Kuwaiti currency basket yield benefits

Kuwait’s abandonment of its strict dollar peg has reduced exchange rate volatility without pushing up inflation. However, it has failed to spur diversification of the Kuwaiti economy.

These mixed results are likely to feed into the thinking of governments across the Gulf region, given heightened expectations earlier this year that the likes of Saudi Arabia could scrap their longstanding dollar pegs.

The recent recovery in oil prices and partial unwinding of the dollar’s erstwhile strong bull run has once again damped down expectations of near-term currency reform in the six-nation Gulf Cooperation Council bloc.

However, many analysts believe if and when any of Saudi Arabia, the United Arab Emirates, Bahrain, Qatar or Oman do decide to abandon their dollar pegs, they are more likely to follow in the footsteps of Kuwait, which manages its dinar against a currency basket, rather than float their currencies freely.

Kuwait itself operated a strict dollar peg between January 2003 and May 2007, when it readopted the basket approach it had previously used between 1975 and 2003.

The move was triggered by a desire to combat the high inflation, which later peaked near 12 per cent, that resulted from the then steep depreciation of the dollar.

Analysis by Dima Jardaneh, head of economic research for the Middle East and north Africa at Standard Chartered Bank, sheds light on how successful, or otherwise, Kuwait’s move has been.

The good news is that “pegging to a currency basket has afforded Kuwait a higher degree of flexibility on exchange rate and monetary policy relative to the rest of the GCC economies,” says Ms Jardaneh.

Since the adoption of the basket, the dinar has ranged from a maximum of $3.78 in 2008 to a minimum of $3.29 in January of this year, while its fellow Gulf currencies have remained rigidly affixed to the greenback.

More importantly, though, measured in trade-weighted nominal terms, Kuwait’s exchange rate has been markedly less volatile than that of its dollar-pegged Emirati and Saudi peers, as the first chart shows. It weakened less in 2008, when the dollar was weak, and has risen less since 2014, when the dollar’s bull rally started.

The divergence is not huge, but this is obviously a result of Kuwait’s choice of basket constituents. The composition has never been revealed, and many observers believe it changes over time, but Ms Jardaneh estimates the current basket weightings at 70 per cent US dollar, 20 per cent euro and 10 per cent Japanese yen.

At first glance this may seem overly concentrated, given that the US, eurozone and Japan account for just 35.4 per cent of Kuwait’s imports. However, much of the remainder comes from elsewhere in the GCC (via dollar pegged currencies) or China, which until recently also had a currency closely tied to the dollar, although it too is now allowing more flexibility after introducing its own currency basket in December.

Moreover, Ms Jardaneh says the composition is designed to reflect capital flows in and out of Kuwait, as well as trade flows.

The impact on inflation also appears beneficial (although, of course, it is impossible to know how things would have differed had Kuwait retained its shortlived dollar peg).

After inflation peaked just below 12 per cent in 2008, it fell back rapidly, reaching 2 per cent in 2009, as the second chart shows. It is logical to think that the speed with which inflation was brought back under control was aided by the strengthening against the dollar that the basket allowed.

More recently, the dinar’s fall against the dollar since 2014 has not proved inflationary, although this may be primarily due to the slowdown in the Kuwaiti economy caused by the slump in oil prices, rather than a lack of pass-through from higher import prices.

Luis Costa, emerging market currency and credit strategist at Citi, who believes the basket has indubitably been beneficial for Kuwait, argues instead that the arrangement has allowed the country to import enough inflation through higher import prices to offset the deflationary effects of weaker domestic demand, keeping everything on an even keel.

Ms Jardaneh says the abandonment of its dollar peg has also given Kuwait a little more freedom to diverge from US monetary policy than its Gulf peers enjoy.

During 2007 and 2008, when the Federal Reserve was cutting interest rates aggressively, Kuwait typically followed suit with a lag of six months, Standard Chartered calculates.

“Given the decoupling between the US and the GCC business cycles at the time, the Kuwaiti government opted to delay the reduction in interest rates given that the economy was overheating and inflation high,” says Ms Jardaneh.

After the Fed raised rates in December 2015, Kuwait did opt to replicate the 25-basis point move, however, even though Qatar and Oman have yet to do so.

The bad news, though, is that Kuwait’s greater degree of exchange rate flexibility and lower volatility, vis-à-vis its GCC peers, does not appear to have boosted the country’s competitiveness.

As Ms Jardaneh points out, the economy remains the least diverse in the Gulf, with oil revenues accounting for about 90 per cent of government revenues and 94 per cent of goods exports.

“Non-oil economic growth in Kuwait has lagged behind its regional peers in recent years,” she says.

This makes Ms Jardaneh think that Saudi Arabia, whose non-oil exports are typically still in oil-related sectors such as petrochemicals, would also struggle to see any great diversification benefit from switching to a basket.

As such the UAE, with its greater economic mix, might be the only Gulf state that would derive any meaningful diversification gains from a basket.

Mr Costa is not betting on any short-term change, but does believe Saudi Arabia could follow Kuwait’s lead if the fiscal pressures that have pushed its budget deficit to 15-20 per cent of gross domestic product become worse still.

“When you are dealing with a basket, and people don’t understand how it works, it’s a nice way to let your currency go without telling the market what your rules are,” he says.

As for generating any serious economic diversification, though, he argues that Kuwait’s gradualist approach has simply been far too timid.

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