Establishing Conversion Values for New Currency Unions: Method and Application to the planned Gulf Cooperation Council (GCC) Currency Union
  • 1 https://isni.org/isni/0000000404811396, International Monetary Fund

Contributor Notes

A key issue in creating a new currency union is setting the rates to convert national currencies into the new union currency. Planned unions in the Gulf region and Africa are seeking methods to set the conversion rates when their new currencies are created. We propose a forward-looking econometric methodology to determine conversion rates by calculating the degree of misalignment in the real exchange rate, and apply it to the GCC currency union. For each GCC currency, we identify the year at which the economy is the closest to its internal and external equilibrium, and then estimate the degree of misalignment in the bilateral real exchange rate vis-à-vis the U.S. dollar based on WEO forecasts until 2013. Application of the methodology to other regions is also considered.

Abstract

A key issue in creating a new currency union is setting the rates to convert national currencies into the new union currency. Planned unions in the Gulf region and Africa are seeking methods to set the conversion rates when their new currencies are created. We propose a forward-looking econometric methodology to determine conversion rates by calculating the degree of misalignment in the real exchange rate, and apply it to the GCC currency union. For each GCC currency, we identify the year at which the economy is the closest to its internal and external equilibrium, and then estimate the degree of misalignment in the bilateral real exchange rate vis-à-vis the U.S. dollar based on WEO forecasts until 2013. Application of the methodology to other regions is also considered.

A. Introduction

1. In creating a new currency union, a key issue is setting the rates to convert national currencies into the new union currency. The review of the related literature reveals a wide gap on this issue, and we were unable to find any clear methodology for determining the conversion rates.

2. The experience of the European Monetary Union (EMU) presents one model but a priori it is unclear how much guidance it can provide to other regions. In essence, the system was based on decades’ long experimentation with the European Currency Unit (ECU) that allowed market forces (operating with certain bounds and with occasional resettings of individual rates) to affect the evolution of exchange rates, leading up to the euro.

3. The notion of a country’s equilibrium exchange rate as guidance for setting the conversion rate into the euro was introduced by the European Central Bank (ECB) in the Exchange Rate Mechanism II (ERM II) for new entrants to the euro area, once it was formed. The ERM II system requires countries to hold their currencies for at least two years within specified bands around a central parity vis-à-vis the euro. It also requires that the central rate chosen should reflect the best possible assessment of the equilibrium exchange rate at the time of entry into the mechanism. This assessment should be based on a broad range of economic indicators and developments (ECB, 2003).

4. Identifying the equilibrium exchange rate at the conversion date is therefore essential. If an exchange rate is misaligned (overvalued or undervalued) at the time of the conversion into the union currency, it will be frozen at that misalignment leading to economic distortions across the union members. An undervalued entry would give rise to a higher competitiveness for the country in comparison with its partners in the currency union, and will require a higher than average inflation rate throughout the union to reduce the misalignment. An overvalued entry could involve significant costs in terms of unemployment and bankruptcies (Wren-Lewis, 2003). Therefore, the fair assessment of the misalignment for all members of the union is crucial.

5. This paper developed from an informal request to one of the authors by a member of the Gulf Cooperation Council (GCC) Secretariat for guidance on how to set the conversion values for the new GCC currency. He subsequently requested such advice from the IMF. This Working Paper describes one method that could be used for the conversion.

6. At first glance, the question may appear irrelevant for the GCC. As an explicit step to prepare for the union, in 2001 the GCC countries pegged their currencies to the U.S. dollar, which is widely used for commerce and for asset-holding in the region. This created a fixed relationship between the GCC currencies. Over time, the fixed relationships could allow the pricing structures in the economies to adjust to each other with virtually no exchange rate risk.

7. This effect has certainly occurred to some extent, but two issues were unresolved – whether the U.S. dollar monetary policy adopted as a result of the peg was appropriate for the region, and how to deal with inflation differentials between countries that change the real exchange rates between the GCC currencies. Both these issues became major concerns in the region. By late 2007, there was widespread concern that the dollar peg was contributing to overheating of the economies and causing large capital losses because of the dollar’s weakness in exchange markets. Numerous proposals for change were made, such as switching to a basket or announcing a large appreciation (20-30 percent) of the GCC currencies against the dollar. At the same time, rapid inflation in Qatar and the United Arab Emirates (UAE) affected their real exchange rates vis-à-vis the other GCC countries. The new union would need to address such issues and their possible effect on the conversion of national currencies into the new union currency,2 as is done in this paper.

8. Using forecasted data, we present a comprehensive approach to determine the conversion rate, taking into account the notion of exchange rate equilibrium. The methodology has an advantage of providing policy makers seeking currency union with a framework to help identify the required exchange rate adjustments in the future. This forward-looking aspect of the approach is an important value added to the literature on currency unions.

9. The methodology consists of three steps:

  • The first step aims at identifying the year in which the economy was closest to its internal and external equilibrium. For that, we use the real exchange rate equilibrium approach that links the exchange rate to its long term fundamentals. The lowest deviation from equilibrium (the lowest misalignment) in the recent years is an indication of the equilibrium year.

  • The second step addresses the issue of estimating the real exchange rate equilibrium and misalignment of each currency vis-à-vis the prospective anchor currency for the union, or vis-à-vis the real effective exchange rate if the anchor is a basket of currencies or if the objective is for the new currency to float freely. We use forecasted values of the real exchange rate and its fundamentals to allow for forward looking perspectives.

  • The final step consists in normalizing the equilibrium exchange rate we obtained in step two to have a value of zero in the year of equilibrium identified in step one. The forecasted real exchange rate misalignment calculated in step two will serve as a measure of the necessary nominal exchange rate (NER) adjustment for the conversion rate.

10. These methods can be used to determine if the existing exchange rate configuration between the GCC currencies is robust or should be changed. This paper seeks to provide authorities a methodology that they should rigorously apply (alongside other methodologies and with full use of information available within the region) to help set the conversion rates for the future union.

11. The paper also examines the possible application of the method to other prospective currency unions.3 In this regard, we presented our method during a workshop, The Establishment of Regional Monetary Unions, at the European Central Bank (January 26-28, 2009), which was attended by representatives of the GCC and three planned currency unions in Africa. Participants representing all unions expressed interest in using our method to examine if it can provide guidance on setting conversion rates in their union situations.

12. The rest of the paper is organized as follows: the following section explains the problem and reviews the example of the Euro area. Section “C” explains the details of the methodology and section “D” presents the results of the application to the GCC countries. Section “E” explores the extension of the methodology to other currency unions and section “F” concludes. Section “G” includes a series of appendices covering special topics in more detail.

