Euro
- A transparent basket consisting only of the U.S. dollar and the Euro:
  - Would be simple to interpret.
  - Would reduce monetary dependence of the GCC on the U.S. Federal Reserve.
  - Would account for the bulk of transactions in goods, services, and financial instruments (now in the U.S. dollar and the Euro Area).
  - Would allow for the use of dollar or Euro hedging instruments to efficiently manage financial risks given the considerable depth in Euro financial instruments.
- Timing considerations:
  - The timing of a move to a basket peg would need careful deliberation.
  - Exchange rate stability would likely be highest if repegging to a basket occurred when the currencies in the basket were broadly in equilibrium, which may be difficult to establish.

### D. Pegging to the Export Price of Oil (PEP)
- Rationale for PEP:
  - Suggested for small open economies specialized in a particular mineral or agricultural commodity.
  - Argument: delivers automatic accommodation to terms-of-trade (TOT) shocks while retaining credibility-enhancing advantages of a nominal anchor.
  - A peg to the price of oil would allow the real exchange rate to move in line with the real price of the main export commodity and decouple oil exporters’ monetary policies from those of oil importers.

- Qualifications and drawbacks:
  1. GCC not a small economy:
     - GCC countries together account for a sizeable part of total world output and exports.
     - The small economy assumption is not applicable; the price of oil cannot be regarded as exogenous.
     - Oil can be seen as a major international currency; pegging fiat currencies to their own commodity currency would not anchor them to something truly exogenous.
  2. Questionable automatic adjustment to TOT shocks:
     - An adverse TOT shock (decline in oil prices) under PEP would result in real depreciation.
     - With oil production constrained by capacity, extraction limits, and the OPEC quota system, adjustment would have to come from expanding non-oil exports or cutting imports.
     - Non-oil exports in the GCC depend on hydrocarbon production for inputs and are therefore not independent from oil and gas production.
  3. Greater volatility:
     - Pegging to the price of oil would introduce greater volatility in the exchange rate (see Figures 7 and 8 illustrating Saudi Arabia).
     - This could lead to lower government revenues and expenditures and higher government debt.
  4. Sectoral volatility and diversification costs:
     - High oil prices → real appreciation → higher cost of other exports → dampened diversification.
     - In the event of a decline in oil prices, it is unclear whether the oil peg would permit sufficient depreciation of the national currency to accommodate adverse TOT changes and stabilize export earnings.
     - Gradual adjustment in the real exchange rate may be preferable until terms-of-trade shifts appear permanent.
     - PEP with daily fixing requires transparency and credibility which may take time to establish.

- Note: A variant is pegging to a basket of commodities and currencies.

### V. Transitional issues (selection relevant to exchange rate choice)
- Determination of the most appropriate exchange rate regime depends on:
  - economic developments at or near establishment of the GCC Monetary Union,
  - whether the monetary union is delayed,
  - whether inflation persists,
  - whether the depreciation of the dollar continues,
  - whether business cycles in the United States and the GCC continue to diverge,
  - and whether real exchange rates are broadly in line with fundamentals.
- Recent staff analysis suggests current inflationary pressures are likely temporary, resulting largely from supply bottlenecks (particularly in housing) and sharp increases in international prices of food, raw materials, and equipment (Box 4).
- If inflation and current account surpluses are temporary:
  - They will likely be reduced by the time of the GCC monetary union.
  - Maintaining the current peg, to which the authorities are committed, would be the best option as the new common central bank would inherit a well-functioning anchor and monetary framework.
- If inflation and current account surpluses persist:
  - A move to greater flexibility via a basket peg is advisable.
  - Pegging to a common basket in the transition would not address misalignment issues but may shield the GCC market from dollar movements against other global currencies.
  - Loss of credibility and transparency could be mitigated if all countries peg to the same disclosed basket.
  - Feasibility depends on progress prior to monetary union in developing institutional infrastructure to facilitate market-based operations and build accountability and credibility.
- If individual exchange rate parities are out of line with fundamentals at monetary union (signaled by continued high domestic inflation):
  - The GCC could retain the dollar peg but effect a one-off coordinated adjustment of the current parities at the establishment of the common currency.
  - A revaluation could dampen imported inflation and help bring real exchange rates closer to equilibrium.
  - But revaluation would impose significant and immediate valuation losses on the large official foreign assets of the GCC countries, and reduce international competitiveness for countries pursuing diversification.
  - A large revaluation could generate sharply lower fiscal revenues in domestic currency and adversely impact government and private sector balance sheets, including banks.
  - Announcement of exchange rate adjustments as a policy instrument could increase market expectations of further revaluations and encourage speculation (Figure 11).
  - Experience: when Kuwait moved to a basket peg and late 2007 investor reactions to GCC official statements led to substantial deposit transfers into the region betting on imminent revaluation.
  - Need for further development of a credible communications strategy.

