Currency Political Economy in the Gulf States
Submission Date: 22, June, 2018
Submitted by: Khalid Tasawar Student number: 10772979 Department: Political Economy
Supervisor: Lukas Linsi University of Amsterdam Amsterdam, the Netherlands
Chapter I ... 1
Introduction ... 1
Chapter II ... 5
Literature review ... 5
The transformation of currency exchange from Gold standard to flexible/fixed ... 5
Theoretical explanation ... 7
Exchange regimes: Fixed versus Flexible ... 8
Political economy theory ... 10
International Political Economy of Exchange rate regime ... 11
Cooperation in International Monetary Relations ... 12
Exchange rate regime: National (domestic) politics... 12
Interest groups and Regime choice ... 13
Political Institution and Regime Choice ... 13
Chapter II ... 14
GCC currency exchange rate regime and its implications ... 14
Literature Economic arguments ... 15
Literature Political Arguments ... 18
Domestic politics ... 19
International level politics ... 20
The establishment of a common currency – The Khaleeji ... 22
Chapter III ... 24
Methodology ... 24
Time frame ... 26
Chapter IV ... 27
Hypothesis 1: A political regime is associated with the currency exchange politics in the GCC countries. ... 27
Hypothesis 2: Trade between the United States and the GCC countries force the Gulf States to remain pegged to the US dollar. ... 27
Hypothesis 3: Oil economy forces the GCC countries to remain committed to the US-dollar peg. ... 28
Results and Implication ... 29
Hypothesis 1: ... 29 Hypothesis 2 ... 32 Hypothesis 3 ... 37 Chapter V ... 40 Analysis ... 40 Conclusion ... 51 Bibliography ... 52 Appendix ... 61
Chapter I
Introduction
In recent years, there is an external and internal pressure on the Gulf Cooperation Council (hereafter, the GCC) countries to change their currency exchange rate regime which is now pegged to the US dollar. The pressure originates from economic insecurity that includes lower purchasing power, real income and increased inflation. The inflation pressure has emerged in these countries due to an unstable oil price, a low US dollar value, a buoyant economic growth and an increasing import from Asia and Europe. The inflation rate has jumped from a single digit 0.2% between 1998 through 2002 on average in the GCC to a double digit between 9% through 10% by the end of the decade within the GCC countries. Additionally, the import price in the GCC countries have coincided with the consequent US dollar depreciation. Economists and politicians in the GCC consider the US dollar peg as the cause of the aforementioned problems. The GCC countries currency is pegged/fixed with the US dollar from 1980s. Exchange rate regime policies have a significant effect on almost all aspects of domestic and international economies of involved countries.
Currencies and their values are central to the world economy. From the economic perspective, they affect international trade, investment, finance, migration, and travel. From the political perspective, they affect the "mass-consuming public, role of elections, organization of economic groups, power of particularistic interests, time horizons of voters and politicians, and responsiveness of political institutions to pressures along with virtually all other features of a national political economy" (Frieden, 2014, p.2). The prevailing exchange rate system often defines the international economic order. On a national level, "the exchange rate is the most important price in any economy, for it affects all other prices" (Frieden, 2014, p.9). For decades, it has been argued and confirmed that the exchange rate regime has a significant effect on macroeconomic outcome (Frenkel & Rapetti, 2010). The currency policy is the most important economic policy of a government, especially in an open economy, to the rest of world.
In currency political economy, policymakers encounter two interconnected options.
The first one is a fixed exchange rate regime, in which the monetary policy of a national currency is fixed to a commodity such as gold, a major currency or a basket of currencies. In
this case, the government has no authority on its monetary policy, meaning the governments with fixed currency regime will have a passive monetary policy. The second option refers to appreciation (high) or a depreciation (low) of the currency value. The latter phenomenon is only valid in a flexible/floating currency exchange regime. In the floating currency regime governments have the authority to intervene and influence demand and supply of their currencies, thus providing the local authority the autonomy to manipulate its currency value if needed. Currency exchange regimes are not restricted to these two. The IMF has classified at least eight types of currency regimes varying from purely floating to hard peg (IMF Report, 2016). The currency regime and level of exchange rate differs per country's national policy. These policies always involve trade-offs, and they have winners and losers, like all other policies.
In the current era, all major currencies such as the United States dollar, the euro, the Japanese yen, the British pound, and the Indian rupee, are floating. These currencies, particularly the United States dollar, are widely traded. In contrast, some countries, especially the Gulf States, have fixed their currencies to the US dollar. This has recently been criticized and is also associated with slower economic growth (Setser, 2007; Buiter, 2008). In spite of association with lower economic growth, higher inflation rate and fierce political criticism, the GCC members have announced that they are committed to their fixed exchange rate regime. Therefore, it is a controversial issue for the economic and political science students/scholars.
This paper attempts to explain the GCC currency exchange rate regime from political economy perspective since it has often been studied merely by economic scholars. The GCC countries are Bahrain, Kuwait, Oman, Qatar, Saudi Arabia and the United Arabs Emirates (UAE). GCC countries have adopted conventional fixed peg arrangements against the US dollar. This means that the fluctuation margin is ±1% or less and it is revised very rarely (OIC Outlook Series, 2012). A total of 16 countries have adopted this currency regime. However, many of them are small islands. Only Jordan, Turkmenistan and Venezuela have an
annual GDP greater than 10 billion1 in this category. This, at first place, begs the question:
why have GCC countries embraced the conventional currency exchange regime pegged to the United States dollar while having a dynamic economic system with an annual GDP of 32 billion through 650 billion.
Scholars have different views on the GCC currency peg to the US dollar. They have advanced certain alternatives to justify and provide a feasible answer to the implication of the fixed exchange rate regime. In this paper, the arguments posed by the different scholars are divided into four mainstream sections.
Firstly, some scholars have advanced the argument that the oil economy is the dominant factor in provision of the US dollar peg since the oil price is determined in the US dollar. Furthermore, the GCC countries have embraced the US dollar fixed exchange rate regime to stabilize their economies and keep the inflation low (Khan, 2009; Kumah, 2009). Secondly, the US dollar is widely traded in the international trade market. It provides an advantage to the GCC countries to trade in the currency in which they have reserve and receive the oil revenue. This, obviously, lowers the exchange rate transaction costs for non-oil sector trade. Furthermore, the GCC countries have a significant amount of trade with the United States which is, of course, exclusively in the US dollar.
Thirdly, some scholars argue that the type of political institutions determines the currency exchange regime type. Democratic regimes tend to favour a floating regime whereas the autocratic regimes tend to have a fixed exchange regime.
