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					                                    GCC Currencies
                                    A Square Peg for a Round Hole?
                                    The decades old dollar-peg by GCC currencies has come under increasing calls for a review as falling interest
                                    rates, a steady decline in the US dollar, and record high oil prices translate to a flood of liquidity and rising

April 2008                          inflation. The peg, which has historically brought stability to the region, faces the challenge of increasingly
                                    looking like fitting a square peg in a round hole. GCC central banks have an unenviable task of conducting
                                    independent monetary policy in a fixed exchange rate regime that allows free capital flows. We explore three
                                    preconditions required for hard currency pegs that are no longer applicable for the GCC:

                                    •        Bulk of the adopting country’s trade must be with the other country: IMF statistics indicate that just
                                             9.7% of the region’s trade was with USA in 2006, with currencies appreciating against the dollar
                                             representing 55% to 60% of GCC imports

                                    •        Business cycles must be well synchronized: While US combats a credit crunch, GCC regulators are
                                             trying to stem inflationary pressures driven by easy liquidity

                                    •        Adopted currency should be strong and value preserving: Weakness in the USD is being perceived
                                             as a structural change as global diversification out of dollars gets underway. The USD’s nominal
                                             depreciation against the Euro has been a steep 78% since 2002.

                                    REER & NEER estimates: Our nominal and real import-weighted exchange rate estimates indicate that all
                                    GCC currencies (ex-KWD) have effectively depreciated by over 37% in nominal terms since 2002. In contrast,
                                    Kuwait has limited its effective depreciation in the Kuwaiti Dinar to 23%.

                                    Solution: The most appropriate solution is a change of peg to a basket of currencies (with components and
                                    weights publicly disclosed in order to avoid speculative pressures) accompanied with a small one-time
                                    revaluation (say 4-5%, to offset part of the sharp loss in value of local currencies). While its impact on inflation
                                    in the short-term will be insignificant (see appendix 1), the move could facilitate greater currency / monetary
                                    flexibility. A larger revaluation could be counter-productive, impairing budgetary / current account balances. In
                                    contrast, a move to a free float would not be advisable at this time as the region lacks a well-developed debt
                                    market that helps transmit interest rate signals (an important pre-requisite for monetary policy to function
                                    effectively in a floating-exchange rate regime).

                                    Concerns: Deposit rates, forced lower to limit speculative inflows, have resulted in negative real interest
                                    rates. In our view, the current situation is an opportunity to push forward a structural change (i.e. any global
                                    slowdown and associated declines in oil prices would lead to lower GCC surpluses, making the burgeoning
                                    wage-bills and subsidies that have helped ward-off inflation thus far increasingly difficult to sustain).

                                    Beneficiaries: Global investors (one-sided currency risk will attract foreign capital leading to higher demand
                                    for local assets), capital-intensive industrial projects (lower import costs), companies with external liabilities
                                    (USD loans become cheaper), GCC importers (where demand is elastic), regulators (greater maneuverability).

                                    Losers: Central banks (fall in value of their USD / gold holdings), investors, sovereign wealth funds, financial
                                    institutions and companies with dollar-assets, investments or foreign subsidiaries (one time translation losses
                                    will impact incomes statements leading in slower growth in profits), exporters (less competitive).

                                    Figure 1: GCC inflation rates (%)                                          Figure 2: NEER: Depreciating steeply
                                                                                                                     140       Rising index values imply depreciation      120
                                        15                                                                                     2000 = 100
                                        13                                                                           130                                                   100
                                                                                                                     120                                                   80

                                        7                                                                            110                                                   60

Bryan D’Aguiar CFA                                                                                                   100                                                   40
Head of Equity Research                 3
Tel.: +973 1754 9842                     1                                                                             90                                                  20
                                                                                                                                                       Oil Price ($/bbl)
                                        -1                                                                                                                   RHS
                                                                                                                       80                                                  0
                                         2002      2003      2004       2005   2006         2007 Latest #
                                                                                                                            95 96 97 98 99 00 01 02 03 04 05 06 07
                                                  Saudi                   UA E                  Qatar
                                                                                                                                    Saudi                  UAE
                                                  Kuwait                  B ahrain               Oman
                                                                                                                                    Qatar                  Kuwait

Please refer to the last page for   Source: NCBC Research, Central Banks, EIU, Bloomberg
important disclaimer                # Refers to latest interim inflation statistics (whereas other data points are annual inflation figures)

             Executive summary
             The decades old dollar-peg by GCC currencies has come under increasing calls for a review
             as falling interest rates, a steady decline in the value of the US dollar against major global
             currencies, and increased economic prosperity driven by record high prices translate into a
             flood of liquidity into the region driving inflation and increasing the challenges to regulators in
             effectively managing monetary policy.

             We evaluate the relevant arguments and opine that the significant changes in the macro
             environment in recent years have changed three key conditions required for hard currency
             pegs to work:

             •   Bulk of an adopting country’s trade must be taking place with the country to whose
                 currency it plans to peg

                 IMF direction of trade statistics indicate that just 9.7% of the regions trade (imports plus
                 exports) was with USA in 2006 (Japan 15.9%, Euro zone & UK 15.3%, Korea 8.0%, China
                 & HK 7.5%, India 3.6%). Thus currencies appreciating against the dollar represent 55% to
                 60% of GCC imports with nominal depreciation of the USD against the Euro at 78% since
                 2002 and approximately 40% against the GBP and Korean Won.

             •   Business cycles in both the pegged and pegging countries must be well-

                 At a time when the US combats a credit crunch, the economies of the GCC are witnessing
                 significant buoyancy with regulators seeking ways to stem rising inflationary pressures
                 being driven by easy liquidity. This has brought the peg under increasing stress.

             •   The adopted currency should be strong and value preserving

                 The current weakness in the US dollar is being perceived as more than just a deviation
                 from the norm. It has acquired the character of a structural change. Anti-recessionary
                 steps by the US Fed and the global diversification out of dollars currently underway will
                 only weaken the dollar further.

             The peg to the US dollar (which has historically brought significant stability to the region) is
             now faced with the challenge that it increasingly looks, from a fundamental perspective, like
             trying to fit a square peg to a round hole. The GCC central banks now have the unenviable
             task of conducting independent monetary policy in a fixed exchange rate regime that allows for
             free capital flows, popularly termed as the ‘impossible trinity’ in economic parlance.

             REER & NEER estimates

             We construct nominal and real (import-weighted) exchange rate indices for the GCC
             currencies in an attempt to unravel the extent to which the dollar-peg has effectively lowered
             their value. We infer that all GCC currencies, barring the Kuwaiti Dinar, have effectively
             depreciated by over 37% in nominal terms since 2002, during which time the dollar slipped
             78% against the Euro. In contrast, currency flexibility and the associated monetary
             independence enabled Kuwait to limit effective depreciation in the Dinar to 23%. We estimate
             the Saudi Riyal, UAE Dirham and the Qatari Riyal have effectively depreciated 40%, 37% and
             47% respectively in nominal terms.

