The puzzle of monetary followership in surplus countries: a

case study on GCC monarchies’ “inflationary” US dollar peg

Nicolò Raico

Ph.D. Student – Doctoral program in Political Studies

Università degli Studi di Milano

Graduate School in Social and Political Studies - Via Pace 10, 20122 Milano

nicolo.raico@unimi.it

Paper presented at the Annual Conference of the Società Italiana di

Scienza Politica (SISP), Firenze, 12 - 14 September 2013

Do not quote without permission

Abstract

The paper aims at completing the main fault of the Monetary Leadership Theory: explainig the

phenomenon of monetary followership by long-term surplus countries. The corpus of theoretical

statements that has been termed Monetary Leadership Theory (MLT) is the current state-of-the-art in the

international structural theories of monetary politics, and sheds light both on the phenomena of monetary

leadership and followership and the distributive outcomes of such international bargaining. Firstly, I

highlight the main problems that the theory finds in dealing with situations going too far from the strong-

weak currency divide. Secondly, I suggest some sofistication to the set of variables usually taken into

account, picking new explanatory factors from the international system, the economic structure, and the

country-level characteristics. The difficulties of the MLT and the possible solutions will be tested on the

case study of the decennial US-Dollar followership by most of the members of the Gulf Cooperation

Council, explainig the reasons why these countries remained ‘loyal’ to their monetary leader despite facing

an asset-price bubble between 2000 and 2010.

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Introduction

The first decade of the 21th century has shown a remarkable shift in the Gulf Arab countries’ net external

position. Due to the soaring of the crude oil price these countries have experienced a steady and large

current account surplus, a net creditor position vis à vis the major developed economies, and a sharp

improvement in the government balance sheet. On the opposite side, this new power position in the

monetary and financial system has carried significant drawbacks as well. The healthy situation of the state

budget fostered, in the whole region, the implementation of massive infrastructural public spending

programs. Such a huge liquidity injection into those relatively small economies, combined with a trend of

rising prices in many essential imported goods, triggered an asset price bubble on some fundamental

commodities for the economy of the region as well as for the every-day life of the lower middle classes.

Further, these problems were exacerbated by the constant and substantial depreciation of the US dollar,

which lost nearly fifty percent of its value on the DXY1 from 2002 to 2008. Given that all of the GCC

currencies had been pegging to the American currency, inflationary pressures touched unbearable levels in

the region, reaching an average peak of 10-11% monthly rise in in the spring-summer 2008, and climbing

higher than 20% in some instances. However, and this is the empirical puzzle that the paper is going to

disentangle, most of the GCC actors neither modified its exchange rate regime (only Kuwait de-pegged its

coinage in early 2007), nor revalued its currency in spite of the mounting societal pressures for inflation

control. Moreover, since fall 2007, as the first signs of the subprime crisis hit the banking sector in the

United States, the Federal Reserve (Fed) started implementing an open-endedly monetary expansion

program, which has flooded the international markets with dollar liabilities. Even in this regard, despite the

rising trend in consumer prices, the GCC countries kept tracking the Fed’s downward benchmark rate

instead of tightening the monetary policy and counterbalancing the inflationary pressure in the overheated

sectors, especially real estate and constructions. This policy precipitated the six Arab countries into a

perfect storm of rising prices, relaxed credit condition and de-facto depreciating currency: the inflationary

peg. Afterwards, since the second half of 2008, the burst of the oil bubble and the spread of the subprime

crisis across the world economy eventually unveiled the contradictions implicit in such a pro-cyclic

monetary and fiscal policy. Qatar slid into deflation, while the emirate of Dubai was subject to a series of

important bankrupts in the constructions and real estate sector. The way out to this financial turbulence

consisted in a massive public recapitalization of those banks and financial institutions more exposed to the

Dubai and the American crisis. In the UAE, the thriftier emirate of Abu Dhabi bailed out its troubled

neighbour.

The conventional wisdom on why the countries of the region, and particularly one as important as

Saudi Arabia, prioritized the exchange parity with the US-dollar ahead of the business cycle is mainly based

1 United States Dollar Index. It measures the spot value of the US-Dollar against a basket of five major floating

currencies: Yen, Euro, Swiss Franc, Pound Sterling, and Swedish Krona.