Finally, the fourth group of scholars has argued that the GCC countries have planned to have a common currency, like the Euro, and the US dollar pegged currency is a great step toward achieving their goal. The GCC organization identified having a common currency as a core achievement of this organization.
All these four hypotheses advanced by the scholars have faced the criticism that these
factors might not be the reason for the implication and continuation of the fixed exchange regime. However, I argue that these four hypotheses did play a major role in determining the US pegged exchange rate regime but they cannot provide an answer to the question why are the GCC remained pegged to the US dollar. There is a less focused/studied issue that has an even greater and an essential effect on remaining committed to the current regime.
This paper asks: why are the GCC countries committed to the US dollar-pegged currency exchange rate regime? In this paper, I argue that the monetary policy in the GCC has always been a more political (geo-political) dilemma than it is an economic dilemma. The political circumstances within and around the GCC countries is the most influential defining factor of their currency exchange rate regime.
The thesis is divided into five chapters. The first chapter explains the relevant theories which verify and shed light on the GCC currency exchange rate regime from different aspects. Furthermore, it explains how the currencies and regimes emerged in the last century
and how the relevant countries to this research adopted their currency regime. In the second chapter, I attempt to elucidate briefly the relevant literature and the GCC implication of the exchange rate regime. Chapter three discusses the methodology of the paper that I have used for the research and, additionally, it further elaborates the timeframe of the research and provides a brief explanation of the concepts that have been used in this paper. In order to keep it more organized, I have added a chapter for hypotheses definitions and tests which is chapter four. In this chapter I have tested theoretically and empirically the conventional hypotheses suggested. Last but not least, chapter five discusses the analysis and conclusion; in this section, the GCC exchange rate regime has been discussed from different perspectives and an answer has been provided to the research question. Finally, I have provided an answer to the research question based on the existing literature and analyses. Moreover, I have suggested further research on the GCC peg to the US dollar.
Chapter II
Literature review
Due to the radical changes that currency exchange rate regimes have experienced in the last century, there is a substantial number of books, academic articles, and journals available on the subject matter. In response to the currency exchange rate regime changes the countries have accordingly adjusted their exchange rate regime policy either based on economic or political desire and necessity. In spite of the substantial pertinent literature, there are still limitations and gaps, particularly from the political economy aspect in the GCC. This research aims to cover the economic and political aspects of the GCC countries’ currency exchange rate regimes in the academic literature.
This section forms a brief literature review of currency exchange rate regime transformation’s theoretical perspective and the GCC countries’ adoption of monetary policies. This covers the period from the 1970s to 2018. The work of prominent scholars in the field of currency exchange regimes and the GCC countries’ reaction has been taken into consideration. This section initially explains the transformation of currency regimes in the last decades and afterwards discusses the reaction of the GCC countries to the radical currency regime changes.
The transformation of currency exchange from Gold standard to flexible/fixed
In the last century, the world has experienced three landmark events in the international monetary orders. Almost all of the first half of the century the world was on the classical gold standard monetary system. In other words, it was a quintessential fixed exchange rate regime where governments were committed to exchange currency for a certain amount of gold at a defined rate. However, some countries abandoned the gold standard during the First World War which destabilized the exchange rate regime. This period was certainly chaotic and the world suffered two world wars and the Great Depression. A great part of this period is also called Interim instability (1914 – 1944) (Frieden, 2014; Wang 2009). World wars and the Great Depression both demanded an enormous amount of money to support the development of economies and the weapon industry. Thus, more gold was required to support these sectors. Since gold was very limited relative to rapid economic development and
requirements, expansion of international trade and the need of money in both world wars, many countries abandoned the gold standard because it prevented them from printing money and investing either in wars or expansion of the economies. As a result, printing money led to higher inflation and a pegged currency to minted gold was neither desirable nor workable (Wang, 2009).
In the 1940s the gold standard was replaced by the Bretton Woods monetary system. The Bretton Woods system offered a modified fixed rate system. This new currency regime was initially linked to the US dollar and eventually to gold, as Frieden et al., (2006) explain: "Under Bretton Woods, currencies were fixed or 'pegged' to the US dollar and the US dollar was fixed to gold" (Frieden, Weingast, & Wittman, 2006, p.588). The gold price was fixed at $35 per ounce. Under this regime, the countries were able to change their exchange rate when it was needed after consulting with the IMF. This system is famously known as the flexible peg, as it was not firmly fixed as it was under the classical gold standard order. The international monetary system enjoyed a great success when the US Federal Reserve held three quarters of central bank gold in the world. At the launch of this regime, the US had monetary supremacy and was the only dominant force in monetary global order. The two major economies, Japan and Europe, had been ruined due to the devastating Second World War. However, with the economic recovery of these two major economies and a rapid increment in international trade, there was a high demand for liquidity in the form of US dollars. As Wang (2009) argues, an increasing demand for liquidity would only lead to outflows of US dollars (p.23). Immediately after an increase in international trade the amount of US dollar circulated in the global economy surpassed the gold reserve held by the United States Federal Reserve. In a couple of decades, the US had only 22% left of their previous gold reserve of 75%. As a result, the US Federal bank had to abandon the foreign banks convertibility of the US dollar to gold. Furthermore, the pressure of domestic problems such as high inflation, an increasing unemployment rate and a lower growth forced the government to take a different monetary policy path. The United States’ president Nixon announced on the 15th of August 1971 that convertibility of the US dollar into gold is suspended (Wang, 2009). All these events contributed to the failure of the Bretton Woods system and created an opportunity to a more independent monetary policy.
The last radical changes in the monetary order happened in 1973 when the largest governments decided to adopt floating currencies. However, some countries have tended either to peg their currencies to a major currency or a basket of currencies (Frieden, et al.,
regime types. They are: “Exchange Arrangements with No Separate Legal Tender, Currency Board Arrangements, Conventional Fixed Peg Arrangements, Pegged Exchange Rates within Horizontal Bands, Crawling Pegs, Exchange Rates within Crawling Bands, Managed Floating with No Predetermined Path for the Exchange Rate, and Independent Floating” (Wang, 2009, p.17). In a broad view, there are two main types of the currency exchange rate regimes, fixed and floating, but within these regime types the IMF has defined eight sub-types of alternatives. My focus from this point forward will be on the current fixed (pegged) and floating (flexible) currency exchange rate regimes.
Theoretical explanation
The theoretical framework will seek to explain why the governments choose either a fixed or a flexible currency exchange rate regime. In order to understand whether the government’s decision on the type of regime is motivated politically or economically, it is important to comprehend the advantages and disadvantages of both regimes. Moreover, this section will also address the existing dominant political economy theories from both perspectives, economical and political, on both the national and international level, in order to shed light on the government’s choice of commitment to the regime.
