In December 2001, the members of the Cooperation Council of Arab States of the Gulf (GCC) decided at a summit conference in Muscat to introduce a monetary union as of January 1, 2010. The history of the GCC (composed of Bahrain, Kuwait, Oman, Qatar, Saudi Arabia and the United Arab Emirates) goes back to the early 1980s. In May 1981, the GCC was founded with the purpose of intensifying cooperation in foreign, security and economic policy issues. The aim for the six GCC economies was to develop into a homogeneous union. In the following year, the individual countries signed the Unified Economic Agreement governing the liberalization of goods traffic. A customs union originally planned for 2005 was actually implemented two years early, and a uniform visa program was also introduced. The next measure planned is to launch a common currency, the Khaleeji, by 2010. We regard the 2010 deadline as too ambitious.

Aim of the Monetary Union

The GCC countries are a relatively homogenous group of countries in terms of proximity, size, fluctuation of output, inflation performance, trade structure, high degree of intraregional capital and labour market flexibility. They also have a common language and a similar history of culture and politics. Moreover GCC countries have been making progress when it comes to bringing in line national laws, regulations and supervisions of their financial industry. These are reasons why we think that a centralized monetary policy and a more concerted fiscal policy will work in the region. Generally speaking, the greatest benefit lies in the reduction of transaction costs, which gives rise to greater efficiency and integration of the participating countries. Enhanced price transparency can also be expected, which in turn leads to greater certainty with regard to planning in the business sector. Nevertheless, it is to be expected that intraregional trade will benefit only marginally in the short to medium term, as the export structures of the participating countries are very similar to one another. However, the non-oil sector should be able to benefit, at least in the medium term.

Which Exchange Rate Regime Is Appropriate?

in 2003, the GCC member states agreed to peg their currencies to the US dollar, although the GCC currencies were already de facto pegged to the dollar before, and to stick to the peg until the Khaleeji would be introduced in 2010. The commitment to pegging their exchange rates was based on the monetary union being established in 2010. We can therefore not rule out that in case of a postponement of the monetary union some countries will switch to a different regime, as the commitment then is not binding anymore. The ongoing transformation toward economies with a stronger non-oil tradable goods and service sector and a probable increase in diversification of assets across countries (at the moment, petrodollars are mainly recycled in the US), argue for more exchange rate flexibility in the longer run. In this context a flexible exchange rate would be able to re-align competitiveness in the tradable non-oil sector in case of a real shock. Moreover a possible diversification of petrodollars toward the euro zone would lead to an increasing importance of the euro for the region. As witnessed in 2007/08, a fixed exchange rate regime does not function optimally for the GCC countries in all circumstances. The high oil price, strong domestic demand in the region in combination with a weak dollar lead to soaring inflation, and negative real rate of returns. Since a currency peg requires similar monetary policies to remain sustainable, the different economic cycles in the GCC and US will continue to be a challenge in the future.

Not Ready for a Flexible Regime

In the short run the Gulf region is not prepared for a flexible exchange rate regime on several fronts. The switch to a flexible regime requires a shift to inflation or monetary targeting. Such policies require institutional and technical resources in order to run monetary operations, which are not established yet. Furthermore transparent monetary policy steps and an independent central bank are necessary conditions for a credible central bank. Another factor posing a risk for the central bank's credibility is that data availability remains limited and is, despite other factors, an obstacle for a transparent monetary policy. We thus believe a pegged exchange rate regime will remain the first choice for the launch of the monetary union. However a switch to a more flexible regime seems reasonable, as the region is likely to diversify with regard to trade and capital flows. A basket peg with a significant weighting in euro seems appropriate and could be the next step on the way to a more flexible exchange rate regime in the longer run.