Monetary Union

Globalization has resulted in economic integration of many countries, as means of developing local or regional competitiveness in the international trade and relationships. European Integration experience, including successful usage of Euro, has encouraged integration among other countries and, specifically, monetary integration. The Gulf Cooperation Council (GCC) was established in 1981 with a sole purpose of economic integration among the member countries: Qatar, Kuwait, Bahrain, Oman, United Arab Emirate (UAE) and Saudi Arabia. Among the major steps taken towards the economic integration was the formation of custom union in 2003. The plans of establishing a common market by 2007 were made. It was also agreed on the formation of a common currency by 2010 during Muscat Summit, held on December 2001. This would be the second monetary union, following the European monetary union (EMU). Among the key players towards success of this integration was the International Monetary Fund (IMF), which offered technical assistance and policy advice.       

There are several benefits that resulted from the establishment of monetary union. These include: low transaction costs, reduction in risks and boosting of trade. However, a member country may experience loss, associated by failure to pursue its own monetary policy. Establishment of GCC economic integration and monetary union has been based on environmental factors, such as similar economic structures, cultural similarities and also common language. The pursuit of monetary union did not happen without challenge: the main one being convergence criteria, as was the case for Euro; also referred to as the Maastricht criteria. The Supreme Council that runs the affairs of the GCC economic integration convened a session in Abu Dhabi in December 2005. This was aimed at endorsing a performance criteria that would ensure convergence among the member countries and, hence the success of the monetary union. The endorsed criteria was based on Maastricht criteria, and consisted of five variables:

 

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1. Inflation rates should not exceed by more than 2% the weighted average of

   inflation rates in the GCC.

2. Average short-term interest rates are not supposed to exceed by more than 2% the average of three lowest rates.

3. Foreign exchange reserves are supposed to cover imports of goods for at least quarter of a year.

4. Annual fiscal deficit is not supposed to exceed 3% of GDP.

5. The public debt ratio is not supposed to exceed 60% of GDP for general government and 70% of GDP for central government.

6. The GCC currencies should maintain a fixed US dollar peg.

The paper will assess the readiness of the GCC to enter a monetary union base on following their commitments to these criteria.

Research Questions:

1. 1.  Are the GCC countries ready for a monetary union?
2. 2.  Does the GCC countries’ economic environment allow for a single currency to exist?  

Literature Review

There are many studies that have been conducted to establish whether the GCC countries are ready for the formation of monetary union, given their economic similarities and common cultural and social backgrounds. Some studies proved that the member countries in the GCC may not be prepared for the monetary union, given the slow progress that would otherwise be if they were serious for the course. On the other hand, some studies support the formation of GCC monetary union.   

Laabas and Limam (2002) conducted an evaluation of GCC countries’ readiness towards the formation of monetary union. Their test was based on generalized measure of purchasing power parity. They found out that the GCC countries were not ready for monetary union. This was a result of not meeting the pre-condition for such union, based on the fact that, their economies are oil-based and little intra-trade takes place. Their findings also indicated a lack of agreement in macroeconomic fundamentals, as well as the business cycle harmonization among the member countries. The authors indicated a possibility of satisfying union criteria ex-post as opposed to ex-ante. According to the authors, formation of monetary union by the GCC countries would lead to alignment of business cycles and, hence increase intra-trade. They were of the view that, elimination or relaxation of factor mobility restrictions and unification of politics was a precondition towards monetary union.        

According to Jadresic (2002), elimination of cross-border and domestic distortions that acts as a hindrance to policy coordination, investment and trade, and increased political unification are fundamental for successful integration. He, therefore, concluded that common currency establishment by the member countries may have many benefits but, not be sufficient for a successful operation of economic integration.    

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A study conducted by Shotar and Shams (2005) focused on the economic structures of the member countries in GCC. Their interest was to establish the possibility of the GCC countries, adopting similar economic policies, while rolling out common currency in 2010. They found out that, the member countries have diverse economic policies sufficiently different for them to harness the benefits associated with monetary unions.       

Darrat and Al-Shamsi (2005) also conducted a study that made them conclude that the member countries had the capacity to form a monetary union. Their study involved the use of inflation rates, monetary bases and exchange rates, while testing for co-integration. They, however, noted that, political constraints were the major hindrance to economic structures harmonization and, hence integration.

According to Hebous (2006), formation of monetary integration by the GCC countries would involve lower costs due to less economic difference that exists among the member countries. He used this to explain the progress made in convergence among these countries.

Abu-Bader and Abu-Qarn (2006) conducted a study by use of three variables while testing GCC economies. Their conclusion was that the countries were not ready for the establishment of monetary union. Their fast method made use of Structural VAR in identifying supply and demand shocks and also establishing whether the shocks were systematic. Their second approach was testing for co-integration to ascertain the existence of long-term real GDP relationship among the countries. Their third approach was aimed at finding out whether common business cycles exist among member countries. None of these approaches supported the formation of monetary union.     

