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Factors Affecting the Exchange Rate Regime

Discuss about the Understanding the International Macro Economy.

The most common decisive factor that is suggested by economists to determine the optimal exchange rate regime is macroeconomic as well as financial stability in the face of transient real or nominal shocks. The GCC was founded in the year 1981 with the objective of relinquishing closer ties as well as powerful links among the six member states. After the establishment of the GCC, member states signed a treaty that established the GCC Free Trade Area as well as delineated the steps for closer economic collaboration (Legrenzi 2015). The most common decisive factor suggested by theoretical literature for concluding the optimal regime of exchange rate is macroeconomic as well as economic stability in the face of real shocks. External stability is described as a balance of payments position that is not probable to lead to disruptive adjustments in the rates of exchange. The position of the balance of payment is reliable with external stability in which current account is widely in line with the level of equilibrium. The predictable view on the choice of regime of exchange rate is useful for macroeconomic as w,ell as financial constancy in the face of real domestic and external shocks. Fixed exchange rate is more effectual in accomplishing macroeconomic as well as financial constancy acting in response to domestic nominal shocks (Gervais, Schembri and Suchanek 2016).

The weakness of oil prices led to questioning of the sustainability of the fixed rate of exchange currency systems in the GCC. There are several imperative causes to believe that low prices of energy could weaken the reliability of pegs in the region. Export revenues are mostly affected due to several oil-related goods that are considered as the major export of the Gulf countries. The foreign reserves of the central banks are likely to be drained due to the historically unrelenting current account surplus of the region that is also likely to put further pressure on the pegs (Arouri, Jouini and Nguyen 2013).  Currencies mostly get prone to suffer exploratory attacks due to excess pressure on the regime of fixed rate of exchange. In this case, the exploratory attacks mostly include deflation as well as shift to a free-floating regime. The government of GCC has stated that they stay open to the choice of exchange rate arrangement under the proposed GCC currency union.  Besides, several advantages free-floating regime leads to several issues for Gulf countries. This is mostly due to the introduction of currency risks for cross-border business as well as expenditures. GCC currencies are likely to face additional pressure, as devaluation expectations are likely to generate considerable capital outflows. A balance of payment deficit of 14 percent and 21 percent are get experienced by both Saudi Arabia and Qatar respectively. This will mostly take place due to deterioration of the current account. Credibility of the fixed exchange rate mostly depends on the holdings of the foreign reserves. The largest volume of central bank reserves in the Gulf are acquired by Saudi Arabia both in absolute and comparative terms. This in turn helps to provide financial support to nine years of BoP deficit of its gross domestic product (Dell and Lawrence 2013).

Current State of Exchange Rate Regime in GCC

The rest of the GCC countries seem to appear in a meager position, if only the central bank reserves are taken into consideration. However, superior wealth fund resources are mostly not included in the reserves of central banks that could be used for monetary approach purposes. The fixed exchange regime are mostly guaranteed in the medium run due to adequate resources that are hold by authorities in the GCC countries.  However, the evolution of oil prices in the long-run determines the adjustments of exchange rate (Ganguli 2016). Even Bahrain and Oman are able to endure comparatively long periods of low prices of oil as they could finance up to one year of imports with their national reserves as well as five years of a corresponding BoP deficit. The insulating properties of exchange rate regimes are affected powerfully by the structural characteristics of the GCC economies. As GCC countries may diversify in the future, flexibility of greater rate of exchange may be warranted. During the year 2003, all the GCC countries (except Kuwait) were already pegged to the US dollar and the decision was made on the basis of the expectation that the dollar peg would maintain constancy and also reinforce confidence in the economies. GCC countries have pursued economic policies that are reliable with exchange rate pegs. Members of GCC have accumulated noteworthy foreign exchange reserves that strengthen the credibility of the peg and deject speculation against their currencies. Macroeconomic circumstance in the GCC countries has been steady for the last two decades mostly during the periods of dollar instabilities. The rate of exchange simplifies trade as well as economic transaction that lead to financial coordination among the member countries (Collins et al. 2017). Even in the absence of a well-developed domestic private market in forward exchange, risk related to exchange rate can be easily evaded as there remains a probability to work with the help of US dollar markets. With the given degree of variability of the GCC countries, it is tremendously difficult to conclude the rate of exchange without any impact on some of the stability characteristics. The predictable unit value of the projected GCC common currency is equal to 0.293 dollars. This rate of exchange is comparatively higher as compared to the existing currency exchange rates among the GCC countries.

