Why do countries decide to join or form a monetary union? The literature on optimum currency areas, initiated by Mundell’s seminal paper (1961), has extensively discussed the potential benefits and costs of monetary unions.1 Countries can gain from a monetary union through lower transaction costs and the elimination of exchange rate variability, spurring investment, intraregional trade, and economic growth. Other benefits are access to bigger financial markets—lowering borrowing costs—and the potential enforcement of monetary and fiscal discipline. The main costs are the loss of national monetary and exchange rate policies. The magnitude of those costs depends on how symmetrical the economies are in terms of business cycles and vulnerability to shocks and the ease with which the economies can adjust to disturbances. These costs are likely to be lower the higher the degree of labor market flexibility across the member countries. In addition, political objectives can also be the driving force behind joining or forming a monetary union. Establishing a regional economic and political power bloc can result in a bigger role in world financial markets for the region as a whole. Other political incentives may include delegating to an institution outside the domestic political process the enforcement of monetary and fiscal discipline (Mundell, 1997).
For the GCC countries, moving to a full monetary union—by fixing bilateral exchange rates irrevocably and introducing a common currency—from the current pseudo-monetary-union arrangement—stable nominal bilateral exchange rates—is likely to be beneficial in several aspects. Although direct gains, such as increased intraregional trade from the union, might be relatively small for these countries, indirect gains should be more significant. The planned monetary union should reinforce the beneficial effects of the on-going and planned structural and institutional reforms to better face the challenges of diversifying the economy and generating employment opportunities for a rapidly rising domestic labor force. The monetary union may also enhance a mutual surveillance mechanism, enforcing in particular fiscal discipline across the membership. In addition, it will likely increase price transparency, facilitating appropriate investment decisions across the GCC area. However, the most important benefit of introducing a common currency among GCC countries will most likely be the integration and development of the area’s bond, equity, and money markets, improving the efficiency of financial services, and in turn (non-oil) growth prospects (see “Potential Benefits from a Monetary Union” below).
In contrast, the main costs of a monetary union—giving up the ability to set independent national monetary and exchange rate policies—should be limited because important exogenous shocks (such as crude oil price changes) would affect GCC countries in a similar way given the still high importance of oil in their economies. Indeed, fluctuations in crude oil price changes have induced comparable effects on the GCC countries’ external current account and fiscal positions (Table 4.1). Moreover, high labor market flexibility in GCC countries has also contributed to the relative ease of adjusting to oil shocks under a fixed exchange rate regime—though this flexibility applies only to the large segment of expatriate workers employed in non-oil activities in these countries. In addition, GCC countries have not relied on monetary and exchange rate tools for quite some time under their pegged exchange rate regimes. Overall, the GCC countries seem well positioned to successfully form and sustain a full monetary union. But the union will need to be supported by appropriate macroeconomic policies, a range of structural reforms, and strong political commitment to be fully effective and beneficial for its members. Moreover, the institutional framework will have to be carefully designed to keep the costs of a monetary union low.
GCC Countries: Actual Impact of Recent Oil Price Changes on Selected Indicators
(In percentage points of GDP, unless otherwise indicated)
Change vis-à-vis 1997.
The improvement in Qatar reflects higher export volume of liquefied natural gas and crude oil.
Percentage points; excluding oil, natural gas, and refineries.
The sharp deceleration in growth in Qatar reflects the completion of several projects.
Negative sign = decline; positive sign = increase.
Including net lending.
Excluding government investment income.
Change vis-à-vis 1999.