- Estimating needed adjustment:
  - Determining the equilibrium real exchange rate is difficult and yields a wide range of results (Box 5).
  - The equilibrium real exchange rate depends on the level and volatility of oil prices over the medium term.
  - Any change in current or future oil prices will alter the equilibrium exchange rate and the current account norm.
  - Available estimates suggesting some undervaluation for the GCC are typically prone to large errors and quantification is difficult.

### VI. Conclusions (extract)
- There are plausible arguments for both:
  - retaining the current fixed exchange rate regime initially, and
  - introducing more exchange rate flexibility in the medium term if needed.
- The dollar peg seems to be the best option leading up to and possibly in the short-run after establishment of monetary union in the near future.
- Authorities would need to reconsider options if inflation persists and there is a further sharp depreciation of the dollar against other major currencies.
- If the monetary union is delayed, the commitment to pegging at given parities until 2010 would no longer hold and other options could be examined.
- The longstanding de facto peg of the GCC currencies to the U.S. dollar has contributed to a strong track record of macroeconomic stability.

*Source: IMF staff chapter content from the provided PDF content unit.*

### Box 5. Exchange Rate Assessment in GCC Countries

### Box 5. Exchange Rate Assessment in GCC Countries

### REER assessment and empirical findings
- GCC countries real effective exchange rates (REER) appear undervalued.
- The positive terms-of-trade shock experienced during 2003–07 likely resulted in an appreciation of the equilibrium REER.
- Preliminary panel-based estimates (using variables suggested by the Consultative Group on Exchange Rate Issues (CGER): the terms of trade, productivity differential with trading partners, net foreign assets, the cumulative current account, and openness) show:
  - The average deviation of the actual REER from the estimated equilibrium REER ranged from 3 percent in Kuwait to 13 percent in Saudi Arabia.
- The recent increase in inflation in GCC countries, owing mainly to domestic demand pressures, supply constraints, and imported inflation, should lead to a narrowing of the differential between the REER and the equilibrium REER.

### Macrobalance approach and current accounts
- The macrobalance approach suggests current accounts of the GCC countries are presently above their medium-term current account norms, implying some undervaluation of the exchange rate.
- Current account surpluses are expected to narrow over the medium term reflecting government spending and higher imports associated with investment projects.
- Strong evidence indicates current account balances in the GCC are determined mostly by fiscal policy and only to a limited extent by the exchange rate.

- Current Account Norms (In percent of GDP) — observed 2006 and medium-term current account norm (2012) from IMF staff estimates:
  - Bahrain: Observed 2006 = 13.3; Medium-Term Current Account Norm = 5.6; Current Account Norm = 6.5
  - Kuwait: Observed 2006 = 50; Medium-Term Current Account Norm = 33.5; Current Account Norm = 41
  - Oman: Observed 2006 = 12.2; Medium-Term Current Account Norm = 2.6; Current Account Norm = 4
  - Qatar: Observed 2006 = 30.5; Medium-Term Current Account Norm = 26.8; Current Account Norm = 30.5
  - Saudi Arabia: Observed 2006 = 20.3; Medium-Term Current Account Norm = 8.1; Current Account Norm = 20.3
  - U.A.E.: Observed 2006 = 22; Medium-Term Current Account Norm = 15; Current Account Norm = 21.1

