Fiscally Good Enough
November 23, 2007
By Boris Segura | New York
The abundance cushion
With oil hovering above US$90 a barrel, it is easy to be upbeat on Venezuela’s economy and the authorities’ ability to service its debt. But we would argue that even if oil prices were to drop sharply from current levels, Venezuela’s ability to service its debt would not be seriously hampered. Whatever your medium- and long-term concerns over the direction that Venezuela’s economy is moving in – and we have plenty – we do not see a payment crisis likely in 2008. Our cautious optimism on Venezuela is based on two pillars: First, Venezuela has a very healthy stock of public-sector liquid assets. We estimate that liquid assets are currently running near US$50 billion – that is equivalent to roughly 24% of 2007 GDP. With liquidity of that magnitude, Venezuela can deal with virtually any financing gap that one can imagine in 2008. Second, Venezuela has a growing and largely captive domestic market for government debt. The combination of exchange controls and years of high oil prices has produced dramatic growth in domestic liquidity, which creates a captive market for placing government debt. Indeed, one of the consequences of the captive local market has been negative real interest rates in the case of domestic debt and below-market interest rates in the case of external debt. This provides the authorities with some insulation in the event that international debt markets should suddenly close to Venezuela. Fiscal accounts in 2008 Indeed, our assumptions for Venezuela’s fiscal accounts might look conservative in light of current oil prices. We are assuming that the Venezuelan oil basket averages US$65 per barrel in 2008, in line with our global economics team’s forecast of US$70 per barrel for Brent in 2008. In contrast, during the first half of November, the Venezuelan oil basket has been near US$85, roughly US$20 above our 2008 forecast average. We are also revising upward our GDP growth forecast for 2008 to 6% from our previous estimate of 4.5%. The revision is based in part on higher oil prices, as well as our assumption that oil production bottoms out at 2.4 million barrels per day in 2007 and gradually increases to 2.5 mbpd in 2008. With higher fiscal revenues and stronger growth, we expect the exchange rate to remain unchanged at Bs 2,150 per US dollar, versus our previous forecast of a devaluation to 2,600 next year. The strong growth is likely to keep inflation high – indeed, the highest officially reported level in the region – at near 20% According to our calculations, Venezuela’s central government accounts will end up almost in balance in 2007. The government was able to slow down the growth in primary expenditure during the first three quarters of this year, from a pace of 70% in late 2006 to a still high but more moderate 40% in the last few months. Even though some slippage is likely to occur in the run-up to the December 2 constitutional referendum, we expect that expenditure will probably come down to just under 26% of GDP in 2007 versus 27.4% of GDP in 2006. This restraint in spending came as the administration became concerned over the uptick in inflation, which reached nearly 20% in 2Q07. A note on our projections: we recognize that central government accounts do not fully measure the growing public sector as more and more expenditure is taking place via the oil company, Pdvsa (Petroleos de Venezuela), and development banks and funds such as Bandes (Banco de Desarrollo Economico y Social) and Fonden (Fondo de Desarrollo Nacional). This raises issues of transparency and accountability of government expenditure. Moreover, the central government accounts do not match up with the ‘restricted public sector’ (which includes not only the central government but also the operational balances of Pdvsa and other non-financial government enterprises). Nonetheless, central government accounts represent more than 75% of the ‘restricted public sector’ expenditure and revenues. And the most readily available data on fiscal accounts are largely limited to the central government’s accounts. For 2008, we are expecting a deterioration of Venezuela’s fiscal accounts, with the overall deficit widening to 1.4% of GDP, a level that we find easily financeable under normal circumstances. With oil prices flat and oil production on the rise, it may seem odd that we are assuming an overall deficit increase. The reason is found in the steady real appreciation of the (official) exchange rate in Venezuela. With 60% of government revenues – namely, oil revenues and tariffs and VAT on imports – linked to the exchange rate, a sharp real exchange rate appreciation is undermining US dollar revenues in bolivares. Of course, expenditure is mostly in bolivares and still growing strongly. Moreover, the non-oil tax administrator (SENIAT) has done a fairly good job in reducing tax evasion, therefore raising the non-oil tax take. Financing plans for 2008 Although the authorities have not published a financing plan, we estimate that total financing needs in 2008 are likely to reach just under US$10 billion, or 3.7% of GDP. We estimate a US$3.9 billion fiscal deficit (1.4% of GDP), as well as just under US$6 billion in amortization of domestic and external debt. One financing route would be to issue all debt to domestic investors. Our assertion is that the authorities have a captive domestic market in which to issue debt, which is paradoxically a distortion caused by the exchange controls. High oil prices, in the context of exchange controls, have caused a dramatic expansion of liquidity. From hovering around 23% of GDP in 2003-05, M2 has shot up to an estimated 33% of GDP this year, which is a sizeable pool of funds to the government. Moreover, Venezuelan individuals and firms find ‘external debt’ attractive because it is ‘Euroclearable’ and thereby provides them with access to dollars to send abroad, although at an exchange