GCC Countries: Actual Impact of Recent Oil Price Changes on Selected Indicators
(In percentage points of GDP, unless otherwise indicated)
| United Arab | |||||||||
|---|---|---|---|---|---|---|---|---|---|
| Bahrain | Kuwait | Oman | Qatar | Saudi Arabia | Emirates | ||||
| Oil price decline, 1998; change in:1 | |||||||||
| Crude oil exports | –3.0 | –11.4 | –10.3 | 7.1 | –10.0 | –7.9 | |||
| Total imports (in percent) | –13.2 | –0.4 | 12.2 | –3.1 | 4.2 | –4.7 | |||
| Current account balance (− = deterioration)2 | –12.0 | –17.8 | –20.6 | 4.9 | –9.2 | –8.7 | |||
| Non-oil real GDP growth3,4 | 0.7 | –1.0 | –3.9 | –12.3 | –2.7 | –4.2 | |||
| Overall fiscal balance (− = deterioration) | –0.6 | –17.8 | –9.9 | –1.4 | –6.4 | –9.2 | |||
| Fiscal policy5 | |||||||||
| Government expenditure | 0.8 | 1.7 | 3.2 | –0.8 | –1.0 | 6.2 | |||
| Current | 0.9 | 1.9 | 2.5 | –0.5 | 1.0 | 3.7 | |||
| Development6 | –0.1 | –0.3 | 0.7 | –0.2 | –2.0 | 2.5 | |||
| Non-oil revenue7 | 1.2 | 0.4 | 2.0 | 0.2 | 3.8 | 1.4 | |||
| Total government gross debt | 5.6 | 5.9 | 7.3 | 7.3 | 25.0 | 2.2 | |||
| Oil price increase, 2000; change in:8 | |||||||||
| Crude oil exports | 4.3 | 12.9 | 9.7 | 4.4 | 9.7 | 6.1 | |||
| Total imports (in percent) | 25.7 | –3.8 | 6.9 | 7.6 | 7.8 | 9.4 | |||
| Current account balance (+ = improvement) | 6.5 | 23.7 | 15.7 | 15.5 | 7.3 | 15.0 | |||
| Non-oil real GDP growth3 | 1.2 | 0.1 | 2.7 | 1.6 | 0.8 | 2.2 | |||
| Overall fiscal balance (+ = improvement) | 15.5 | 10.0 | 8.8 | 10.4 | 9.2 | 11.6 | |||
| Fiscal policy5 | |||||||||
| Government expenditure | –2.7 | –0.1 | –3.1 | –5.6 | 2.8 | –4.7 | |||
| Current | –1.7 | 0.2 | –2.5 | –11.7 | 1.8 | –1.1 | |||
| Development6 | –1.0 | –0.3 | –0.6 | –0.9 | 1.0 | –3.4 | |||
| Non-oil revenue7 | –1.4 | 1.7 | –2.2 | –1.7 | –0.9 | –1.2 | |||
| Total government gross debt | –0.1 | –12.7 | –6.7 | –12.0 | –16.3 | –2.7 | |||
Change vis-à-vis 1997.
The improvement in Qatar reflects higher export volume of liquefied natural gas and crude oil.
Percentage points; excluding oil, natural gas, and refineries.
The sharp deceleration in growth in Qatar reflects the completion of several projects.
Negative sign = decline; positive sign = increase.
Including net lending.
Excluding government investment income.
Change vis-à-vis 1999.
