A Test of compatibility among
GCC Member Countries toward a Common Currency Area
Prepared by Abdullah Alshebel
I . Introduction
The Gulf Cooperation Council (GCC), consisting of Saudi Arabia, Qatar, Oman, United Arab Emirates, Bahrain , and Kuwait, has been in existence since 1981. The GCC member states share a number of characteristics which reinforce the objectives of the GCC agreement. First, political and social structures are comparable among the Gulf states. Second, all Gulf states are oil producing and exporting countries, so oil income is the main source of government revenues and expenditure. Third, they share comparable economic and financial systems emphasizing a free and open market with a few institutional restrictions, differing only slightly from one country to another. While the GCC has fostered a significant degree of cooperation toward establishing common policies among the members, so far a formal common currency area has not been established under the GCC umbrella. However, as all GCC countries other than Kuwait effectively peg their currencies to the US dollar, characteristics of a common currency area apply to the GCC.
Although, it is difficult to draw a definite and clear conclusions with regard to the feasibility of forming a common currency area among the GCC countries, high labor mobility, common economic diversification efforts, increasing trade within the GCC, and the degree of openness of the economies, all suggest that some form of monetary integration may be beneficial to the GCC countries.
The rest of the paper is organized as follows. The next section discusses the common currency area original literature . Section III discusses the analysis technique. In this section also analyzes the underlying criteria that are essential for forming a common currency area, while section IV concludes.
II. Theory
A common currency area can be defined as a group of countries, for which it is optimal to have fixed exchange rates, and ultimately, a common currency, while preserving some degree of exchange rate flexibility with the rest of the world. The formation of a currency area helps eliminate costs usually associated with flexible exchange systems. Two main costs may be identified in a flexible exchange rate system. The first is transaction costs associated with exchanging money. The second is the costs resulting from currency fluctuation. The uncertainty associated with exchange rate fluctuations since the collapse of the gold standard 1973 resulted in the development of financial instruments to reduce the uncertainties. For example, forward exchange contracts, one of the major financial innovations to deal with exchange risk, are widely used for protection against future exchange fluctuations.[1] The formation of a common currency area would help eliminate significant transaction costs. In addition, a currency area would also ameliorate the uncertantity associated with flexible exchange rates and stimulate specialization in production and the flow of trade and investments among member countries. Investment would be allocated towards high productivity regions in the integrated area. The formation of a common currency area also encourages producers to view the entire area as a single market and to benefit from greater economies of scale in production. Further, with fixed exchange rates, a common currency area is likely to experience greater price stability ( actual and expected) leading to better resource allocation.
The formation of a currency area may also benefit the members by reducing the need for foreign exchange reserves. If a currency area is to develop to a full monetary union, the need for foreign exchange reserves (saving on exchange reserves) can be reduced in two ways. First, no foreign exchange reserves are needed for intra-area transaction. Second, some member states would have a positive external balance while others would have a negative balance. The ability to substitute the positive balance for the negative within the union, would further reduce the need for foreign reserve through the economizing of reserves ( Kafka, 1969).
A significant disadvantage of a common currency area is that each member country can not pursue its own independent stabilization and growth policies attuned to its particular preferences and circumstances. However, on balance, the formation of a currency area is likely to be beneficial under the following conditions: (1) greater mobility of resources among the various member countries, (2) greater structural similarities, and (3) the degree of the willingness to closely coordinate macroeconomic policies.
Most of the analytical literature on monetary integration has focused on the experience of European (EC); EMU. The objectives of the European Monetary System were aimed at establishing stability in intra-European currencies exchange rates, promoting economic cooperation, and encouraging economic convergence among member countries. The outcomes of the EMS are more difficult to evaluate, but many economists agree that EMS outcomes in policy coordination for the last decade are less impressive than the exchange rate stability policy. In this regard, a number of authors have tried to assess the viability of CCA for Europe. Willms (1990) concluded that in the case of Europe, the degree of labor mobility is substantially low and the participating countries are definitely less suited to form a monetary union, in most sectors for some European countries is far away from offering a diversified spectrum of goods and services. In study of Ghosh and Wolf (1994), Europe can not form an optimum currency area because the costs of adopting a single currency exceeds estimates of the transaction cost savings Eichengreen (1990) gets to the conclusion that “the establishment of a currency union in Europe will be associated with non-negligible regional problems despite the 1992 programme. This makes it all the more essential to develop the political and economic institutions necessary for smooth operation of a currency union”.
The economics of the Communaute[L1] Financiere Africanine (CFA) franc zone in Africa is another experience of monetary integration. Boughton (1993) concluded that the CFA franc zone is far from qualifying as an optimum currency area because of lack of intra-regional trade, some inflexibility of prices and wages, and a wide diversity of incidence of shifts in the terms of trade.