With cross-rates steady, intra-GCC business deal benefits as traders as well as investors do not have to take any risk that is associated with exchange rate. This in turn encourages further incorporation of members. GCC mostly considers the real exchange rate as a measure of competitiveness. The small model of GCC comprises of four equations for the real rate of exchange as well as real output and price level. The doubling-up of the real oil price appreciates the real rate of exchange of the GCC countries by about 3 percent on an average. Exchange rate arrangements other than the dollar peg could be considered in light of emerging changes in business as well as investment prototypes. With augmented mobility of capital, trade openness as well as foreign direct investment, the requirements for supporting an exchange rate peg become more challenging. The maintenance of a tight peg to the dollar forces the GCC countries to depend almost completely on fiscal policy in order to manage oil-related instability (Basher 2015). A more flexible regime of exchange rate is likely to provide these countries with another tool for adjust to oil shocks. However, the GCC countries also operate under large current account surpluses and as a result, their current exchange rate is undervalued. The dollar peg provides a powerful and easily understood anchor for monetary policy however; it is not possible to diverge too much from the rate of inflation of the US. Global competitiveness can be maintained under a fixed rate of exchange in the GCC countries due to flexibility of the labor market. The peg of the exchange rate also simplifies business as well as economic transaction. A single GCC currency float against other currencies would have the benefit of permitting the GCC countries to make the use of monetary policy in order to alleviate inflation and also non-oil productivity and to promote the expansion of the private non-oil economy. In the light of the present structural characteristics of the GCC countries, the active monetary and exchange rate policies are put to question that whether these policies will be able to accomplish external stability (Bouoiyour and Selmi 2014).

The risks that are associated with floating rates of exchange are the large swings in prices of oil that could lead to volatile rate of exchange and to larger fluctuation in non-oil productivity in the end. The implementation of basket peg may be helpful way in order to introduce several flexibility of the exchange rate. However, one of the disadvantages that are associated with basket peg is that it may diminish the microeconomic and informational advantages to maintain a constant two-sided rate of exchange. Gulf countries require to implement further long-term reforms in order to enhance the sustainability of their financial system and currency regime. Diversification is particularly requisite as it would shield the balance of payment from instability of oil price (Ghosh, Ostry and Qureshi 2015).

  • σ (R) = α ($) + (1 - α)(€)

Here R stands for the common currency of GCC. An optional to pegging to an individual currency, the dollar, is pegging to a basket of two currencies. However, α and σ are constants in order to determine the nominal rate of exchange between R and the basket. In other words, the basket peg rule fixes the values of α and σ.          

It can be concluded that the economies of GCC are identical in terms of their structural as well as financial fundamentals. The GCC states look identical in terms of sustainable expansion as well as price stability. It can be concluded the rate of exchange abridges trade as well as economic business that lead to financial organization among the member countries. At the exchange of GCC, real-time currency rates of exchange are provided. Due to weakness in the oil price, the sustainability of the fixed rate of exchange systems in the GCC is put to question. The currencies are mostly prone to undergo exploratory attacks mostly when fixed exchange rate are under pressure. It can concluded that the current rate of exchange for all the six countries of GCC are fixed except that of Kuwait and the exchange rate of those countries are comparatively higher than that of existing rates. 

References

Arouri, M.E.H., Jouini, J. and Nguyen, D.K., 2013. On the relationship between world oil prices and GCC stock markets.

Basher, S., 2015. Regional initiative in the Gulf Arab States: the search for a common currency. International Journal of Islamic and Middle Eastern Finance and Management, 8(2), pp.185-202.

Bouoiyour, J. and Selmi, R., 2014. GCC Countries and the Nexus between Exchange Rate and Oil Price: What wavelet decomposition reveals?. International Journal of Computational Economics and Econometrics, 5(1), pp.55-70.

Collins, R.D., Selin, N.E., de Weck, O.L. and Clark, W.C., 2017. Using inclusive wealth for policy evaluation: Application to electricity infrastructure planning in oil-exporting countries. Ecological Economics, 133, pp.23-34.

Dell, S. and Lawrence, R., 2013. The Balance of Payments Adjustment Process in Developing Countries: Pergamon Policy Studies on Socio-Economic Development. Elsevier.

Ganguli, S., 2016. An economic analysis of sustainability of a potential GCC economic and monetary union during 2005-2014. World Journal of Entrepreneurship, Management and Sustainable Development, 12(3), pp.194-206.

Gervais, O., Schembri, L. and Suchanek, L., 2016. Current account dynamics, real exchange rate adjustment, and the exchange rate regime in emerging-market economies. Journal of Development Economics, 119, pp.86-99.

Ghosh, A.R., Ostry, J.D. and Qureshi, M.S., 2015. Exchange rate management and crisis susceptibility: A reassessment. IMF Economic Review, 63(1), pp.238-276.

Legrenzi, M., 2015. The GCC and the international relations of the Gulf: Diplomacy, security and economic coordination in a changing Middle East (Vol. 44). IB Tauris.

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