GCC Countries: Actual Impact of Recent Oil Price Changes on Selected Indicators
(In percentage points of GDP, unless otherwise indicated)
| United Arab | |||||||||
|---|---|---|---|---|---|---|---|---|---|
| Bahrain | Kuwait | Oman | Qatar | Saudi Arabia | Emirates | ||||
| Oil price decline, 1998; change in:1 | |||||||||
| Crude oil exports | –3.0 | –11.4 | –10.3 | 7.1 | –10.0 | –7.9 | |||
| Total imports (in percent) | –13.2 | –0.4 | 12.2 | –3.1 | 4.2 | –4.7 | |||
| Current account balance (− = deterioration)2 | –12.0 | –17.8 | –20.6 | 4.9 | –9.2 | –8.7 | |||
| Non-oil real GDP growth3,4 | 0.7 | –1.0 | –3.9 | –12.3 | –2.7 | –4.2 | |||
| Overall fiscal balance (− = deterioration) | –0.6 | –17.8 | –9.9 | –1.4 | –6.4 | –9.2 | |||
| Fiscal policy5 | |||||||||
| Government expenditure | 0.8 | 1.7 | 3.2 | –0.8 | –1.0 | 6.2 | |||
| Current | 0.9 | 1.9 | 2.5 | –0.5 | 1.0 | 3.7 | |||
| Development6 | –0.1 | –0.3 | 0.7 | –0.2 | –2.0 | 2.5 | |||
| Non-oil revenue7 | 1.2 | 0.4 | 2.0 | 0.2 | 3.8 | 1.4 | |||
| Total government gross debt | 5.6 | 5.9 | 7.3 | 7.3 | 25.0 | 2.2 | |||
| Oil price increase, 2000; change in:8 | |||||||||
| Crude oil exports | 4.3 | 12.9 | 9.7 | 4.4 | 9.7 | 6.1 | |||
| Total imports (in percent) | 25.7 | –3.8 | 6.9 | 7.6 | 7.8 | 9.4 | |||
| Current account balance (+ = improvement) | 6.5 | 23.7 | 15.7 | 15.5 | 7.3 | 15.0 | |||
| Non-oil real GDP growth3 | 1.2 | 0.1 | 2.7 | 1.6 | 0.8 | 2.2 | |||
| Overall fiscal balance (+ = improvement) | 15.5 | 10.0 | 8.8 | 10.4 | 9.2 | 11.6 | |||
| Fiscal policy5 | |||||||||
| Government expenditure | –2.7 | –0.1 | –3.1 | –5.6 | 2.8 | –4.7 | |||
| Current | –1.7 | 0.2 | –2.5 | –11.7 | 1.8 | –1.1 | |||
| Development6 | –1.0 | –0.3 | –0.6 | –0.9 | 1.0 | –3.4 | |||
| Non-oil revenue7 | –1.4 | 1.7 | –2.2 | –1.7 | –0.9 | –1.2 | |||
| Total government gross debt | –0.1 | –12.7 | –6.7 | –12.0 | –16.3 | –2.7 | |||
Change vis-à-vis 1997.
The improvement in Qatar reflects higher export volume of liquefied natural gas and crude oil.
Percentage points; excluding oil, natural gas, and refineries.
The sharp deceleration in growth in Qatar reflects the completion of several projects.
Negative sign = decline; positive sign = increase.
Including net lending.
Excluding government investment income.
Change vis-à-vis 1999.
Potential Benefits from a Monetary Union
A monetary union among GCC countries can serve as a catalyst for stronger integration and deepening of financial markets if the introduction of a common currency is accompanied by the full liberalization of financial markets across its members.2
Integration of Money Markets
A single currency can foster the integration of interbank money markets across GCC countries, but at the same time, it is also a precondition for effectively conducting a common monetary policy. Since monetary policy is set at a regional level, and the liquidity is managed for the region as a whole, money markets need to redistribute the liquidity within the region in a way that leads to a common short-term yield curve. Cross-border arbitrage ensures that monetary stimuli are felt by the entire banking system. Establishing an efficient, fully integrated payment system is key to facilitating cross-border payments and the integration of money markets. The necessary harmonization of monetary policy instruments, and complete move to market-based instruments, can also contribute to money market development. At present, monetary policy instruments in GCC countries are not all market-based and often not designed in a way that is conducive to the development of money and securities markets (Table 4.2). For example, Oman applies ceilings on personal loans lending rates (set at 11 percent in early 2003), and Kuwait on all types of loans—though rates are frequently revised. The United Arab Emirates operates mostly through the issuance of central bank certificates of deposit at the initiative of banks. Since these certificates can be sold back to the central bank any time at a very low penalty, interbank activities have been discouraged.
GCC Countries: Monetary Policy Instruments
Traditional credit ceilings have been eliminated. The remaining ceilings have regulatory purposes with the aim of financial sector stability.