During the 1950s, the bulk of the literature on economic integration focused on the custom Union theory. The optimum currency area was debated during the 1960s and was concerned with the factors that would facilitate the formation of a common currency area. Mundell (1961), McKinnon (1963), Kenen (1969), and Fleming (1971) emphasized factor mobility (Mundell), openness of the economy (McKinnon),the degree of economic diversification (Kenen), and similarity of inflation rates (Fleming).
A major contribution to currency area theory was made by Mundell (1961) defines a common currency area as a domain within which exchange rates are fixed. The argument which must be looked into when determining an optimum currency area is the stabilization argument. Mundell (pp. 657-665) contends that
the stabilization argument for flexible exchange rates is valid only if it is based on regional currency area. If the world can be divided into regions each having factor mobility and between them factor immobility; each of these regions, then, should have a separate currency fluctuating relative to all other currencies.
Mundell's condition for the formation of an optimum currency area can be summarized as follows. If high factor mobility exists between a number of countries and there is a low factor mobility with the rest of the world, then a common currency area is a logical conclusion, since the movement of production factors will substitute for exchange rate adjustment. In the case of low factor mobility, exchange rates should be left to float against other currencies.
McKinnon (1963) describes an optimum currency area as an arrangement with
a single currency within which monetary, fiscal policies and flexible exchange rates can be used to give the best resolution of three (sometimes conflicting) objectives: the maintenance of full employment, the maintenance of balanced international payments, and the maintenance of stable internal average price level. (pp. 717-725)
McKinnon proposes that the degree of economy openness should serve as the determining factor in forming a common currency area. The effect of exchange rate change in an open economy would be reflected fully on domestic prices. Hence, the more open the economy is , the stronger the argument for the formation of a currency area. As an index of openness, McKinnon points to the ratio of tradable goods to non-tradable goods. In a small economy, non-tradable goods are indirectly affected by exchange rate changes. Relative price changes between tradable and non-tradable goods might, in extreme cases, change a good's nature from non-tradable to tradable. To deal with the problem of dividing goods into tradable and non-tradable categories, McKinnon proposes a weighting system to determine total production in each category.
Kenen (1969) proposes the degree of economic diversification as a yardstick in determining the viability of an optimum currency area. The higher the production diversity among a group of countries, the higher the benefits from a currency area formation. Kenen argues that a well-diversified national economy will not have to undergo changes in its terms of trade as often as a single-product national economy. If a country with a diversified economy faces a drop in the demand for its principal exports, unemployment will not rise as sharply as it would in less diversified national economy.
Finally the link between external and domestic demand, especially the link between exports and investment, will be weaker in a diversified national economy so that variation in domestic employment imported from abroad will not be greatly aggravated by corresponding variations in capital formation (pp. 41-60).
Fleming (1971) proposes the criterion of similar inflation rates, which diverts attention from microeconomics disturbances in demand and supply conditions and focuses it on macroeconomic phenomena. While Fleming’s analysis agrees with most of the arguments presented so far on the determination of a common currency area, he emphasizes other factors, especially inflation and related issues. Similarity in inflation rates is a paramoccut condition, for the formation and stability of a currency area. Thus, three factors would determine inflation rates, namely, national employment goals, rates of productivity growth, and the degree of trade union aggressiveness (p 476).
In this paper, we assess the degree of compatibility among GCC countries toward establishing a common currency area by ranking countries according to certain criteria essential in forming a viable common currency area. The assessment is based on three criteria: (1) degree of similarity among inflation rates; (2) level of economic diversification; and , (3) the openness of the economies. The analysis does not include a ranking according to factor mobility, although a very important factor in the formation of a common currency area, due to lack of sufficient data.
III. The Analysis
In order to test these criteria empirically for the GCC countries, the present paper utilizes the ranking method in Zizek (1989). According to each criteria the GCC countries are ranked as potential candidates for a common currency. The first criterion we consider is the similarity of inflation rates. Inflation rates in member countries are weighted in proportion to each country’s GDP in the total GDP of the GCC countries. Then, deviations of inflation rates from the weighted average inflation rate for the GCC countries is computed, and ranking is done according to deviation of each country from the GCC average.
