United States of Petrodollars
March 15, 2007
By Serhan Cevik | Boston
Oil-rich countries of the Gulf region are moving towards monetary unification. The six countries of the Gulf Cooperation Council — Bahrain, Kuwait, Oman, Qatar, Saudi Arabia and the United Arab Emirates — took the first step towards economic integration a long time ago, in 1981, with the ultimate objective of establishing a monetary union. After decades of protracted preparations, the GCC has already become a customs union and now plans to introduce a common currency within three years. With similar socio-cultural values, political institutions and comparable economic compositions, these countries seemingly form an optimum currency area and therefore could benefit from greater monetary integration. However, the harmonization of economic institutions and policies is still a major hindrance that may not allow all the countries to be ready for the adoption of a single currency by 2010. Although a variety of cracks has already become apparent, especially with Oman’s decision to opt out of the planned monetary union, our main worry is not really about the establishment of a unified monetary system in the region. Instead, we are concerned more about its sustainability in the longer term.
Gulf countries could benefit from monetary integration, but not as much as Europe. The European Monetary Union has confirmed theoretical benefits of monetary unification in practice. Within a robust institutional framework, member countries benefit from lower transaction costs and currency risks, which would bring economic savings and promote intra-regional trade and investment. Furthermore, greater transparency and competitive pressures would help maintain price stability, while fiscal requirements would lower the risk premium. As a result, the unified zone would lead to new investment opportunities and higher income growth. These are all great points in favor of establishing a monetary union, but do not necessarily mean that the GCC could enjoy such benefits as much as the Eurozone countries. First, even though the GCC has a reasonably open economy, intra-regional trade is still too small — barely 10% of exports or less than 5% of GDP — to bring significant gains from lower transaction costs. Second, the degree of economic diversification is very low, making the planned monetary union highly exposed to shocks. Third, all the GCC members have long demonstrated a preference for investment outside the region, which of course limits the gains from financial integration. Although the adoption of a common currency could arguably accelerate economic convergence and deepen financial integration, a monetary union without necessary foundations and policy coordination is unlikely to survive global and/or regional shocks, in our view. Oil dependence is the most significant threat to the sustainability of monetary unification. Even just to achieve minimal benefits of a common currency, the GCC countries must remain faithful to a strict set of convergence criteria on monetary variables and real economic factors. Following Europe’s footsteps, they have already pledged to keep inflation rates at no more than 2% above the weighted regional average, budget deficits below 3% of GDP, public debt less than 60% of GDP and interest rates at no more than 2% above the average of the lowest three countries. Thanks to the windfall from higher oil prices, all the countries now run huge budget surpluses and have public debt levels well below the 60% threshold. However, macroeconomic synchronization is still limited, especially in terms of inflation dynamics. Even at relatively low rates, there is really no sign of inflation convergence across the region, and it is likely to become more problematic as the countries experience a marked increase in inflation rates. Furthermore, today’s supportive fiscal figures are simply a reflection of the region’s excessive dependence on the oil sector and therefore may deteriorate quickly if oil prices move below budgetary projections. This is indeed the most significant threat to the sustainability of the planned monetary union, in our view. In addition to creating fiscal challenges, the low degree of economic diversification and the prevailing differences in resource endowment undermine the stability of monetary union. Revaluing national currencies and switching to a ‘basket peg’ could help the convergence process. Abundant liquidity and expansionary macroeconomic policies have fuelled domestic demand and led to a surge in inflation rates in the Gulf region. However, we must not ignore inflationary consequences of the exchange-rate peg to the US dollar. With the dollar’s weakness, the GCC countries have experienced a sustained depreciation of their real effective exchange rates and an increase in imported inflation (see Pegged Pains, February 20, 2007). This is why we have argued in favor of revaluing national currencies and switching to a peg against a basket of currencies, rather than just the dollar. In our view, although the inflation problem and enormous current account surpluses alone justify currency revaluation, it would also help accelerating convergence for the planned monetary union. Likewise, while pegging to a single currency is a simple approach (especially given the fact that oil and natural gas prices are priced in dollars), a more flexible exchange-rate regime would allow these economies to manage the volatility of oil prices better and make monetary integration sustainable.