### External-sustainability (intergenerational equity) approach and annuity framework
- The external sustainability approach for depletable resource-based economies:
  - Uses fiscal rules to convert oil wealth into financial assets, calculates the net present value of oil wealth, and makes assumptions on rates of oil extraction, future oil prices, and the discount rate.
  - To ensure fiscal sustainability, the primary non-oil fiscal deficit should be equal to an ‘optimal’ annuity.
  - The annuity can be defined as:
    - a constant share of GDP,
    - constant in real per capita terms, or
    - constant in real terms.
- Illustration for Saudi Arabia uses the following assumptions:
  - Reserves = 264 billion barrels
  - Recovery rate = 78 percent
  - Depletion by 2085
  - Real GDP growth rate = 3.5 percent
  - Discount rate for future oil revenue = 8 percent
- Each annuity definition yields significantly different current account norms, and therefore different degrees of misalignment.

### Policy implications and exchange rate regime options
- The existing peg has:
  - provided a credible nominal anchor for monetary policy and is easy to administer,
  - simplified trade and financial transactions, accounting and business planning,
  - provided clarity about parities for entering a GCC Monetary Union.
- High labor market flexibility in the private sector has supported international competitiveness and quick adjustment to shocks.
- The current jump in inflation is viewed as temporary and expected to come down as large infrastructure projects are completed and absorptive capacity expands.
- With increasing international integration, GCC countries are more prone to external shocks; a higher degree of exchange rate flexibility may become more desirable to ensure external stability and international competitiveness.
- As oil reserves are depleted in some member countries and the non-oil tradable sectors expand, maintaining competitiveness in the private non-oil sector is critical for employment creation.
- Policies aimed at higher participation rates by nationals in GCC labor markets could erode over time the partial offset provided to the peg regime by flexible labor markets.

- Exchange rate regime alternatives and trade-offs:
  - Basket peg:
    - Can dampen volatility from swings among major currencies and avoids tying monetary policy exclusively to one country.
    - Would not eliminate effects of imported inflation, nor allow countries to operate an independent monetary policy.
  - Pegging to the export price of oil:
    - Could deliver automatic accommodation to terms-of-trade shocks.
    - Would likely transmit significant volatility to non-oil sectors.
  - Moving toward exchange rate flexibility or a different peg would need to reflect projected medium- and long-term developments and require institutional capacity (initial parity setting, compensating/incentive mechanisms such as fiscal transfers, efficient decision-making processes, and market-based monetary operations).
  - Exchange rate flexibility is feasible primarily as a longer-term option given institutional requirements.
  - Under a monetary union, the choice of regime depends on policy objectives and authorities’ preferences; regime choice is not necessarily permanent (e.g., peg to the U.S. dollar initially, then move to more flexible regime later).
  - A forward-looking monitoring framework will be essential for the monetary union.
  - The exchange rate regime must be compatible with monetary, fiscal, structural policies, and broader institutional development.

### Key data points and indicators (selected figures from IMF staff estimates)
- Average deviation of actual REER from estimated equilibrium REER: Kuwait = 3 percent; Saudi Arabia = 13 percent.
- Saudi Arabia illustrative assumptions for annuity calculations:
  - 264 billion barrels; 78 percent recovery rate; depletion by 2085; real GDP growth rate = 3.5 percent; discount rate = 8 percent.
- Example country-level headline figures (selected):
  - GCC nominal GDP (2007) = 815.2 (In billions of U.S. dollars)
  - Saudi Arabia nominal GDP (2007) = 381.9 (In billions of U.S. dollars)
  - GCC current account balance (2007) = 210.4 (In billions of U.S. dollars)
  - Saudi Arabia current account balance (2007) = 95.8 (In billions of U.S. dollars)
  - GCC consumer price inflation (2007, year average) = 6.3 percent
  - Qatar consumer price inflation (2007, year average) = 13.8 percent
  - GCC gross official reserves (2007) = 420.1 (In billions of U.S. dollars)
  - Saudi Arabia gross official reserves (2007) = 305.3 (In billions of U.S. dollars)

*Source: IMF staff estimates and analysis in Box 5. Exchange Rate Assessment in GCC Countries.*

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_Source: https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/np/pp/eng/2008/_082808a.pdf_