rate between the official and the (much weaker) permuta one. In the context of exchange controls, this is the only legal vehicle for domestic agents to access forex at a subsidized exchange rate, in case they do not have recourse to dollars provided by Cadivi. The government can issue debt at below-market rates domestically because its buyers are not interest rate-sensitive, but exchange rate-sensitive. As reported in the local press, the authorities may want to raise US$2 billion in ‘external debt’, and to roll over its maturities of domestic debt coming due in 2008. Again, this shouldn’t be troublesome; this would leave us with an (ex-ante) financing gap of almost US$4 billion (1.5% of GDP) for 2008, easily financeable out of Venezuela’s liquid assets, if need be. Of course, in the extreme case that Venezuela is unable to or chooses not to issue any debt at all, it can tap into a variety of liquid assets, which we estimate reached nearly US$50 billion at the end of September 2007. Nearly half of these assets are in US dollars. Together with the central bank’s international reserves, Venezuela has a war chest of US$80 billion, more than eight times the financing needs identified above. What if oil prices collapse? We must consider what would happen to fiscal accounts in the case of a sharp collapse of oil prices, however unlikely at this point. Our calculations show that if Venezuela’s oil basket price were to fall to US$50 per barrel, the fiscal deficit would more than triple to 4.4% of GDP. The financing needs would widen by 3% of GDP, assuming no reduction in primary spending (which we assume to grow at 22%Y in 2008), still easily financeable by drawing down the public sector’s liquid assets. Of course, this a partial-equilibrium analysis; if oil prices drop, and the government restrains expenditure, the economy will decelerate and non-oil tax revenue will also fall. Moreover, if oil prices drop, Pdvsa will be forced to not only make smaller transfers (i.e., royalties, dividends, income and exploitation taxes) to the budget, but also cut back on its ‘social development expenditure’ (direct expenditure in the ‘misiones’ – the parallel government structure in charge of delivering social services – and transfers to Fonden). In 2006, Pdvsa spent US$13.8 billion (7.6% of GDP) on those items. Judging by the 2002-03 experience during the ‘oil sabotage’ (as the strike at Pdvsa is referred to by the authorities), the administration was able to cut (or at least delay) spending, under a severe stress scenario. Given that public expenditure is become progressively more rigid, the eventual cuts are likely to be very inefficient and would likely require that the authorities slash investment programs and run wages and payables in arrears. Of course, if necessary, the administration could always devalue the official exchange rate. A real depreciation would boosts US dollar revenues in bolivar terms and should improve the fiscal balance, as long as the government allows real expenditure to contract. In the current environment of the introduction of a bolivar fuerte, however, we tend to rule out this policy option, as the strong bolivar is the only nominal anchor at the disposal of the authorities. Caveats Although we believe that the fiscal and financing challenges to Venezuela in 2008 are limited, there are several downside risks to our outlook. There is some risk of political upheaval surrounding the December 2 referendum on the constitutional amendments. The recent diplomatic spat between the Venezuelan authorities and the King of Spain has served to remove the spotlight from the referendum and may end up drowning out the voices of those critical of the amendments. But if, as we expect, the constitutional amendments are approved on December 2, there is the risk of political upheaval later in the year or in 2008. While the majority of investors tend to view the amendments as merely the formalization of steps taken in recent years, we believe that the new amendments are likely to further radicalize the economic policy stance pursued in the recent past. The new amendments increase the rigidities of public expenditure, giving constitutional rank to the ‘misiones’ and increasing transfers to states, municipalities and the new ‘Popular Power’. The amendments also create new entitlements (a Social Stability Fund for Self-Employed Workers, reduced workweek, etc.) that might be difficult to fund. Finally, we are concerned that the constitutional changes weaken private property rights, as the state can reserve for itself the exploitation of natural resources and ‘any other activity deemed to be strategic’. In our opinion, these changes are likely to increase the distortions that the Venezuelan economy has been accumulating over the last few years. This in turn could further depress private investment and runs the risk of fueling capital flight. Bottom line While Venezuela’s spending has increased as oil revenues have risen, the authorities have also taken advantage of the abundance of inflows to build a massive safety cushion. With more than US$50 billion in liquid assets at its disposal, in addition to US$30 billion of reserves held by the central bank, the authorities have ample room to finance any reasonable shortfall from its fiscal accounts in 2008. Indeed, even if oil prices were to fall to near US$50 per barrel – roughly half of where they have been in the first weeks of November – and even if Venezuela were closed from any domestic or external financing, it could still comfortably fill the US$17 billion additional gap that would arise. There are plenty of reasons to be cautious. We fear that the December 2 referendum is likely to radicalize further the policy mix in Venezuela. But starting points matter. And Venezuela has used the abundance of recent years to build a powerful cushion, allowing it to engage in counter-cyclical policy if it needs to in the event of a sudden collapse in oil prices.