APRIL 2008                                                                                                    2

             The ideal solution…

             We consider the most appropriate policy response would be a change of peg to a basket of
             currencies. We stress that the move should be conducted in a transparent manner with the
             components and weights publicly disclosed in order to avoid speculative pressures. The move
             should simultaneously, in our opinion, be accompanied with a small one-time revaluation (say
             4-5%), to offset part of the sharp loss in value of local currencies.

             While we expect the move will not have a material impact on cushioning inflation in the short
             term (see appendix 1), it would act as a cautious transitional first-step towards achieving
             greater currency flexibility, a critical pre-condition for monetary-policy maneuverability. The
             gradual move will help market participants prepare for the eventual managed / free-float
             regime, however distant that might seem at present. It will also enable GCC authorities to hone
             the skills required for managing currency volatility and setting interest rates independently. A
             larger revaluation will be counter-productive, as it would impair budgetary balances and current
             account surpluses, not to mention the translation losses on the large pool of dollar
             denominated assets that oil revenues have bought into.

             A move to a free float would not be advisable at this time as the region lacks a well-developed
             debt market that helps transmit interest rate signals (an important pre-requisite for monetary
             policy to function effectively in a floating-exchange rate regime).


             We believe the move must be concerted and synchronized, lest the future of the monetary
             union is inadvertently pushed into jeopardy. Further, transparency in the central bank’s
             activities must be ensured so that policy-uncertainty and currency fluctuations do not hamper
             growth. For starters, making public the weights of the currency basket, could quell uncertainty
             and curb speculation.

             Who stands to gain from a potential re-pegging / revaluation?
             •    The one-sided currency risk of appreciating GCC currencies present an opportunity to
                  global investors and can potentially attract foreign capital to the region leading to higher
                  demand for local assets (both financial and real)

             •    Capital-intensive industrial diversification effort - due to lower import costs

             •    Companies with net dollar liabilities - as dollar loans become cheaper in local currency

             •    Expatriates in the region - increase in their value of their savings / repatriation flows

             •    Margins for GCC based importers – for industries where demand is highly price sensitive

             •    GCC regulators – potentially gain greater maneuverability in monetary policy

             Key concerns
             •    Deposit rates have been forced lower to limit speculative inflows. Our concerns stem from
                  real rates moving further into negative territory.

             •    A missed opportunity: In the event that a global slowdown materializes and oil prices
                  decline, GCC surpluses will shrink. Burgeoning wage-bills and subsidies that have helped
                  ward-off inflation thus far will become increasingly difficult to sustain. Currency flexibility
                  could come handy in such an event.

APRIL 2008                                                                                                     3

             Key losers
             •   GCC central banks will see the value of their USD / gold holdings lose value in local
                 currency terms

             •   Investors, sovereign wealth funds, bank / financial institutions and GCC companies with
                 investments in dollar denominated assets (including subsidiaries and associates that
                 report in USD) will face one-time translation losses

             •   Losses will flow through incomes statements - resulting in slower profit growth

             •   Exporters - makes exports less competitive

APRIL 2008                                                                                            4
                                       GCC CURRENCIES: A SQUARE PEG FOR A ROUND HOLE?

                                       GCC currency regime under stress
Healthy oil revenues have enabled      The quadrupling of oil prices since 2002 and efforts at diversification of income streams have
the GCC region to decouple its
                                       bestowed the GCC region with unprecedented growth, with compound annual growth in
economy from that of the US to a
                                       nominal GDP at 12.8% between 2005 to 2008E (as per IMF forecasts). This has enabled the
great extent
                                       region to decouple from the US, which increasingly exhibits signs of an economic downturn.

                                       However, the peg to the USD that the constituent nations retain has left the decoupling
                                       incomplete. All the GCC countries, with the exception of Kuwait, have maintained a hard-peg
                                       against the dollar for over two decades now, helping reduce volatility in export revenues
                                       (predominantly from dollar-denominated oil exports) due to fluctuating oil prices. In addition,
                                       the peg has also ensured the much-needed stable financial conditions that importers and
                                       investors prefer.

                                       The sustained slide in the dollar against all major currencies and the US Federal Reserve’s
                                       anti-recessionary policy of loosening interest rates has brought the peg under increasing
                                       stress. At a time when the US combats a credit crunch, the economies of the GCC are
                                       witnessing significant buoyancy with regulators seeking ways to stem rising inflationary
                                       pressures driven by easy liquidity. This contradicts a basic pre-condition for the
                                       sustenance of currency pegs – synchronized business cycles.

The decoupling entails a unique        The GCC central banks now have the unenviable task of conducting independent monetary
monetary policy prescription for the   policy in a fixed exchange rate regime that allows for free capital flows, popularly termed as the
GCC. The dollars peg disallows         ‘impossible trinity’ in economic parlance. Monetary policy in such a regime boils down to
such independence                      liquidity management, aimed at defending the peg. The central banks intervene in the currency
                                       markets, buying up excess dollar inflows as market participants anticipate an appreciation of
                                       the local currencies. The consequent increase in money supply is then sterilized using various
                                       debt market instruments. Unsterilized intervention can potentially cause inflation to rise. M2
                                       (money supply excluding government balances), have risen sharply in recent months (see
                                       table 1) reflecting the sharp increases in liquidity due to oil prices at record levels and the
                                       falling interest rates in the region (mirroring the fall in US interest rates as the Fed moves to
                                       ease liquidity and cushion an impending recession).

                                        Table 1: Expansion in money supply in GCC economies
                                        Country                                                           Latest M2              Period
                                                                                                      Growth %YoY
                                        Oman                                                                    40.0             Jan-08
                                        Bahrain                                                                 38.2             Jan-08
                                        Qatar                                                                   32.8             Oct-07
                                        UAE*                                                                    32.4             Jun-07
                                        Saudi Arabia                                                            28.5             Jan-08
                                        Kuwait                                                                  26.2             Feb-08
                                       Source: Reuters (*refers to Money Survey)

                                       The chart below shows how, in the case of Saudi Arabia, the sharp fall in US interest rates
                                       since late 2007 have resulted in lower deposit rates that have fuelled the spike in liquidity to
                                       the highest levels in over a decade. SAR deposits now yield lower than 3 month Libor for the
                                       first time in over a decade.

APRIL 2008                                                                                                                             5
                                        GCC CURRENCIES: A SQUARE PEG FOR A ROUND HOLE?