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Made to Measure
March 15, 2007
By Gray Newman and Daniel Volberg | New York
It might seem like a ‘slow news’ day in the region to find us commenting on a mid-level personnel change in a government statistics agency. Compared to US President George Bush’s trip to the region this week, you might wonder why we’re focusing on the removal of a mid-level official in Argentina’s national statistic institute (INDEC) that took place almost a month and a half ago. Perils of abundance We’re highlighting the INDEC affair because we believe that it epitomizes the perils of abundance in the region. Faced with persistent demand for the region’s exports, Latin America has been awash with a level of abundance rarely seen. That in turn has boosted economic activity, international reserves, fiscal coffers and risk appetite around the region. Unfortunately, the new-found abundance has also produced complacency and has boosted policy blunders, which eventually could prove costly to Latin America’s long-term health. While the precise details of the INDEC affair remain murky, we do know that the head of the institute’s consumer price unit was relieved of her post in late January. The move in turn led to a delay in the release of the January inflation report in early February and accusations in the local press that the intent was to manipulate Argentina’s consumer price index. The authorities have strenuously denied that the move was designed to manipulate the inflation index and have accused critics of a political agenda. We’re not interested in weighing in on what the intent behind the move was — we’re not in a strong position to be able to do so and suspect that neither are most Argentina watchers — but we are concerned with the subsequent developments on the inflation-reporting front. Both the January and February inflation reports raise questions on how inflation is being reported. January’s inflation report at 1.1% came in well below initial market expectations, in large part due to the unusual treatment of health care expenses and tourism. Healthcare providers had announced that monthly fees would rise by 22% unless users switched to a new program that increased monthly fees only modestly in exchange for new co-payment charges. January’s inflation reading made little attempt to deal with the dilemma and used the government-approved modest increase rather than the 22% increase that most users would face. Meanwhile, the usual seasonal jump in tourism-related prices that surfaces in December and January suddenly turned out to be even more muted in January than in December, according to the official price index. But for the modifications, local analysts estimate that inflation in January would have been closer to 2% or a bit higher. Once again in February, the index suggested that the authorities were largely using controlled prices for both healthcare packages as well as tourism. While the difference between reported February inflation (0.3%) and local measures (0.4-0.5%) was more modest, the damage from January’s move appears to have set in. To be fair to the authorities, measuring inflation is a difficult task. Indeed, inflation, unlike GDP growth or industrial output, is ultimately personal. My inflation, based on the basket of goods that I regularly consume, is likely to be different from your inflation. A consumer price index tries to come up with the basket for the typical consumer. We have heard from some in Argentina that the healthcare charges introduced in January were relevant only to a small number of consumers, and therefore including the larger increase would have been misleading. But we are afraid that this misses the point. It is not unusual for statistical agencies to revise the consumer basket to, for example, give cell phone fees a greater weight or to add iPods while removing portable tape players. The problem in the case of Argentina is that decisions over how the consumer price index is being calculated appear to have taken place unannounced and on an ad hoc basis. To date, the statistical authority has not produced a detailed explanation of the decisions made in calculating monthly inflation in January or February. Given the backdrop of price agreements, price controls, export restrictions and cross-subsidies designed to deal with inflation, it is hardly surprising that INDEC’s moves have raised concerns over the credibility of Argentina’s inflation measure. And that is what most concerns us. If the authorities fail to provide a greater level of transparency regarding the decisions taking place at INDEC, they run a serious risk of undermining the credibility of Argentina’s inflation measure. Workers may conclude that the official index was made-to-measure to understate inflation and begin to rely on other measures. Multiple inflation measures are hardly unusual — look at the alphabet soup of inflation measures in Brazil. Still, the erosion in confidence in Argentina’s principal inflation index could further complicate the authorities’ attempts at preventing a wage-inflation spiral. Wage risk The INDEC affair, we fear, is likely to complicate the authorities’ attempts at moderating wage inflation in Argentina. After wages rose by 19% on average last year, the administration appears keen on keeping average wage settlements closer to 15%. So far, however, the announcements that we have seen have been closer to 20% or even higher. We expect the next two months to be crucial in determining if wage demands can be tamed. We suspect that a wage-inflation spiral is unlikely in the near term. The administration has strong ties with key labor leadership and has used price controls to provide a group of basic goods available for workers. But our concern is that instead of annual agreements, we could see more six-month agreements on the wage front — similar to was achieved by the electric power generation union. That could postpone the wage-inflation problem until the politically sensitive eve of the upcoming presidential election in October. Measuring the gap So far, the level of under-representation of inflation appears to be modest. If we estimate CPI inflation using the private consumption component of the GDP deflator, there appeared to be a significant gap that opened up between the official CPI measure of inflation and our estimate in mid-2006. However, the gap did not widen during the third quarter. The construction cost measure, while not a proxy for consumer prices, does suggest that other measures of inflation are quickening even as consumer prices as measured by the official INDEC survey are not. Finally, most interesting is that if we look at inflation measured throughout the country excluding the capital city of Buenos Aires, we see that non-Buenos Aires inflation has begun to exceed that of the capital, in sharp contrast to the past. There has been talk that the price measures have been most rigorously applied in the Buenos Aires metropolitan area: the divergence between the two measures of late could suggest that the force of the price agreements is beginning to deteriorate elsewhere in the country. Oddly enough, while Argentina has recently begun to produce a national CPI measure, most of the focus remains on the official measure, which calculates prices only for the Buenos Aires metropolitan area. Bottom line We don’t want to overplay the recent turmoil over inflation measurements in Argentina. Ultimately, both the administration and the central bank recognize that inflation is too high and needs to be brought down. Moreover, there is intense effort to control expectations and a careful focus on wage negotiations taking place this year, which should yield increases below those of last year. And all this comes as the administration wisely remains focused on avoiding the traditional fiscal habit of living beyond one’s means. However, we are concerned that the relative nonchalance among market participants to the INDEC affair could be misread by the authorities as a sign of endorsement of the policy. After all, Argentine instruments sold off only modestly in the aftermath of the INDEC affair. In a world with an abundance of risk appetite, we would warn not to construe near-term acceptance by investors as a sign of sound macro policy. The accusation that inflation is being made-to-measure can have dire effects on the ability of the authorities to conduct fiscal, monetary and wage policy, making each more costly. While we are not willing to label the inflation credibility scandal as a ‘tipping point’ quite yet, we are afraid that it could emerge as a greater problem before the year is out.
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