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Portfolio Allocation for Sovereign Wealth Funds
November 23, 2007
By Stephen L. Jen & Luca Bindelli | London
Summary and conclusions Sovereign wealth funds (SWFs), especially oil-based SWFs, face interesting investment opportunities. In this note, we present some considerations that may help us assess what SWFs’ investment portfolios may look like, and therefore how these SWFs may affect the underlying markets. Specifically, we document the long-term (since 1985) returns on various asset classes and their associated risk levels. Past performances suggest that oil-exporting countries should indeed convert their wealth held underground (in the form of oil reserves) into financial wealth above-ground, as the latter is superior in terms of both return and risk. Global equities, especially emerging market (EM) equities, real estate and bonds form the ‘efficiency frontier’, while gold and non-energy commodities have significantly underperformed in the past two decades in risk-adjusted terms. Past performances of various asset classes SWFs may have important implications for financial markets. But to assess these effects, we need to first form a general opinion on what their investment portfolios may look like. While different SWFs will almost certainly have different preferences and therefore different investment portfolios, we think that collectively they have some unique traits relative to official reserve mangers and pension fund managers, which could help us understand their strategies. If one had invested US$100 in 1985, the investment would be now worth US$739 for global real estate, US$639 for equities, US$403 for global bonds, US$264 for non-energy commodities and only US$182 for crude oil (including the recent surge in oil prices toward US$100 a barrel). That the performances of various asset classes can be so diverse should not be news. What is important to investors is not just the investment return, but also the associated risk of various investments. We make the following observations: Observation 1. Crude oil has been a pretty lousy investment in the last two decades. As pointed out by Deputy Governor Knut Kjaer of the Norges Bank and ourselves, oil has generated sub-par returns, and has had immense volatility. This means that oil-exporters should not be shy about converting their wealth underground to above-ground financial wealth, since the latter should significantly outperform the former, in risk-adjusted terms. Even though oil prices are likely to continue to drift higher, given the demand and supply outlook in the crude oil market, we suspect that oil will be unlikely to outperform the ‘higher-octane’ assets. Observation 2. EM equities mark one end of the efficient frontier. EM equities have, in the past two decades, generated more than 700bp of excess return compared to sovereign bonds, though their risk level is also quite high. In a way, sovereign bonds and EM equities mark the two ends of the efficient frontier for most investors, including the SWFs, though some SWFs may be able to extend further out on this frontier through private equity investments. We do not have data on the average return on private equity investments, but presume that they could be closer to where ‘100% EM Equities’ is. Further, since many of the larger SWFs in the world are from emerging economies, there may be greater familiarity and less of a risk-aversion towards these markets. We are, therefore, likely to see a good deal of EM-to-EM investment flows through the SWFs. Observation 3. No clear under- or outperformance of US equities. ‘100% Global Equities’ marks the risk-return profile of MSCI-Global in SDR (Special Drawing Rights) terms. Compared to the ‘100% US Equities’, these points are not too far apart. (We presume that the gap is not statistically significant.) Thus, over the last two decades, US equities in dollar terms have performed on par with global equities in SDR terms. The underperformance of US equities in USD terms in the last few years has offset its outperformance in the late 1990s. There are no clear implications for the dollar here. However, if one believes that there will be a generalised rebalancing of portfolios towards EM, the dollar and the euro could suffer from a long-term perspective. Observation 4. ‘Beta’ is not a four-letter word. In the financial industry, there is somewhat of a fixation on ‘alpha’, and the word ‘beta’ is unglamorous. However, there could be ample scope to enhance the portfolio return if the SWF is sufficiently inclined to be exposed to a bit higher risk. Outperforming sovereign bonds by 200-300bp with a long-term investment horizon seems very achievable. Considering the significant difference in the costs of beta and alpha portfolio management, many SWFs may be inclined to have a high beta component to their portfolios. This also means that, over time, SWFs are likely to manage much of their funds in-house, though equities, sophisticated products and alpha activities may still be outsourced. Bottom line The willingness and ability of SWFs to invest in a broader set of assets than sovereign bonds opens up interesting opportunities for themselves and has implications for various markets that matter to us. In this note, we document the risk-return profiles of various asset classes in the last two decades, and make some observations concerning the investment portfolios that SWFs may adopt.