SAR deposits yield lower than US         Figure 3: Falling global interest rates exacerbates liquidity in KSA
rates for first time in a decade

                                           8                                                                                                                                                                                                      30

                                                                                                                                                                                                                                                        Growth in M2 (% yoy)
                                           5                                                                                                                                                                                                      20
                                           3                                                                                                                                                                                                      15
                                           2                                                                                                                                                                                                      10
                                           -                                                                                                                                                                                                      5
                                          (3)                                                                                                                                                                                                     (5)



















                                                                  Spread (3M Libor, SAR 3M Deposit)                                                                            SAR 3M Deposit
                                                                  US 3M Libor                                                                                                  KSA M2 (RHS)

                                        Source: NCBC Research, Reuters

                                        GCC currencies: trade partners and the falling USD
The slide in the dollar assumes         The fixed exchange-rate regime has come under increasing pressure in recent months, owing to the
relevance as 55 to 60% of GCC
                                        dollar’s slide against major global currencies, which include 23% and 11% depreciation s against
imports are now denominated in
                                        the Euro and the Pound Sterling, since the beginning of 2006. During the same period, the dollar
appreciating currencies
                                        depreciated by 21% against the Thai Baht and 13% against the Chinese renminbi (which was de-
                                        pegged in July 2005). Currencies appreciating against the dollar currently represent roughly 55% to
                                        60% of the region’s imports. We estimate that all GCC currencies, barring the Kuwaiti Dinar, have
                                        effectively depreciated by over 37% in nominal terms, since 2002.

                                         Table 2: Currency depreciation since 2002 and partner-wise import shares
                                                                                             Nominal US                                                                        Import shares (%)
                                                                                                                                 Saudi                      UAE                 Qatar               Kuwait                    Oman               Bahrain
                                        USA                                                       0%                               12%                      11%                   9%                    14%                    8%                  6%
                                        Euro Area                                                78%                               24%                      20%                  35%                    20%                   13%                 14%
                                        UK                                                       39%                                5%                       6%                   6%                     5%                    4%                  6%
                                        China                                                    18%                                8%                      11%                   3%                     6%                    3%                  4%
                                        India                                                    21%                                3%                      10%                   2%                     4%                    4%                  3%
                                        Japan                                                    33%                                7%                       6%                  10%                     8%                   16%                  7%
                                        Korea                                                    32%                                4%                       2%                   5%                     4%                    3%                  1%
                                        Thailand                                                 40%                                2%                       1%                   1%                     1%                    2%                  1%
                                        Singapore                                                33%                                1%                       3%                   1%                     1%                    1%                  1%
                                        Malaysia                                                 19%                                1%                       2%                   1%                     1%                    1%                  1%
                                        Hong Kong                                                 0%                                1%                       2%                   0%                     0%                    0%                  1%
                                        11 Major Partners                                                                          68%                      74%                  75%                    65%                   56%                 44%
                                        Intra GCC                                                                                   5%                       4%                  11%                    13%                   29%                 43%
                                        NEER Depreciation                                                                          40%                      37%                  47%                    23%                   39%                 37%
                                        REER Depreciation                                                                          46%                      16%                  12%                    22%                   37%                 40%
                                        Source: NCBC Research, IMF Direction of Trade Statistics and International Financial Statistics

 The effective loss in value of GCC     The resulting effective loss in value of the GCC currencies has been partly responsible for
 currencies is partly responsible for   pushing up inflation. In addition, the influx of expatriates and the resultant demand for real
 record high inflation rates            estate has driven rents and property prices higher across the region. Apart from demand
                                        pressures, higher construction costs have also contributed to increasing rentals. Average
                                        inflation for 2007 (on a year-to-date basis) stands at 4.2%, 13.8% and 5% in Saudi, Qatar and
                                        Kuwait, respectively. Significantly, the IMF has recently raised its 2008 inflation forecast for
                                        GCC from 6% to 7%.

APRIL 2008                                                                                                                                                                                                                                                                     6
                                                         GCC CURRENCIES: A SQUARE PEG FOR A ROUND HOLE?

                                                         Potential solutions
                                                         The table below highlights the three basic potential courses of action (alternate scenarios
                                                         could be a combination of these). We provide investors with an objective assessment of the
                                                         potential implications of these three scenarios. We also identify the potential beneficiaries and
                                                         losers and the likelihood that these alternatives will be considered.

 No change                                                 One time revaluation                                     Change peg to basket

 Pros                                                      Pros                                                     Pros
     Provides economic stability in the face of                If meaningful in size, the move may reduce               Will provide much-needed independence to
     fluctuating oil prices                                    prices of imported goods, though we do not               central bankers for setting interest-rates that
     Exchange rate stability is a pre-condition for            expect this will result in a meaningful                  are more appropriate for the region
     the proposed currency union                               contribution to reducing inflation in the short          Will help train market participants and assist
     Given that the region derives a significant               term (given that inflation reflects a rate of            monetary authorities in gearing up
     portion of its revenues from dollar based                 change over the preceding year)                          implementation of the finer nuances of
     exports, a status quo would not impact export             Placates the public due to the efforts by the            monetary policy-making as the Gulf Central
     revenues in local currency terms                          government to reduce the sharp rises in cost             Bank moves closer to becoming a reality
                                                               of living (please see appendix 1 for a more              Will require transparency on the components
                                                               detailed discussion on the impacts of a                  and weights of the basket and the basis for
                                                               revaluation on cost of living and inflation)             rebalancing
                                                               Ongoing implementation would be more                     Will enable the region to capitalize on a
                                                               practical for businesses (as distinct from a             strengthening of the USD in the long run as
                                                               dynamic currency)                                        the credit crisis and US recession passes by
                                                                                                                        and creates value opportunities for global
                                                                                                                        investors in USD assets (both real and

 Cons                                                      Cons                                                     Cons
     GCC central banks forced to drop interest                 If the revaluation is relatively small in                May jeopardize currency union plans if
     rates lower (in line with the Fed’s                       magnitude, it will reward speculators who                members make unilateral moves
     expansionary policies) resulting in even higher           anticipated the revaluation, without making a            Basket will inevitably have a higher weight on
     liquidity despite concerns of overheating in              material impact on inflation.                            the US dollar
     regional markets                                          Fails to provide a basis for monetary                    Ongoing implementation would add an
     Pegging to the weakening dollar may prove                 independence                                             additional layer of risk and operational
     counter-productive as global diversification out          Dollar assets will fall in value and budgetary           requirements to a region that has got
     of the USD continues                                      outlays will shrink                                      acclimatized to a fixed peg for over two
                                                               Creates a basis for subsequent revaluations              decades
                                                               resulting in higher speculative capital inflows
                                                               further deteriorating the liquidity situation