In the recent decades, particularly after the collapse of the Bretton Woods system in the 1970s, the exchange rate regimes attracted some remarkable attention in international finance (Kato & Uctum, 2007). The exchange rate regime characterizes the mechanism by which the countries manage their currencies in the international arena and in respect to other countries.
A fixed exchange rate regime is a commitment that governments make in order to keep and maintain a certain fixed parity of the currency against a basket of currencies or a single currency of another country. While a floating currency exchange rate regime is a commitment that governments make to leave the determination of the exchange rate to the market through the demand and supply mechanism. However, the government does also have some authority to appreciate and/or depreciate the currency in a floating regime. This will be explained briefly in the upcoming paragraphs.
The classical and widely accepted theoretical literature claims that the most common criteria for determining a certain type of exchange rate regime is a country’s financial and macroeconomic stability against financial disturbance and shocks (Mundell, 1963). The traditional assumption is that the fixed exchange rate regime helps in achieving financial and
macroeconomic stability whereas the flexible exchange rate regime isolates the economy from financial disturbance (Friedman, 1953). Deciding between the two exchange rate regimes involve numerous arguments and counterarguments whether to establish a fixed or a floating exchange rate regime (Poirson, 2001; Edwards et al. 2003; Bergsten, 1999, Haggart, 1999; Sachs & Larrain, 1999). The arrangement of a fixed or floating regime requires in-depth macroeconomic consideration and it depends on a country’s objectives and goals. The next section explains in further detail the advantages and disadvantages of both types of exchange rate regimes.
Exchange regimes: Fixed versus Flexible
As mentioned earlier, in the taxonomy of exchange rate regimes, there are at least eight types of exchange rate regimes on the continuum from pure flexible to hard peg. However, for the purpose of this paper, my focus is merely on the two broad concepts/types, fixed and flexible. I try to concisely explain both types and their weaknesses and strengths.
In an open economy, a fixed exchange rate regime provides “lower exchange rate risk and transaction costs that can impede international trade and investment” (Frieden & Broz, 2001. p.322). According to fixed exchange regime advocates, volatile exchange rates bear uncertainty in transaction costs and the costs of goods/assets traded internationally. Thus, stable currency provides an opportunity for risk-avert investors to trade and invest in a greater and desirable environment (Frieden & Broz, 2001; Beker, 2006). Fixing the exchange rate with a low inflationary country’s currency is meant to achieve a low inflation rate. The credibility of this argument is for the countries that experienced hyperinflation or are prone to hyperinflation, and furthermore, if the country is desperate for rapid disinflation. A country might achieve macroeconomic stabilization and/or achieve disinflation. However, the absolute guarantee of credibility cannot be promised. Therefore, a possibility of devaluation can create a vacuum for speculative attacks that result in currency crises (Beker, 2006). Bubula and Otker-Robe (2003) studied fixed and flexible exchange rate regime vulnerability for all IMF members for the period of 1990 to 2000 and concluded that approximately ¾ of crises in the studied reports were linked to fixed parities.
Furthermore, a country with a fixed exchange rate reduces the uncertainty of exchange rate costs, but in doing so, it must sacrifice its monetary policy. An ideal situation would be to have financial market integration, exchange rate stability and monetary policy independence but Mundell (1962, 1963) explains this impossible trinity trade off (trilemma).
Mundell-Fleming in the 1960s. Two of the three options are possible: financial integration, exchange rate stability, and monetary interdependence. It can either be financial integration with a fixed exchange rate or a monetary policy. If a government prefers a fixed exchange rate, it will have no monetary autonomy and its monetary policy will be dependent on the pegged currency.
On the other hand, a flexible exchange rate regime provides a mechanism to absorb internal or external macroeconomic disturbances/shocks. The mechanism works through appreciation or depreciation of the exchange rate depending on the economic situation. Furthermore, a flexible exchange rate regime provides the autonomy of a monetary policy and greater flexibility of macroeconomic policy adjustment. Having monetary policy autonomy, governments can increase of decrease interest rate in order to decelerate or stimulate the economy. In addition to monetary autonomy, Broda and Tille, confirm that flexible currency exchange can absorb external shocks compare to the fixed exchange rate regime (2003). Additionally, Edwards and Yeyati empirically confirmed that flexible exchange rate regime can easily absorb external shocks, denoted by negative changes in exchange rate ratio or export and import prices (2005). In order to adjust export and import price; a country needs to have monetary policy which is only possible under flexible exchange rate regime.
Evidence shows that financial integration has progressed to a phase in which capital mobility can be taken as a given both in developing and developed economies (Frieden & Broz, 2001; Edwards, 1999; Marston 1995). This simplifies the choice between stability and flexibility. A fixed exchange rate regime is beneficial to the countries that have experienced high inflation rates and other monetary disturbances. This means that a country prone to high inflation and monetary disturbances could be better off to peg its currency to a country’s currency which has a consistent lower inflation rate and is protected against monetary disturbances. However, as mentioned earlier, this renders a monetary policy ineffective and cannot guarantee the credibility.
In fact, pegging a currency to a country with a low inflation rate is not the only solution to avoid high inflation risks. A country’s central bank independence “with price level or inflation target may be an alternative – its transparency makes it a common commitment technology in contexts where the alternatives cannot easily be mentioned by public” (Frieden & Broz, 2001, p.324). A floating exchange rate regime allows a country to have its own monetary policy and there is no obligation to adjust the monetary policy in line with other countries. This regime is important because it provides the opportunity to accommodate
domestic and foreign shocks. It furthermore provides the flexibility to accommodate external terms of trade and interest rates. Flexibility of a currency can be used as a great policy tool. In many developing economies that rely on a fixed currency regime, when there is an appreciation, caused by either inflation or huge capital inflow, it can harm competitiveness and threaten to create a balance of payment crisis (ibid). In a flexible regime, however, the government (in the form of the central bank) has the possibility to adjust the exchange rate in order to ensure competitiveness of the trade sector in the international market and avoid economic disturbances.
To summarize, there is no optimal exchange rate regime for all regions and countries. The exchange rate regime depends on many factors including but not limited to, openness of a country, economic size, labor mobility, inflation rates and nominal shocks. In a broad sense, when the countries within a region are highly integrated and have similar economic disturbances, they might be better off with a fixed exchange rate regime. On the other hand, countries prone to volatility in terms of trade are generally better off with a floating exchange rate regime, having the autonomy of monetary policy. Now that we know the economic benefits of both types of exchange regimes, it is essential to understand the political implications of such decisions. As mentioned earlier, an exchange rate regime involves trade-off, creating a strong vacuum for interest groups and politicians to influence the government’s decision in choosing exchange rate regime.