B. Background

The Problem

13. The creation of a currency union involves the creation of a new currency for the union that becomes the legal currency for all member countries. All preexisting national currencies are absorbed into the new union currency. With a single currency for all member countries there will be only one monetary policy and only one exchange rate for the union.

14. A critical step in the process is converting the individual national currencies into the new union currency. A conversion rate must be set to redeem the national currencies for the union currency and to redenominate all values expressed in the old national currencies into the value of the union currency.

  • Redemption of national currencies for the union currency involves turning in the national currency at banks or other exchange stations in exchange for the new union currency. A rate of exchange must be agreed that applies to all residents. For example, (in an union of countries known for their trees) citizens of Alder turn in 2 of their Alder dollars to receive one unit on the union currency; whereas citizens of Banyan pay 3 Banyan dinars to receive one unit. The conversion rates are thus; Alder: 2 to 1, and Banyan: 3 to 1.

  • Redenomination of currency values must also occur at the same rate. Alder must redenominate all Alder dollar values used on boxes of cereal, contracts, deeds, wage agreements, tax schedules, securities, and so on into the new union currency, using the 2 to 1 rate. Banyan must do the same using a rate of 3 to 1.

  • The rate for each currency must be set and must apply to all relevant transactions. It should be set by law so that all parties involved know the value they are receiving in exchange for the value they are giving up.

15. It matters what conversion rates are used.

  • The rate should be set so that the conversion itself does not create gains or losses in value for any party involved. For example, the relative value of domestic versus cross-border investments prior to the conversion should not change post conversion.

  • The conversion establishes relative prices of goods and services between member countries of the union, which affects competitiveness. For example, a shirt valued originally at 20 Alder dollars would be valued at 10 units of the union currency, the price at which a consumer in Banyan could buy it. However, if the conversion value for Alder was set at a lower value of 2.5 to 1, the same shirt would then be valued at 8 units, making it cheaper for Banyan to purchase. This directly affects the competitiveness of goods and services between the two economies.4

  • The conversion rate affects the relative wealth of the economies and estimates of the size of the economies. Suppose, for example, that at conversion rates of 2 to 1 and 3 to 1 two citizens of Alder and Banyan, respectively, find that they have equal net worths in the union. But if the rate for Alder is 2.5 to 1, the citizen of Alder discovers he is 20 percent less wealthy than the fellow in Banyan. Applied to macroeconomic statistics, the conversion rate will determine whether Alder and Banyan are estimated to have the same size GDP or GDPs that are 20 percent different. Applied to financial accounting, the conversion rates similarly affect the value of consolidated cross border investments. Another important area affected is the value of government debt converted into the new union currency. The list can be extended to numerous other important issues, such as the sustainability of external debt positions.

  • Finally, the conversion rates should not create shocks between the member economies of the union. Countries within unions will have long-standing cross-border trade and investment relationships. They are adjusted to a certain configuration of exchange rates – if a conversion rate is set out of line with the configuration it could unfairly advantage or disadvantage countries, and trade and investment relations for the entire union could be affected.

16. Thus, it can be seen that it may matter a great deal what conversion rates are used. A method needs to be found that is methodologically robust and can deliver estimates of conversion values that all parties involved find equitable. Serious imbalances can result if the rate is not set in line with economic fundamentals.

The European Example

17. This section reviews the process for setting the conversion rates for national currencies into the euro. This occurred in two phases – in 1999, an initial eleven countries joined the Euro area and irrevocably linked the value of their currencies to the euro; five more countries that later adopted the euro followed a revised step of procedures comprising the Exchange Rate Mechanism II, or ERM II.

18. The process of setting the conversion values for the euro was long and convoluted, with successes and failures. The process began in 1975 by creating a unit of value (the European Unit of Account, or EUA) to handle official cross-currency business for what would later become the European Union. Even from its earliest phases, the EUA acted to establish a configuration of exchange values between the participating currencies that was roughly fixed. In 1979, the European Monetary System (EMS) was created to strengthen monetary and exchange rate stability and enhance economic cooperation. It introduced the European Currency Unit (ECU) to replace the EUA. Each participating currency fluctuated based on market conditions in a narrow band around the central parity value of the ECU, which was a weighted average of the currencies. 5 Ultimately, in 1999, the ECU evolved into the euro, with each currency being irrevocably converted into euros using conversion rates derived from the ERM system. In total, 24 years of preparations occurred before national currencies were converted into euros. Over that long period, rates of exchange between the European currencies, although subject to numerous shifts in value and evolving policy regimes, were deeply integrated into the macroeconomic and financial situations of the European countries.

19. The ERM had a rocky history, with some notable failures, but the 1991 Maastricht Treaty to set up the European Monetary Union adopted the ECU and the ERM structure as the basis for setting the value of the euro and conversion of national currencies into the euro. The ratio of the value of the individual national currencies to the euro was defined as the “irrevocable conversion rates” that had to be used for all transactions between national currencies and the euro.

20. Countries that joined the Euro area later used an abbreviated version of the ERM called ERM II in which they set bands around a central parity vis-à-vis the euro. The central rate chosen had to reflect the best possible assessment of the equilibrium exchange rate at the time of entry into the mechanism (ECB, 2003). Countries had to remain within their bands for at least two years to be eligible to adopt the euro, but the system also provided for specific procedures to formally review the exchange rates, if needed.6

21. Horváth and Komárek (2006) estimated the real exchange rate equilibrium for the new EU members and concluded that the misalignment for their currencies compared to the central parity vis-à-vis the euro is low and does not require any adjustment, at the time of their research. They also recommend adjusting the central parity only if the real exchange rate misalignment exceeds 10%.

22. Future unions may choose to follow the European model of using a precursor unit of account such as the ECU. For example, a currency unit called the ECO has been considered in West Africa. Appendix 1Setting the rates for conversion into the euro – describes the European approach in more detail for planned unions that may wish to follow that approach.

The Gulf Cooperation Council

23. The Gulf Cooperation Council consists of six Arab countries along the Arabian Gulf comprising Saudi Arabia and smaller countries along the coast – Kuwait, Bahrain, Qatar, the United Arab Emirates, and Oman. The countries share many historical and cultural ties and hope to develop more diversified intra-union trade over time. There has been an urge for greater union since the 1980’s. Plans were made in 2000 to set up a monetary union and work towards it has gradually proceeded. In 2002, the states agreed to peg each of their currencies to the U.S. dollar as a step towards creating a common currency.

