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GCC currency union unlikely to affect governments' bond ratings

The Gulf Cooperation Council (GCC) currency union that is planned for 2010 would be unlikely to affect the government bond ratings of its six member states, Moody's Investors Service said in a new Special Comment.

Many of the common advantages of a currency union are muted in the case of the GCC and the disadvantages are also less applicable given that GCC states already have fixed exchange rate pegs.

Moody's noted that most economic studies indicate that currency unions tend to encourage and facilitate trade between member states, chiefly through the removal of exchange rate volatility and transaction costs within the currency area. However, in the case of the GCC, the stimulus to trade from the adoption of a common currency would likely be more limited than has been the case with other currency unions, for two main reasons.

“Firstly, there is already very little exchange rate risk within the GCC because all six member states have longstanding pegged exchange rates - Kuwait's to a dollar-heavy currency basket and the others straight to the dollar. Hence, traders within the GCC already enjoy a stable exchange rate environment. Secondly, there is less potential for trade within the GCC than in other currency unions because of a lack of economic diversification. All six economies are heavily concentrated in hydrocarbons,” said Tristan Cooper, a Moody's Vice-President / Senior Analyst and author of the report.

“In addition, the substantive institutional reform that has accompanied the creation of the EU and the Eurozone, for example, has not yet been seen in the case of the GCC,” Cooper says. This is particularly relevant given that institutional shortcomings remain one of the main constraints of sovereign ratings for GCC member states.

Similarly, the primary disadvantages associated with membership of a currency union - i.e. ceding control over monetary and exchange rate policies - are less immediately relevant for GCC members given their currency pegs. “Paradoxically, the formation of a currency union presents an opportunity for the GCC to move to a more flexible exchange rate regime in an orderly fashion,” Cooper adds.

For the smaller GCC members, the argument that they will benefit from protection against potential currency crises, which has boosted the ratings of some smaller Eurozone members, is less compelling given these countries' generally strong balance of payments, sizeable external assets and long history of exchange rate stability.

“Although GCC states' economic cycles are broadly in tune, the risk of asymmetric shocks is likely to grow over the longer term as some states' hydrocarbon reserves deplete more quickly than others. For these countries, exchange rate flexibility could at some point aid diversification and economic adjustment,” explains Cooper. (press release)