GCC pegged exchange rate regimes will remain in place, S&P said and noted all GCC sovereigns are having sufficient access to foreign currency assets, or external financial support, to meet pressures on their exchange rates.
Exchange rate pegs against the US dollar — or in the case of Kuwait to an undisclosed currency basket believed to be dominated by the dollar — are longstanding and have lent the GCC monetary policy credibility over the decades.
A key assumption that continues to underpin S&P ratings on GCC sovereigns is that their pegged exchange rates are likely to remain in place.
"We believe that GCC sovereigns can maintain their pegged exchange rates because we view all of them as having sufficient access to foreign currency assets, or external financial support, to meet pressures on their exchange rates," said S&P Global Ratings credit analyst Trevor Cullinan.
"Although we view the GCC pegged exchange rate regimes as supportive of sovereign ratings in the region, there is necessarily a trade-off against the benefits of more flexible arrangements," Cullinan added.
S&P expects that GCC sovereigns would use their liquid external assets to support their economies in times of financial distress, including in defence of their currency pegs.
For example, when several Arab countries imposed a blockade on Qatar, outflows of nonresident funding from Qatari banks totaled $22bn (14% of GDP) in 2017.
However, an injection of $43bn (27% of GDP) by the government and its related entities — mostly the Qatar Investment Authority — more than compensated for the outflows.
Two distinct groups emerge from S&P analysis of reserves adequacy. Kuwait shows clear strength in terms of the availability of reserves to cover the monetary base and current account payments over the next four years.
Qatar, and two other GCC countries also show “significant” strength.
Importantly, in terms of reducing pressures on GCC exchange rate pegs, S&P expects oil prices to recover in 2021, with Brent averaging $50 during the year, up from $30 in 2020. This will provide a key support to the economies and foreign reserves positions of GCC central banks.
“The longer oil prices remain low, the higher the likelihood that pressure would increase on GCC exchange rate pegs. However, for most of the GCC countries, our oil price assumption for 2021 is below the IMF's respective fiscal breakeven oil price. This suggests that fiscal pressures will not be completely alleviated in the region,” S&P said.
On why higher-rated GCC sovereigns would support lower-rated ones to defend their pegs, S&P said, “We see two main reasons: to prevent financial contagion and promote their foreign policy interests. We believe that should the currencies of lower-rated Bahrain and Oman come under significant pressure, higher-rated sovereigns would provide financial support to prevent contagion to their own financial markets.”
On whether the GCC pegged exchange rate regimes are supportive of sovereign ratings in the region, S&P said, “In our view, yes, they are. However, there is necessarily a trade-off against the benefits of more flexible exchange rate regimes. Fixed exchange rates have worked well for the GCC through various oil price peaks and troughs. This reflects the reality that energy production (a dollarised industry) makes up a sizable share of gross value added in the region. Given the dollar-based nature of their economies, the pegs have provided a nominal anchor for inflation, supporting monetary policy credibility by outsourcing it to the US Federal Reserve.
“However, adopting US monetary policy can also bring challenges because at times interest rate settings may not be supportive of nonoil output growth in the GCC. Moreover, economic theory suggests that a flexible exchange rate allows a currency to act as a shock absorber during balance-of-payments crises and increases monetary policy flexibility, via the interest rate channel.
“A floating exchange rate can provide a shock absorber for small open economies facing external shocks, by boosting exports and supporting domestic demand and output. However, in our view, these effects are likely to be relatively muted for the GCC because, in many cases, their nonhydrocarbon export base is small, limiting the benefits of a more competitive exchange rate.”