  • The choice of the dollar peg reflects heavy earnings of dollars because of exports of oil and natural gas, which are denominated in dollars. The dollar peg sets the external value of each currency against the dollar, which also establishes the bilateral exchange rates between each of the member currencies. The external peg and the heavy reliance on the dollar have meant that the region has imported U.S. monetary policy. For example, interest rates in national currencies closely parallel movements in U.S. interest rates. This has led to complaints in the past that U.S. monetary policy is not appropriate for the region, especially around 2006 and 2007 when some local economies were overheating, but dollar-based interest rates remained low.

  • Rapid price increases in Qatar and the UAE, with fixed nominal exchange rates, caused rapid appreciation of their real exchange rates against the other GCC currencies in 2007 and 2008.

  • In June 2007, Kuwait formally depegged from the dollar and announced that it would peg its exchange rate to a basket of currencies. This potentially complicates the conversion of the GCC currencies to a new union currency. For example, the Kuwaiti dinar depreciated rather sharply against the dollar in early 2009, which affected the bilateral rates of the dinar against the other GCC currencies.

  • Oman in December 2006 and UAE in May 2009 announced that they had decided to not enter the GCC currency union for the time being.7 Therefore, we focus our analysis on the four remaining candidates for the currency union; Bahrain, Kuwait, Qatar, and Saudi Arabia.

  • We believe that our methodology could be a useful tool to guide Oman and UAE on the appropriate rate of conversion of their respective currencies if they decide to join the GCC currency union at a later date. 8

  • As a result of following the U.S. policy lead, local mechanisms for monetary and exchange policy research and policy development are weak and monetary policy instruments are underdeveloped..

24. The GCC has now agreed that a Monetary Council will be set up in Riyadh to make arrangements for the planned currency union. One task of the Council will be to set the rates for conversion of national currencies into the new currency. This paper is intended to contribute to that effort.

African Unions

25. There are three active currency unions in Africa and several regions are moving actively to create currency unions. Building of currency unions in Africa is likely to be one of the most important transforming trends in African development and institution building during the next decade.

26. There are three existing arrangements;

  • CEMAC (Economic and Monetary Community of Central African) – An union using the African Financial Community (CFA) franc comprised of six mostly francophone countries in Central Africa. (Members include Equatorial Guinea, Central African Republic, Chad, Republic of Congo, Cameroun, and Gabon.) 9 The CFA is pegged to the euro, and many administrative arrangements are through the French Treasury.

  • CMA (Common Monetary Area) - An arrangement between South Africa, Lesotho, Namibia, and Swaziland in which the national currencies are at par with the South African rand and can circulate freely. Monetary policy and arrangements are dominated by the South African Reserve Bank.

  • WAEMU (West African Economic and Monetary Union) - WAEMU comprises eight francophone countries in West Africa (Benin, Burkina Faso, Cote d’Ivoire, Mali, Niger, Senegal, Togo, and Guinea-Bissau). It also uses the CFA franc, under arrangements similar to CEMAC. Because the CEMAC and WAEMU currencies are both linked to the euro with the same exchange rate, and with convertibility guaranteed by the French Treasury, the two unions are often considered to comprise a single currency zone.

27. There are several active programs to build new unions.

  • East African Community (EAC) – Five countries in East Africa are actively working to build a currency union. Tanzania, Uganda, Kenya, Rwanda, and Burundi currently have their own currencies and will face the issue of setting conversion rates.

  • Southern African Development Community (SADC) – This group is working to create a currency union by 2016. It will absorb the CMA and may ultimately include about 15 countries (CMA plus Angola, Botswana, Democratic Republic of Congo, Madagascar, Malawi, Mauritius, Mozambique, Seychelles, Tanzania, Zambia, and Zimbabwe.)10 The countries within the CMA will have adjusted to a common currency value, but the conversion rates for the other currencies will need to be set.

  • West African Monetary Zone (WAMZ) – Five mostly Anglophone countries in West Africa are now accelerating their push for a currency union. Gambia, Ghana, Guinea, Nigeria, and Sierra Leone have not established pegs to each other. They are considering setting up a virtual currency similar to the ECU, called the ECO, which would allow the national currencies to adjust to a common value. However, there is also interest in exploring other methods to set the conversion rates to the union currency, including the method discussed in this paper.

  • ECOWAS (Economic Organization of West African States) – This is a West African regional organization that encompasses both the WAEMU and WAMZ regions. It is considering merging the regions into a single currency union. Methods to set the conversion rates are relevant for this region.

C. Methodology to Set Conversion Values11

28. The convergence rate should reflect the best possible assessment of the equilibrium exchange rate at the time of entry into the mechanism. This assessment should be based on a broad range of economic indicators and developments (ECB, 2003).

29. If the exchange rate is misaligned at the time of the conversion (overvalued or undervalued) it would be frozen at that misalignment leading to economic distortions across the members. As the date of the conversion is an event that will occur in the future, the assessment of the misalignment should have a forward-looking perspective based on forecasted data.

30. Our proposed methodology to set the conversion values for currency unions consists of three main steps: (1) Identifying the year the economy is at equilibrium to serve as a guide for the initial appropriate exchange rate level, (2) measuring the real exchange rate (RER) yearly deviation from equilibrium (RER misalignments) using forecasted values, (3) adjusting the initial exchange rate in step one by the rate of misalignment in step two to estimate the conversion value in any prospective year.

Step One – Identifying periods of equilibrium

31. In order to set a conversion value for a currency, either in the context of a multilateral monetary union or bilateral peg to a single currency, the authorities need first to determine the most recent year(s) in which the economy has been the closest to an equilibrium level. By equilibrium, we mean both external equilibrium or balance of payments equilibrium and low exchange rate volatility, and internal equilibrium where the economy is growing at sustainable rate, inflation is under control, and the budget deficit and debt levels are at acceptable standards.

32. Several methodologies exist to assess exchange rate equilibrium and misalignment; each having its pros and cons:

  • One common approach is to analyze the macroeconomic indicators of each country and judge the year(s) in which the economy seems closest to both internal and external equilibrium, taking into consideration any potential lagged effect of any internal or external shocks. The application of this judgmental approach to the GCC countries is available in Appendix 2. The advantage of this judgmental method is that it is easy to implement and does not require any econometric expertise. The disadvantage is that it is not precise as the indicators might diverge from each other without pointing to a certain year. It is also prone to criticism as it depends on the analyst’s subjective judgment.

