The End Of The GCC Monetary Union?

The idea of a joint GCC currency now looks even more distant, writes Mark McFarland, chief investment strategist, Emirates NBD Private Banking.

It is over two years since Europe’s ill-fated experiment with monetary union began to fall apart, and it is obvious that the whole proposition of unifying diverse countries under one currency has fallen into disrepute. Even plans that seemed sophisticated and well thought out in advance of the European Monetary Union have proven to be perilously incomplete. Worse, a union that was supposedly built on fraternity and mutual co-operation has proven to be a circus of finger pointing and a slow move towards nationalistic politics.

This development does not bode well for the Middle East and its proposed plans for a GCC monetary union. The EU’s example shows that fiscal and political unification are a necessary requirement. There has already been much discussion regarding which country would be home to the GCC Central Bank, and future control of the region’s treasuries and political fraternities could prove to be an issue where consensus is most difficult to achieve.

While it seems highly likely that an EMU-style union may not be the ideal way forward for the GCC, discussion now needs to focus on how policy- making in the region should evolve in its absence. For sure, the lessons of Europe are a stark reminder that a common market of trading nations is a great thing, as long as member states maintain the cost of borrowing at rates which reflect financial risks inside their own countries and where their financial accounts are transparent and open to scrutiny by the others.

This applies, particularly, to those states doing the cross-border lending.

The most important policy change over the coming years needs to be the full implementation of the GCC’s common market, to allow for cross border trade without quotas and tariffs and its extension to other MENA markets. This is essential for the development of trade and, with it, new companies. It will also help the region to guard against rising inflation. In 2006/07, high inflation rates were partly responsible for a real estate boom as they made the inflation-adjusted cost of borrowing negative. The region’s central banks were unable to stop inflation because currencies and local interest rates are tied to USD rates.

The rate of diversification of the region’s economies should also speed up to make them much less susceptible to commodity price fluctuations. These upswings and downswings are largely driven by movements in the US dollar and emanate from the US. Economic policy in the US has a completely different set of objectives to those of the Arab world, especially now that US interest rates are likely to be extremely low for years.

The final item is the creation of a credible local currency bond market.

In the absence of control of local monetary policy, it is vital that the region avoids the pitfalls of EMU – where policymakers mistook low interest rates for economic convergence where in fact they represented mispriced risk. A local currency bond market achieves two welcome aims. It creates much deeper financial markets, which can absorb foreign investment flows, thus making boom-bust cycles much less likely.

Secondly, it creates a means of pricing risk in local currency, which then allows for greater development of financial instruments within the region.

With improved regulation, the region’s economic development can accelerate, as was the case with the creation of Asian currency debt markets in the late 1990s.

Rather than opting for grand schemes, which have already passed their sell- by-date, the region should concentrate on enhancing competition, accelerating diversification and creating financial markets that reflect local conditions and not those of others. Adoption of these three principles will go a long way to accelerating economic change in the region.