Political economy theory
The exchange rate regime politics’ theoretical framework is mainly based on Jeffry Frieden’s Lawrence Broz (2001), Andrew Walter, and Gautam Sen (2008) writings. They are the prominent scholars of the exchange rate regimes in the political economy field. As explained earlier, monetary regimes tend to lean toward one of the two regimes: a flexible (floating) or a fixed (pegged) exchange rate. These ideal regime types can be both regional and global. Generally, there are two interrelated factors in international monetary system decision making – national and international political decision making. In this paper, I will look at national and international politics of these two regime types. Exchange rate regime policy, at the national level, is determined by the influence of interest groups, partisan pressure, the structure of political institutions, and the electoral incentives of politicians. At the international level, it involves strategic interaction, coordination and explicit cooperation between sovereign states (Frieden & Broz, 2001). As mentioned, there are two main levels
that contain different groups to lobby and influence the exchange rate regime for their own interests. This, as a result, involves, a trade off. One groups win will be at the cost of the second group. In the section below I will explain both groups’ interests in further detail.
International Political Economy of Exchange rate regime
On the international level, some countries have pegged (fixed) their currencies to that of a larger or economically stronger nation, as an example, several African countries had fixed their currencies to the French Franc and now some of them to the Euro (Broz & Frieden, 2006). As Walter and Sen (2008) argue, a fixed exchange rate regime requires strong coordination of both countries, the principle and the subordinate (agent). The subordinate country should follow the monetary policy of the principle country and adjust its economic policy to the principle. However, “The political problem is that large countries, whose policies have most impact on the rest of the world, have fewer incentives to coordinate macroeconomic policies. Others may simply have to bear the costs of adjustment that emanate from large country policies” (Walter & Sen, 2008, p.110). This means that the subordinate country, for instance, should adjust its interest rate according to the principle interest rate even if it is at the cost of national interests or financial disturbances.
Frieden and Broz (2001) explain, coordination in international monetary relation is an important aspect in order to attract more countries to join the club. The more the countries fixed to a particular currency the better it would be overall, since the pegged currency policy would be similar to one another and its transaction costs would be low. The fixed exchange rate might live as long as both countries actively coordinate on its monetary policies. However, there is a well-known problem attached to a fixed exchange rate regime and the coordination of the countries that is international gain from cooperation could be at the cost of national interests (Frieden & Broz, 2001). In other words, with a fixed exchange rate regime, a country should give up its monetary policy which is a great policy tool for domestic politics in order to keep the import- and export-based market competitive. Giving up the authority of depreciation and appreciation of the currency harms some interest groups, increases inflation rates and slows economic growth down. This as a result could destabilize the internal stability. This will be explained further in upcoming sections.
Cooperation in International Monetary Relations
In order to have a fixed exchange rate regime, countries have to cooperate with one another. Pegged countries have to help each other in times of hardship and agent (subordinate) country should follow the monetary policy of the principle country. It requires explicit cooperation among the countries. There is often profit in international cooperation but at the national cost, a well-known dilemma in these situations.
As mentioned earlier, having a currency fixed to a different currency comes at a cost. The first and most important one is that pegged country must give up its autonomy of monetary policy. The problem with fixing the currency to a foreign currency is not only on the side of agent but principle, too. Under Bretton Woods’ monetary system when European currencies were pegged to the United States Dollar, European countries put pressure on the United States to tighten its policy in order to decrease inflation, however, the United States denied to imply. The same problem happened when the Netherlands and other European countries currencies were pegged with the German’s Mark. The subordinates (agents), in the sense of currency, put pressure on the German government to restrict its policy in order to prevent inflation but the German central bank refused (Wang 2009). This problem is common in international monetary systems between the nations who opt to peg their currencies to a foreign currency.
Exchange rate regime: National (domestic) politics
The national government is the only entity to decide whether to fix its currency to a foreign currency or to allow it to float. These decisions have significant effects on the political and economic situation of a country. However, such decisions are not taken merely by government bodies, depending on the countries’ constitution and political regime, but also by interest groups, the electorate and politicians. As a result, like all other policies, this also involves tradeoff between groups within the country. There are different views about which groups are strongly involved in trade off or decision making but, the most widely accepted interest groups by political economy scholarships are: “the role of interest groups, partisan pressure, political institutions, and the electoral incentives of politicians” (Broz & Frieden, 2001, p.322). For the sake of this paper, I will only focus on the groups relevant to this research, for instance, interest groups and political institution. The next two sections explain why the electoral incentives of politicians and partisan pressure are irrelevant to this paper.
Interest groups and Regime choice
As mentioned earlier, currency exchange rate regime implication involves trade-off. It always has winners and losers, the same like all other policies. A policy which is optimal for a country as a whole might not be in the interest of a particular group.
Groups heavily involved in international trade, particularly groups that are producers of exportable goods as well as international merchants, would prefer stability (fixed exchange rate regime). This policy lowers the risk of daily volatility of exchange rates (Broz & Frieden, 2001). In contrast, groups largely involved in domestic economic activities such as transportation, construction and services along with import-competing producers of goods should favor a floating exchange rate regime. The domestic traders are highly sensitive to macroeconomic policies and therefore it is in their best interest to have a government with monetary policy autonomy. This applies to import-competing traded goods, too (ibid). Exchange rates therefore encourage groups to lobby and influence policy makers in favor of a certain type of exchange rate regime.
Political Institution and Regime Choice
In addition to interest groups, political institutions play a significant role in exchange rate regime choice, too. Scholars such as Leblang (1999) and Broz (2002) argue that the political regime type is highly correlated with the type of exchange rate regime particularly in the developing countries. Autocratic or monarchy regimes tend to favor a fixed exchange rate regime for credibility purposes (Broz & Frieden, 2001). As mentioned earlier, interest groups, electoral and legislative institutions have significant effect on determining an exchange rate regime. “In countries where the stakes in elections are high, politicians might prefer floating exchange rates, so as to preserve the use of monetary policy as a tool for building support before elections” (Broz & Frieden, 2001, p.329). This is valid only in a democratic country where elections are being held.
In this research, the concept of the autocratic regime is conceptualized as the absolute or active constitutional monarchy. The term autocratic regime is used as a synonym to the absolute monarchy regime and vice versa.
Chapter II
GCC currency exchange rate regime and its implications
In the previous section, I briefly reviewed the theoretical framework of the currency exchange rate regime, and its advantages and disadvantages in the context of the national and international political and economic decision-making. Additionally, I reviewed dominant theories on how interest groups and institutions on a national and international level influence governments’ choice of exchange rate regime. This section will review the existing literature about the GCC and its currency exchange rate regime implication. In the last radical changes in currency regime in the 1970s many major countries opted to float their currencies. However, some countries decided to peg their currencies to one of the major currencies. The Gulf countries were among those that tended to fix their currencies to a major currency, particularly the United States dollar. Within the context of currency exchange rate regime politics, I will attempt to explain the political and economic desire/benefit of the GCC peg to the US dollar from the existing literature.