 Beneficiaries                                             Beneficiaries                                            Beneficiaries (in addition to beneficiaries of a
     Asymmetric currency risk for investors as the             GCC companies who are short on the USD               one time revaluation)
     local currencies can only gain in value                   (companies with USD denominated loans) will              The increased need for currency hedging tools
     Investors in dollar denominated assets will get           have lower servicing / repayment                         would provide demand for related products
     more time to diversify their portfolio                    requirements in local currency terms                     GCC regulators would have greater
     Continuance of the peg reduces currency                   Currency gains (in USD terms) on investments             maneuverability in terms of monetary policy
     related risks for companies and investors                 in GCC assets by investors from outside the
     US economy – the sustained peg results in                 region
     demand for US dollars in the region,                      Expatriates in the region will see an increase
     supporting the value of the greenback                     in their value of their savings / repatriations to
                                                               their home country
                                                               Importers from the GCC (specially for
                                                               industries where demand is price elastic)

 Losers                                                    Losers                                                   Losers (in addition to losers of a one time
     Speculators who have bet on a currency                    GCC central banks will see the value of their        revaluation)
     revaluation                                               USD / gold holdings lose value in local                  US economy – the sustained peg results in
     Companies whose margins are under                         currency terms                                           demand for US dollars in the region
     pressure due to increased import costs                    Investors, sovereign wealth funds, banks /               supporting the value of the greenback
     Consumers as higher costs of imports reflect              financial institutions and GCC companies with
     in higher costs of living and lower savings in            investments in dollar-assets including
     their home currencies                                     subsidiaries and associates that report in USD
     Companies who have significant capex plans                will face one time translation losses
     and need to import capital goods in currencies            Losses for companies / institutions will have to
     other than the USD                                        flow through incomes statements resulting in
                                                               slower growth in reported profits
                                                               One time hit to exporters (makes them more
                                                               expensive in USD terms)

 Likelihood                                                Likelihood                                               Likelihood
     A long established history of the peg in                  Given political pressures this is likely to be a         Though the most pragmatic of alternatives,
     addition to political compulsions is resulting in         probable scenario. We would strongly                     this would be politically less expedient.
     resistance to a potential revaluation. But as             encourage a peg to a basket instead (as this             Kuwait’s move of its peg to a basket has set a
     governments run out of measures to slow the               alternative builds speculative interest and the          useful precedent and we hope that Qatar and
     rise in inflation coupled with a weakening                ensuing capital flows will lead to an even               UAE (likely to be the most probable countries
     dollar, the likeliness of action will rise                higher liquidity problem)                                to initiate a change in the currency peg) would
                                                                                                                        follow suite

APRIL 2008                                                                                                                                                                7
                                       GCC CURRENCIES: A SQUARE PEG FOR A ROUND HOLE?

                                       In summary: A change in peg to a basket with a small one-
                                       time revaluation

Most economists agree that the         The current debate on whether or not the GCC countries should discontinue their decades-old
region will have to move in the        peg has thrown up one common conclusion - from a fundamental standpoint economists agree
direction of freeing its exchange      that the region should move towards freeing its exchange rates at some point of time.
rates at some point
                                       Disagreements remain over when this move will be politically expedient and what alternate
                                       regime should be adopted. We opine that with average fiscal and current account surpluses
                                       riding at 22% and 26% respectively in 2006 and with official foreign exchange reserves at
                                       comfortable levels, the region is suitably positioned for a change in currency regime.

The appropriate course of action       We are of the view that the appropriate course of action for the GCC countries would be to peg
would be to revalue the currencies     their currencies to a basket dominated by dollars and make a small initial revaluation (say 4%
by 4 to 5% and peg them to a           to 5%). A full-float or even a managed-float, although desirable in the longer-run, would be
basket, heavy in dollars, for now
                                       impractical as long as the pre-dominant source of government revenues continues to be
                                       hydrocarbons. Besides, corporate and consumer indebtedness along with a well-developed
                                       debt market that helps transmit interest rate signals are important pre-requisites for monetary
                                       policy to function effectively in a floating-exchange rate regime. At the same time, continuance
                                       of the dollar-peg would undermine monetary independence, which is imperative for setting
                                       interest rates and curtailing credit expansion when an economy is over-heated.

We see the move as a transitional      Pegging to a basket that continues to be dollar-heavy, would not significantly lower
first-step towards further exchange-   inflation in the near term (see appendix 1). We perceive the move as a transitional first-step,
rate flexibility in the future         which would provide some maneuverability to central banks. As industrial diversification opens
                                       up alternate channels of income-generation and a well-functioning capital market providing
                                       transmission mechanisms for policy signals emerge, the GCC countries can progressively
                                       adopt a managed-float regime. The resultant exchange-rate flexibility can also be used to
                                       depreciate the currency in the future, if domestic non-oil exports have to be made more price-

                                       Any revaluation of a larger magnitude would not be advisable as it would drastically shrink
                                       budgetary and current account surpluses and result in a fiscal shock. Despite attempts to
                                       diversify asset holdings out of dollars, a large proportion of oil-revenues are still held in dollar-
                                       denominated assets, the value of which will be impacted adversely.

                                       The monetary authorities should make greater attempts to improve transparency in their
                                       activities particularly in making public the currency-weights in any potential basket. This would
                                       reduce policy-uncertainty and currency volatility (both of which could prove detrimental to long-
                                       term economic growth). The gradual move will also help educate market participants and the
                                       industry and prepare them for the eventual managed / free-float regime, however distant that
                                       might seem at present.

APRIL 2008                                                                                                                                8
                                    GCC CURRENCIES: A SQUARE PEG FOR A ROUND HOLE?

                                    Effective currency depreciation quantified
                                    As pointed out earlier, the GCC currencies have been depreciating against the currencies of all
                                    major trading partners of the GCC. More recently, they have also been weakening against the
                                    Japanese Yen. Japan is currently the third largest exporter to the region.

                                    In the section below we describe our efforts to quantify the magnitude of the effective fall in
                                    value that the GCC currencies have been subjected to, due to their peg to a depreciating
                                    dollar. We have estimated monthly Real Effective Exchange Rate (REER) and their nominal
                                    counterpart (NEER) for each of the GCC countries starting 1985. 1


Our import-weighted exchange rate   Our NEER index is a weighted arithmetic average of bilateral exchange rates of 11 of the
indices indicate that the GCC       GCC’s major trading partners (see table 2). We employ import shares of the trading partners
currencies, barring the Kuwaiti     as weights, in contrast to the usual practice of using trade (export and import) shares. We
Dinar, have depreciated by over
                                    consider this weighting method to be appropriate for our present analysis of imported inflation
37% in nominal terms since 2002.
                                    as trade shares or export-shares are employed when export-competitiveness of a country is
                                    being monitored. Besides, GCC exports are predominantly comprised of hydrocarbons, which
                                    is largely denominated in US dollars. We also deviate from the practice of keeping trade
                                    shares constant for considerably long periods. This is usually done, so as not to misinterpret a
                                    change in trade shares as a rise or fall in competitiveness. Changing import shares assume
                                    importance in the context of measurement of imported inflation over time.