GCC Countries: Monetary Policy Instruments
| Bahrain | Kuwait | Oman | Qatar | Saudi Arabia | United Arab Emirates | |
|---|---|---|---|---|---|---|
| Direct instruments | ||||||
| Interest rate controls | None. | Yes. Ceilings on all lending rates tied to discount rate. For loans of up to one year the rate is 250 basis points above the discount rate; and for loans exceeding one year, 400 basis points above. | Yes. Interest rate ceiling on personal loans (11 percent). | None. Long-term rates for small projects are subsidized. | None. Long-term rates are subsidized. | None. Mortgage rates are subsidized. |
| Directed loans | Development/specialized banks direct credit to specific sectors. | None. | Development bank directs credit to specific sectors. Long-term rates are subsidized. | Development bank directs credit to specific sectors. | Public credit institutions direct credit to specific sectors. | Government credit to specific sectors. |
| Credit ceilings and others1 | None. | None. | Maximum of personal loans set at 40 percent of total bank lending. Maximum of 5 percent of bank’s net worth for any nonresident individual borrower in foreign currency. Maximum of 30 percent of bank’s net worth for all loans to nonresidents in foreign currency. | Bank credit to any one country should not exceed 20 percent of the bank’s capital and reserves. Banks are not allowed to lend more than 20 percent of the total value of a real estate project. | None. | None. |
| Indirect instruments | ||||||
| Reserve requirements | Yes, unremunerated; 5 percent on dinar deposits. | Yes, unremunerated; reserve ratio based on maturity. | Yes, unremunerated; 5 percent on domestic and foreign currency deposits. | Yes, unremunerated; cash reserves of 2.75 percent of total deposits (including foreign deposits). | Yes, unremunerated; 7 percent on demand deposits and 2 percent on time deposits. | Yes, unremunerated; 1 percent on time deposits and 14 percent on current deposits. |
| Open market operations | Repos with treasury bills; foreign exchange swaps. | Liquidity scheme; foreign exchange swaps; deposit operations. | Repos. Foreign exchange swaps. | Periodic repo operations and deposit facility (Qatar monetary rate mechanism). | Repos are most important instrument. Foreign exchange swaps. | Foreign exchange swaps. Repos/reverse repos to be developed. |
| Central bank paper | No. | No. | Yes. | No. | No. | Yes. |
| Memorandum item: | ||||||
| Primary market sales of government securities through central bank | Yes, treasury bills and development bonds. | Yes, treasury bills and government bonds. | Yes, treasury bills and developments bonds. | Yes, treasury bills and government bonds. | Yes, treasury bills and government bonds. | No, federal and local governments have not issued securities. |
Traditional credit ceilings have been eliminated. The remaining ceilings have regulatory purposes with the aim of financial sector stability.
GCC Countries: Monetary Policy Instruments
| Bahrain | Kuwait | Oman | Qatar | Saudi Arabia | United Arab Emirates | |
|---|---|---|---|---|---|---|
| Direct instruments | ||||||
| Interest rate controls | None. | Yes. Ceilings on all lending rates tied to discount rate. For loans of up to one year the rate is 250 basis points above the discount rate; and for loans exceeding one year, 400 basis points above. | Yes. Interest rate ceiling on personal loans (11 percent). | None. Long-term rates for small projects are subsidized. | None. Long-term rates are subsidized. | None. Mortgage rates are subsidized. |
| Directed loans | Development/specialized banks direct credit to specific sectors. | None. | Development bank directs credit to specific sectors. Long-term rates are subsidized. | Development bank directs credit to specific sectors. | Public credit institutions direct credit to specific sectors. | Government credit to specific sectors. |
| Credit ceilings and others1 | None. | None. | Maximum of personal loans set at 40 percent of total bank lending. Maximum of 5 percent of bank’s net worth for any nonresident individual borrower in foreign currency. Maximum of 30 percent of bank’s net worth for all loans to nonresidents in foreign currency. | Bank credit to any one country should not exceed 20 percent of the bank’s capital and reserves. Banks are not allowed to lend more than 20 percent of the total value of a real estate project. | None. | None. |
| Indirect instruments | ||||||
| Reserve requirements | Yes, unremunerated; 5 percent on dinar deposits. | Yes, unremunerated; reserve ratio based on maturity. | Yes, unremunerated; 5 percent on domestic and foreign currency deposits. | Yes, unremunerated; cash reserves of 2.75 percent of total deposits (including foreign deposits). | Yes, unremunerated; 7 percent on demand deposits and 2 percent on time deposits. | Yes, unremunerated; 1 percent on time deposits and 14 percent on current deposits. |