From 195 countries recognized by the United Nations only a total of 16 countries have a fixed exchange rate regime to the US dollar. However, many of them are small islands and only Jordan, Turkmenistan and Venezuela have an annual GDP greater than 10 billion in this category aside from the GCC countries. This begs the question: why have the GCC countries embraced a conventional currency exchange rate regime pegged to the United States dollar while having a dynamic economic system with an annual GDP of 32 billion through 650 billion? The existing literatures’ answers vary and are mostly focused on trade, the oil economy and the political institution type. This section explains the literature briefly and provides a concise history of the GCC countries’ steps towards the fixed exchange rate regime to the US dollar.
The Gulf States, except Kuwait, have been pegged to the US dollar now for more than three decades. Only from 2003 to 2007 all the Gulf States were exclusively pegged to the US dollar. In fact, Kuwait's dinar is heavily weighted on the US dollar (Sturm & Siegfried, 2005). This means that the appreciation or deprecation of the US dollar has almost the same effect on Kuwait as on the rest of the GCC members. In 2003, the GCC countries formally adopted the US dollar as their monetary anchor until Kuwait abandoned the peg in 2007.
From the beginning of the modern exchange rate regime era in 1973, the GCC countries have changed their exchange rate regime within the fixed exchange rate regime category. Saudi Arabia’s riyal was initially pegged to the IMF’s Special Drawing Rights (SDR) basket of currencies with a fluctuation margin of +/- 7.5 percent. In 2003 Saudi Arabia pegged its currency to the US dollar (Alkharief & Qualls, 2016).
The UAE’s dirham has been in circulation from 1973 and since then the value of the currency is unofficially pegged to the US dollar. The currency is officially pegged to the US dollar since February 2002, however, buying and selling was fixed from 1997 to the present at the rate of 3.6725 dirham per dollar (Ishfaq, 2010).
The Omani riyal is fixed to the US dollar from the start of the post-Britton Woods era. Oman has initially fixed its currency in 1973 at the rate of 2.895 USD per Omani riyal. In 1986 Oman took the initiative to change the price to 2.6008 USD per riyal and it has since then remained unchanged (Al Raisi, Pattanaik, & Al-Raisi, 2007).
The Bahrain and Kuwait currencies have experienced a different root of currency exchange rate regimes. Both countries initially used Gulf rupees which was equivalent to a British Pound Sterling in 1961. In 1980, Bahrain pegged its currency to the IMF’s SDR basket and eventually in 2001 pegged its currency officially to the US dollar. Kuwait is an exceptional case in the GCC because of its current exchange rate regime pegged to a basket of currencies whereas all other GCC state members are pegged to the US dollar at this moment. As mentioned earlier, Kuwait’s basket of currency is heavily weighted by the US dollar (Sturm and Siegfried, 2005). It is an ongoing academic debate whether the GCC countries should drop the current fixed exchange rate regime. I have tried to concisely explain prominent scholars’ work on the economical and political aspects and the reason behind the pegged currencies in the following section.
Literature Economic arguments
Some scholars have advanced the argument that the oil economy is the dominant factor in the provision of the US dollar peg since the oil price is determined in the US dollar. The oil revenue constitutes the major part of the government’s budgets in the GCC countries. Moreover, the GCC countries have embraced the US dollar fixed exchange rate regime to stabilize their economies and keep the inflation low (Khan, 2008; Sturm, Strasky, Adolf & Perschel, 2008). Khan (2009) further argues that a fixed exchange rate to the US dollar has helped the GCC countries to avoid nominal shocks from geopolitical risks feeding affecting
the economy. Additionally, it has helped the GCC countries to maintain competitiveness in the international arena in spite of trade shocks relating to oil price fluctuation (Kumah, 2009). In contrast, some prominent scholars such as (Setser, 2007) argue that the US dollar pegged currency has not helped to keep inflation low or/and has not provided any solutions for fiscal problems. Additionally, some of the Gulf countries’ major incomes are from non-oil sectors, too. Moreover, Setser (2007) argues that oil-exporting economies, pegged to the US dollar, make a policy mistake because these economies require a different monetary policy. They would be better served by an exchange rate regime that “assures their currencies depreciate when the price of oil falls and appreciate when the price of oil rises” (p.1).
It is widely believed that this strategy, the fixed exchange rate regime, has worked in the last decades in initial developing phases. However, now that the GCC has become a dominant Asian trade partner (oil and goods), its economy diverges from that of the USA. This provides an opportunity for other alternative regimes. As Khalid Al Khater, the director of research and monetary policy of the Qatar Central bank stated: "We in the GCC need more than an outdated four-decade-old simple uni-instrument, uni-tool macroeconomic policy framework" (Gulf News, 21, May, 2013, p.1). He further said that this system was suitable four decades ago in the developmental stages but because the economic world has changed, the GCC should adjust itself to the new currency regime. He presented this at the Doha Economic Forum, fully aware that it would have an economic and political effect on the ties between Qatar and the United States. Furthermore, many economists and bank directors in the GCC countries have urged to drop the US dollar peg and consider a more flexible exchange rate regime to better manage inflation rates and risks (Gulf news, 21, May, 2013; Buiter, 2008).
Furthermore, some recent economic developments in the GCC as well as in the global economy necessitated a shift in internal and external economic order. The GCC countries, in some views, should adjust their macroeconomic policy including their exchange rate regime. In the first years of this decade, rapid economic growth which was facilitated by higher oil prices and revenue has caused inflation in the GCC countries. The inflation rate skyrocketed from 0.2% between 1998 through 2002 to 10% by the end of the decade. This differs per country within the GCC. In fact, some members are running an even (a) higher inflation rate than the mentioned figures (Mohaddes & Williams, 2011; Sturm et al. 2008). The common assumption which is widely believed among economists is that the fixed exchange rate regime has played a fundamental role in inflation rate increment.
The persistent depreciation of the US dollar against other major currencies such as the Euro and the Japanese Yen has increased the cost of import goods in the GCC countries. This has affected the prices ranging from the basic needs such as food, to domestic wages and the housing market. As Setser (2007) argued that the GCC countries are making a policy mistake because the inflationary pressure of the US dollar peg is believed to have been further broadened and accelerated the inflation through the volatile oil price in the US dollar and the persisting US dollar depreciation. Clearly the United States and GCC countries diverge in the business cycle (Sturm et al. 2008). The GCC countries cannot diverge from the economic policy that the US is implementing because of its peg to the US dollar. Indeed, this situation of the GCC countries reflects the unholy trinity of Mundell, the open economy, fixed exchange rate regime and monetary policy independence.
