Currency Strength May Hinder GCC’s Economic Diversification Efforts

A sharper rise in US interest rates is expected to manifest in dollar strength effectively reflecting in the appreciation of GCC currencies, impacting competitiveness of many sectors such as trade, tourism, hospitality and real estate.

The impact on exchange rates may be cause for concern for GCC according to analysts. “Beyond funding-cost considerations, higher US rates are likely to impact the GCC via further strengthening of the dollar, which we expect will make new highs. The dollar appreciation would lead to further real appreciation in the GCC’s pegged currencies, reducing their competitiveness and increasing their purchasing power abroad,” said Carla Slim, an economist at Standard Chartered.

Strengthening of local currencies could encourage capital outflow as regional investors seek to diversify their portfolios internationally through purchase assets abroad. The Saudi Arabian riyal (SAR) and the UAE dirham have both appreciated by about 10 per cent in real terms since end-2014. The Kuwaiti dinar (KWD) has appreciated by 7.5 per cent during the same period.

The real effective exchange rate of GCC currencies has already appreciated and are expected to appreciate further. While the region’s goods export base outside of oil and oil-related goods is quite narrow, nonetheless services exports may deteriorate as a result of the strengthening in the currencies. This is most relevant for the UAE where services export receipts stand at around 7 per cent of GDP.

On a positive note, strengthening currencies will reduce cost of imports, thereby improving the terms of trade. Strengthening terms of trade are generally a good thing for an economy as they imply a higher standard of living and stronger economic growth, particularly where economic inputs are largely imported. They also imply lower inflationary pressures as the imported basket of consumption will see price deflation. In the GCC, where a large percentage of domestic consumption is import dependent, this effect is significant.

On the other hand, a strengthening in the terms of trade may not be such a good thing in the context of efforts to diversify GCC economies.

“A stronger currency erodes competitiveness, for example, which will have a negative impact on non-oil exports such as tourism, a major pillar of the economy in Dubai and Oman. It also hinders inward FDI flows as operating costs for foreign companies rise. Finally, it dampens incentives for import substitution, reducing the viability of nascent domestic industries which have to compete with cheap foreign imports,” said, Farouk Soussa, Middle East chief economist of Citi.

Although economists do not foresee any change in GCC FX policy in 2017, they do not rule out rising pressure on currency pegs in the context of down side risks to oil prices that could renew speculation or capital outflows could accelerate in an environment of tighter US monetary policy.

The rising divergence between the US business cycle (where growth is accelerating along with inflationary pressures) and the GCC cycle (where it is decelerating) as happened in2007-2008, going forward there could be calls for greater monetary policy independence.

source : gulfnews