Gulf States and the Dollar Link

Andrew Critchlow, WSJ:

PEGGED DOWN

• The News: Saudi Arabia, the United Arab Emirates, Qatar, Kuwait and Bahrain followed the Fed's decision to cut interest rates by a quarter percentage point.
• Background: The Gulf states' exchange rates are pegged to the dollar, whose decline has diluted the benefit of record oil prices.
• What's Next: Rampant inflation in the region has increased pressure, particularly on the U.A.E., to sever ties with the dollar, which could further add to the dollar's woes.


DUBAI, United Arab Emirates -- Oil-rich Arab sheikdoms, risking new inflation pressure, followed the U.S. Federal Reserve's lead by lowering official interest rates to keep their currencies aligned with the dollar.

Saudi Arabia, the United Arab Emirates, Qatar, Kuwait and Bahrain followed the Fed's decision to cut interest rates by a quarter percentage point.

Because their exchange rates are pegged to the dollar in fixed trading ranges, monetary policy in the Persian Gulf states must mirror U.S. moves to avoid pressures from capital drifting to the currency with the most favorable interest rates.

The moves came despite concerns over rampant inflation in the region, which suggest central banks should be raising, instead of lowering, rates. Bankers said the policy conflict is building pressure on the Gulf states to unbind from the dollar.

In European emerging markets, meanwhile, the Central Bank of Iceland raised its key rate 0.45 percentage point to a record 13.75% in an effort to slow annual inflation, running at a 4.5% rate, down closer to its 2.5% target rate. It was the 19th time since 2004 that the Icelandic central bank has raised rates to keep its economy from overheating. The Romanian central bank Wednesday raised its key rate by one-half percentage point to 7.5%, fighting a 6% inflation rate the bank blamed on soaring household income and rising public spending.

In Asia, meanwhile, sharper-than-anticipated consumer-price inflation last month -- 3% above year-earlier levels -- prompted speculation the Bank of Korea will raise its policy rate, now at 5%, in the first quarter next year. The Hong Kong Monetary Authority, also struggling to balance domestic considerations with pressures from overseas investors, has been intervening to keep its currency from rising above publicly set bands.

Nowhere in the Middle East are the strains more acute than in the U.A.E., where investors are betting on a "depegging" of the dirham as domestic inflation pressures increase.

"Speculators are definitely bidding on a depegging, and that's why they're increasing their dirham deposits," Henry Azzam, Middle East chief executive at Deutsche Bank AG, told Zawya Dow Jones Newswires in an interview.

Attracting that money are chances of a quick profit once the peg snaps. Deposits held in the emirates' banks have exceeded one trillion dirhams ($272.3 billion) for the first time, more than is deposited in the region's largest economy, Saudi Arabia, latest central-bank figures show.

"The probability of depegging has increased," said Kamran Butt, Dubai-based chief economist at Credit Suisse Group. "The market consensus is for the U.A.E. to depeg." A decision by the U.A.E. to sever ties with the dollar could alienate the U.S. and add to the dollar's woes at a time of economic uncertainty and record oil prices.

The dollar, which fell to all-time lows against the euro and 26-year lows against sterling in the aftermath of Wednesday's rate cut, was at $1.4437 against the euro, from $1.4486 Wednesday. The U.K. pound was at $2.0787, from $2.0793 Wednesday.

The dollar's slump has pushed up the cost of imports to the Gulf, fueling inflation. The dollar's decline has watered down the benefit of record oil prices in the region that is expected to accrue a surplus in excess of $500 billion this year, according to Saudi lender Samba Financial Group.

Kuwait, the region's third-largest Arab oil producer, was the first to break ranks with its Gulf peers in May when it shunned its peg with the dollar by allowing the dinar to float against a basket of currencies and in a range against the dollar. It retains a loose dollar peg and joined other states in cutting rates yesterday.

The seven emirates are Abu Dhabi, 'Ajman, Al Fujayrah, Sharjah, Dubai, Ra's al Khaymah and Quwayn.

With inflation expected to exceed 10% for a second consecutive year in the U.A.E., the emirates' ruling sheiks face the region's greatest fiscal policy challenge since the U.K. devalued sterling in 1967, forcing Gulf states to turn to the dollar as a benchmark.

When the emirates created the dirham in 1973 they linked it effectively to the dollar. Now bankers such as Deutsche's Mr. Azzam are unsure whether the U.A.E. is ready for another such change. "I don't think a depeg will happen because that's a regional decision and it has served the U.A.E. so far," he said.