In addition to the fierce comments from economists and policymakers on the current currency exchange rate regime, the currency of Bahrain, a member of the GCC, is facing the most risk of de-pegging from the US dollar. According to the Institute of International Finance (IIF), public debt in Bahrain is projected to rise to 83% of the GDP in 2018 and the next upcoming years, compared to 18% in 2008. The country is required to take necessary measures such as having its monetary policy authority back and managing the inflation rate. According to The Financial Times’ report on Bahrain economic condition to balance its budget the price of oil approximately "needs to reach $99 a barrel for Bahrain to balance its budget, about $37 above its current level" (Blitz & Wheatley, 2017, p.1). In addition to high inflation and debt, there are other reasons to de-peg that includes the emerging change in investment and trade patterns in the GCC countries. This is closely related particularly to Oman and Bahrain because of their limited natural resources compared to the other members of the GCC. Hence, these countries should boost their non-oil sectors such as tourism and the financial sector. In doing so, a flexible regime is important to ensure competitiveness in the international trade arena (Sturm et al., 2008, Iqbal 2010).
The country has asked its neighbours for financial assistance but there has yet to be any positive response. However, some analysts argued that Saudi Arabia will bail out Bahrain rather than jeopardise its own peg. “The authorities know that de-pegging will cause speculation to rise in other countries. It is not that much effort for Saudi Arabia to support Bahrain," (Blitz & Wheatley, 2017, p.1).
In addition to the oil economy or pricing the oil in the US dollar, some scholars advances the factor of trade between the United States and the GCC. The US and GCC trade has a longer history that the creation of the GCC. The US enjoyed commercial exchanges
with Oman from the 1700’s and onwards. The first treaty was signed between the US and Oman in 1833 which is named the Roberts Treaty. The last half century the most dominant trade components were oil and gas. The United States is by far the world’s greatest consumer whereas the GCC countries are the greatest producers (Anthony, 1999). Anthony (2009) further argues that:
along with the GCC's sale and America's purchase of oil, there are concomitant commercial components in the energy relationship that translate annually into billions of dollars for both sides. These include energy research and technology development; oil and gas exploration and production; the construction and operation of fuel storage tanks and marine terminals; reservoir and onshore as well as offshore drilling platform maintenance, pipelines, pumping stations, refineries, shipping, marketing, and management and operations (Anthony, 1999, p.2).
In most of these areas the United States was the most important producer and the
leader in the world as well as in the GCC countries. After the 1970’s and 1980’s bilateral
contract between the GCC and the United States the trade increased to 300% (Anthony, 1999). The United States’ private companies have invested billions of dollars in the six GCC countries. Accordingly, it is argued that the exchange rate regime fixed to the US dollar is beneficial to the GCC countries and have increased trade among these countries as a result of contracts and fixing its exchange rate to the US dollar. Now that we know the economic arguments for the fixed exchange rate regime, it is important to understand the political arguments from the existing literature that pave the way/lead to my research.
Literature Political Arguments
This section discusses the political desire and necessity of the GCC and the US behind the fixed exchange rate from the existing literature. Political and economic decisions are interdependent, particularly in the case of the exchange rate between the United States and the GCC countries. The GCC’s political desire is divided into domestic and international politics. At both levels, the national and international level, interest groups influence the choice of the exchange rate regime politically. I will explain the existing literature on domestic politics first and subsequently the international level politics between the GCC countries and the United States.
Domestic politics
First of all, scholars have advanced the domestic political argument on the role of institutions. Broz (2002) argues that democratic countries tend to have a floating exchange rate regime rather than a fixed one. On the other hand, autocratic (monarchy) countries favour a fixed exchange rate regime (ibid). This claim has also been confirmed by scholars such as Bearce and Hallerberg (2011). They studied the relation between political regime and exchange rate regime and concluded that the political regime has strong positive correlation with the exchange rate regime. Hence, based on these arguments one can say that the GCC countries’ political regime has a significant effect on choosing their exchange rate regime.
The second domestic political economy argument advanced by Feldman’s (2008) research article is that the rapid rise of the economic growth in the GCC was accelerated by the high oil price and there was an increasing concern about the adverse effects of the inflation which will blunt the achievement of the economic surge. The loss through inflation has generated political tension and sparked calls to drop the current exchange rate regime pegged to the US dollar and favour a more responsive exchange rate regime to the current economic condition of the GCC countries (Feldman, 2008). The recent reports released at the beginning of 2008, predicted further increase of the inflation rate and prices of the basic needs such as food. This report had ignited a wave of speculation that the GCC members might drop their current permanent link to the US dollar in order to block speculative attacks on the GCC currencies, increasing inflation rates or the rise of the prices of basic and fundamental needs (prices) (ibid).
To be more specific, according to many scholars, increasing inflation rates in the last decades was due to the US dollar peg in the GCC countries, and this created domestically social tensions as the purchasing power of citizens, particularly among those whose incomes are below the average income in the GCC countries, decreased (Ramady, 2009). The governments are trying to raise the wages and subsidized some sectors but the inflation rate at some point reached a peak that the governments could not fund. Furthermore, some countries for instance Bahrain, cannot fund its public and private sector in order to make up for inflation rate losses (Sergie, 2018).
As long as the governments in the GCC countries could and will cover the inflation costs, the problems will not be grave but the government’s sovereign funds are not unlimited. Soon the government would stop increasing the wages and subsidizing other public sectors. This will create instability within the GCC countries. According to the Chatham house
organization report there are ongoing calls for an increase in wages in order to cover inflation. They also mentioned that people are taking more revolutionized ways and challenge the governments of the GCC countries (Chatham house, 2012).
In the last couple of years, the oil price reached its lowest point of the decade and that affects the total government revenue. The consequences of a lower revenue affects the government’s spending to limit inflation rate effects. As long as the price of oil falls or stays under the 100 US dollar per barrel for some countries, the political instability and sparked calls to change the currency exchange rate regime will increasingly challenge the GCC governments. Furthermore, the forecast for the years to come show that the US dollar will depreciate which will as an external effect increase inflation in the GCC countries which concerns the governments and rulers of the GCC countries.