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A Managed Float Is the Ultimate Goal for the GCC
November 23, 2007
By Stephen Jen & Charles St-Arnaud | London
Summary and conclusions In theory, the GCC countries should adopt a managed float exchange rate regime, with or without a monetary union. However, in practice, limitations on the effectiveness of monetary instruments may prevent the GCC from moving to a fully flexible exchange rate regime immediately, and the USD peg or a basket peg should thus be seen as a transition regime to buy the GCC time to develop their financial and monetary instruments. Regarding the alternative interim regimes, we believe that a dollar peg is no worse than a basket peg, particularly when EUR/USD may be close to its multi-year high. We agree that the GCC currencies should be allowed to strengthen in nominal terms, but the case for a maxi-revaluation, as some analysts are suggesting, is not convincing to us or to many GCC members. This is why we believe that the probability of revaluations is not above 50%, and even if some GCC members revalue, the magnitude of the revaluation will be limited, similar to what Kuwait has done with the dinar, which has appreciated by only 4% since May 20, 2007 – highly inadequate to contribute to disinflation in Kuwait. Also, the overall impact on the GCC economies from such changes will likely be minimal. Perhaps more important, in our view, is that such a prospective revaluation, or abandonment of a pure dollar peg, would deal yet another psychological blow to the dollar. Placing the debate in the right context In our view, the USD’s descent and the ‘Impossible Trinity’ are secondary in thinking about the exchange rate regime for the GCC countries; the primary factor driving inflationary pressures in the GCC region is high oil prices. If one believes that the positive oil price shock since 2002 is permanent and that oil prices are trending higher in the coming years, and that a meaningful portion of these windfalls will be spent in the domestic economy, then it is inevitable that the dollar pegs currently in place in the GCC countries will be stressed. But as the primary cause of such inflationary pressures in the GCC is oil, not the USD, neither a EUR peg nor a basket peg would be an obviously superior regime compared to a USD peg. In other words, inflation in Qatar and the UAE would have risen toward 10% even if these currencies were pegged to the EUR. The best exchange rate regime for the GCC countries, in theory, is a managed float, in our opinion. However, the main reason why the GCC are still contemplating various forms of pegs is the relatively ineffective monetary instruments that render an independent monetary policy a non-viable option at this point. This practical concern brings the GCC countries to square one on the debate: if the GCC need a peg of some form, a dollar peg is arguably no worse than other pegs. This is why there is still strong support among some members of the GCC for maintaining the dollar peg, as an interim regime. Three distinct shocks impinging on the GCC countries The GCC countries have experienced three rather distinct shocks in recent years: (i) A positive oil price shock; (ii) The anchor currency – the US dollar – being in a protracted and sharp descent; and (iii) The Fed’s policy being out of sync with the GCC’s needs. While there are several reasons why the GCC may want to abandon the dollar pegs, (i) is the most legitimate motivation for such a de-peg, while (ii) and (iii) are secondary factors, in our opinion. Oil prices have risen from US$20 a barrel in late 2001 to close to US$100 a barrel now, which has translated to a rise in oil export receipts of the GCC countries from US$120 billion to US$360 billion during this period. Oil accounts for 78% of the GCC’s total exports and 79% of its tax revenues. If little of these oil windfalls were spent on the domestic economy – as is the case in Norway – then there should be little impact on domestic inflation and economic growth. However, the fact is that, in contrast to previous oil price booms, the GCC countries have significantly increased their spending on infrastructure in the current episode and this, in our view, is the main source of inflationary pressures in the GCC. While there has been much focus on the impact of a descending dollar on inflation in the GCC countries, the theoretical underpinning of this popular notion is rather weak. We are not saying that a weakening dollar, and therefore weakening GCC currencies, is not inflationary. Rather, we believe that the magnitude of the pass-through is modest relative to other factors. The biggest sources of inflationary pressures in Qatar and the UAE are from non-tradable items such as rents, which do not have a clear link with the dollar. Further, the wide disparity in inflation rates across the GCC casts doubt on the ‘weak dollar’ thesis behind inflation. Qatar (being the fastest-growing country among the GCC), not