                                    REER is constructed by adjusting the NEER index for relative prices changes in the domestic
                                    economy vis-à-vis its trading partners. Relative prices have been computed as a ratio of
                                    import-weighted foreign CPI to domestic CPI. We measure exchange rates in domestic
                                    currency terms. Hence, a rise in the constructed indices imply depreciation, while a fall
                                    indicates appreciation. 2

                                    Take aways from our REER & NEER estimates

The Saudi Riyal has effectively     The dollar-peg has caused the Saudi Riyal to effectively depreciate 40% in nominal terms and
depreciated by 46% in real terms,   46% in real terms, since 2002, when the oil prices began rising. The larger increase in REER
since 2002.                         reflects the slower pace of domestic price rise (inflation) when compared to its trading partners.

                                    In the same period, the UAE Dirham and the Qatari Riyal effectively depreciated by 37% and
                                    47%, respectively, in nominal terms. REER for UAE and Qatar appear to have stabilized within
                                    a narrow band, while the NEER has exhibited a sustained increase.

                                      The International Monetary Fund (IMF) publishes NEER and REER estimates for Saudi Arabia and Bahrain in its
                                    International Financial Statistics (IFS) database. Our estimates closely track the indices and differ due to the choice
                                    of trading partners, weights-used and definition of relative prices. The estimates were prepared using nominal
                                    exchange rates, trade shares and CPI published by IMF IFS and the IMF DOTS.
                                      The effective exchange rate estimates can only convey changes in effective valuations of currencies. They do not
                                    enable us to make judgments on misalignments in exchange rates. The latter would necessitate construction of
                                    econometric models for the behavior of real effective exchange based on a set of macroeconomic variables, which
                                    is beyond the purview of the present report.

APRIL 2008                                                                                                                                               9
                                          GCC CURRENCIES: A SQUARE PEG FOR A ROUND HOLE?

                                           Figure 4: Nominal variations in USD #                           Figure 5: Saudi Arabia

                                           180                                                               130

                                           160                                                               120




                                                                   Index for nominal currency changes.
                                                                   High vaulues imply depreciation            70
                                                  95      97     99       01      03       05       07        60
                                                       USD/EUR           USD/GBP                USD/CNY            85   87    89    91   93   95   97   99   01    03   05   07

                                                       USD/INR           USD/JPY                                        REER                  NEER                 SAR/USD

                                          Source: NCBC Research, IMF IFS; 2000 = 100
                                          # All GCC currencies have varied by the same proportion due to their peg to the US Dollar

UAE and Qatar appear to face real          Figure 6: UAE                                                   Figure 7: Qatar
appreciation pressures, as they            130                                                               130
have higher inflation relative to their
                                           120                                                               120
trade partners. Ideally, appreciation
should be achieved by allowing             110                                                               110
productivity enhancements and the
                                           100                                                               100
windfall from oil revenues to pass
through to exchange rates.                   90                                                               90

                                             80                                                               80

                                             70                                                               70

                                                  85 87 89 91 93 95 97 99 01 03 05 07
                                                                                                                   85 87 89 91 93 95 97 99 01 03 05 07
                                                         REER          NEER            AED/USD
                                                                                                                             REER             NEER            QAR/USD

                                          Source: NCBC Research, IMF IFS ; 2000 = 100

                                           Figure 8: Oman                                                  Figure 9: Bahrain

                                           130                                                               130

                                           120                                                               120

                                           110                                                               110

                                           100                                                               100

                                             90                                                               90

                                             80                                                               80

                                             70                                                               70

                                             60                                                               60
                                                  85 87 89 91 93 95 97 99 01 03 05 07                              85 87 89 91 93 95 97 99 01 03 05 07
                                                        REER             NEER               OMR/USD                          REER             NEER                BHD/USD

                                          Source: NCBC Research, IMF IFS ; 2000 = 100

APRIL 2008                                                                                                                                                                        10
                                       GCC CURRENCIES: A SQUARE PEG FOR A ROUND HOLE?

                                       Stability in real exchange rates is an important policy objective for most open economies. The
                                       real ‘appreciation’ pressure has come in the form of higher inflation, thereby ‘stabilizing’ the
                                       REER. Ideally, the stable REER should have been achieved by allowing productivity
                                       enhancements and the windfall from higher oil prices to pass-through to nominal rates.

Oman and Bahrain obtain 29% and        The estimates for Oman and Bahrain come with a caveat. Unlike their other counterparts, a
43% of their imports from within the   large portion of their imports comes from within the GCC region. The eleven countries chosen
GCC - effective indices for these      for constructing the effective exchange rate estimates accounted only for 56% of Omani
countries would be more stable
                                       imports and 44% of Bahraini imports in 2006. Inclusion of GCC imports (denominated at a
than indicated here
                                       fixed exchange rate) would result in more stable estimates. Nevertheless, it is instructive to
                                       note how the currencies have depreciated against their non-GCC exporters. The NEER for the
                                       Omani Riyal and the Bahraini Dinar have depreciated 39% and 37% respectively since 2002.

APRIL 2008                                                                                                                          11
                                       GCC CURRENCIES: A SQUARE PEG FOR A ROUND HOLE?

                                       What is driving inflationary pressures?
Food, fuel, rentals, transport and     In the section that follows we attempt to delineate the factors that have driven consumer price
communications have become             inflation up recently, by analyzing the weighted contributions of commodities and services.
dearer in the region, though their     Food, rented properties, transport and communications have become dearer in the region,
relative contributions vary across     though their relative contributions vary across countries.
                                       Food represents 26% and 36% of the CPI baskets in Saudi and Kuwait, while accounting for
                                       15% and 21% in UAE and Qatar, respectively. Food prices that accounted for roughly half of
                                       Saudi and Kuwaiti inflation in 2006 continued to exert pressure in 2007 too. However, their
                                       contribution to inflation in UAE and Qatar has been relatively subdued. Global food prices have
                                       been rising steeply on account of changing consumption patters, diversion of certain crops for
                                       bio-fuel generation and so on. The Food and Agriculture Organization of the United Nations
                                       (FAO) food price index rose by 9% in 2006 and by 23.6% in 2007. By January 2008, the FAO’s
                                       food price index was as much as 47% higher than at the same time in the preceding year. To
                                       the extent that food imports are denominated in appreciating currencies, the region would pay
                                       even higher prices.

Appreciation in rentals is also due    The rent and fuel price index, which has stood out as the primary source of price appreciation
to higher construction costs, apart    in UAE and Qatar for the past few years, contributed significantly to Saudi inflation in 2007,
from the paucity in supply of real     despite its relatively lower weight of 18% in its CPI basket. For instance latest preliminary
estate                                 inflation estimates released for Feb ’08 in Saudi Arabia indicate an 18% rise in rents. The
                                       appreciation in rentals can be attributed to higher construction costs resulting from higher
                                       prices of building materials, which are largely imported.