| Open market operations | Repos with treasury bills; foreign exchange swaps. | Liquidity scheme; foreign exchange swaps; deposit operations. | Repos. Foreign exchange swaps. | Periodic repo operations and deposit facility (Qatar monetary rate mechanism). | Repos are most important instrument. Foreign exchange swaps. | Foreign exchange swaps. Repos/reverse repos to be developed. |
| Central bank paper | No. | No. | Yes. | No. | No. | Yes. |
| Memorandum item: | ||||||
| Primary market sales of government securities through central bank | Yes, treasury bills and development bonds. | Yes, treasury bills and government bonds. | Yes, treasury bills and developments bonds. | Yes, treasury bills and government bonds. | Yes, treasury bills and government bonds. | No, federal and local governments have not issued securities. |
Traditional credit ceilings have been eliminated. The remaining ceilings have regulatory purposes with the aim of financial sector stability.
Integration of Bond and Equity Markets
A monetary union for the GCC countries could also contribute to the integration and development of the region’s bond and equity markets, which would be beneficial for the financing of economic growth and investment and mobilization of savings. At present, government debt is issued in all GCC countries, except the United Arab Emirates, but secondary market turnover is minimal. In addition, the tradable stock of government debt within the region is relatively low (less than 20 percent of GDP), and banks tend to hold securities up to maturity given their excess liquidity and the still limited choice of alternative domestic (regional) investment instruments. Each GCC country has a stock exchange as the trading platform for equities, government securities, and corporate bonds. However, capitalization of most GCC countries’ equity markets is still relatively low and turnover minimal.3 Supervision and regulation of capital markets also exhibit weaknesses that authorities have only just begun to address. With the exception of Oman, the other GCC countries had until recently very restrictive rules for foreign investors in their stock markets. Qatar still does not allow nonnationals to buy stocks and securities (except for two listed companies), while in some other GCC countries, foreigners can invest only through open-ended mutual funds.
Measures conducive to market development and integration that should accompany a monetary union include harmonizing national taxes, legislation,4 and accounting rules related to the holding and trading of securities, while putting in place integrated securities settlement systems. The latter are important to ensure that trades are secure and can be carried out at low transaction costs within the region. Economies of scale could be captured by linking or consolidating stock exchanges, in particular given the limited size of each national market; such a trend can also be observed internationally. Experience with the EMU shows that the introduction of the euro has fostered the integration and development of deeper and more liquid Euro-bond and equity markets, but it has not eliminated all barriers to market integration. The sources for the remaining market fragmentation are differences in tax, accounting, and legal frameworks, and lack of fully integrated clearing and settlement systems. Deficiencies in all those aspects together with the small size of the markets have kept bond and equity markets in the ECCU and CFA zones fragmented and undeveloped.
Integration of the Banking System
Whether a monetary union can contribute to stimulating cross-border banking operations depends foremost on the degree to which the region’s banking systems will be liberalized, and legislative, regulatory, and supervisory frameworks harmonized. The banking systems in the GCC countries are already well developed and capitalized, as well as profitable, and have become a major factor in diversifying the production base in some countries, particularly in Bahrain (Table 4.3). Most GCC countries have, however, refrained from licensing any new banks since the early 1980s. Moreover, the role of foreign banks is somewhat limited and confined to the smaller GCC members, where about half of the credit institutions are foreign owned, but account for a smaller percent of banks’ assets, except in Bahrain.5 Only a few local banks have established branches in other GCC countries—though they have branches in other countries in the region and in Asia.6
GCC Countries: Selected Financial Sector Indicators1
Latest available information.