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on the Mundell-Flaming model. According to this well-known trilemma, a country can achieve at most two

out of three main goals of economic policy such as stability of the exchange rate, full capital mobility and an

autonomous monetary policy [Cohen 2000; Mundell 1961]. In this instance, the GCC countries were fixing

their currency to the Dollar, and have always had as high a level of capital account openness as the major

developed economies [Chinn and Ito 2008; K. M. Hassan, Nakibullah and A. Hassan 2013]. As regards the

fixed-rate regime and the peg to the dollar, they are taken as granted given the economic and political

conditions of the six countries [Luciani 2011]. Easily, virtually all the analyses concluded that the

followership of the currency leader’s monetary policy (namely, the tracking of the Fed’s main policy rate)

was unavoidable. However, at least three main questions remain open. The first is why one of the six

countries, Kuwait, actually abandoned the dollar followership completely, that is, changing its exchange

rate regime as well as gaining monetary policy autonomy. The second is why all the other countries did not

even modified temporarily the parity of their coinage with the dollar, maintaining as immutable the

exchange rate with the greenback. Finally, using the theoretical tools of the Monetary Leadership Theory

(MLT), conveniently improved, this work is meant to propose a different explanation to the phenomenon of

the interest rate followership. Indeed, in this paper it is argued that countries tied to a leader currency, but

characterized by large and persistent current account surplus, gain the possibility of escaping, especially in

the short term, the constraints posed by the aforementioned trilemma of open macroeconomics. This

consideration is grounded on up-to-date empirical studies on the Mundell-Flaming model and foreign

exchange intervention.

The Monetary Leadership Theory will step in as a structural tool for analysing the asymmetric

monetary arrangements. Through a parsimonious two-variable model, consisting of the systemic capital

mobility and the actors’ current account performance, this theoretical approach aims, in its original

formulation, at interpreting the phenomenon of monetary policy followership in a context dominated by

the dichotomy between debtor and creditor countries. In this case, dealing with a reversed situation

characterized by a deficit leader (the United States) and many surplus followers, a modified version of the

theory will be developed to explain the tendency of a long-term creditor country to follow the leader’s

monetary policy. Eventually, since the modified version of the MLT will turn out useful but insufficient to

account for all the strategies followed by the different GCC countries, the model will be further enriched

with some country-level variable and interacted with the broader security environment in the attempt of

filling the gaps of a purely international-structural approach. Conclusively, the expectations of this large

theoretical enquiry will be tested in an in-deep analysis of data and historical facts, coming from recent

studies and original sources (like diplomatic cables) concerning the Gulf monarchies’ monetary and

exchange rate policy.

The paper is organized as follows. Section 1 reviews the main features and faults of the MLT as a

useful structural theory of international monetary politics. Here the concepts of leadership and

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followership in monetary and exchange rate matters will be better clarified, and the puzzle of surplus

countries will be sketched. In Section 2, a modified version of the original model will be outlined in order to

deal with the circumstance of a surplus follower tracking the monetary policy of a deficit leader (which is

the case of the GCC-US relationship in the last ten years). Section 3 then assesses to what extent even the

modified MLT is not able to capture properly the outcome of the GCC-US implicit bargaining. In Section 4,

given the anticipated poor results of the base modified model, new causal relationships will be

hypothesized of the kind delineated above. Hence, Section 5 tests the new models with the actual

behaviour of the GCC countries during the inflationary peg and its immediate aftermath. Finally, Section 6

concludes.

1. The Monetary Leadership Theory: Outlines and Theoretical Gaps

If one looked for the words “Monetary Leadership Theory” on an IPE textbook, taken in this order to form a

meaningful definition, she wound find nothing of this kind. This is indeed the label through which, in the

present context, a series of theoretical assumptions and hypotheses from different authors are going to be

systematized. A similar contribution, for example, was performed by Robert Keohane when he built on the

works of Krasner, Kindleberger and Gilpin to define the Hegemonic Stability Theory (HST) in his 1984

masterpiece [Keohane 1984]. MLT stems mostly from articles and books written between 1994 and 2006 by

Andrews, Webb, Kaelberer and Adbdelal [Abdelal 1998; Andrews 1994a, 1994b, 2006; Kaelberer 2001;

Webb 1994, 1995]. The mission of the theory is explaining the reproduction of monetary systems in which

the flow of benefits and the burdens of adjustment have systematically favoured the monetary leader vis à

vis its many followers.

