Credit FAQ: Why GCC Pegged

Exchange Rate Regimes Will

Remain In Place
When oil prices fall sharply, investors often question the sustainability of exchange rate
arrangements in Gulf Cooperation Council (GCC) countries. The countries' exchange rate
pegs against the U.S. dollar--or in the case of Kuwait to an undisclosed currency basket
believed to be dominated by the U.S. dollar--are longstanding and have lent the GCC
monetary policy credibility over the decades. A key assumption that continues to underpin
our ratings on GCC sovereigns is that their pegged exchange rates are likely to remain in
place. Here, we respond to frequently asked questions by investors about the GCC's
pegged exchange rates.

Frequently Asked Questions

Can GCC sovereigns maintain their pegged exchange rates?
Yes, we believe so. We view all GCC sovereigns as having sufficient access to foreign
currency assets, or external financial support, to meet pressures on their exchange rates.

Rules of thumb for estimating "reserves adequacy" include reserves coverage of imports,
monetary aggregates, and short-term debt. To assess the capacity of GCC sovereigns to
defend their currencies and therefore for their exchange rate pegs to remain in place, we
have used relatively conservative measures. We look at reserve coverage of total current
account payments and the reserve coverage of broad money, M2, rather than the
monetary base M0 (see chart 1).

Chart 1

For the purpose of this article, we define reserves as gross central bank reserves plus our
estimates of government liquid external assets. We expect that GCC sovereigns would use
their liquid external assets to support their economies in times of financial distress,
including in defense of their currency pegs. For example, when several Arab countries
imposed a boycott on Qatar, outflows of nonresident funding from Qatari banks totaled $22
billion (14% of GDP) in 2017. However, an injection of $43 billion (27% of GDP) by the
government and its related entities--mostly the Qatar Investment Authority--more than
compensated for the outflows.

Two distinct groups emerge from our analysis of reserves adequacy. Kuwait shows clear
strength in terms of the availability of reserves to cover the monetary base and current
account payments over the next four years. Qatar, the United Arab Emirates (UAE), and
Saudi Arabia also show significant strength.

In the second tier, we have Bahrain and Oman, sovereigns that have a lower level of
government external liquid assets. One common assumption is that three months'
coverage of imports is adequate to protect against external shocks. Of the GCC
sovereigns, Bahrain has lower reserves adequacy than its peers, which we estimate at one
month's coverage of current account payments in 2020-2023 (a more conservative
measure than imports). The kingdom's coverage of broad money stands at 12% over the
same period. Oman is in a relatively stronger position with seven months' coverage of
current account payments and 59% coverage of broad money.

We do not view Bahrain, on its own, as having sufficient foreign currency resources to meet
potential pressures on its exchange rate. However, we expect the Bahraini peg to remain in
place because we continue to factor further GCC financial support to Bahrain should
financial pressures mount, on the exchange rate peg, or otherwise. Bahrain is currently
benefiting from a $10 billion financial support package pledged by Kuwait, Saudi Arabia,
and the UAE in October 2018. This amounts to about 5% of GDP in annual concessional
lending over the four years to 2022.

Importantly, in terms of reducing pressures on GCC exchange rate pegs, we expect oil
prices to recover in 2021, with Brent averaging $50 during the year, up from $30 in 2020
(see "S&P Global Ratings Cuts WTI And Brent Crude Oil Price Assumptions Amid
Continued Near-Term Pressure," published March 19, 2020, on RatingsDirect). This will
provide a key support to the economies and foreign reserves positions of GCC central
banks. The longer oil prices remain low, the higher the likelihood that pressure would
increase on GCC exchange rate pegs. However, for most of the GCC countries, our oil
price assumption for 2021 is below the IMF's respective fiscal breakeven oil price. This
suggests that fiscal pressures will not be completely alleviated in the region, particularly
with regard to Bahrain and Oman (see table 1). Under the same framework, external
pressures should be more muted across the GCC, with only Bahrain and Oman's IMF
external breakeven oil price above our assumption of $50.

In the worst case scenario, perhaps due to oil prices remaining lower for longer, pressures
could result in a forced devaluation of the currencies of lower-rated sovereigns such as
Bahrain or Oman. This could be, for instance, if they were to experience a significant drain
on their international reserves to maintain the status quo and external financial support was
not forthcoming. However, this scenario is not our base-case expectation.

Table 1

Breakeven Oil Prices For GCC Sovereigns

($/barrel) Fiscal Breakeven Oil Prices* External Breakeven Oil Prices§

2020F 2021F 2020F 2021F

Bahrain 96 84 81 74
Kuwait† 61 60 51 50
Oman 87 80 62 56
Qatar 40 37 38 40
Saudi Arabia 76 66 44 45
United Arab Emirates 69 61 32 26
*The oil price at which the fiscal balance is zero. §The oil price at which the current account balance is
zero. †Kuwait's fiscal breakeven oil price is before the compulsory 10% revenue transfer to the Future
Generations Fund including investment income. F--forecast. Source: IMF.