GCC countries differ significantly in their size and in economic capacity. Therefore, different weights need to be assigned to each country whenever averages for the GCC as a whole are computed. A simple arithmetic average may lead to incorrect conclusions. Therefore, the country weights are based on the share of the one country’s GDP in the total GDP of all GCC countries together. Based on GDP data for the period from 1970 to 1993 are from WEO database, average gross domestic products in the period 1970-1993 for each country are computed. The share of one country’s average GDP in the average total GDP for the GCC represents the weight assigned to the country. The following weights are assigned to each country:
|
Country |
WEIGHT |
|
Bahrain |
0.02 |
|
Kuwait |
0.13 |
|
Oman |
0.04 |
|
Qatar |
0.04 |
|
Saudi Arabia |
0.60 |
|
United Arab Emirates |
0.17 |
a. Degree of Similarity in Rates of inflation
If there are significant differences in the inflation rate prevailing in prospective member of a CCA, it is more difficult to maintain fixed exchange rate among the members and there the greater the need for frequent adjustments in the exchange rates.
Data on inflation rates for the GCC countries during the 1970-1993 period summarized in table 1. Until 1972, inflation rates were moderate, increasing on average at an annual rate of approximately 3 percent. Starting in 1973, an inflationary cycle developed which was fed and accelerated by external as well as internal factors. The cycle reached its peak during 1974-1976, and began to recede, declining to negative levels by mid 1980s. Reflecting the openness of the GCC economies, domestic inflation largely followed the world inflation during that period. Inflation rates soared in Saudi Arabia, rising higher than in most of the other Gulf states. This increased largely occurred because of infrastructure; bottlenecks in 1974-75. With oil price increases in 1973, government expenditure increased almost tenfold over the next four years, creating a substantial increase in demand for goods and services. Since the domestic supply of goods and services was limited, the increase in demand was met through imports. However. during this period, the Saudi Infrastructure was not yet fully developed. Seaports and roads could not accommodate the increased volume of imported goods leading to bottlenecks in domestic supplier and increase in prices.[2] In this regard the infrastructure in the other Gulf states, also underdeveloped, fared far better than Saudi Arabia.
Inflation rates differ significantly among GCC countries, in general with the highest rates observed in Saudi Arabia and the lowest rates in Oman over the period 1970-1993. Comparing the average inflation rates in the periods 1979-1987 and 1988-1993 with the average inflation rates in the period 1970 to 1993 or with the average of the period 1970-1978 shows significant decline in inflation rates the last fourteen years, especially after 1981(table 3).The data indicate that inflation rates have been , on average, more similar in the period after the creation of the GCC than before (table 11 and 12). For example, before 1981 there was a difference of 12 percentage point between the lowest inflation rate, for Oman, and the highest inflation rate, for the United Arab Emirates. Since 1981, inflation has decelerated everywhere and generally more so in the high inflation countries, and the lowering of both the average inflation rate and the standard deviation around it continued through 1993. The indicators of divergence reached their minimum in 1993, when the difference in inflation rates for the highest inflation country and the lowest inflation country was above 5 percentage points. The real effective exchange rates for the GCC currencies have declined at different rates since 1985 due to the low rate of inflation relative to that of their trading partners (figure ).[3]
A more appropriate measure than differences between inflation rates is their deviations from the weighted average inflation rate for the GCC. So, the Inflation rates in member countries were weighted by the proportion of one country's GDP in the total GDP of the GCC countries. Weighted averages for the GCC are presented at the last column of table 1. Table 2 shows deviation of inflation rates in each member country from the weighted average in different years. Table 3 shows average inflation rates in the period 1970-1993 and average absolute deviations of an individual country's inflation rate from the weighted average for the GCC for the same period. Since 1979, weighted average inflation rate has gradually declined for GCC countries and convergence in inflation rates can be observed as seen in graph (1).
To answer the question if the GCC countries are good candidates to form a common currency area according to the criterion of degree of similarity of inflation rates, average annual inflation rates of GCC countries in the period 1970-1993 are compared. It is deemed that all countries with lower inflation than the weighted average inflation rate (sometimes referred to as the “convergence criteria), 6.19 percent would satisfy the condition for a common currency area exist. In table 4 countries are ranked according to this criterion. Therefore, this criterion suggests that the GCC countries can form a common currency area. Moreover, table 4 contains data about price stability in the GCC countries, where annual inflation rates are used as a measured of price (in)stability. The comparison shows that the average deviation rates are lower than the weighted average inflation rate of the GCC and they can benefit in terms of price stability by forming the currency area.
b. Degree of Openness of an Economy
According to Mckinnon (1963), openness can be measured either as the ratio of tradable to non-tradable goods or a proportion of imports to national income. The first measure cannot be used in the case of the GCC countries because data differentiating goods into tradable and non-tradable categories are not available. Therefore, for each GCC country only the imports from other GCC countries will be used to measure the openness of each country relative to the other GCC countries. Degree of openness of an economy is calculated according to the following equation:
MGCC
OPENi= ------- * 100[L2]
GDPi
Where OPEN : index of the degree of openness of country i;
MGCC : value of imports of country i from the rest of the GCC countries;
GDPi : gross domestic product of country i.
