May 23, 2007

NEW YORK (MarketWatch) -- The Central Bank of Kuwait's decision over the weekend to untie its currency from the U.S. dollar might signal a growing trend among global central banks, especially those with large foreign-exchange reserves, to more actively manage their currencies.

And such a shift is likely to put the U.S. dollar under increasing pressure, analysts said.

Kuwait on Sunday, in a move to combat inflation, abandoned its dinar's peg to the U.S. dollar in favor of a basket of international currencies. The dinar had been pegged against the dollar since 2003. The central bank has not announced the composition of its currency basket. Kuwait also announced it would revalue the dinar by 0.37% against the dollar.

Weakness in the U.S. dollar has pushed up inflation and hurt the domestic economy, the central bank said.

"The significant drop in the exchange rate of the American dollar against most other major currencies had a negative impact on the Kuwaiti economy over the past two years," Sheikh Salem Abdel Aziz Al Sabah, governor of the central bank, told the official Kuwait news agency.

"In the Middle East, it's a story of dollar-concentration risk," said Stephen Roach, chief economist of Morgan Stanley. Kuwait's just-announced decision "may well be the first step in a regional diversification strategy that attempts to temper such risks," he said.

Oil producers in the Gulf not only price their one commodity -- oil -- in dollars, but their currencies for the most part are also dollar-pegged, Roach said.

"As a result, their foreign exchange reserves are massively overweight dollars," he said. "The region worries increasingly about excessive exposure to a chronically weak dollar scenario as an unavoidable outgrowth of a prolonged U.S. current account adjustment."

Growing speculation that the Federal Reserve will lower interest rates to spur the economy even as central banks elsewhere continue to tighten monetary policies pushed the dollar to an all-time low against the euro and a 26-year trough against the British pound last month.

Inflation in Kuwait stood at around 3% last year, consistently above the central bank's 2% target.

"Moreover, with the dollar's steady decline, the dinar has followed suit. This has made European imports more expensive, which is an important consideration for Kuwaitis," said Charmaine Buskas, economist at Moody's Economy.com.

"The Central Bank of Kuwait's decision shows a recognition that a dollar peg does not provide the flexibility small countries need in a global economy," she said.

Follow suit

The move by Kuwait sparked speculation other members of the Gulf Cooperation Council -- Saudi Arabia, U.A.E., Qatar, Oman and Bahrain -- will soon follow suit. However, these countries have promised to keep the dollar peg for now.

Some analysts say the U.A.E. and Qatar are the most likely candidate because both countries have by far the strongest price pressures in the Gulf region.

"With Kuwait's non-concerted move, the 2010 deadline for the launch of a single currency has become even more at risk," said Koceila Maames, Africa and Middle East economist at French bank Calyon. "What the other Gulf countries will do preliminary hinges on the fate of the ongoing monetary union process."

"If the next few weeks/months confirm further questioning of the monetary union project, the U.A.E. and Qatar will be the next candidates for revaluations, be it straight ones or through a peg to basket of currencies," the analyst said in a research note.

In the big picture, Moody's Buskas said the move by Kuwait suggested that "currencies pegged to the dollar will increasingly come under pressure as the dollar continues to adjust lower."

"Countries in the Middle East and throughout Asia will increasingly be forced to reconsider their pegs to the dollar," she said. "The trend to de-peg from the dollar and move to a basket will most likely affect other Asian countries, newly emboldened by China's recent decision to widen its yuan-dollar trading band to 0.5% from 0.3%."

This trend has been widely discussed "as a long-term dollar drag" and one likely to continue as central banks with large reserves "become more proactive in managing their currencies," she said.

Dollar negative

Kuwait's decision to drop its currency peg to the dollar had a muted impact on the currency market Monday.

"The market is temporarily distracted," said Brian Dolan, chief currency strategist at Forex.com, a division of Gain Capital. "Had a move like that come a month ago, you would have seen the dollar weaken much more significantly."

"It certainly represents further diversification away from the dollar," he said. "It'll reverberate once the dollar direction turns negative again."

The limited reaction in the market also reflected the fact that the dollar weighting in the dinar's basket peg will initially remain at a relatively high level, likely making up 75% to 80% of the new basket.

But the dollar's share will be reduced gradually, said analysts at BNP Paribas. Russia's move towards a currency basket, where the weighting of the euro is now dominant, can be used as an example, they said.

Global central banks' ongoing reserve diversification has been a main factor weighing on the U.S. currency and Treasury market in recent years. Many people argue because foreign central banks have played a vital role in financing U.S. borrowing by buying U.S. debt, a diminished appetite for dollar-denominated reserves could have a significantly negative impact on the dollar and the U.S. economy.

The news from Kuwait "cannot be seen as U.S.-dollar supportive," said Dennis Gartman of the Gartman Letter. "For if Kuwait, who owes the U.S. so much for having liberated it from Iraq's clutches in the war there during Bush senior's tenure in office, abandons the dollar, what then of the other currencies of the world still pegged to the dollar?"

Wanfeng Zhou is a markets reporter in New York.

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