However, compared to its predecessor, the Hegemonic Stability Theory, the scope of the MLT

inquiry is not the whole sphere of international economic cooperation, but the monetary and exchange

rate coordination under conditions of capital mobility. An unrestrained cross-border capital flow is an

essential assumption for the cause-effect relationships underpinning the theory. First, because capital

flows, and especially portfolio-type transactions, tend to challenge permanently the exchange-rate

misalignments that inevitably emerge when different currencies are involved in a sub-optimal currency

area [Cohen 2000; Kenen and Meade 2008; Krugman and Obstfeld 2008; Krugman 1979; Mundell 1961;

Obstfeld and Rogoff 1995; Webb 1994]2. Second, because capital mobility tends to order the national

coinages hierarchically. Specifically, international investors are apt to reward the strongest currencies by

holding their liabilities, and to punish the weaker ones by selling them out in the foreign exchange market

2 The possibility that countries, perfectly aligned in terms of monetary policy, inflation rates, economic cycles and

labour market, institutionalize a monetary cooperation is not of a great concern for political science. The situation, very rare empirically, is best defined as harmony than coordination, fruit of randomness rather than politics.

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[Kaelberer 2001]. This trend has been cleverly defined the ‘currency pyramid’ by Benjamin Cohen, who

identified seven layers of ‘strength’ of a money, from the top currencies to the so-called pseudo-currencies

[Cohen 1998].

A monetary leader, therefore, is the issuer of a top currency, that is, according to Cohen’s

classification, a coinage that is widely accepted, at least within a regional currency area, as a store of value,

a unit of account, and a means of payment. Thanks to a longstanding record of macroeconomic

performances, the leader has gained the confidence of international private investors and foreign central

banks. The literature on portfolio asset allocation, so far, has identified some elements that are considered

to bolster the appetite for assets denominated in a top currency. They could be, inter alia, a strong and

sustained current account surplus, a history of low inflation, a democratic and stable governance, a strong

rule of law and judicial protection of investments, a deep, liquid, large and developed domestic capital

market, sometimes also safe and well-secured national borders [Andrews 2006; Kaelberer 2001; Norrlof

2010; Schultz and Weingast 2003; Walter 2006]. On the other side, the follower is the country that, for one

reason or the other, has adopted the leader’s money as an anchor to fix its money’s value vis à vis the other

world currencies. Generally, it is thought of as country whose currency tends to depreciate on the long run;

often, it is also assumed an identity between this monetary weakness and a chronic and significant current

account deficit [Abdelal 1998; Kaelberer 2001]. Finally, it needs another indicator to operationalize the

phenomenon as monetary followership, i.e., the fact that the weaker country subordinates its monetary

policy to the decisions of the leader’s central bank. The reason for the follower to accept such an unfair

burden sharing is that the Mundell-Flaming Trilemma does not allow any deviation from the leader’s policy

setting. Otherwise, the yield differential on each country’s interest rate is expected to cause capital

outflows from the follower’s to leader’s market, jeopardizing the established exchange rate parity within

the currency area [Kaelberer 2001; Krugman 1979; Obstfeld and Rogoff 1995; Webb 1995]. Overall, this

phenomenon of monetary instability, repeated anytime the domestic conditions of the leader and the

follower diverge, would make the consequences for the weak-currency actor painful enough to

overshadow any possible advantage of a more autonomous policy setting. In order to keep a minimum

necessary level of external stability, the deficit actor has no alternatives but bearing the bulk of the internal

adjustments though a cure of deflation and tightening policies.

Now, many elements of this scheme would deserve a critical discussion, but the most evident limit

is the fact of being tailored on the circumstance of a weak-currency actor following a large exporter country

or the issuer of an international key currency. And yet, no research so far has said anything about those

instances in which an actor with a solid external position decides nonetheless to keep a followership

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(properly intended as both exchange rate and monetary policy tracking) against a leader affected by a

chronic debtor position3.

In the next section, the same theoretical framework of the original MLT model (that is, main

assumptions and variables) will be used to develop a version of the theory able to explain the followership

behaviour observed between the Arab Gulf monarchies and the United States.

2. The Politics of Monetary Followership in Surplus Countries

The MLT in its original version is of little help for understanding the GCC-dollar affair. In fact, while the

assumptions hold (full capital mobility and different currency vulnerability), the causal mechanism is hardly

suitable for interpreting a game that is played in reversed roles. On the one hand, the United States has

been experiencing a deep trade deficit for the last two decades, a problem that has worsened further in the

last ten years, when a mix of tax cuts and military spending drew also the federal budget on a negative

ground (the so-called twin deficit). On the other hand, Saudi Arabia and the other Arab Gulf monarchies, as

already mentioned, have upgraded their position until becoming some among the main world financial

players.