Does not cover the loans of two Islamic banks.
GCC Countries: Selected Financial Sector Indicators1
| United Arab | ||||||||
|---|---|---|---|---|---|---|---|---|
| Bahrain | Kuwait | Oman | Qatar | Saudi Arabia | Emirates | |||
| Total number of banks | 22 | 10 | 17 | 15 | 11 | 46 | ||
| Public banks | 2 (specialized banks). | Government owns minority shares in several banks. | 2 (specialized banks). | 1 | 0 | 0 | ||
| Mixed-capital banks | 5 | 8 | 1 (government owns part of one national bank). | 1 | 1 (government owns 40 percent). | 5 | ||
| Private domestic banks | 2 | 1 | 4 | 6 | 9 (7 joint ventures with foreign banks). | 15 | ||
| Foreign banks | 13 | 1 | 9 | 7 | 1 (branch of a GCC bank). | 26 | ||
| Other credit institutions | 0 | 0 | 1 specialized private bank. | 0 | 4 specialized credit institutions. | 0 | ||
| Asset quality | ||||||||
| Nonperforming loan ratio | 13.1 percent2 | 5.2 percent | 11.3 percent | 10.7 percent | 9.6 percent | 11.2 percent | ||
| Credit to the public sector/total credit | 20 percent | 45 percent | 12 percent | 38 percent | 30 percent | 10 percent | ||
| Credit to the private sector/total credit | 80 percent | 55 percent | 88 percent | 62 percent | 70 percent | 90 percent | ||
| Of which: personal credit | 36 percent | 18 percent | 35 percent | 33 percent | 22 percent | 25 percent (includes “for business purposes”). | ||
| Earnings and profitability | ||||||||
| Return on assets | 1.6 percent | 2 percent | 0.1 percent | 2 percent | 1.8 percent | 1.7 percent | ||
| Return on equity | 12 percent | 18 percent | 1.2 percent | 17.1 percent | 30.8 percent | 14.6 percent | ||
| Liquidity | ||||||||
| Loans to deposit ratio | 63 percent | 68 percent | 82.1 percent | 80 percent | 69 percent | 92 percent | ||
| Domestic government securities | ||||||||
| Held by local banks (in percent of GDP) | … | … | 6.2 percent | 11.3 percent (1999). | 17.3 percent | No government securities issued. | ||
| Stock market | ||||||||
| Capitalization (in billions of U.S.dollars) | 6.6 | 18.9 | 3.6 | 5.3 | 74.0 | 13.5 | ||
| Number of companies listed | 42 | 91 | 45 (regular market). | 22 | 76 | 12 (in Dubai); 15 (in Abu Dhabi). | ||
| Deposit insurance | Implicit. | Implicit. | Explicit (established in 1995). | Implicit. | Implicit. | Implicit. | ||
Latest available information.
Does not cover the loans of two Islamic banks.