                                       Transport and communication comprise roughly 16% of the CPI basket across the region.
                                       However, their contributions vary. While these prices in UAE and Kuwait have hardened, their
                                       contribution to the Saudi headline index has been negative. Interestingly, clothing and footwear
                                       prices have contributed significantly to Qatari inflation in the past year.

Subsidies and price controls mask      The true nature of imported inflation in the GCC region is masked to some extent by government
the true nature of inflation to some   subsidies and price controls for many basic commodities. In May 2006, while international oil prices
extent                                 were on a steep uptrend, the Saudi government slashed petrol prices by 30% in the kingdom.
                                       Recently, the government announced subsidies for imported rice and baby milk.

                                       The Saudi Chambers of Commerce has expressed its opposition to unified low prices and
                                       suggested targeting such subsidies at low-income groups only. The UAE government too, has
                                       set maximum price ceilings for specific basic goods such as cooking oil, milk and bread.

GCC governments and private firms      Rising inflation is beginning to exhibit social repercussions and labor unrest, especially
have been raising wages in order to    amongst the expatriate communities, as wages have not kept pace with rising prices. The UAE
limit the social repercussions of      has already announced 70% higher public sector wages. Large private companies in Saudi like
inflation                              Aramco and Mobily have announced 15% - 40% higher wages, with the government following
                                       suit soon. The Kuwaiti parliament recently crafted and approved a draft law urging the
                                       government to raise public and private sector wages for employees earning less than KWD
                                       1,750 or USD 6,385. Similarly, Bahrain has approved a 15% increase in public sector wages.
                                       The latest on the list is Qatar, which recently amended its civil services law to facilitate salary
                                       hikes for government employees.

                                         Saudi Arabia is the largest importer of rice in the Middle East. A little under half of Indian rice exports of 1.01
                                       million tones in 2006-2007 was destined for Saudi Arabia, while the rest of West Asia imported 291,000 tones, as
                                       reported by quoting data published by India’s Directorate General of Commercial Intelligence
                                       and Statistics (DGCIS).

APRIL 2008                                                                                                                                               12

              Figure 10: Saudi inflation no longer subdued

                        1991          1993         1995    1997          1999           2001       2003         2005         2007

                                Food & Beverage                      Clothing & Footwear                    Rent, Fuel & Water
                                Home Furnishing                      Medical Care                           T'port & Comm.
                                Other                                Education & Ent.                       CPI (Wtd Avg)

             Source: NCBC Research, Ministry of Economy and Planning: Saudi Arabia             YTD value for 2007

              Figure 11: Rentals dominate UAE price appreciation

                               2001                2002           2003               2004              2005               2006
                                 Food & Beverage                      Clothing & Footwear                   Rent, Fuel & Water
                                 Home Furnishing                      Medical Care                          T'port & Comm.
                                 Education & Ent.                     Other                                 CPI (Wtd Avg)

             Source: NCBC Research, Ministry of Finance UAE

              Figure 12: Qatar faces high rents and fuel price too








                         1991           1993        1995      1997       1999         2001        2003         2005         2007
                                Food & Beverage                      Clothing & Footwear                  Rent, Fuel & Water
                                Home Furnishing                      Medical Care                         T'port & Comm.
                                Education & Ent.                     Other                                CPI (Wtd Avg)

             Source: NCBC Research, General Secretariat for Development Planning: Qatar

APRIL 2008                                                                                                                          13

              Figure 13: Revaluation not showing in Kuwaiti prices yet





                          2001            2002               2003           2004    2005   2006          2007

                            Food                                    Bev & Tobbaco           Clothing & F'wear
                            Housing Svcs                            Household Gds           T'port & Comm.
                            Edu. & Med. Svcs.                       Other                   CPI (Wtd Avg)

             Source: NCBC Research, Central Bank of Kuwait

APRIL 2008                                                                                                      14
                                        GCC CURRENCIES: A SQUARE PEG FOR A ROUND HOLE?

                                        Kuwait de-pegging experience can be instructive

The Kuwaiti exchange rate regime        The exchange rate regime in Kuwait has differed from those in the rest of the GCC countries.
always differed from the rest - two     The Kuwaiti Dinar was pegged to a basket of undisclosed currencies till the beginning of 2003.
revaluations totaling 3.4% were         It can be construed from the minor fluctuations in the Dinar, that the US dollar had a dominant
carried out even while being pegged     weight in the basket prior to 2003. In 2003, they adopted a de jure peg to the dollar in
to the USD
                                        preparation for the monetary union in 2010. Two revaluations totaling 3.4% were carried out
                                        even while Kuwait was pegged to the dollar. However, Kuwait went back to pegging the Dinar
                                        to a basket in May 2007 as the dollar continued to decline.

Currency flexibility has ensured that   Nine months and a further 5.3% appreciation of the Dinar against the dollar make Kuwait a
the Dinar effectively depreciated       good case for analyzing the immediate effects of de-pegging. Since May 2007, the Dinar has
only by 21% in nominal terms, since     depreciated 10.5% against the Euro, while its regional peers have weakened by 17%.
                                        Flexibility has ensured that the nominal effective depreciation of the Dinar, since 2002, remains
                                        limited at 23%, compared to over 37% depreciation in the other regional currencies.

                                         Figure 14: Kuwait                                      Figure 15: Kuwait currency variations

                                         130                                                     150
                                         110                                                     120

                                          90                                                      90

                                          70                                                      60
                                                                                                   1995   1997   1999   2001   2003   2005   2007
                                          60                                                                KWD/USD                   KWD/EUR
                                                85 87 89 91 93 95 97 99 01 03 05 07                         KWD/GBP                   KWD/CNY
                                                    REER             NEER             KWD/USD               KWD/INR                   KWD/JPY

                                        Source: NCBC Research, IMF IFS ; 2000 = 100

                                        The modest monetary independence that the peg to the basket provides has enabled Kuwait
Kuwaiti interest-rate policy has
been relatively independent, when       to set interest rates based on its own economic conditions, to some extent. While it’s regional

compared to its peers, in the wake      peers have been forced to slash deposit rates sharply to discourage speculative inflows after
of the Fed rate cuts                    the recent policy rate cuts by the US Fed, Kuwait has enjoyed relatively more maneuverability.

                                        However, Kuwait has not been able to keep a lid on inflation, which has averaged 5% on an
                                        YTD (until November) basis in 2007. In September 2007, a steep increase in housing prices
                                        took headline inflation up to its highest ever 6.7% on a year-on-year basis. The government
                                        has recently implemented a slew of fiscal and demand management measures to contain price

APRIL 2008                                                                                                                                          15
                                         GCC CURRENCIES: A SQUARE PEG FOR A ROUND HOLE?

                                         Will currency-flexibility endanger monetary union plans?