Proceeding from this consideration, it can be illustrated what is the main element differentiating

the politics of followership in a deficit and a surplus country. It is relevant noting that a current account

surplus generally determines a sustained demand for the local currency and a consequent inflow of foreign

exchange. Hence, under a pure floating regime, the consequence would be an appreciation of the over-

demanded currency leading to an almost automatic adjustment of the macroeconomic imbalance. Yet, if

the appreciating coinage is handled, somehow, to preserve its value against a foreign anchor, as it is the

case in a monetary followership, things might be easier for a surplus economy with respect to a deficit one.

In the former indeed, the central bank is able to carry on an open-ended foreign exchange intervention.

This entails selling home for foreign liabilities on the exchange market, until any excessive demand of the

undervalued currency is satisfied. By this way, a central bank is able to preserves the value of the national

currency by offsetting the movements generated by capital and trade flows, so giving the local government

a remarkable breathing space in macroeconomic management. If necessary, the potentially inflationary

effect of the intervention might be sterilized trough issuing home-denominated securities or changing

bank’s reserve requirements, so to clean up the excess money supply that has been artificially created.

So far, the literature on exchange rate cooperation has often considered foreign exchange

intervention as an outdated practice [Cohen 2000, 2007; Eichengreen 2008; Fischer 2001; Obstfeld and

3 Obviously, empirical cases are present also about surplus leaders followed by other surplus countries (Switzerland,

Austria, Norway and so on). In this paper, anyhow, the theoretical advancement is limited to the game fitting the case study of the Arab Gulf monarchies.

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Rogoff 1995; Webb 1995]. Although heavily employed during the financially repressed Bretton Woods era,

it would be an almost unsustainable policy nowadays, because after the great return of cross-border

finance in the 1970’s, the daily volume of capital market transactions nearly double the total amount of

foreign reserve stock of the major central banks. In this view, for a country which aims at maintaining a

soft-peg regime4, open market operations would be nothing more than a mere support work. The bulk of

the job instead would be performed by unavoidable (and politically sensitive) internal monetary and fiscal

adjustments. In spite of this widespread wisdom, the empirical studies on foreign exchange intervention

has remarkably advanced in the last 15 years, partly reversing the conclusions reached by previous works,

especially as far as emerging surplus economies are concerned5. Among several empirical articles published

in the last 15 years, some of them coped with the policy of sterilized foreign exchange operations by

surplus countries. Nearly 80% of the studies referred to in this paper assessed this practice to be effective

in short and medium term [Disyatat and Galati 2005; Fatum and Hutchison 2003; Hassan, Nakibullah and

Hassan 2013; Levy-Yeyati, Sturzenegger and Gluzmann 2013; Schnabl and Chmelarova 2006; Siklos and

Weymark 2007; Turner and Mohanty 2006], while some works specified that sterilized intervention might

be efficacious, in some instances, even without the support of monetary policy [Al-Jasser and Banafe 2005;

Fratzscher 2005]. Finally, almost all the studies, even skeptical ones, agreed on considering central banks in

emerging financial markets as better placed in performing such operations successfully [Bordo, Humpage

and Schwartz 2012; Canales-kriljenko 2004; Menkhoff 2012; Turner and Mohanty 2006]. Considering this

recent empirical research, it is possible to claim that, ceteris paribus, the Mundell-Flaming trilemma is more

a constraint for a deficit country than it is for a surplus one, which could obtain macroeconomic policy

autonomy and unrestrained capital mobility without excessively affecting exchange rate stability.

The game representing the intricate bargaining between a potential surplus follower and a deficit

monetary leader does not resemble any of the classical two-player game-theoretical models. Firstly,

because the decision-makers in the surplus country must take into account primarily the strategy of the

other surplus followers, more than the leader’s, whose moves are given by its status and widely

predictable. Secondly, because it makes a remarkable difference being a major or a minor holder of the key

currency. A country’s importance for the leader’s currency status is given by its financial size as well as by

the composition of its official reserves and investment portfolios. The key point is that any possible

defecting move by a main surplus follower would be interpreted by all the other private and public holders

worldwide as a potential overflow of the leader currency on international markets. This may cause a

generalized run on it, with investors selling out their securities and deposits, and fleeing the leader’s capital

4 According to the formal IMF arrangement and the alternative classifications, this denotes any kind of regimes like

fixed parity, crawling peg, oscillation bands or crawling bands. 5 Many factor has contributed to this revival. Firstly, the availability of high-frequency data on central banks’ daily

transactions. Secondly, a methodological innovation that introduced, besides the classical panel data regression, the so-called event-analysis technique. Thirdly, the fact that foreign exchange intervention has never stopped being a key instrument of central banking, in spite of the academic wisdom on its inefficacy.

