Gulf dollar peg not dead yet

As the dollar keeps setting record lows this week, we have evidence from the Middle East that the destruction of the dollar will be a slow-motion event.

Unlike last month, the Saudi Arabian government has followed the Fed's lead in cutting interest rates, thus maintaining a fairly credible dollar-riyal peg.

Saudi Arabia, the largest economy in the region, reduced one of its interest rates by 25 basis points while raising banks’ reserve requirements to limit the growth of monetary supply in a bid to tame rising inflation. Five of the six Gulf Co-operation Council members peg their currencies to the US dollar and therefore usually follow US interest rate decisions. Kuwait in May abandoned its dollar peg, citing rising levels of inflation imported by the weakening dollar.

The economic boom in the oil-rich Gulf, where oil prices have quadrupled during the past five years, should dictate higher interest rates, rather than the looser monetary policy being dished out to a US economy struggling to come to terms with the summer’s subprime mortgage crisis. “Increasing the Saudi reserve requirements is a way of tightening the monetary environment without raising rates,” said Simon Williams, an economist with HSBC in Dubai.

Speaking to reporters in London, Prince Saud al-Faisal, foreign minister, quelled speculation of any Saudi intention to drop the dollar peg. “Why would one do that?” he said, adding only half-jokingly that there “aren’t enough euros” around.

But Prince Saud went a step further, indicating the single currency project in the Gulf states continues to move forward:

Saudi Arabia on Thursday also gave plans for a single Gulf currency a much-needed boost, predicting the majority of states in the Gulf Co-operation Council, including Riyadh, would join by the agreed date of 2010.

“Perhaps not collectively, but the majority will achieve it,” Prince Saud said, referring to the single currency.

Oman has already counted itself out of the project, but the creation of the euro wasn't exactly a seamless process either.

Of course, a lot can happen between now and 2010.  But for now, the Gulf sheikdoms' commitment to a dollar peg remains strong — at least if the sheiks can be taken at their word.