Industrial diversification will create   Exchange rate stability was one of the criteria for convergence that the Maastricht Treaty
alternate objectives for exchange        prescribed for entry into the European monetary union. All Euro area currencies were first
rate policy in the future                pegged to the German Mark for two years before being pegged to the Euro. Despite free
                                         capital flows, the GCC countries have maintained remarkable nominal exchange rate stability,
                                         which has weathered large oil-price fluctuations, emerging market crises that had global
                                         repercussions and even wars. Critical features that have helped sustain this stability are the
                                         pan-regional predominance of oil, the credible commitment to the peg and foreign exchange
                                         reserve accumulation. In the future, structural changes in the individual economies will
                                         progressively create alternate objectives for exchange rate policy and the relative under-
                                         valuation of the GCC currencies will undermine the credibility of the peg.

                                         A host of other monetary and fiscal criteria aimed at reducing the probability and severity of
                                         asymmetric shocks were also laid down for preparing economies for the European Monetary
                                         Union (EMU). Countries were expected to a) lower interest rates below ‘average of the lowest
                                         three countries’ rate + 2%’, b) lower inflation below EU ‘average of the lowest three countries
                                         inflation + 1.5%’, c) reduce budget deficit below 3% of GDP, d) reduce public debt below 60%
                                         of GDP and e) ensure currency reserves are more than four months of imports.

Record high oil revenues have            The thresholds set for the EU convergence are not necessarily reasonable or plausible for the
ensured that the GCC countries           GCC. In the absence of a mutually consistent set of convergence criteria for the GCC region,
meet fiscal convergence criteria,        we use the criteria set for EU as a yardstick to judge where the region stands in its preparation
but fall short of meeting the            for the union. As shown in table 3, record high oil revenues have ensured that the region meet
monetary ones                            the fiscal criteria. However, it falters on the monetary side, especially on the one for inflation. 4

                                          Table 3: Performance of GCC countries against EU convergence criteria

                                                                                                                 Budget          Forex        4-month
                                                                                     Interest     Public debt
                                                                    Inflation (%)                             balance (% of    reserves        imports
                                                                                     rates (%)    (% of GDP)
                                                                                                                  GDP)         (USD bn.)      (USD bn.)

                                                                                    Less than                  Greater than
                                          EU convergence criteria                                                               Forex Res > 4-Mth Imp
                                                                         5.1            4.1            60          -3.0

                                          Saudi                          4.2            2.9           27.3         25.8           31.5           23.4
                                          UAE                            12.0           1.3            2.8         10.0           27.9           38.1
                                          Qatar                          13.8           3.6           24.4         20.3            5.5           5.3
                                          Kuwait                         4.3             2            11.9         7.3            19.1           5.6
                                          Bahrain                        2.9            2.7           23.5         32.0            3.0           2.9
                                          Oman                           3.8            4.8            9.5         15.6            5.8           3.9
                                         Source: NCBC Research, Bloomberg, Respective Central Banks, IMF IFS

An element of exchange-rate              In the present context, apart from reducing imported inflation, exchange-rate flexibility can also
flexibility will provide some            provide monetary independence, which is critical for reigning in inflation arising out of excess
maneuverability to the region’s          demand. A free hand at setting interest rates will enable the central banks to limit credit
central banks in interest-rate
                                         expansion and overheating to the extent that banks channel investible funds.

                                         As suggested earlier, pegging the GCC currencies to a basket, with a large weight for the
                                         dollar, could be a cautious transitional first-step towards achieving a more flexible exchange-
                                         rate regime at some point in the future. Contrary to what many argue, an element of currency
                                         flexibility that allows for measured appreciations need not jeopardize the future of the currency
                                         union. In fact, it could help hasten the process of convergence.

                                           Inflation rates for Saudi Arabia, Kuwait and Qatar refer to 2007 YTD values, while those mentioned against UAE,
                                         Bahrain and Oman are EIU Forecasts; Interest rates refer to latest available 3M money market rates; Public debt
                                         and budget balance numbers are for 2006; Foreign-exchange reserves are the latest available from the respective
                                         central banks; 4-month imports refer to one-third annual imports for 2006.

APRIL 2008                                                                                                                                              16
                                               GCC CURRENCIES: A SQUARE PEG FOR A ROUND HOLE?

                                               What do the markets price in and why?

Markets currently price in a 2%                12-month currency forwards suggest that Saudi Arabia‘s commitment to the peg is considered
appreciation in the Saudi Riyal,               relatively more credible, with the markets pricing in 2% appreciation for the Saudi Riyal as of
down from 3.7% before the                      25th March, down from 3.7% in November end. UAE Central Bank Governor, Al Suweidi’s
December GCC council meeting
                                               insistence that the Dirham peg would be maintained had reduced the expected appreciation to
                                               1.8% in January, but subsequent rate cuts by the US Fed have resulted in renewed
                                               pessimism, reflected by the 3% forward premium as on 25 March. Essentially, despite
                                               repeated assertions, the GCC authorities’ commitment to the peg has not gained credibility.

Markets have interpreted any delay             The delays in the GCC central banks’ response following the recent Fed rate cuts have fuelled
in GCC response to Fed rate cuts               speculation of impending revaluations. Monetary authorities in the region have been left with
as possible signs of revaluation               absolutely no independence in their interest rate policymaking. Policy rates that guide lending
                                               rate setting by banks have been kept largely unchanged, in order to restrict credit expansion.
                                               Central banks in the region have also raised reserve requirements for banks for the first time in
                                               years. On the other hand, policy rates that guide banks’ deposit rates have been slashed
                                               following the Fed rate cuts. This has been done in order to discourage speculative inflows into
                                               higher yielding GCC bank deposits.

The central banks have been trying
                                               Deposit-rates in the region have fallen more than proportionately, leading to a progressive

to curb speculative inflows into               widening in spreads vis-à-vis the US over the last three months (see figure 3 on page 5). With
deposits, through successive rate              inflation rates rising, real deposit rates are marching further into negative territory (see figure
cuts                                           17). Any further dollar depreciation and expansionary moves by the Fed would only serve to
                                               precipitate the much-delayed de-pegging and revaluation exercise.

Figure 16: 12-month currency forwards                                   Figure 17: Real three-month deposit rates (%)

   4%                                                                      10


   3%                                                                        6


   2%                                                                        2


   1%                                                                       -2


   0%                                                                       -6
    Jul-07    Aug-07 Sep-07 Oct-07 Nov-07 Dec-07 Jan-08 Feb-08                2001      2002      2003     2004   2005   2006   2007     2008

                           Saudi                 UAE                                               Saudi             Kuwait

Source: Bloomberg                                                       Source: NCBC Research, Bloomberg

APRIL 2008                                                                                                                                      17
                                      GCC CURRENCIES: A SQUARE PEG FOR A ROUND HOLE?

