The optimal currency invoicing for oil : the case of the countries of the Gulf Cooperation Council
Stability in exchange rates has been the objective of several international monetary agreements since the early twentieth century. Thus the par value of currencies was determined in terms of a specified amount of gold, under the gold standard, whilst, the Bretton Woods agreement and the Smithsonian agreement defined the value of each currency in terms of the dollar, where the dollar was defined in terms of gold. Nevertheless, all these various systems have failed to eliminate the arguments between the proponents and the opponents of flexible and fixed exchange rate regimes. Although the major industrial countries have adopted a relatively flexible exchange rate regime, most developing countries have held their currencies pegged to the currency of a major industrial country, or a basket of currencies, with the aim of meeting a particular macroeconomic criterion. The choice of pegs tends to be influenced by trade shares, however, adopted according to the objective function the domestic authorities aim to fulfil. The literature has defined several macroeconomic objectives of a peg but found no particular peg to be universally adopted by all developing countries. An examination of the contract invoicing literature shows that, international trade involves incurring of risk by firms, exporters and importers. This risk is partly determined by the choice of currency denomination of contracts, which firms are expected to seek means of minimizing. With respect to currencies used to invoice contracts, there is overwhelming evidence to suggest that it is the currency of the exporter which tends to be used to denominate trade contracts. However, on an ad hoc basis, certain commodities and raw materials were found to be invoiced in vehicle currencies, such as the dollar. Moreover, the choice of currency invoicing is found to be influenced by many factors. In particular, inflation differentials were essential. Low inflation currencies are generally preferred by trading partners. A major issue of concern discussed in the literature is the potential effect of exchange rate fluctuations on the volume of international trade. The evidence on this has gone both ways. Some have argued that these fluctuations are of less concern because firms can use the forward market as means of reducing their impact. The analytical framework presented in the present thesis deals with an important issue for the member states of the Gulf Cooperation Council (GCC). These economies depend on oil revenues as the main source of income. Consequently, both government and private spending rely heavily on the oil sector. However, analyzing this invoicing policy without considering the behavior of the exchange rates between the currencies of these countries and those of their major trading partners, would be misleading. Thus, the present model adopts an integrative approach aimed at choosing a currency or a basket of currencies for invoicing oil, and determining how the choices of the same arrangements or alternative arrangements adopted for pegging the domestic currencies can affect the welfare function adopted for the choice of currency(s) for invoicing oil. This welfare function, as it is argued in the thesis, is based on stabilizing the real, rather than the nominal, value of oil revenues. The historical perspective has demonstrated close correlations between inflation rates, money growth rates and oil revenues in the GCC economies. Moreover, the dependence of these economies on oil revenues as the major source of income, has been argued to be the decisive factor that has resulted in their currencies being pegged to the dollar. The results from the estimation, however, do not support a peg to the dollar, nor invoicing oil in dollars. Nonetheless, other single currencies have failed to fulfill the optimality condition, thus favoring pegging to a trade-weighted basket of currencies, and an invoicing scheme for oil which is based on a basket of currencies. Trade shares prove to be important, since deviations from purchasing power parity are passed via them. Despite the different levels of stability resulting from alternative combinations of peg and invoice choices, statistical evidence concludes that there are no significant differences amongst the resulting variances of the real value of oil revenues in terms of the domestic currencies of the GCC member states. Accordingly, it may be argued that if the sole objective of the authorities in these countries is to stabilize the real value of oil revenues, any choice of the alternatives considered in the present thesis would yield the same result in terms of stability.