  • Another approach is the CGER methodology for exchange rate assessment developed by the IMF as part of its core mandate to promote the stability of the international monetary system12. The CGER methodology supports Article IV analysis of countries while fostering cross-country consistency (Appendix 3 taken from Abiad et al (2009), briefly describes the three methods used in the CGER). Based on the use of multi-country panel data, the CGER approach is designed to be easy for IMF staff economists to apply to countries under investigation, but it might not be ideal to tackle the issue under investigation in our paper. As recognized by its authors13, assessments of exchange rate misalignment will always need to be informed by country specific factors that are difficult to incorporate into studies based on large cross-country datasets. Moreover, for the particular case of oil exporting countries, the application of the CGER methodology is a difficult exercise14 and often can yield a wide range of results (Appendix 4 presents results from CGER assessments of the exchange rate alignment of the GCC countries during several recent years). This is in part due to the importance of intertemporal aspects (as the real exchange rate may affect the optimal/equitable rate of transformation of finite resource wealth into financial assets), as well as risk considerations given the relatively high volatility of commodity prices. (Enders, 2009)

33. In order to be able to identify with precision the years of equilibrium and the years in which the exchange rate is misaligned, we need a robust and reliable econometric technique that reflects the best the specificity of each economy. Therefore, we use the equilibrium real effective exchange rate (REER) approach, applied to each country separately.

34. Since our aim is to determine the conversion rate within prospective currency unions, we use the long-term fundamental values of the determinants of the REER behavior to identify its level of equilibrium and its yearly misalignment (deviation from equilibrium). This methodology due to Clark and MacDonald (1998) is widely used in the REER literature.15

35. The year at which the REER is the closest to its fundamental equilibrium (the lowest misalignment level) will be considered as the equilibrium year. This approach should be applied to each country individually using the most reliable data, preferably coming from the same database to avoid discrepancies. In our analysis of the GCC, we will have a separate equilibrium equation for each country based on the specific determinants of the behavior of its REER. This requires applying time series cointegration techniques, such as Engle and Granger (1987) two step error correction models (which is what we apply in this paper), or also Johansen cointegration and VAR analysis approaches16, depending on data availability.17 Using panel data techniques is unadvisable as the resultant coefficients usually point to the similarity of the impact of the REER determinants across the panel, which masks the specificity of each individual country that we are seeking to capture in order to identify the appropriate equilibrium year for each country.

36. The determinants of the REER behavior commonly used in the literature are the terms of trade (TOT), productivity (PROD), government consumption to GDP (GCON), capital flows to GDP (CAPF), the degree of openness of the economy (OPEN), the budget balance to GDP (BUDG), and the money supply to GDP (LIQ). Other variables could be included in the equation to test for the significance of their impact on the REER behavior on a case-by-case basis. Also, different proxies for each of the determinants could be tested alternatively to identify the most appropriate for each country. In cases where proxies have nearly identical impacts, it is advisable to keep in the model the proxies that witness significance in the majority of the countries under investigation. For a detailed explanation of the calculations and the expected impacts of each variable, refer to Appendix 5.

Measuring the Misalignment: Why the Choice of the Real Exchange Rate Matters

Misalignment is defined as a deviation from a certain level of RER equilibrium. The multilateral REER misalignment identifies the period (year) in which the overall economy is closest to internal and external equilibrium, in comparison with its trading partners, and will inform about any deviation from that level of equilibrium in any other year. When the misalignment is equal or close to zero, the economy is at equilibrium, and if the misalignment points to an overvaluation (undervaluation), a devaluation (revaluation) is necessary to correct the rate for conversion to the union currency at the conversion date.

If the new currency were to float or to be pegged to a basket of currencies, the measured REER misalignment would be a good indicator for the required adjustment in the conversion rate. The use of forecasted data for the REER could inform about the misalignment in the future at the date when the union is to take place.

However, if the new currency is to be pegged to a single currency, the REER misalignment might not give a precise measure of the required adjustment. Equilibrium vis-à-vis the anchor currency might take place in a different year and the misalignment might be of different magnitude.*

Instead, the use of the bilateral RER equilibrium gives an indication of the misalignment vis-à-vis a single trading partner. Thus, the RER equilibrium alone is not sufficient to identify the period (year) in which the economy is closest to its overall internal and external equilibrium.

In our methodology, we consider that the conversion rate is optimal when the economy is at its internal and external equilibrium. Therefore, using the REER approach is essential as a first step to determine the equilibrium year. In the second step, if the conversion is to be set vis-à-vis an anchor currency, the US dollar for example, the misalignment should be seen as the deviation from a bilateral RER at the date of the entry. A separate forward looking estimation of the RER misalignment is then required to calculate the conversion rate.

The third step consists of using the identified equilibrium year in step one to normalize the misalignment calculated in step two. The deviation of the bilateral RER after this equilibrium year will be an indication of the required adjustment in the conversion rate.

Therefore, the choice between the RER and REER misalignment has to be made case by case depending on the prospective exchange rate regime decided for the new currency.

* For example, consider the case of a country pegging to the US$ with two equal trading partners, USA and the EMU at 50% each. If the REER is misaligned by 30% in 2008, does it follow that the peg to the US$ should be devalued by 30%? But what would be the case if the national currency is not misaligned vis-à-vis the US$? For example, the US$ could be overvalued vis-à-vis the euro. We don’t think there is a need to devalue vis-à-vis the US dollar in this case as this might create even more economic distortions.
The Econometric Approach

37. The application of the cointegration technique requires some preliminary statistical analysis of the data to test if the dependent and independent variables are non-stationary (the presence of unit roots). We use the standard Augmented Dickey Fuller or ADF (1979) and Phillips-Perron (1988) tests in order to determine the order of integration of the individual data series.18 All variables should be nonstationary at the level, and stationary at the first difference; i.e. integrated of order one, I(1).19 Next, we estimate the long-run relationship, which requires a test for the cointegration of the variables, either by the Engle and Granger (1987), or by the Johansen methodology. The Johansen procedure assumes the definition and the estimation of a well-specified full system of equations, which makes estimations more difficult. Moreover, in applying that technique, we are limited by the size of our sample. As pointed out by Baffes, Elbadawi, and O’Connell (1997), evidence suggests that the Johansen procedure deteriorates dramatically in small samples, generating estimates with “fat tails”.

38. Therefore, we proceed to the first step in the Engle-Granger cointegration method, which is applying Ordinary Least Squares (OLS) to a static regression relating the levels of the real exchange rate and the variables that determine its behavior.

39. We assume that the long-run static relationship provided by theory is a linear composition of the logarithmic transformations of the variables (V) chosen:

lnEt=c+β1*lnVt1+β2*lnVt2++βN*lnVtN+εt(1)

where E is the real exchange rate, β are the coefficients that we are looking to estimate, V are the N independent variables, c is a constant, and ε is an i.i.d., mean-zero, stationary random variable (the residual). Bearing in mind our small sample20 and the consequent insufficiency of degrees of freedom, we test subsequently several proxies of openness and capital flows.