by coincidence, also has the highest inflation rate. In short, the weakening dollar has been somewhat of a scapegoat in this debate on the GCC’s inflation, in our opinion. We believe that it is important to point this out, as a policy solution based on revaluing against the dollar would likely fail to arrest inflation, as this would be a prescription based on a mis-diagnosis. The third complication that the GCC faces is the ‘Impossible Trinity’ their policy makers confront when the US economy is out of sync with the oil market. In the past, the US economy drove global demand and therefore also the commodity markets. It made sense, from this macroeconomic management perspective, for the GCC countries to be pegged to the US dollar: the Fed policy that was good for the US was good for the GCC. No longer is this the case, however. Thus, in addition to a fiscal stimulus from the ToT shock, as we discussed above, the GCC countries now also have to deal with a monetary stimulus from the Fed. We will not belabour this notion, since we’ve written on this in the past (see Dollar Peggers to Stretch the ‘Impossible Trinity’, September 27, 2007). This policy complication, in our view, was not the cause of GCC inflation in the first place, since the Fed only began to cut rates in September, but the average inflation rate in the GCC has been rising gradually since 2003, possibly because the GCC central banks’ ability to deal with rising inflation may have been constrained by the impossible trinity. In sum, our point is that, while many, including some GCC officials, have blamed the rising inflationary pressures on the weakening dollar and the Fed, the real reason behind the GCC inflationary pressures is the demand effect from the five-fold increase in oil prices since 2002. Moving to a EUR peg or revaluing the GCC currencies against the dollar would not have prevented the inflationary pressures, in our opinion. Four questions regarding the GCC countries With the above being the backdrop of the macroeconomic tensions in the GCC countries, we address four frequently asked questions about the GCC: Question 1. What exchange rate regime should the GCC have? In our view, in the long run, the GCC should eventually adopt a managed float exchange rate regime, regardless of whether this is done through a monetary union. In this increasingly dynamic and multi-polar world, the terms of trade (ToT) shocks from changes in oil prices will likely remain so large and persistent that absorbing these shocks through changes in inflation rates may no longer be optimal. Nominal exchange rates, rather than relative inflation rates, should be permitted to rise and fall with oil prices, we believe. Unlike Norway, the GCC countries arguably have more infrastructural projects and large-scale public spending that could be justified on the grounds of social development needs and to facilitate the development of the non-oil sector, i.e., not all of the oil receipts need to be saved, particularly when these oil prices changes are judged to be more permanent in nature. In other words, in the GCC countries, ToT shocks could much more easily translate into fiscal shocks, and a flexible exchange rate regime could better absorb these shocks, in theory. Question 2. What exchange rate regime will the GCC countries likely choose to have? What may make sense in theory may not work in practice, at least not in the short run. The monetary instruments of the GCC countries are still considered too underdeveloped and ineffective, much like those of China or Russia, for them to operate totally independent monetary policies. For example, China fully understands the difficulties and the dangers of moving too abruptly in this transition toward establishing a financial and monetary framework that will be needed to support an independent central bank. It has thus been very gradual in its liberalisation of the CNY market. There is no compelling reason to believe that the GCC countries are better positioned to succeed with a ‘Cold Turkey’ approach, rather than a ‘Gradualist’ approach taken by China. Beijing chose, as an interim exchange rate framework, a quasi-crawling band regime, while ‘buying time’ to develop the financial and monetary framework. The GCC could, in theory, pursue a similar strategy of adopting a second-best exchange rate regime to buy time. It could also stick with the dollar peg and accept a temporary period of higher inflation. Or, it could adopt a basket peg, with the dollar making up a high weight in this basket. In contrast to popular opinion, we don’t particularly think that the choice among the various pegs would make that big a difference for the economy. Question 3. How does the planned GCC Monetary Union affect the debate on the currency regime? The GCC Monetary Union was agreed in 2001. While the agreed launch date of 2010 is likely to be postponed, the support for such a monetary union remains strong, particularly in the UAE and Saudi Arabia. The idea is