Why would higher-rated GCC sovereigns support lower-rated ones to defend

their pegs?
We see two main reasons: to prevent financial contagion and promote their foreign policy
interests. We believe that should the currencies of lower-rated Bahrain and Oman come
under significant pressure, higher-rated sovereigns would provide financial support to
prevent contagion to their own financial markets. We note the $10 billion each in project
funding pledged to Bahrain and Oman in 2011 by Kuwait, Qatar, Saudi Arabia, and the
UAE. We also note the more recent $10 billion in direct financial support pledged to
Bahrain in October 2018.

Another aspect of their support may be to advance their foreign policy interests in the
region. Our report "How Middle Eastern And African Sovereigns Benefit From Gulf
Financial Support," published Nov. 27, 2018, shows how GCC governments have
significant regional aid programs, which, like the aid provided by other governments around
the world, they can use as a foreign policy tool as well as a way of providing humanitarian
or financial aid. GCC financial support increasingly takes the form of deposits in central
banks and other forms of conditional concessional funding, while budgetary grants, the
most fungible form of aid, are becoming less prevalent.

Which GCC sovereigns would provide financial support to Oman?

The answer will likely depend on several factors including the extent of financial stress in
Oman and regional political considerations. Bahrain and Oman were pledged $10 billion
each in project funding by the other GCC sovereigns in 2011. In Oman's case, however,
we understand that disbursements were largely only realized from Kuwait. Oman's neutral
foreign policy stance potentially affects the propensity of its neighbors to provide it with
financial support. However, we believe that either in their own self-interest--to prevent
financial contagion--or to advance their own foreign policy agendas, one or several GCC
sovereigns would provide financial support to Oman in the case of financial distress (see
"How Oman Could Weather Tough Funding Conditions Ahead," published May 11, 2020).
We note the extremely high level of external liquid assets available for use by sovereigns in
the region should they deem it politically expedient (see "Government Liquid Assets And
Sovereign Ratings: Size Matters," published Aug. 27, 2018). Indeed, Oman itself has a
relatively strong balance sheet despite rapidly rising government debt in recent years,
reducing the likelihood that it will require near-term external financial support. We estimate
Oman's government liquid assets at just over 60% of GDP in 2020, albeit falling relatively
sharply to a still high level of 47% in 2023 (see "Oman," published April 18, 2020).
Are the GCC pegged exchange rate regimes supportive of sovereign ratings
in the region?
In our view, yes, they are. However, there is necessarily a trade-off against the benefits of
more flexible exchange rate regimes.

Fixed exchange rates have worked well for the GCC through various oil price peaks and
troughs. This reflects the reality that energy production (a dollarized industry) makes up a
sizable share of gross value added in the region. Given the dollar-based nature of their
economies, the pegs have provided a nominal anchor for inflation, supporting monetary
policy credibility by outsourcing it to the U.S. Federal Reserve. However, adopting U.S.
monetary policy can also bring challenges because at times interest rate settings may not
be supportive of nonoil output growth in the GCC. Moreover, economic theory suggests
that a flexible exchange rate allows a currency to act as a shock absorber during balance-
of-payments crises and increases monetary policy flexibility, via the interest rate channel.

A floating exchange rate can provide a shock absorber for small open economies facing
external shocks, by boosting exports and supporting domestic demand and output.
However, in our view, these effects are likely to be relatively muted for the GCC because,
in many cases, their nonhydrocarbon export base is small, limiting the benefits of a more
competitive exchange rate. Even the GCC economies with a more diversified export base,
such as Bahrain and the UAE, import most consumer, intermediary, capital goods, and
labor. The negative impact on import costs of a devaluation or depreciation of the
exchange rate is likely to more than offset any positive impact on nonhydrocarbon exports,
while the side effects of overvalued exchange rates (were oil prices to remain at current
levels indefinitely) appear to us to be manageable. We believe that the inflationary
pressures and social costs of a devaluation could increase domestic political pressures, an
outcome that GCC governments would want to avoid.

We note, however, that a currency devaluation would increase the local currency value of
U.S. dollar-priced oil- and gas-related revenues. This would improve government fiscal
balances as long as governments are able to contain their spending, which may not be so
easy given the inflationary aspects of such a devaluation.

Related Research
 How Oman Could Weather Tough Funding Conditions Ahead, May 11, 2020
 Oman, April 18, 2020
 S&P Global Ratings Cuts WTI And Brent Crude Oil Price Assumptions Amid
Continued Near-Term Pressure, March 19, 2020
 How Middle Eastern And African Sovereigns Benefit From Gulf Financial
Support, Nov. 27, 2018
 Government Liquid Assets And Sovereign Ratings: Size Matters, Aug. 27, 2018