As the existing literature argues from domestic political perspective, there are many voices in all the GCC countries against the current exchange rate regime permanently linked to the US dollar, yet nothing significant has happened. In fact, this concerns the governments about the tension that is generated and the stability of the domestic economy. However, changing exchange rate regime according to some scholars implies an important trade-off on an international level between the GCC countries and the United States which I will here call international level politics. The next section explains, using the existing literature, the effect and possibility of the change of a currency exchange rate regime from the international politics perspective, the perspective of the GCC’s and the United States’ interests.
International level politics
In political context, the scholars are dived into different groups and focus on different political phenomena. The first group advances the argument that countries who are not militarily well equipped and depend on an ally country for their security would stock a bulk of reserve of the protector’s currency. The GCC countries have extensively reserved US dollars in order to guarantee their security against any potential risk. The GCC countries almost exclusively reserve in the US dollar while no other oil exporting countries do, for instance Iran and Russia do not reserve exclusively in the US dollar. They are stronger from the military perspective and therefore have the option to choose whatever currency they find beneficial (Eichengreen et. al, 2008). According to (Eichengreen et. Al, 2008) the GCC countries have fixed their currency exchange rate regime to the US dollar to have the opportunity to influence the United States’ political decisions through their massive US dollar reserve and get the security guarantee from the United States.
The United States is concerned about, due to internal and external pressure on the GCC countries, the possibility that one of the five member states would de-peg its currency. This would be the first step towards dollar the end of the US dollar peg era in the GCC countries. As a result, it would decrease the dollar’s demand and would signal loss of faith in the United States currency hegemony (Feldman, 2008). Feldman further argues:
A loss of faith in the dollar is often perceived as a threat to the national interests of the United States, since the dollar's standing is one of the sources underlying American power. The fact that the United States pays for its imported goods in the currency that it itself issues gives it a unique status in the financial system, and this standing allows it to finance its domestic and international activity easily. The willingness of countries such as China and Saudi Arabia to receive dollars for their product, and their willingness to use these dollars to purchase bonds issued by the American government allows the United States to maintain low interest rates and cut funding costs on its “double deficit” (budget deficit and balance of payments deficit). In addition, the willingness of the world’s economies to accumulate dollars gives the US the ability to increase the rate of dollar printing without generating internal inflationary pressure (Feldman, 2008, p.6).
The possibility that the GCC countries would drop the peg to the US dollar became even more intriguing when Michael McConnell, the U.S. National Intelligence Director, briefed the Senate’s committee in 2008 on the consequences. As he said “Departing from familiar security issues, McConnell surprised the committee when he declared that the decline of the dollar could have considerable impact on the US national security. He noted that the decrease in the value of the dollar in 2007 prompted Syria, Iran, and Libya to ask their oil importers for non-dollar currencies and contributed to Kuwait's decision to stop linking the local currency to the dollar. These trends, he contended, might gain momentum and spill over to other oil exporters, should faith in the US currency continue to decline” (Feldman, 2008, p.1). Based on the arguments above some scholars have aruged that "there is a belief that the peg is preserved at the behest of US pressure" (Jumean, and Saeed 2011, p.1). In other words, the United States might push the GCC countries to stay pegged to the US dollar. Whether the United States puts pressure on the GCC to remain their currency pegged to the US dollar will be further discussed in the analysis section.
In addition to the domestic and international political and economic arguments that I explained, some scholars alternatively make a good case for the monetary union of the GCC. The scholars argue that having the US dollar as an anchor currency to the GCC is an important and essential phase in the process of establishing a common currency or monetary union. Furthermore, the GCC countries can achieve further economical and political integration through a monetary union. I consider a common currency to be an economical and political phenomenon, and therefore, have created a sub category for the Khaleeji.
The establishment of a common currency – The Khaleeji
In 2001’s economic agreement between the GCC members, they agreed on a long-standing ambition to establish a common currency by the year 2010. The GCC is a homogenous region and has many factors that could lead these countries to deepen economic integration like in the European Union. The GCC member states have many things in common, including cultural backgrounds, language and religion which make further integration relatively easier. In addition, these countries all have a fixed currency exchange rate regime pegged to the US dollar.
The GCC countries agreed on creating a Common Currency by the year 2010. However, Oman could not meet the target by the defined date, thus the officials have announced its temporary withdrawal from the pact with a proposal that they will join the union at a later date. Shortly, Kuwait de-pegged its currency from the US dollar which made the common currency more complex because the US dollar was seen by many a good platform for a common currency pegged to the US dollar (Buiter, 2008). Kuwait’s decision was mainly to reduce the inflation rate and pressure. The common currency would have many economic benefits, including but not limited to, omitting the exchange rate costs between the countries, creating strong economic ties between the countries, and lower transaction costs. However, it is not only an economic or monetary issue but it is more dominantly a political and constitutional issue. It demands the surrender of national sovereignty involved in monetary and economic policy. It subjects countries to a supranational authority (Buiter, 2008; Raison, 2011). Due to high inflation rates in the GCC countries and Kuwait de-pegging its currency from the US dollar, the Gulf Cooperation Council could not achieve establishing the common currency yet.
This paper asks why are the GCC committed to the US dollar-pegged currency exchange rate regime. In this paper, I argue that aside from economic and political contract
between GCC and United States the geopolitics plays an important role to keep the US dollar-pegged exchange regime. My contribution to the literature will be to add a geo-political aspect to the US dollar fixed exchange rate regime in the GCC region.
Chapter III
Methodology
This research paper explains the GCC countries’ currency exchange rate regime’s political and economic perspectives. To be more specific, this paper focuses mainly on the question of: why are the GCC countries committed to the US dollar-pegged exchange rate regime. As briefly explained above, there are two main reasons for pegging a currency to either a basket of currencies or a single major currency. The first and most common argument is macroeconomic policy, inflation rate stability and encouraging international trade and investment (Frieden & Broz, 2001). However, in the case of the GCC, some economists and politicians have argued that the current exchange rate regime does more harm to GCC countries’ economy than good. The GCC countries have pegged their currencies in order to stabilize the economy and keep the inflation rates low, but in reality the inflation rate has gone from 0.2% to almost 15% in some individual states within the GCC in the last couple of years. The second argument is that it is the political force that has kept these countries dollar-pegged. The latter argument contains a gap that requires further research. The reasons and motivation behind the political force has not been studied yet. Therefore, this paper will look at the reasons behind it thoroughly. There is only a limited number of studies and data available on the political aspect of currency exchange for many reasons, including the GCC’s secrecy about their political contracts and political institution system which also allows the rulers to be in a position where they have to provide accountability to no one. The paper has initially tested conventional hypotheses which are broadly used as the main reason, to peg the currency in the first place and now to remain pegged. These hypotheses are political institution, trade and the oil sector economy. The hypotheses will be analysed and tested in order to see whether they force the US-dollar peg to remain. The most suitable and best method to obtain a possible answer is to use case study in the context of the GCC.
