The feasibility of currency union in Gulf Cooperation Council countries: A business cycle synchronisation view

• Author: Essahbi Essaadi
• Date: 01 October 2017
• DOI: http://doi.org/10.1111/twec.12490
• Published date: 01 October 2017

ORIGINAL ARTICLE

The feasibility of currency union in Gulf

Cooperation Council countries: A business cycle

synchronisation view

Essahbi Essaadi

1,2

1

SEPAL - University of Tunis, Tunis, Tunisia

2

Umm Al Qura University, Mecca, Saudi Arabia

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INTRODUCTION

Regional economic integration in the Gulf region has improved in the last two decades, and we

expect greater convergence in macroeconomic policy. This study empirically investigates the feasi-

bility of creating a currency union among Gulf Cooperation Council (GCC) countries (i.e., Bah-

rain, Kuwait, Oman, Qatar, Saudi Arabia and the United Arab Emirates [UAE]), following closer

monetary cooperation in recent years. One of the objectives of these countries is the establishment

of a common currency the khaleeji. The political and economic will to create this single currency

for all GCC countries is a subject of great interest. The similarities among these economics in

terms of both economic structure and their attachment to the US dollar provide an additional argu-

ment for this proposed union. In addition, GCC countries have since December 2000 adopted an

exchange-rate regime pegged to the US dollar—with the exception of Kuwait, which since May

2007 has repegged to an undisclosed weighted basket of international currencies. Indeed, these

countries “have successfully maintained pegs among themselves for two decades despite their fail-

ure to meet a number of important OCA [optimum currency area] criteria”(Willett, Al-Barw ani, &

El Hag, 2010, p. 1716). Furthermore, these countries’macroeconomic similarities have allowed for

considerable harmonisation in terms of inflation rates (see Figure A5 in Appendix B).

One of the main determinants of the success of a monetary union is whether the common mon-

etary policy set by a common central bank is suitable for all member countries. This suitability in

turn depends on the degree to which business cycles are synchronised across the countries

involved. “According to the classical OCA criteria, two countries or regions would benefit from

forming a monetary union if they are characterised by high similarity of business cycles”(Babets -

kii, 2005, p. 106). For this reason, we need to determine the degree of business cycle synchronisa-

tion among GCC countries.

In a monetary union, an independent counter-cyclical monetary policy cannot be tailored to sta-

bilise individual cyclical fluctuations. Since the seminal study by Mundell (1961), economics has

identified different criteria by which to assess the welfare effects of a monetary union; factors

mobility, wage and price flexibility, and similarity preferences among member countries need to

be considered. Business cycle synchronisation among member countries is one of the

DOI: 10.1111/twec.12490

World Econ. 2017;40:2153–2171. wileyonlinelibrary.com/journal/twec ©2017 John Wiley & Sons Ltd

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pre-conditions of a monetary union: indeed, the lower the level of business cycle synchronisation

among the countries looking to form a monetary union, the higher the costs of this union will be.

The endogenous approach with an OCA (Frankel & Rose, 1998) considers that a monetary union

affects the nature of domestic business cycles.

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The establishment of a currency union increases

trade intensity, and this in turn leads to an increase in output correlation—and thus to an increase

in business cycle synchronisation. The new economic geography stresses that trade integration

may increase country-level specialisation, leading to lower business cycle synchr onisation. Empiri-

cal studies dedicated to industrialised countries show that trade intensity increases business cycle

comovement among them (Clark & Van Wincoop, 2001). For emerging and developing countries,

research results are mixed (Calderon, Chong, & Stein, 2007). Differences in the patterns of special-

isation and bilateral trade are the main explanations for these results. While trade among industri-

alised countries is largely of an intra-industry nature, in developing countries, interindustry trade

tends to prevail. Consequently, the relationship between trade intensity and the alignment of busi-

ness cycles is positive in the former case, but negative in the latter.

The introduction of a single GCC currency began with the establishment of a Monetary Union

Committee in 2002; the underlying concept was born much earlier, however, with the GCC Char-

ter and the Economic Agreement in 1981. Low regional intracountry trade constrained the related

countries to postpone pursuance of this single currency until after the development of certain inte-

gration stages, including the Customs Union (launched in 2003) and the common market (2005).

However, GCC countries rely heavily on expatriate labour. A labour market that features a Kafil

(citizen guarantee) system creates a concentrations of foreigners in the private sector and citizens

in the public sector. Labour immobility is compensated with a high foreign labour percentage of

total employment (i.e., 55% in Bahrain and greater than 80% in Kuwait, UAE and Qatar). We can

conclude that the labour market criteria were satisfied (Willett et al., 2010). The integration process

seems to be very slow, but heading in the right direction. At the end of 2005, the GCC approved

the convergence criteria, to ensure financial and monetary stability. The monetary criteria include

inflation rates and sufficiency of foreign cash reserves, while the financial criteria include the ratio

of the annual government finance deficit to gross national product (GNP), as well as the ratio of

public debt to GNP.

The objective of this study was to assess the feasibility and desirability of creating a GCC

currency union, based on a framework of OCA theory. Since Mundell (1961) first introduced

the concept of the OCA, a vast body of literature has developed around it. Focusing on the rela-

tionships among potential OCA members, they examine the extent of trade, mobility of labour

and capital, the risk-sharing system and similarities in terms of shocks and cycles. Without deny-

ing the importance of the first three criteria, we focus on the last one: it is generally accepted

that comovement among business cycles is a crucial criterion in a country’s decision to join a

currency union.

We focus not only on the feasibility of a monetary union, but on which circumstances country-

pairs best comove, and in which period. Relying on a new measure of synchronisation, we identify

various subperiods in which comovement of business cycles change in the six GCC econom ies.

We are interested in two types of cycles—namely, short and long term. These correspond to a 40-

quarter cycle length (i.e., the Juglar fixed investment cycle of 7–11 years) and a 10-quarter cycle

length (i.e., the Kitchin inventory cycle of 3–5 years), respectively.

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The basic idea of this approach is that “a country is more likely to satisfy the criteria for entry into a currency union ex

post than ex ante”(Frankel & Rose 1998, p. 1024).

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ESSAADI