GCC Countries: Selected Financial Sector Indicators1
| United Arab | ||||||||
|---|---|---|---|---|---|---|---|---|
| Bahrain | Kuwait | Oman | Qatar | Saudi Arabia | Emirates | |||
| Total number of banks | 22 | 10 | 17 | 15 | 11 | 46 | ||
| Public banks | 2 (specialized banks). | Government owns minority shares in several banks. | 2 (specialized banks). | 1 | 0 | 0 | ||
| Mixed-capital banks | 5 | 8 | 1 (government owns part of one national bank). | 1 | 1 (government owns 40 percent). | 5 | ||
| Private domestic banks | 2 | 1 | 4 | 6 | 9 (7 joint ventures with foreign banks). | 15 | ||
| Foreign banks | 13 | 1 | 9 | 7 | 1 (branch of a GCC bank). | 26 | ||
| Other credit institutions | 0 | 0 | 1 specialized private bank. | 0 | 4 specialized credit institutions. | 0 | ||
| Asset quality | ||||||||
| Nonperforming loan ratio | 13.1 percent2 | 5.2 percent | 11.3 percent | 10.7 percent | 9.6 percent | 11.2 percent | ||
| Credit to the public sector/total credit | 20 percent | 45 percent | 12 percent | 38 percent | 30 percent | 10 percent | ||
| Credit to the private sector/total credit | 80 percent | 55 percent | 88 percent | 62 percent | 70 percent | 90 percent | ||
| Of which: personal credit | 36 percent | 18 percent | 35 percent | 33 percent | 22 percent | 25 percent (includes “for business purposes”). | ||
| Earnings and profitability | ||||||||
| Return on assets | 1.6 percent | 2 percent | 0.1 percent | 2 percent | 1.8 percent | 1.7 percent | ||
| Return on equity | 12 percent | 18 percent | 1.2 percent | 17.1 percent | 30.8 percent | 14.6 percent | ||
| Liquidity | ||||||||
| Loans to deposit ratio | 63 percent | 68 percent | 82.1 percent | 80 percent | 69 percent | 92 percent | ||
| Domestic government securities | ||||||||
| Held by local banks (in percent of GDP) | … | … | 6.2 percent | 11.3 percent (1999). | 17.3 percent | No government securities issued. | ||
| Stock market | ||||||||
| Capitalization (in billions of U.S.dollars) | 6.6 | 18.9 | 3.6 | 5.3 | 74.0 | 13.5 | ||
| Number of companies listed | 42 | 91 | 45 (regular market). | 22 | 76 | 12 (in Dubai); 15 (in Abu Dhabi). | ||
| Deposit insurance | Implicit. | Implicit. | Explicit (established in 1995). | Implicit. | Implicit. | Implicit. | ||
Latest available information.
Does not cover the loans of two Islamic banks.
In a GCC monetary union, some consolidation of the banking systems might take place. The potential impact of a monetary union on the growth of bank loans and the type or structure of banking activities is, however, indirect. Whether overall lending increases is mostly a question of economic growth and new investment opportunities in the region. Greater competition for borrowers is more likely to have an effect on credit conditions than on the overall lending level. Diversifying the credit portfolio could be beneficial for banks’ risk management since in several GCC countries bank credit is concentrated in consumer loans. The overall development and integration of financial markets could affect the type of bank operations.7
Potential Costs of a Monetary Union
Having operated under a pegged exchange rate regime and liberal capital flows, the GCC countries have de facto refrained from using national monetary and exchange rate policies for more than two decades. Nevertheless, since in the long term, the importance of oil production is likely to diverge among the GCC countries, relinquishing these policies could be costlier in the long run. Thus, a higher degree of domestic labor flexibility and flexible fiscal policies would then be needed to facilitate adjustments to external shocks. Moreover, an important cost factor or risk for a monetary union could arise from negative externalities from the lack of fiscal prudence in one or more member countries. As a result, negative spillover effects could spread from one member country to the entire membership, with the potential need of the union’s central bank to raise interest rates particularly in the case of an exchange rate peg of the common currency. A key challenge is therefore to set up rules, penalties, and institutional procedures to prevent major macroeconomic imbalances and lack of fiscal discipline in the monetary union. Rigorous macroeconomic policymaking would not only be an outcome of a monetary union but is an essential condition for its functioning (see Section V for more details).
Cost of Institutional Changes
Replacing the existing national currencies by a common currency involves changeover costs. One-time costs are related, for example, to the conversion of accounts and means of book-money payments (checks, transfer forms, cards), price lists and catalogues, adjustment of cashiers and automats, and educating the public about the new currency—the introduction of the euro is estimated to have cost about 0.5 percent of the euro area GDP.