Through the qualitative case study, I will look at whether it is a political force that keeps these countries with the US dollar pegged or is this due to economic reasons? If it is political, what political issues are these? Eventually, is the political agreement at the cost of national interest? Such questions will be answered and discussed in the analysis and discussion section.
The qualitative case study is the most suited research method for this project because it provides the opportunity to explore and comprehend complex issues. Furthermore, it
enables a researcher to analyse the data within a specific context. The GCC exchange rate policy is a complex phenomenon since it has multiple aspects of influence and requires in-depth and close study. Through the case study, a researcher can go beyond quantitative statistical outcomes. It provides a framework to understand behavioral conditions through the actor's perspective. In this context, each state can be considered (as) a single actor. Yin (1984) explains the case study as “an empirical inquiry that investigates a contemporary phenomenon within its real-life context; when the boundaries between phenomenon and context are not clearly evident; and in which multiple sources of evidence are used" (p.23). However, the method has its flaws so it cannot be generalized. In a case study, it is often nearly impossible to generalize the results since each actor/agency has a different setting. The problem of generalization will not affect my research since the purpose of this paper is merely to study the GCC and not to generalize it.
As mentioned in the above paragraph, this paper will look at the case closely both at the national and international level economics and politics. I will use primary and secondary data such as policy papers, research papers, newspapers, journals, books, and other available resources to identify the variables affecting the currency exchange rate regime policy in the GCC. Therefore, it is necessary to use explanatory cases study in order to explain why the GCC as a whole use a fixed currency exchange rate regime despite all critiques and the tough economic situation in some member states.
This paper considers the GCC countries’ currency exchange rate regime as one case because of the nature of their political institutions, economics and political policies. The GCC as the intergovernmental organization aims to coordinate and integrate all members’ political, economic and cultural aspects. A political threat to one member is considered a threat to all. All the GCC countries, except Kuwait, have been pegged to the US dollar for more than three decades. However, it is argued that Kuwait’s basket of currencies is heavily weighted on the US dollar because of its oil export. Therefore, the currency exchange rate regime affects Kuwait’s currency in the same way as it does the other GCC countries’. This research uses Saudi Arabia as the main actor in defining the macro-level political and economic policies for the entire GCC. Saudi Arabia is financially and militarily as big as the five other GCC members combined. Furthermore, Saudi Arabia, as the leader of the GCC, has often taken the initiative to sign political contracts with the United States on behalf of the GCC and later lobbied with the rest of the GCC to join the contract with the United States. Hence, it is logical to focus on Saudi Arabia as the main actor and other countries as the shadow cases or
sub-actors. Of course, I will discuss the other five GCC members when required. Due to the limited number of words of this paper, I cannot discuss each member state individually.
Time frame
In the 1970s the United States' suspension of the convertibility of the United States dollar to gold has opened a new era to the free-floating exchange rate regime. Major economies have rapidly changed their currency exchange rate regime from a flexible gold order, Bretton Woods, to a free-floating (flexible) exchange rate regime while some small countries tended to fix their currency to a major currency or to a basket of currencies. From 1973, the Gulf states have been pegged, first to IMF SDR and eventually adopted the US dollar fix exchange rate regime. Therefore, this paper will mainly focus on the period of 1973 to the present.
Chapter IV
In order to get a feasible answer to the research question, this research paper will test the following hypotheses:
Hypothesis 1: A political regime is associated with the currency exchange politics in
the GCC countries.
The common assumption regarding the relationship between the political regime and the currency exchange rate regime is quite varied. Broz (2002) argues that autocracies tend to have a fixed currency exchange rate regime rather than a floating one. Autocratic regimes, in fact, value currency exchange rate regimes that provide a higher degree of stability of the exchange rate because failure of the exchange rate stability can generate inflation, reduce foreign investments and reduces purchasing power of citizens as well as job security to name just a few (Walter & Sattler, 2010).
Institutions and the political system do matter in deciding on the currency exchange rate regime. Democracies tend to favour flexible exchange rate regimes based on two main factors. The first is voter pressure and financial contribution, and the second one is collective interest groups’ (private interests’) pressure. Governments are subject to these two groups in a democratic regime, whereas in an autocratic regime, governments are, to a certain limit, subject to private interests groups only. Thus, a fundamental difference between democratic and autocratic regimes' exchange rate policy is setting the currency exchange rate regime by electoral pressure.
It does not mean that there is no pressure at all, there are still interest groups such as businesses and different sectors who have a particular interest in the exchange rate regime. To be more specific: the import-based businesses involved in international trade and investment would prefer stability (fixed exchange rate) in order to prevent the risk of volatility. However, the export-based businesses would rather lobby for a flexible rate in order to compete in the international market.
Hypothesis 2: Trade between the United States and the GCC countries force the Gulf
States to remain pegged to the US dollar.
The classical belief among academics is that a fixed exchange rate boosts trade between the countries, and particularly of the country who has pegged its currency to that of the principle.
This means that pegging a currency to the US dollar will foster bilateral trade between the United States and the country who has pegged its currency to the US dollar (Klein & Shambaug 2006). In addition, the countries who are pegged to a single currency, in this case the US dollar, will also have an increase in bilateral trade (ibid).
As shown in trade model (figure 1), when subordinate countries are pegged to the principle country, their trade increases. However, this has a sub-effect on both subordinate countries since they are both pegged to the same country, they also achieve an increment in internal trade, in this case, between X and Y (Frieden, 2014; Anthony, 1999). Furthermore, Klein & Shambaug (2006) argue that “we find that with few controls pegging appears to increase trade by as much as 80%. These are clearly over-estimates and when more appropriate controls are included, the results are 40% with country effects or 20% with country pair fixed effects” (Klein & Shambaug, 2006, p. 27-28).
Frieden (2014) and Damaceanu, (2007) have confirmed that having a pegged currency or a union currency increases the trade between countries up to 30%. He further states that some scholars even argued that it increases trade with more than 100%, of which he is sceptical.
Hypothesis 3: Oil economy forces the GCC countries to remain committed to the
US-dollar peg.
Some economists argue that it is the oil price that keeps the GCC countries pegged to the US dollar since the oil price is determined in the US dollar. Furthermore, the fixed exchange rate to the US dollar eliminates the mismatch between the real revenue in the US dollar from the oil sector and the local currency. Additionally, it helps oil-based economies against strong fluctuation and economic shocks. However, there are different views on these assumptions.
Setser (2007) argues that the peg to the US dollar eliminates the apparent mismatch between the oil revenue and the local currency. But it fails to diagnose the fiscal problem.
Principle Country
Subordinate X Subordinate Y