                                      Closing comments

The gradual global diversification    The current weakness in the USD is being perceived as more than just a deviation from the

out of dollars and industrial         norm - it has acquired a structural character. Recent IMF data show a fall in the dollar-share of
diversification within the GCC        foreign exchange reserves, from 65% in June to 63.8% in September 2007. The global
require appropriate monetary          diversification out of dollar assets is underway, albeit at a slow pace.
policy responses
                                      Meanwhile, the GCC region is undergoing a transformation that will enable it to reduce its
                                      dependency on dollar-denominated oil and enhance intra-GCC trade. (Please refer to NCBC’s
                                      Investment Strategy - Capitalizing on the Petrodollar Windfall released in Jan 2008). The
                                      requirements of the industrial diversification process will have to be supported with appropriate
                                      monetary policy responses.

                                      As these two long-term phenomena unfold, a fixed-exchange rate regime appears
                                      conservative. We have argued that the appropriate strategy, from a long-term perspective,
                                      would be to move towards a more flexible currency regime that allows for monetary

A small revaluation and re-pegging    More immediately, repeated deposit rate cuts, aimed at curtailing speculative liquidity inflows,
of GCC currencies to a dollar-heavy   have turned real rates negative and yet not succeeded in keeping away speculators. Currency
basket seem apt both from the         forwards have amply demonstrated this, lately. Defending the credibility of the peg will become
near-term and long-term
                                      tougher with each Fed rate cut and discouraging piece of data from the US.

                                      As outlined earlier in the report, a 4% to 5% revaluation and a peg to a dollar-heavy basket,
                                      while incapable of reducing inflation in the near term, will serve to provide some independence
                                      in interest-rate setting and set the ball rolling for the flexible regime of the future. At the same
                                      time, the move will recognize the current pre-dominance of oil revenues and their investments
                                      in dollar assets.

                                      The formation of a common market is evidence of the GCC states’ commitment to the eventual
                                      currency union, although the 2010 deadline for its formation does not look plausible. Pan-
                                      regional judicial, consultative and executive bodies, like the ones in Europe, will emerge. It
                                      would be difficult to imagine policy-making institutions like a regional central bank, function with
                                      limited independence.

APRIL 2008                                                                                                                             18

             Appendix 1: Estimating the impact of a
             revaluation on prices & inflation
             Case example: Saudi Arabia (cost of living data available up to 31-01-2008)

             In the section that follows, we explain our view that a small revaluation will not materially
             impact inflation in the short term (though in the longer term it will lead to a cushioning of the
             inflation rate). Note that ‘inflation’ is a first level derivative (in simpler words it is a rate of
             change in the levels of prices in an economy). Thus, a slowing down of inflation does not
             necessarily mean that prices are falling.

             Below we present a very simplistic model of how inflation is likely to behave under three
             different scenarios in Saudi Arabia. Note these do NOT represent forecasts but are meant
             to illustrate our contention that a small revaluation will be ineffective in reducing inflation in
             the short term.


             We present three potential scenarios assuming ceteris paribus (i.e. no further initiatives
             are announced by the government in order to curb inflation.

             1.   Scenario A: Absolute price levels remain unchanged over the next 12 months, i.e. there
                  is no change whatsoever in prices levels across any of the eight broad components of the
                  cost of living index – This is a highly unlikely situation.

             2.   Scenario B: We model price levels for the next 12 months in each of the eight broad
                  categories, assuming an increase (or decrease as the case may be) in line with the simple
                  average sequential rise of the respective categories over the last 12 months. This is a
                  likely scenario assuming there is no revaluation of the SAR and no further initiatives
                  announced by the government to curb inflation.

             3.   Scenario C: Combination of two factors as detailed below. This represents our ‘best case

                       We model a hypothetical revaluation of 5% in the SAR in April 2008 (for illustrative
                       purposes). We also assume a 100% pass-through with retail prices in three out of
                       eight segments (foodstuff & beverages; fabric, clothing and footwear; home furniture)
                       each falling by 5% in April 2008. The other five segments are unlikely to be impacted
                       by a revaluation, as they are either service based or driven by domestic pricing. This
                       situation is unrealistic given that not all imports are non-USD based (hence this
                       represents a best-case scenario).

                       Similar to scenario B, we model a change in absolute price levels for the next 12
                       months for each of the categories assuming an increase (or decrease as the case
                       may be) in line with the simple average of respective categories sequential rise over
                       the last 12 months

APRIL 2008                                                                                                    19

              Figure 18: Inflation scenarios for Saudi Arabia


                  Inflation (% change YoY)

                                                                Inflation for 2007 was 4.2%















                                                                       Historical Inflation
                                                                       Scneario A (Least likely :assumes flat prices for next 12M)
                                                                       Scenario B (Highly likely: Price movements based on history; assumes no reval)
                                                                       Scenario C (Most Probable: 5% reval + Price movements based on history)

             Source: NCBC Research, Bloomberg

             Summary of analysis for Saudi Arabia

             1.                              In Jan’08, components such as rent / fuel and foodstuff have witnessed a sharp rise (see
                                             table below). Even if these remain unchanged for the rest of the year, they will contribute
                                             to inflation (given that inflation is a rate of change over levels in the preceding period)

                                             Table 4: Cost of living index components (Jan 2008)

                                             Segment (weight %)                                                                                                        Inflation (YoY)

                                             General index (100)                                                                                                                          7.0%
                                                  Foodstuffs and beverage (26)                                                                                                           7.9%
                                                  Fabric, clothing and footwear (8)                                                                                                      -1.6%
                                                  Renovation, rent, fuel and water (18)                                                                                                  13.8%
                                                  Home furniture (11)                                                                                                                    3.6%
                                                  Medical care (2)                                                                                                                       7.5%
                                                  Transport and telecommunications (16)                                                                                                  0.7%
                                                  Education and entertainment (6)                                                                                                        1.7%
                                                  Other expenses and services (13)                                                                                                       11.4%
                                             Source: SAMA

             2.                              Both scenarios B and C will result in an increase in inflation in Q1-08. In the case of
                                             Scenario B (assumes no revaluation), inflation could continue rising to 9.5% by June 2008
                                             before the base impact of the preceding year leads to a decline to 7.4% by end of the year
                                             and an annual average of 8.3% (this would represent a sharp rise of more than double the
                                             annual average inflation for 2007 at 4.2%). (Note these are excerpts from our
                                             illustration and not forecasts).

             3.                              In scenario C (a best case situation of a 100% pass-through to retail prices due to a
                                             hypothetical 5% revaluation), inflation will continue to be around 7.1% over the next 6
                                             months but drop to 5.0% by end of the year (representing a annual average of 6.4% for
                                             the year). (Note these are excerpts from our illustration and not forecasts). This
                                             validates our contention that in the short run the impact of a price cut will not materially
                                             impact the climb in inflation, but would be beneficial for longer term structural changes to
                                             the economy and aid lower long-term inflation.

APRIL 2008                                                                                                                                                                                  20

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