that, once the monetary union is in place, the Gulf ‘dinar’ could be pegged to the dollar, to the EUR, to a basket of currencies, or be on a managed float. In any case, the six GCC members will eventually have the same currency. This political and economic objective is complicating the current debate on the interim currency regime, since it would not make sense for the UAE, for example, to unilaterally revalue its currency when no other country does the same. In addition to the UAE’s respect for the GCC’s collective opinions, this fear of having an overvalued currency heading into a monetary union is one strategic concern of the UAE, we believe. We presume that other GCC members are likely to have the same concern. The next GCC Summit will be held on December 3-4, 2007. It is unlikely that Saudi Arabia will abandon the dollar peg, in our opinion. Not only because some Saudi officials have already ruled this out, but also because this is a policy choice that makes logical sense. Saudi Arabia is by far the largest economy in the GCC. With a population of 23 million, it accounts for two-thirds of the entire population of the GCC. Exchange rates tend to not have the same ‘leverage’ in large economies as in smaller and more outward-oriented economies. This is why Kuwait’s decision on May 20, 2007 to revert back to its basket peg could be replicated by other smaller GCC members, but not Saudi Arabia. Further, as we mentioned above, it is far from clear that, with measured inflation hovering at around 3.0%, Saudi Arabia is in desperate need of revaluing its currency. Thus, just like in OPEC, Saudi Arabia’s opinion matters a lot. If SA doesn’t revalue, it will be difficult, but not impossible, for the other countries to revalue. Question 4. What are the implications for the dollar if a GCC member abandons the dollar peg? If one of the GCC countries were to move to a basket peg, with a step revaluation, as Kuwait did in May, would the dollar suffer? We suspect that there would likely be a negative psychological, not real, effect for the dollar. Here are several thoughts: First, some commentators confuse the issue of currency diversification by GCC investors and the exchange rate regime. Even with the latter unchanged, GCC investors could still divest from USD assets whenever they want. When Kuwait revalued and moved back to a basket peg, nothing happened to the dollar. When China revalued in July 2005 and moved to a crawling band, again nothing happened to the dollar. Having said this, however illogical the link between these two concepts, in the current environment, should another GCC country de-peg from the dollar, it will likely be dollar-negative. Second, GCC investors are genuinely concerned about the dollar. Not only have Middle Eastern funds been an important driver behind the dollar’s descent in recent months, they likely still maintain the same dollar-unfriendly posture. This dollar-negative opinion has confused the discussion on the currency regime, as the GCC officials may have helped play up the importance of a depreciating dollar on the GCC’s inflation and other economic ills. Similarly, non-Middle Eastern investors’ fixation on the GCC’s currency regime also appears to reflect their intense angst about the dollar. Third, a modest revaluation by a GCC country does not imply less intervention. This is yet another popular notion that we do not find convincing. How much intervention a central bank has to conduct, to preserve a certain exchange rate parity, is not a function of the level of the exchange rate, but what speculators expect this level will be in the future. Small revaluations could fuel the expectation of further revaluations, and the central bank may be forced to intervene more, rather than less. Revaluation does not imply less intervention; revaluations do not necessarily mean dollar weakness. Modest impact on the GCC economies Whatever the GCC countries decide to do with their dollar pegs, we believe that the net impact on their economies will be very modest. It is very unlikely that any GCC country will revalue their currency by a magnitude big enough to hold down inflation. Also, the dollar is likely to make up a very high weight in any basket peg, we suspect. Bottom line The GCC’s long-term goal is likely to be a managed float regime, through a monetary union. A USD or a basket peg should be seen as an interim/transitory framework. Oil prices have been the main reason behind inflationary pressures in some GCC countries, which makes it less material if the GCC adopt basket pegs or stay with the dollar pegs. Also, at this level of EUR/USD, it is far from clear that moving to a basket peg now is sensible. Because of all these complications, we believe that the probability of either Saudi Arabia or the UAE abandoning the dollar pegs is not high; however, smaller GCC members may follow Kuwait’s footsteps, which could deal another psychological blow to the dollar.
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