Currency: IMF discussion paper on common currency in the Gulf

THE IMF has produced a discussion paper about the creation of a single currency in the Gulf. For a simple and clear explanation of the arguments for and against a single currency, read this.

What a shame no one made widely available such a document explaining the creation of the Euro.

But the paper is flawed: in a discussion of an Arab region it talks about interest rates and ignores Islamic banking. The IMF paper relate to the longstanding proposal for a common currency in the Gulf Co-operation Council States, or GCC.

The objective of the single Gulf currency was first brought into official policy in 1982 with the "Unified Economic Agreement" and, according to the IMF the "successful" creation of the Euro has provided fresh impetus for the Gulf proposal.

For Euro watchers, where economic convergence remains a significant issue that maintains tensions within the group and provides frictions for those considering joining, the IMF has an interesting comment: it is useful to note the remarkable convergence of exchange rate policies followed by countries in the region around pegs to the U.S. dollar."

This is not, one should not, the same as economic convergence but it does demonstrate the effect that alignment to a large currency block can have. Indeed, Hong Kong tied the HKD to the USD in a time of decline and during the period of that tie had a general currency stability, at least in international trade. Malaysia tied to the US dollar during the 1997 currency crisis and, despite some calls for the release of the tie, the government has held firm and, again in international markets, the MYR has been less volatile than many other countries.

However, the GCC argument has two sides: if there has been such convergence of external currency policies, then does this imply a loss of control over the currency? The IMF does not address this issue. It does, however, explain that the pegs are not official pegs but that a complex arrangement results in what amounts to a peg in all but name.

So, the paper takes as a starting point the assumption that there is a "revealed preference of the GCC countries for a [US] dollar peg."

The benefits are listed and micro-economic savings in transaction costs and the removal of intra-GCC currency exchange rates will be removed. However, this will be at the cost, on a political-economic level, of the ability for each country to set its own economic policy.

The macro-economic costs flow from the fact that countries will lose their freedom to set economic policy with reference to exchange rates and (as we have seen in Europe) to a great extent, interest rates.

The IMF is generally obsessed with the economics of Milton Friedman, who - as his central thesis - declared that the only effective tool for managing the economy is interest rates. However, there is a problem for Gulf states to set interest rates: under Islamic Banking, it is illegal to charge or pay interest. Yet even in Islamic banking, money has a price. It is important for that price to be controlled as a part of managing an economy, according to Friedman. Other economists favour a range of controls, such as credit control or a cap on prices.

The paper says that a common currency may have the effect of reduce and stabilise domestic interest rates. The paper does not discuss the Islamic banking alternatives to interest rates.

The question of inflation is dealt with in a novel way: the paper suggests that the GCC countries would not have to resort to printing money (which as any study of hyper-inflation shows is a short term approach which ultimately leads to economic disaster such as seen in Argentina where the money supply was completely out of control yet the government maintained its policy: and the IMF was not especially strong in its condemnation of the actions (indeed, only the much derided Paul O'Neill, not generally a man much on top of his game, was a lone voice in telling the IMF it was wrong)). The paper says that the GCC members have such large assets overseas that they will provide an effective cushion against economic problems at home.

The paper says that history shows that the creation of a common currency follows on from political integration, not the other way around. That is a truism that was largely hidden from the UK population in 1973 when a common currency was explained as a benefit to business in referendum proceedings. The question of political integration was barely, if at all mentioned.

The creation of such a policy will require considerable political will, says the paper.

The paper can be found at http://www.imf.org/external/pubs/ft/pdp/2002/pdp12.pdf

GCC members are Bahrain, Kuwait, Oman, Qatar, Saudi Arabia, UAE.

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