40. To finalize this first step of the cointegration test, we shall test the residual (ε) from the regression of equation (1) for stationarity. If the residual term is stationary, then we could conclude that our variables are cointegrated.

41. The last step estimates a dynamic version of our model in order to verify the short-run effects of our variables on the RER. The traditional ECM form is as follows:

ΔlnEt=b+α*εt1+γ1*ΔlnVt1+γ2*ΔlnVt2++γN*ΔlnVtN+ut(2)

Where α is the error correction term21, εt-1 is the residual from regression (1), calculated as the difference between the actual and the fitted values of the real exchange rate, and ut is a mean-zero, stationary random variable.

42. Using our model, we proceed to construct indexes of REER equilibrium (REERE) and REER misalignment (REERMIS), using the following approach:22

  • Assume that the real exchange rate at any time t is given by loget=α^+β^Ft, where F stands for the fundamentals and the corresponding parameters are the estimated regression coefficients;

  • Using time series decomposition (e.g. Hodrick-Prescott procedure23) decompose the

  • fundamentals into permanent (F˜) and transitory (FF˜) components;

  • Construct the equilibrium REER: loge˜t=α¯+β^F˜t, where β^ are the coefficients estimated in the long-run regression and α¯ is the intercept that reflects the specificity of each country, only when significant;

  • The REER misalignment is given by reermis(t) = (logetloge˜t). 100%, where positive (negative) values indicate REER overvaluation (undervaluation).

43. Finally, the year at which the misalignment is the lowest, meaning that the REER is the closest to equilibrium, will be considered the equilibrium year at which the exchange rate could be used as the initial conversion rate. The evolution of the fundamentals after this year should determine the deviation of the conversion rate, from this initial level, requiring therefore further adjustment at the date of the establishment of the common currency.

Step Two – Measuring real exchange rate misalignments

44. The conversion to the new union currency is a prospective event that will occur in the future. Thus, the methodology relies on forecasted data for all the variables and proxies in the models. Depending on the expected exchange rate regime of the currency union, we could either use the bilateral RER if the objective is to peg to a single currency, or to use the REER of the aggregated economic partners of the members of the union if the objective is to peg to a basket of currencies.

45. In the case of the GCC currency union, odds are high that the new currency will be pegged to the US dollar at least for the first year of its launch. Therefore, we use the bilateral RER vis-à-vis the US dollar expressed as a logarithm. Ratios are constructed using their respective US equivalents. For example, government consumption to GDP in Qatar is divided by government consumption to GDP in the US. The ratios are expressed as logarithms. This is the case for the series GCON, PROD, TOT, and OPEN. When the series contain negative data, the US series is subtracted from the national one and the ratio is not expressed as logarithm. This is the case for the series BUDG, TKF, NKF, and CAPF. The variables used are listed in Table 1 and discussions of each variable are in Appendix 5.

Table 1:

RER behavior determinants

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46. We use the forecasts provided in the WEO database as they are available for all the countries for the coming five years in a harmonized fashion.

47. The steps we follow to determine the equilibrium and misalignment of the RER are the same as those used in step one to determine the equilibrium and the misalignment of the REER as explained above. We start with the unit root tests of the newly constructed variables and proxies and we integrate the I(1) variables in a long-run model. We check for the validity of the model using the adjusted R square and the Durbin-Watson statistics. We test for the stationarity of the residual and we then include it lagged in our dynamic model where all the variables are I(0). We make sure the error correction coefficient is significant, negative, and between 0 and 1. We calculate the equilibrium RER and its misalignment, as explained above.

Step Three – Adjustments to conversion rates

48. The last step consists of determining the deviation of the exchange rate from its initial rate that we identified in points one and two, using the macroeconomic indicators or/and the REER equilibrium. We normalize the equilibrium bilateral RER to equal zero at the predetermined equilibrium year, and we add to it the misalignment to get the required percentage of adjustment for each year following the initial established rate. For example, if the REER was at equilibrium in year 1996, and the misalignment in year 2010 is +27% (i.e., overvalued by 27%), 23% in 2011, and 17% in 2012, the exchange rate needs to be devalued by 27% if the currency union takes place in 2010, by 23% if the currency union takes place in 2011, and by 17% if the common currency in established in 2012.

49. The methodology has the advantage of providing policy makers seeking currency union with a framework to help identify the required adjustments in the future. This forward looking aspect of the approach is an important value added to the literature on the currency unions. It is therefore highly recommended that the authorities regularly update the forecasted conversion rates using the most updated statistics forecasts, for example, using the semi-annual WEO updates. This would also allow the authorities to expand the forward looking horizon.

D. Application to the GCC Countries

50. As explained above, it is crucial to determine with precision the year in which the economy has been closest to internal and external equilibrium in the recent years. We are seeking to identify a recent period of noninflationary economic growth – internal equilibrium – and sustainable capital flows. Because of the structural changes in the GCC during the last decade, the equilibrium year to use as a benchmark should be fairly recent.

51. The concept of “sustainability” has to be put into perspective due to the unique features of the GCC economies. They are oil exporting countries with a fixed exchange rate regime against the US dollar. Such a situation generally means on the internal side that maintaining an independent monetary policy is challenging and on the external side that a current account surplus is reflected mostly in increases in foreign reserves that reduce the potential impact on the real exchange rate.

Background: Approach of Kamar and Ben Naceur

52. In a previous study, Kamar and Ben Naceur (2007) reviewed the success of convergence of the GCC countries by taking independent actions in preparation for the union. They used a panel analysis of variables possibly related to behavior of real exchange rates to identify common determinants of inflation differentials, which provided information on real exchange rate convergence given the common currency peg to the U.S. dollar. They identified a set of five significant variables and found increased convergence in their real exchange rate indices. The period of high convergence coincided with apparent domestic and external equilibrium around the 2003 or 2004 period. They concluded that this provided an important prerequisite for the planned union.

53. Their study however did not focus on the level of the equilibrium real exchange rate, but only used it as a benchmark for calculating the apparent misalignment of the individual currencies and whether the degree of misalignment narrowed over time. They showed that overall misalignments declined by 50 percent over the 1991 – 2005 period, with the most extreme initial misalignment (between Saudi Arabia and the UAE) decreasing by about three-quarters by 2005.25

54. This study extends the earlier results to update the analysis to more recent periods, when inflationary bursts (most strongly in Qatar) might have affected the results, and to move from the panel analysis to more rigorously examine conditions in individual countries in order to pin down periods of internal and external equilibrium and the degree of misalignment. Increased misalignment of a currency could provide a basis for adjusting its bilateral relationship against the exchange rates of the other GCC currencies. The following pages present the analysis of the conditions in the individual countries.

