Creating a common currency

27 August 2004
At the summit of GCC leaders in Manama in December 2001, a momentous decision was made. As the culmination of a process of greater economic integration among the six states, the rulers pledged that by 2010, individual Gulf currencies would be abolished. For the first time since the 1960s and the abandonment of the Gulf rupee, a single currency would be accepted in souks from Muscat to Manama to Mecca.

GCC-wide projects are not renowned for their ease of execution, but so far the milestones along the road to monetary union have been passed on schedule - even two years early in the case of customs union. From January 2003, a unified external tariff of 5 per cent came into force. The previous month, Kuwait fulfilled another key criterion, joining the rest of the GCC states in pegging its currency to the dollar.

Because of the dollar peg, many facets of currency union are already in place. Nevertheless, the step to complete monetary union is a big one. Governments must undertake intimate policy co-ordination and co-operation to create common institutions - most importantly, a single central bank - and budgetary rules. They must also willingly wave farewell to what monetary policy independence is available to them, and with it a good deal of flexibility to respond to asymmetric economic shocks. The political benefits of closer regional integration are clear in terms of global voice. And there exists a well-established body of economic theory setting clear criteria for an economically successful monetary union.

American economist Robert Mundell pioneered optimum currency area theory in the 1960s. Existing economic ties are crucial. Key criteria are that states undergo convergent business cycles, possess complementary specialisations, and engage in high levels of intra-regional trade. Labour force mobility and 'fiscal federalism' - the willingness to transfer funds from richer to poorer regions - are necessary to absorb economic difficulties affecting the region unevenly, in the absence of monetary and fiscal tools to do the job. The eurozone experience in the EU has added an additional layer of tests. Interest rates and inflation rates should diverge only within a narrow range, while budget deficits and public debt must remain below certain ceilings.

Some of the benefits of union apply regardless, in the form of greater price transparency and savings in transaction costs as spenders criss-cross the Gulf. However, the particular barometers of success are that the policy should materially enhance trade - rather than merely prompting trade substitution - and stabilise employment and prices across the area.

GCC states fulfil a number of the conditions. Heavy dependence on hydrocarbons creates similar economic structures. The dollar peg has kept regional interest rates within a narrow band while inflation rates are also broadly similar and far less divergent than were those of the eurozone economies before union.And accustomed to the exchange rate peg, GCC finance ministers are also used to constraints on their monetary policy flexibility.

The development of greater fiscal discipline in recent years, particularly in Saudi Arabia, has left projected budget deficits within the 3 per cent of gross domestic product (GDP) limit set by Brussels. Similarly debt-to-GDP ratios fall well within the EU's 60 per cent ceiling in all but Saudi Arabia, where most of the debt is to the Public Investment Fund and therefore poses little structural risk. A degree of fiscal federalism already takes place on an informal basis - through for example Riyadh's gift of oil to Bahrain - which creates some precedent for official transfers.

The key concerns surround intra-regional trade and labour mobility. GCC states, with the exception of Bahrain and Oman, conduct less than 10 per cent of trade with their neighbours (see table). However, when the overlapping oil,

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