To answer the question if the GCC countries are good candidate to form a currency area according to the criteria of degree of openness, we estimate the degree of openness of each country for the period from 1973 to 1993. The average openness over the period was taken as the final measure. Table 2-2 shows the openness of GCC countries in the period 1973-1993. From this table we can conclude that openness did not vary significantly over this time period as well for GCC (see graph 2), except for Bahrain, 90 percent whose imports are from Saudi Arabia, mostly crude oil. The standard deviation, are very small (table 2-3) which supports the stability of openness during the period 1973-1993. The average degree of openness of all GCC countries was 19.21 percent, with minimum 11.97 (Kuwait and Saudi Arabia) and maximum value of 28.14 percent (Bahrain). In table 2-4, all GCC countries are ranked according to the degree of openness.
Applying this criterion of openness of each country to the whole GCC shows that they have low degree of openness during 1970s, but they have become more open to each other in the last seven years (table 2-2). Although it isn’t possible to conclude that there is necessarily a positive gain for the GCC members in employing fixed exchange rates; however, the less will be the cost of keeping it, the more open the economy (the greater the propensity to import), the smaller will be the variation in income and employment needed to correct a given external imbalance. Of course, price stability may also be an important positive result of fixed exchange rates in some economies.
c. Degree of Diversity of Product - Mix in an Economy
Kenen (1969) concluded that for a well-diversified economy, a fixed exchange arrangement is optimal; for a less diversified economy, a high flexibility in exchange rate is optimal. Presley and Dennis (1976) constructed a measure for diversification by calculating the percentage contribution of eleven sectors of the economy to the total gross domestic product of European economic community members. The diversification measure, or diversification statistic (DS), is computed as the number of sectors contributing more than 9.9 percent of the total GDP. The diversification statistic of any country would range from one to eleven.
A similar measure for the GCC was calculated. Each sector’s percentage participation was computed for the period 1975 to 1992 for all the GCC countries. The average share of each economic sector was calculated and presented in table 3-1. According to the diversification statistic (table 3-2), Saudi Arabia seems to be the most diversified economy among the Gulf states. Bahrain, United Arab Emirates, and Qatar followed, then Kuwait and Oman as the least diversified economies. According to this measure, all of the GCC countries would satisfy the criterion of diversification.
Kenen’s position that product diversification is the main criterion for forming a currency area does not necessarily mean that economically diversified countries necessarily benefit from forming a common currency area. However, the criterion implies that a well-diversified economy is less vulnerable to relative price movements than an economy with a high concentration in production and export of smaller number of products. Therefore, for a well-diversified economy it is easier to peg its exchange rate vis-à-vis another currency since demand shocks in a given sector will not affect the exchange rate very heavily. In the context of the GCC, because they are large net exporters of oil, their currencies are subject to external influences. Shifts in world demand for oil affect the GCC currencies strongly and would require more realignments. However, the shares of oil sectors for Saudi Arabia and Bahrain do not support this argument very strongly as being low comparing to the other GCC countries.
IV. Conclusion
Since the establishment of the GCC in 1981, a number of steps have been completed toward the implementation of the GCC’s unified economic agreement objectives. Monetary integration can lead to economic integration. In this paper, we assess the degree of compatibility among GCC countries toward establishing a common currency area. There is some empirical evidence in support of the criterion of similarity in inflation rates, openness of an economy, and economic diversification, for the GCC countries. Ranking the GCC countries is made to show if they satisfy the above criteria and which one come first in fulfillment.
Taking into consideration the rapidly changing in GCC economies, especially the improvement of the GCC economies’ diversification, it appears reasonable to support the argument for some form of monetary integration may be beneficial to the GCC countries.
References
Mundell, R," A Theory of Optimum Currency Areas," American Economic Review 51 (1961).
Ronald McKinnon, 'Optimum Currency Areas," American Economic Review 53 (1963).
Peter Kenen," the theory of Optimum Currency Areas: An Eclectic View", in " Monetary Problems of the International Economy”, ed. by R. Mundell and A. Swoboda, 1969.
J.M. Fleming,” On Exchange Rate Unification”, The Economic Journal,1971, n.323,vol. 81.
Presley, John and G. Dennis, Currency Areas. Wooster: The Andrews Library, College of Wooster, 1976.
[1]These contracts simply transfer the cost associated with avoiding exchange risk from one sector of the economy (traders) to another sector (financial institutions), resulting in consumers having to pay the cost associated with forward contracts (the cost of hedging).
[2] Ships carrying goods to Saudi ports had to wait in port up to six months before unloading their cargo.
[3] The reason why domestic inflation rates didn’t increase to transfer the imported price inflation since these countries are small open economies is due to utility subsidies of the GCC governments to keep their prices constant or to some degree low.