Step One: The REER equilibrium approach to determine the equilibrium year

55. The methodology to determine the equilibrium year that will serve as a base for calculating the required adjustment in the nominal exchange rate relies on the identification of the lowest misalignment in the REER in comparison to its equilibrium values. The equilibrium is calculated using the permanent components of the fundamental determinants of the REER behavior as explained in the methodology section.

56. We use the Engle and Granger (1987) cointegration to identify the fundamental determinants of the REER behavior that we will use to calculate the equilibrium. We applied all the necessary unit root tests to confirm that all the variables we incorporate in our models are I(1). The results are available in Appendix 6.

57. Next, we started incorporating the theoretical determinants of the REER behavior one by one first, and we kept in the model the most statistically significant variables, and for which the R2 and the DW statistics were the most appropriate. We then included one by one the other theoretical determinants of the REER behavior, and again kept those most statistically significant, and for which the R2 and the DW statistics were the most appropriate. This approach provided us with the best specification for our models. We tried several combinations of variables that all provided coherent economic explanations of the REER behavior and also presented acceptable statistics values. The final model for each country is a representation of the long run relation between the REER and its determinants26.

58. We then tested the stationarity of the residual27 we obtained from our long run model and incorporated it lagged in the error correction model where all the other variables are also stationary (I(0)). For the cointegration to hold, the lagged residual in this dynamic model should be significant and of negative sign, and its absolute value should be between 0 and 1. Appendix 7 presents the results that verify this prerequisite.

59. The model we retained for each country (Table 2) shows that the REER behavior in all countries is affected by almost the same determinants, with the same expected signs in almost all cases, yet with different magnitudes.

Table 2:

OLS Estimations of the long-run determinants of the REER

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Note: Data in brackets indicate the t-Student.***, ** and * denote a significance of the coefficient at the 1%, 5% and 10% levelsThe ADF test in the last row refers to the t-statistic of the residual series from each regression. t-satistics are compared to the McKinnon critical values table (1991).

60. The main determinants are the terms of trade, the foreign reserves, the broad money, the trade openness, the net capital flows, the government consumption and in the case of Qatar - the US nominal effective exchange rate.

61. TOT has a positive significant effect on REER in all countries except Bahrain. The positive sign is in line with the theoretical explanation provided in Appendix 5. The non-significance of TOT in the case of Bahrain could be explained by the fact that oil exports represent a minor component of its total exports, so oil prices do not play such an important role as in the other five GCC countries.

62. The RES variable is also positive and significant in all cases except for Qatar. An increase of the reserves in the context of a fixed exchange rate regime can lead to the increase of money supply in the absence of sterilization, leading to higher inflation and translating into REER appreciation. We controlled for money supply by including LIQ in our models and it seems that it captured this effect in the case of Qatar, but not in the cases of the other GCC countries. For example, LIQ still has a positive significant effect in the case of Bahrain, with the presence of RES in the equation. On another hand, LIQ has a significant and negative effect in the case of Saudi Arabia, which contradicts our theoretical intuition. Broad Money/GDP has been relatively stable in Saudi Arabia during the period under investigation, while the REER was depreciating due to a very low inflation. We might consider that in this particular case the Saudi Arabian authorities relied on sterilization to offset the impact of the increase in reserve on money supply and inflation, while achieving their nominal exchange rate peg objective.

63. Trade Openness proxied by imports to GDP has a significant positive impact on the REER in Kuwait and Qatar, and no impact in the cases of Bahrain and Saudi Arabia. As explained in Appendix 5, trade openness can lead to an improvement in trade balance and an appreciation of the REER (Egert, 2003) as we see in Kuwait and Qatar. We also included in our tests the USNEER variable to capture the implication of the peg to the US dollar on inflation. An appreciation of the US dollar vis-à-vis the rest of the world’s currencies would lead to a similar appreciation of the GCC currencies and of their REER. We couldn’t include the USNEER variable in all our models as it is highly correlated with the REER28, except in the case of Qatar where the correlation was sufficiently low (0.60). As expected, USNEER has a positive impact on REER in both countries and is very important for the stability of the long-run cointegration. We also included NKF to control for capital flows and we obtained significant and expected positive results in Bahrain, and Saudi Arabia, and nonsignificant coefficients in Kuwait and Qatar.

64. Government Consumption shows negative impact on REER, which is an indication of the dominance of tradable goods in both public and private spending. In addition to these variables, we used tailor-made dummies that fit the specificity of each country, especially when dealing with the first Gulf war. The dummy for Bahrain takes the value of zero in all years except 1991 and 1992 where it takes a value of 1, and it has a negative sign. The dummy for Saudi Arabia also has a negative sign but it has a value of 1 in 1990, 1991 and 1992. For Kuwait, the country that was the most exposed to the shock, the dummy takes a value of 1 in 1990 and -1 in 1992, reflecting the capital flight in 1990 right before and during the Iraqi attack, and a return of the capital after the end of the crisis. These dummies are important for fine-tuning the coefficients in the equation in order to get the most robust estimation of the REER equilibrium.

65. Once we finalized the estimations of the long-run relations, we applied the HP filter to separate the transitory components of these determinants and used the permanent components to recalculate the REER using the coefficients in our equation to obtain the so-called equilibrium REER. The difference between the REER and the equilibrium REER is the REER misalignment shown in Figure 1.

Figure 1:
Figure 1:

REER Misalignment

Citation: IMF Working Papers 2009, 184; 10.5089/9781451873313.001.A001

Authors’ calculation

66. Figure 1 shows that the years 1997 to 2006 are those where the misalignment is relatively low. Since we are looking for the most recent year, we will consider 2003 as being the equilibrium year for Saudi Arabia and Kuwait, 2005 for Qatar, and 2006 for Bahrain. These results are consistent with what we found in our macroeconomic analysis; yet more precise. When calculating the adjustment required for each currency in the final stage of our paper, we will use these years as the equilibrium ones.

67. The observation of Figure 1 also highlights the fact that the misalignments declined significantly over the period. This is an indication of overall convergence and more harmonization and policy coordination between the GCC countries, as observed by Kamar and Ben Naceur (2007).