Readiness of GCC Countries for a Single Currency

a. Member Country Inflation Rate Must not Be in Excess of GCC Weighted Average Plus 2%

Though it was not specified formally in the criterion, inflation refers the change in annual average of the aggregate Consumer Price Index. Weighted average denotes the proportion to the country’s GDP. In 2007, work was still in progress in coming up with a standardized classification of CPI basket among the GCC countries. By then, it had been unanimous to adopt COICOP system, by making use of the household expenditure and income weights in 2007. The base year was year 2000. Beginning from 2003, the inflation rates had been rising and depicted more country divergence. In addition, most of the countries had released CPI data, relating to the first quarter for the year 2008 and the GDP data was up to 2007. Within the period, Qatar recorded the highest level of inflation while Bahrain recorded the lowest.         

In 2007, the weighted inflation rate for the member countries in GCC was 6.91% while the simple one averaged to 7.29%. For the countries forming a monetary union, their inflation rates must not exceed 8.91%. However, based on the data available in 2007, UAE and Qatar had their average exceed this limit. 

b. The Average of the Lowest Three Interest Rates Plus 2% in Each Member Country Must not be Exceeded by The Average Short-Term Interest Rates

In this case, we use three month inter-bank market rates though not specified formally. The average used in this case is not weighted because it seems to be the preferred measure by national authorities. Among the member countries, the lowest interest rate in the first quarter in 2008 was 2.29% for Qatar, followed by Kuwait with 2.44% and then that of Saudi Arabia with 2.5%. The three yielded an average of 2.44% while the limit for interest rate is 4.4%. Apparently, the GCC countries met the interest rate criteria. The GCC countries met the interest rate criteria, though they needed to follow the US Federal Reserve interest rate policy, so as to be able to maintain a fix to US dollar. This was with the exception of Kuwait which had adopted currency basket peg.      

The Foreign Exchange Reserves Should be Able to Import for a Minimum Of Four Months

Reserve assets for the central banks consist of SDRs and gold. All countries possess foreign reserves to enable coverage of more than reserve position in funds for the foreign exchange reserve four months of imported goods and securities.  

Annual Fiscal Deficit Must not be in Excess Of 3% Of GDP

Owing to the revenue from high energy commodities, the GCC countries have been able to record fiscal surpluses. For instances, in 2006 UAE had a fiscal surplus of DH 72466 million (12.1% of the GDP). Based on the available data, IMF was able to make estimation for the UAE surpluses in the following year (2007). We may, therefore, with a significant level of confidence, assert that, the GCC countries meet this criterion. 

e. The Public Debt Ratio for General and Central Government Should not Exceed 60% and 70% Of GDP Respectively

As provided by the IMF, Social Security Systems or pension funds and extra budgetary entities, including Sovereignty Wealth Funds, are used to account for the difference between Central Government Debt (CGD) and General Government Debt (GGD). This criterion indicated larger figures for the case of CGD than that of GGD. However, majority of the country had not recorded up to date data for central bank debt. It was only for the Oman and Saudi Arabia, which had figures relating to 2007 while for the case of Bahrain, it had recorded 23.68% which related to 2006. However, for the case of Qatar, Kuwait and UAE, no data from official sources could be obtained. It was observed that, all the GCC countries, except for UAE whose data was unavailable met the CGD criterion. Similarly, all the countries also met the GGD criterion, except for UAE whose figures for the year 2007had not been disclosed.    

GCC Currencies Formally Pegged to a Fixed Exchange Rate With The US Dollar

During the 21^st session for the GCC countries convened by Supreme Councils held in Manama in December had them decided to use US dollar as their official anchor for currencies beginning 1^st January 2003. They also agreed to maintain bilateral exchange rate fixed with US dollar up to when common currency is adopted in 2010. Except for Kuwait, the rest of the member countries met the exchange rate criterion.    

According to this analysis, it was only for Bahrain, Saudi Arabia and Oman that met all the criteria. For the case of Omani, the authorities have reiterated on their wish not to form part of GMU at inception. For UAE and Qatar, their inflation rates exceed the targeted inflation while Kuwait does not peg US dollar but rather, the currency basket.

Literature Overview

UAE and Qatar fail to meet Inflation criteria while on the other hand; Kuwait does not succeed in meet the exchange rate criterion. Though UAE has not disclosed its fiscal figures yet, it is not likely that GGD and CGD would exceed the required limits. It is clear that, no revisions are done to the exception criteria, or else, inflation rates would not have converged, then, it is only Saudi Arabia, Bahrain and Oman that would be qualified for the formation of monetary union. However, from a general perspective, convergence criterion application may depict an impression that, the process is not going to be successful.                 

