Modelling Macroeconomic Shocks in the GCC: Is Monetary Unification Viable?

Rutledge (2009), for example, argues that because all of the GCC countries are dependent on oil their commonly undiversified production structures make them suitable for currency unification.

On the basis of Chow’s break point test and Chow’s predictive failure test, there is a strong evidence of a break in the GDP growth series for all except two of the economies (Kuwait and Saudi Arabia) in 2004. Therefore, since the economies are being modelled as a system, the sample period is truncated at 2004.

RGDP is used instead of non-oil RGDP because oil represents the largest source of economic activity in both the private and public sectors of the region, this is in line with most empirical papers analysing the GCC such as Darrat and Al-Shamsi (2005), Bacha (2008) and Abu-Bader and Abu-Qarn (2008).

The world trade index is used as a proxy for foreign income, see data appendix.

A third of the region’s GDP directly stems from oil and gas exports and “oil income contributes around 80% to government revenues” Sturm and Siegfried (2005, 17).

In Islam “riba” is prohibited – “riba” can be translated as usury or an exorbitant high amount of rate of interest. As a result, there is a segment of the population that do not participate in the conventional banking system because it is based on interest receipts and payments. The muted response to interest rates in the GCC adds to the difficulty of implementing open market operations and explains why more direct tools are used to conduct monetary policy. Further discussions on the conduct of monetary policy and the tools used in the GCC are provided by Fasano et al. (2003) and Al-Raisi, Pattanaik, and Al-Raisi (2007).

Further details on the endogeneity of oil price for the Saudi Arabian economy are discussed in Section 4.3.

The absence of some quarterly data series motivates a two-stage estimation procedure which makes use of the information in both the annual and quarterly series; this procedure is elaborated in Section 4.2.

Clearly, it is possible that the empirical results might be sensitive to the method of interpolation chosen. This particular interpolation approach was selected on the basis of consideration of economic criteria over statistical criteria on deriving some of the quarterly series.

Two missing values for Oman’s oil index in 1993 and four missing values for Kuwait during the Gulf War in 1990 and 1991 are linearly interpolated.

Three missing values for the money supply for Saudi Arabia in 1983, UAE in 1986 and Kuwait during the war are linearly interpolated.

The average coefficient of variation of prices is 0.14, which is lower than the coefficient of variation of 0.49 for money in the GCC.

Since the dynamics of are not central to the questions addressed in this paper, the interpolation of the fluctuations in the series have an insignificant impact on the results.

The treatment of and as I(1) is in line with other GCC studies that have analysed their unit root properties, such as Hasan and Alogeel (2008), Abu-Bader and Abu-Qarn (2008) and Bacha (2008).

If quarterly data were available for all of the series then there would be no advantage in using the annual data set and both the long and short-run coefficients could be estimated with quarterly data.

It is also found that these relationships are compatible with the quarterly data when the long-run coefficients are imposed on the VECM. However, the LM relationship for Bahrain does not hold when incorporated in the VECM with quarterly data and is therefore not included in the final estimation.

With limited observations, long-run variables with a t-stat greater than unity are considered important in the relationships.

Kandil (1991) estimates the interest rate sensitivity of investment demand.

Based on the contribution of the mining sector to GDP which includes oil and gas (GCC Statistical bulletin, 2005, http://library.gcc-sg.org).

The unit root tests reported in the Appendix indicate that real exchange rates were non-stationary, which is an indication that PPP does not hold (Sarno, Taylor, and Frankel 2002). However, the long-run PPP tests conducted in this section are more sophisticated than the unit root tests since the world price coefficient is not restricted to one and dummy variables are included in the ARDL regressions to account for shifts in the mean. Wald tests were conducted on the estimated coefficients to see if they were significantly different to one. For the PPP relationships, the null hypothesis that the world price variable had a unit coefficient was rejected for all countries except Kuwait and Oman at the 5% level. In the IRP relationships, all GCC countries except for Saudi Arabia had US interest rate coefficients that were significantly different from one. These results coincide with the summarized long-run relationships at the bottom Tables C.3 and C.4 in the Appendix.

This statistic refers to the average traded goods and services as a percentage of GDP from 1990–2002, World Bank (WDI 2007).

As in the ARDL specification search, estimates with a t-statistic of one or more are retained within the model. The coefficients of the VECM are available on request.

The re-estimated long-run relationships are based on the same variables and dummies that were used in Section 4.3. Core terms that were deemed insignificant in the ARDL regressions were not included in these simulations.

Increasing the number of simulations from 1,000 to 2,000 made little difference to the confidence intervals.

Based on the contribution of the mining sector to GDP (GCC Statistical bulletin, 2005, http://library.gcc-sg.org).

The authors consider Kuwait, Oman, Saudi Arabia and the UAE as the GCC. Bahrain and Qatar are not included in the study.

The responses of GCC prices and the money aggregates to an oil price shock were also investigated but the responses were not significant for all GCC countries.

Due to the lack of data on domestic interest rates in the UAE, the pass-through effects could not be examined.

However, the speed of the pass-through is quicker in their study.

The responses of local prices to a US monetary shock are summarized in the Appendix. In many open economies, a hike in US interest rates can be inflationary abroad. In the GCC, such effects are insignificant as seen in the Appendix.

Since the nominal exchange rate is fixed for these countries, the real exchange rate is tested for a unit root.

For Kuwait, is included because the exchange rate fluctuates slightly for most of the period. For Saudi, is a contemporaneous dummy to adjust for the depreciation in 1986. Although fluctuates in Saudi from 1980 to 1986, for most of the sample is fixed. D86_shift was not used for Saudi because it fails to dummy out the early movements in . Shift dummy variables were not required in the IS relationships because not was used.

For Qatar, the sub-sample period 1992–2004 is used because prior to 1992 US interest rates are used to proxy local rates.

For Saudi Arabia, the exchange rate was insignificant in the IRP relationship.