Step Two: The bilateral RER misalignment between each GCC currency and the US dollar forecasted until 2013

68. In this step, we apply the same methodology we already used to calculate the REER misalignments, but with some adjustments. The bilateral RERs use the CPI from the WEO from 1970 to 2013, with the assumption that the nominal exchange rates vis-à-vis the US dollar will remain fixed at their 2008 values. When using bilateral RER, all variables we incorporate in our model should be calculated in relation to their equivalent in the USA.

69. Figure 2 suggests that the GCC countries’ RERs witnessed a sharp appreciation after the first oil shock in the second half of the 1970s, followed by a gradual depreciation during the 1980s and 1990s. After a period of relative stability, RERs started appreciating again since 2005/2006, especially for Qatar. The forecasted RERs from 2008 onward point towards a clear divergence, with Bahrain and Saudi Arabia showing minor RER appreciation, while the expected appreciation in Kuwait, and Qatar is 27.5%, and 60.1% respectively in comparison with their 2005 values.

Figure 2:
Figure 2:

The Bilateral Real Exchange Rates

Citation: IMF Working Papers 2009, 184; 10.5089/9781451873313.001.A001

Authors’ calculation based on WEO data, September 2008.

70. In this case, using the simple inflation differential adjustment to correct the nominal exchange rate parities could be misleading since inflation could result from the behavior of the economic fundamentals, which might not necessarily require any nominal exchange rate adjustment. Therefore, the assessment of the misalignment based on a derived RER equilibrium using the economic forecasted values of the economic fundamentals could be more accurate. To calculate the misalignment, we apply the same econometric approach used to assess the REER equilibrium in the previous section.

71. The results of the unit root tests are available in Appendix 8. Again, all the variables we use in our models are I(1). The long run relations between the RERs and their respective determinants are available in Table 3, and the error-correction model is available in Appendix 9.

Table 3:

OLS Estimations of the long-run determinants of the RER

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Note: the ADF test refers to the t-statistic of the residual series from each regression.t-Student are in brackets.***, ** and * denote a significance of the coefficient at the 1%, 5% and 10% levels

72. The main determinants are the trade openness, the foreign reserves, the terms of trade, the government consumption, the net capital flows, and the euro/dollar exchange rate.

73. OPEN has a positive significant effect on REER in all countries. Calvo and Drazen (1998) showed that trade liberalization of uncertain duration could lead to an upward jump in consumption and, hence, real appreciation. The positive sign we obtain for all countries would thus reflect an upward jump in consumption including nontradables through within-period optimization (Edwards, 1989).

74. TOT has the expected positive sign in Kuwait and Qatar. The non-significance of TOT in the case of Bahrain could be explained by the fact that oil exports represent a minor component of its total exports, so oil prices do not play such an important role as in the other five GCC countries. Saudi Arabia could be a different case. Since Saudi Arabia does not invest its oil surplus abroad through sovereign wealth funds like Kuwait, an increase in oil revenue will translate into an increase in reserves and net foreign assets, because of the peg to the US dollar. The authorities therefore might decide to sterilize the impact of the increase in reserves on money supply and inflation, by reducing their net domestic assets.

75. The RES variable is also positive and significant in all cases except in Saudi Arabia, possibly for the same reasons as above. An increase of reserves in the context of a fixed exchange rate regime can lead to increase of money supply in the absence of sterilization, causing higher inflation and translating into RER appreciation.

76. We also included NKF to control for capital flows and we obtained the expected positive results in Saudi Arabia and non significant coefficients in the other three countries. Still, the magnitude of the coefficients is relatively small (0.05) in comparison with the other determinants.

77. Government consumption shows negative impact on RER in the cases of Qatar and Saudi Arabia, which is an indication of the dominance of tradable goods in both public and private spending. On another hand, GCON has a positive sign in Bahrain, which is an indication of a dominance of nontradables in government consumption.

78. We also included in our tests the EURUSD variable to capture the implication of the peg to the US dollar on imported inflation. EURUSD has a positive impact on RER in Kuwait and Qatar. An appreciation of the US dollar vis-à-vis the Euro (the currency of a major trading partner) would lead to a similar appreciation of the GCC currencies and of their RER.

79. In addition to these variables, we used tailor-made dummies that fit the specificity of each country, especially when dealing with the first Gulf war. The dummies take zero values in all years with the exception of a specific year(s) where they take value 1. The dummies for Bahrain and Saudi Arabia have a negative sign and take the value of one in 1991 and 1992. For Kuwait, the dummies take values of 1 in 1990 (positive), in 1991 and in 1992 (both negative). Qatar was a special case where a dummy for years 2002 to 2005 is unavoidable for the stability of the equation.

80. We followed the same procedure as explained above to calculate the RER equilibrium for each country, using the permanent values of the fundamentals. We then calculated the misalignment presented in Figure 3 as the difference between the calculated RER and the equilibrium RER.

Figure 3:
Figure 3:

RER Misalignment

Citation: IMF Working Papers 2009, 184; 10.5089/9781451873313.001.A001

Step Three: Identifying the new conversion rates

81. The last step consists in normalizing the misalignment obtained in step 2 to have a value of zero in the equilibrium year we identified in step 1, for each country. Given the forward-looking nature of our approach, our methodology can inform the policy makers on how much the adjustment of their respective nominal exchange rate should be in order to eliminate the misalignment.

82. The results for the GCC countries are presented in Table 4. As can be seen, if hypothetically the GCC decides to establish the new currency in its original planned date, 2010, Saudi Arabia would need to revalue its currency by 2.94% vis-à-vis the US dollar, Kuwait by 5.15%, Qatar by 4.54%, and Bahrain by 1.09%. The methodology provides an estimate of the required adjustment for each currency if the conversion is to take place in 2011, 2012, or 2013.

Table 4:

The required percentage change in nominal exchange rates vis-à-vis the US dollar

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83. The results presented in Table 4 reflect a low rate of misalignment (the highest is 5.41% for Kuwait in 2010) in all countries in the different forecasted years. Given these low estimates of the degree of misalignment, the GCC authorities might choose to not modify their current parity vis-à-vis the U.S. dollar, nor the relative configuration of the GCC currencies.

84. Bolstering the case for not adjusting the configuration of currencies in cases of small misaligments, agents in the economy are highly sensitive to exchange rate variation, especially after a long period of strong peg. In addition, if information of possible adjustments filters to the market, the agents might undertake speculative attacks that might undermine the exchange rate adjustment and could harm the creation of the new currency.

E. Application to Other Currency Unions

85. The methodology applied to the GCC countries can potentially be used in other new unions or when countries seek to join existing unions. At the time of writing, this means mainly in Africa.

  • The method first determines the factors underlying the evolution of the real exchange rate for the countries. The process may be simpler in the GCC case because of the peg of the GCC currencies to the dollar, which makes real exchange rate changes a function of changes in inflation differentials against the United States, but in principle the method can be applied elsewhere.