Convergence Criteria were advanced largely from the Maastricht criteria. However, the Maastricht criteria were not initially meant for GCC and, therefore, their suitability is limited. Their usefulness in establishing limits for the debts and fiscal deficit for countries which has experienced excess current account surpluses and large fiscal surpluses is only limited the near and median terms. Similarly, by setting the national currency fixed to the US dollars, a no arbitrage requirement is ensured, all the interest rates become very close. For this reason, use of interest criterion is highly redundant. Ideally, the short term rates are specifically dependent on interest rates as set by the central bank. Therefore, in the presence of the central bank, it would be simple to meet the interest rate criterion without necessarily having a peg and achieve the low rates before deadline. For the case of Maastricht criteria, the interest focus is for ten year dependent on the market as opposed to the authorities.                               

The inflation criterion is quite significant for the formation of the monetary union. For the case of European Union, the low inflation rates were achieved for the union to take place. However, it is different for the GCC countries, where convergence is occurring at double digit figures. The problem arises from criterion conflict between exchange rates and inflation. Pegging currency to the US dollars deprives a necessary monetary tool that is critical in fighting inflation. For the case of European countries, the test for inflation was imposed and binding discipline. In addition, the European currencies were to be maintained within a narrow range of fluctuation band, compared with each other currencies as opposed to an external currency, as for the case of GCC countries. Mainly, the European Monetary Union was established to purposely eliminate competitive devaluation of currency that threatened the success of the European Union single market. Much of these devaluations were due to fiscal laxity by countries, such as Spain, Italy, Portugal and France to some extent. This necessitated the introduction of fiscal consolidation to ensure convergence of long term rate of interests, and hence the inflation rates.           

To the contrary, for the GCC de facto, there was the existence of pseudo monetary union which had been in place for many decades, where the countries’ had maintained associations to the dollar. The GMU would help to strengthen the commitment, while extending benefits of the currency stability to citizens, industries and financial markets by ensuring strong trade relationship and also attracting international capital.                

Therefore, there are pre-conditions necessary to set up GMU. To start with, there must be governance and institutional framework for transparent, smooth and efficient decisions on monetary policies among other policies by the central banks. Secondly, there was a need for harmonized and reliable statistics to ensure efficient conduct of monetary policies and also, the guidance of financial and economic agents released on time. Lastly, presence of efficient payment system was necessary in ensuring transfer of funds across the GCC countries swiftly while maintaining uniform interest rates. Given that these conditions are met, the GCC could easily take-off regardless of the condition of other convergence criteria. As for the case of euro area, banknotes can also be issued many years after the Monetary Union is launched. The knowledge gap in these studies is that, they were conducted long time ago, and we need to establish whether the current situation is in support of monetary union.

Methodology

The objective of this study is to find out whether the current economic environment is in support of monetary union. It, therefore, aims at assessing the compliance of the member countries towards convergence criteria. This is based on the fact that no clear situation has been given on the progress made by these countries. This study will make use of two variables, exchange rates and interest rates for all the member countries and compare them with the required conditions for the monetary union.

Research Design

The model in this study will be based on Abu-Bader and Abu-Qarn (2006) who in their study used three variables. However, in this study, we shall only consider the exchange rates and interest rates.

Sample Design

The sample will contain all the member countries in the union. The study will, however, make use of secondary sources of data which will be obtained from quarterly reports on balance of payment and statistics from international financial reports. The period to be covered by the study will range from the year 2000 to 2010. The data will be used to indicate the different convergence criterion condition. The data will be collected by developing a data collection guide, where statistics will be recorded as obtained from the secondary sources. The research will be the used to indicate the trends of the structural variables, necessary for monetary union establishment. This analysis will be relevant in providing the answers to the question on how ready are the firms to establish the union.

Working Hypothesis

The working hypothesis for this study is that the member countries are not ready for monetary union, given their diverse economic structure and political orientations.

Data Collection Instruments

Any data received from the secondary sources will be first recorded in the data collection guide. Data collection guide will be appropriate because the data to be used will be historical and, hence need to be organized in a sequence form to make it simpler for computation.

Theoretical Model

The study will involve the analysis of exchange rates with their ragged values to be able to estimate a model that will be used to predict the possibility of any convergence of exchange rates into the levels that are acceptable.

Et= β₀+ β₁E_t-1 + β₂E_t-2 + β₃E_t-3+ ….+ β_nE_t-n

For the case of the interest rates, the study will also test for the observed trend by use of the ragged values, so as to be able to predict the possibility of a convergence to some recommended rates necessary for single currency.

Xt= α₀ + α₁X_t-1 + α₂X_t-2 + α₃X_t-3+ … α_nX_t-n

 Where:

Et- the exchange rate at time t

Xt- is the interest rate at time t

These analyses are based on the assumption that there is a relationship between the values of different variables at different periods of time.

Data Analysis and Presentation

The study will make use of regression analysis and descriptive statistics. The analysis will be made with a help of SPSS.