Gulf FX reform pressures remain amid dollar rally

DUBAI (Reuters) - The case for Gulf oil producers to switch to flexible exchange rates to fight high inflation and strengthen their currencies will not go away even as the U.S. dollar's rebound buys them time to rethink their dollar pegs.

Gulf policymakers who faced growing popular pressure to revalue their currencies have been relieved as the greenback recouped most of its 2008 losses and the U.S. Federal Reserve stopped slashing interest rates.

Yet while the dollar rebound will dampen inflationary pressures by easing the cost of food and commodity imports to the desert states, their booming economies -- and monetary policy needs -- remain out of step with the United States.

"The case for currency reform is still strong even if the pickup in the value of the dollar has made it less urgent," said Simon Williams, senior economist at HSBC in Dubai.

"The Gulf is a fast-growing, dynamic economy that would benefit immensely from having control over its own monetary policy."

Even before the dollar began rising in late-July, Gulf policymakers threw their support behind reviving a regional plan to create a single currency, and managed to ward off bets other states would follow Kuwait's lead and sever their dollar pegs.

Kuwait started tracking an undisclosed currency basket in May 2007, when the euro-dollar was $1.34, arguing that dollar weakness was stoking inflation by making imports more expensive.

Gulf currencies remain weak as their economies, set to soar past $1 trillion in size this year, defy a global economic downturn on a more than five-fold rise in oil prices since 2002.

In February, months before the euro-dollar hit a record above $1.60, Qatar's Prime Minister said his country's riyal currency was about 30 percent undervalued. At the time, the euro-dollar was at $1.48, just above its level on Thursday.

INFLATION SPIRAL

Since then, inflation has soared above 10 percent in five of the six states that make up the Gulf Cooperation Council (GCC), sparking protests among migrant workers in the United Arab Emirates, Bahrain and Kuwait over wages lost to the weak dollar.

"The currencies are still undervalued so the dollar rally hasn't really altered the reform argument," said Paul Gamble, head of research at Riyadh-based Jadwa Investment.

"The relevant authorities have been more consistent in expressing their willingness to maintain these pegs. The dollar rally is making it a lot easier for them not to do anything."

If the dollar continues to recover losses against the euro and Asian currencies, that will ease the cost of non-dollar food imports to Gulf states, one key driver of regional inflation.

Gains in the U.S. currency also boost the value of regional sovereign wealth fund assets, heavily weighted in the dollar.

Still, while the United States worries about its worst financial crisis since World War 2, booming Gulf states are experiencing the biggest growth in their history.

Gulf central banks do not, however, have the tools to tackle inflation. They were forced to shadow seven U.S. interest rate cuts starting almost a year ago, even though their inflation problems would usually demand rate rises, not cuts.

Real interest rates -- the official rate minus inflation -- are also negative, compelling residents to pull money out of bank accounts and invest in assets such as property while spurring demand for cheap credit.

Even if the Fed begins raising rates again to tackle higher U.S. inflation, it may not be enough.

POLITICAL DECISION

Gulf advisory bodies have called on their governments to consider currency reform as they prepare for a 2010 monetary union deadline that is likely to be pushed back.

Economists at the Dubai International Financial Centre (DIFC) made a case for currency reform in August, a month after similar calls from the Saudi shura advisory council and the Abu Dhabi Department of Planning and Economy.

But rallying support for currency reform is entangled in politics as the region's staunch U.S. allies contend with mounting tensions in nearby Iran.

Whatever the economic pros and cons for or against floating the currencies, these arguments first have to reach the ears of the country's rich, autocratic rulers.

"You can look at the economic arguments, but this is a political decision in the end," Gamble said.

(Reporting by Daliah Merzaban; Editing by Thomas Atkins)