  • The divergence and convergence trend of each currency against some benchmark can be estimated. This could be done vis-à-vis the largest economy in each prospective union.29

  • The panel approach used in Kamar and Ben Naceur (2007) permits estimating the convergence to an estimated long-run equilibrium real exchange rate.

  • In the GCC case, we could define a specific period of internal and external equilibrium. In other unions, such a period may not exist, and thus policy makers will only be able to establish an econometrically determined equilibrium. In either case, it is possible to define a conversion rate for the individual currencies.

  • The conversion rates should take into consideration changes in the real exchange rates at the time of actual conversion, or in the projected rates as we did for the GCC in this paper.

86. If the new currency is to float or to be pegged to a basket of currencies, the use of the REER misalignment would be more appropriate, as explained in Box 1. With this regard, alternative methodologies to assess exchange rates misalignment, mainly the CGER methodologies, could be useful and complementary to get more information on the macro-balance and external sustainability of the members to the union.

87. Some unions may create a virtual currency similar to the ECU with central rates set for each member country currency. The rates may differ in the degree to which they are market determined. The method proposed here remains applicable in such cases to determine if there are apparent imbalances requiring policy responses, to check if the central rate for a currency needs adjusting, and to help determine the final conversion rate into the new currency.

88. Each prospective union will face challenges to its credibility and the new union currency may be subject to speculative attacks. Information from this method can impart a view to the public that exchange rates are based on fundamentals, which may contribute to greater stability for the currencies.

89. In all regions, data issues will present challenges. Historical time series going back well before the planned start-up date for the union will be needed. For this reason, programs to compile the relevant statistics under common standards should begin in all potential member countries early in the process of developing the union. A centralized database is required to make use of the data to estimate the conversion factors.

90. Finally, decision makers should address the issue of manipulation of bilateral conversion rates just prior to setting up the union. The application of the method in this paper can provide independent information that may be relevant to help avoid possible manipulation.

91. The process described above requires some intense and sophisticated data collection, estimation, and analysis. Each prospective union needs to undertake such investigations, ideally starting well before the official beginning date of the currency union. In our view, the application of the method described here will make a positive contribution to the convergence and policy oversight process leading up to the union by providing a framework for policy research and analysis, and establishing requirements for statistics compilation. The information generated will provide key insights on the convergence process that can help evaluate the process of union building. One possibility is to apply different scenarios to the underlying parameters to reflect possible policy or exchange rate regime options.

92. We recommend regular publication of convergence reports as part of the union building process that can use information from this analysis.

F. Conclusions

93. The paper addresses a crucial issue for currency unions by providing a practical forward-looking methodology to determine the conversion rates for each of the members’ currencies, over a medium term horizon. We applied it to the GCC countries, but we believe that it can be extended to other planned unions.

  • The first step of the methodology identifies the year at which the economy is the closest to its internal and external equilibrium. It considers the period with the least deviation from equilibrium (the lowest misalignment) in the recent years as an indication of the equilibrium year. This requires measuring the real exchange rate equilibrium based on the long-term component of the macroeconomic fundamentals. We calculated the REER misalignment for each of the GCC currencies and identified the year 2003 as the equilibrium year for Kuwait and Saudi Arabia; 2005 for Qatar, and 2006 for Bahrain. The theoretical determinants of the REER equilibrium vary across countries and are summarized as the terms of trade, openness, foreign reserves, government consumption, net capital flows, broad money, and the U.S. nominal effective exchange rate.

  • The second step addresses the issue of calculating the real exchange rate equilibrium and misalignment of each currency vis-à-vis the prospective anchor currency for the union, or vis-à-vis the real effective exchange rate if the anchor is a basket of currencies or if the new currency will be freely floating. We used forecasted values of the real exchange rate vis-à-vis the U.S. dollar and its fundamentals to allow for forward-looking estimations. The determinants of each bilateral RER are government consumption, openness, terms of trade, foreign reserves, net capital flows, and the euro-dollar exchange rate.

  • The final step consists in normalizing the misalignment from the bilateral RER equilibrium equations we obtained in step two to have a value of zero in the year of equilibrium identified in step one. The forecasted real exchange rate misalignment calculated in step two serves as a measure of the necessary nominal exchange rate adjustment for the conversion rate in the coming years.

94. Our calculations suggest that only a small nominal exchange rate adjustment (less than 5%) is needed for the GCC currencies to establish the conversion at the closest level to equilibrium; moreover, the adjustment tends to decline from 2010 to 2013. We recommend that the GCC authorities rigorously apply our proposed method (alongside other methodologies and with full use of information available within the region) to test these results to help set the conversion rates for the future union.

95. In a broader perspective, we recommend a regular update of the forecasted misalignment using the bi-annual WEO publications, in order to monitor the conversion rate and make sure it is still the closest to the equilibrium value. It could also be useful to calculate the RER equilibrium and misalignment using forecasts from other databases, like the Economist Intelligence Unit database, or using the national agencies’ forecasts.

96. The methodology also allows for using different scenarios by creating forecasted variables that reflect different shocks. For the example of the GCC, one option would be to construct several terms of trade variables that would reflect different oil prices and use these variables to calculate the RER misalignment to see how the different currencies would deviate from the equilibrium, and calculate the required exchange rate adjustment if any of the scenarios is to occur.

97. Since the entire methodology and the macroeconomic analysis rely on the assumption that the data are accurate, the creation of a reliable and harmonized database for all variables is an essential step towards the creation of a currency union.

98. The methodology we propose can be used as a single tool to estimate conversion rates. However, whenever possible, policy makers should use it in conjunction with other methods such as the CGER, the macro-indicators judgmental analysis, surveys of purchasing power parity in prospective union members, or divergences in movements of consumer prices. In addition, we feel that it is advantageous (if schedules for setting up new unions permit) for planned unions to use an ECU-like virtual currency arrangement in which member countries establish a conversion grid so that the rates can be tested against market forces and the configuration of bilateral rates can be embedded into the national macroeconomic frameworks.

99. Finally, the methodology is applicable elsewhere. The multiple union-building efforts in Africa are potential users of the method, and the tests can apply to other regions too. Conditions will be different and perhaps more challenging and some interesting innovations to the method may result. We have great interest in seeing the directions and results of such work.

Establishing Conversion Values for New Currency Unions: Method and Application to the planned Gulf Cooperation Council (GCC) Currency Union
Author: Mr. Bassem M Kamar, Jean-Etienne Carlotti, and Mr. Russell C Krueger