Creating a new monetary institution initially also requires additional resources. There is room for overall savings if central bank functions are organized more efficiently, and duplication of functions at the national and regional level is avoided.8 While a monetary union requires a centralized decision-making body for the entire region, other key functions can be allocated at either the national or regional level. As discussed in Section V, practical and political considerations, including cost efficiency considerations, suggest that national central banks could maintain the functions of implementing regular monetary policy and foreign exchange operations, supervising banks, and collecting data. A common GCC central bank or supranational monetary authority would then be in charge of policy decision making, communicating the policy with the public, consolidating financial data at the regional level, and coordinating issues of regional importance. Overseeing and operating the payment systems could either be done at the centralized or decentralized level. Other potential costs for members of a GCC currency union could result from potentially lower central bank profits and negative spillovers from a financial crisis. However, both can be limited by appropriate institutional arrangements.
Credit Policies
Retaining national credit policies in a monetary union could impede the effectiveness of monetary policy for the region as a whole as well as the development and integration of securities markets. The importance of credit policies varies among GCC countries. These policies generally aim at stimulating investment in certain sectors, and they are also a tool for the authorities to distribute the proceeds from the oil wealth to its residents. The governments in GCC countries, directly or through specialized credit institutions or development banks, provide soft long-term funding or grants for investment projects, including housing.
The government’s involvement in credit allocation and funding has two side effects that create negative externalities for other monetary union members. First, the credit channel is disrupted, since the favored sectors are far less responsive to interest rate changes. This limits the effectiveness of monetary policy for the union. Interest rate changes will be felt and transmitted more strongly to the real economy in countries where the government’s involvement in credit allocation and funding plays a smaller role. And second, the government’s involvement in credit allocation and funding discourages other forms of long-term financing, such as the issuance of securities and the development of securities markets, thus reducing a potential benefit for monetary union. In essence, GCC countries have to decide whether they want to create a level playing field among their economies with the objective of fostering competition and integration by liberalizing credit policies, or they are willing to tolerate distortions created by subsidized (long-term) interest rates with the negative implications for monetary policy effectiveness and overall capital market development.
For a survey of the optimum currency area literature see, for example, Masson and Taylor (1993). Attempts to estimate the benefits and costs for monetary unions have been made by, among others, De Grauwe and Vanhaverbeke (1991), Bayoumi and Eichengreen (1994), Mélitz and Weber (1996), Rose (2000), and Persson (2001).
While there have been numerous theoretical and empirical studies on the effects of monetary unions on the real economy, the impact on financial integration has hardly been discussed other than under the scenario of a common market. The European Central Bank (ECB), however, has conducted a detailed assessment of the impact of the euro on money, bonds, and equity markets. See ECB (2001a, 2001b, and 2001c); and Santillán, Bayle, and Thygesen (2000).
Except the stock market of Saudi Arabia, which with a market capitalization of more than 40 percent of GDP, is by far the largest in the region and Arab world.
For example, limits on foreign ownership of stocks, either by law or under the companies’ articles of association.
In addition to the onshore markets, Bahrain has developed into an offshore banking center with close to 50 offshore banks.
Two U.A.E. banks have branches in Bahrain, Oman, and Qatar, and one bank has branches in Bahrain and Kuwait. One Omani bank has a branch in the United Arab Emirates and recently bought an existing bank in Bahrain.
In the euro area, some changes in the structure of the banking system have taken place since the introduction of a single currency. The trend toward consolidation has been mostly among domestic banks. Despite the intention of some large European banks to merge, national political interests have prevented a stronger cross-border consolidation. Banking systems in the other monetary unions continue to be not well integrated even after the introduction of a common currency a long time ago.
The costs for operating the European Central Bank, measured as expenditure for staff, administration, and depreciation of fixed assets, amounted to 0.0025 percent of GDP on average for 1999 and 2000. At the same time, most national central banks of the European System of Central Banks have begun to streamline their organization and reduce the number of staff.