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market. With no more capital inflows to offset the current account deficit, a hard lending of the exchange

rate and a painful contraction of the absorption capacity would hit the leader country. Conversely, no

“domino effect” is expected in case a minor follower decides to drop its peg to the leader, or diversifying its

private and public holdings of foreign-denominated assets.

Concretely, a surplus country who chooses to follow a deficit leader has three main ways to

coordinate its policies in favour of the leader’s currency stability. The first is favouring capital outflows to

offset the leader’s external deficit, for example, tracking the leader’s monetary policy makes securities and

deposits in the leader’s market more palatable to liquidity-rich nationals. The second is withholding a large

amount of key-currency liabilities instead of claiming goods and services for it. Finally, when possible the

leader need the follower to reduce its surplus in order to relieve some pressure on the anchor currency

[Cooper 2006; Kirshner 1995]. In conclusion, although all the actors are supposed to be better off in case

the key-currency standard is maintained, the less advantaged by the bargaining environment are the major

surplus followers, whose macroeconomic policy adjustment is essential in order to support the monetary

leader’s imbalance. On the contrary, minor surplus followers enjoy the opportunity of free-riding on the

major followers’ efforts, since their single contribution in terms of surplus recycling and key-currency

holding in negligible. Lastly, the leader conducts by definition a completely unconditioned macroeconomic

policy, exploiting the follower’s necessity for monetary stability, and thus its strategy may be considered

defective as a nature move. Here below, a game tree tries to represent the situation in extensive form for a

Deficit Leader-Surplus Follower model (DL-SF).

Nash Equilibium: (DCC)

mF= Minor follower

MF= Major follower

1-MF= any other

major follower

C= Coordination

D= Defection

Orders of Preference

mF: DCC>DDC/DCD>DDD>CCC>CCD/CDC>CDD

MF: CCC>DCC>CDC>DDC>CDD>CCD>DDD>DCD

1-MF: CCC>DCC>CCD>DCD>CDD>CDC>DDD>DDC

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As expected, the formalization confirms the minor followers’ possibility to play on the big followers’

responsibility as last-resort defence of the overvalued key currency. Accordingly, the main holders’ mutual

strategic interaction results in a de-facto game of harmony, at least as long as the present leader keeps

issuing the sole universally recognized key currency. Historically indeed, the catastrophic status

downgrading of an international top currency occurred only when an alternative key currency stepped in

the monetary system, widening the bargaining range of the main followers [Eichengreen 2011a]. For

instance, the story of the British sterling area in the last years of its long life witness meaningfully about the

dialectic between a weakening leader and a group of surplus followers, in this case the Commonwealth

countries, that found in the US dollar an alternative to the Pound Sterling [Cooper 2006, 2008]. For the

moment, the present international monetary system can be assumed as a single key-currency system.

In the next section, the theoretical predictions elaborated above will be compared with stylized

facts and data concerning the period of the “inflationary peg”.

3. The Inflationary Peg and the modified MLT

The Gulf Arab states have achieved in the last decade a prominent role as holders of US dollar liabilities.

Further, because of the project for a common regional currency, all the six countries decided to peg

officially to the greenback as of 20026. According to a well-established strand in the study of the dollar’s

role as an international key currency (the so-called instrumental approach [Helleiner and Kirshner 2009]),

the choice of the GCC monarchies at the crossroad of the new century represents a crucial event for

determining scope and future of the dollar’s international hegemony for the successive decades. In brief,

the view of this approach holds that the permanence of the dollar at the top of the currency pyramid,

namely as a globally accepted store of value, negotiated currency and unit of account, is due predominantly

to the number and the weight of countries which peg their currency to it, formally or informally. The GCC

countries accordingly, are deemed to be among the major supporters of the dollar, which prevent its hard

lending on international markets by reinvesting their capital surpluses in dollar-denominated assets as well

as avoid to turn those dollars into claims for goods and services [Helleiner and Kirshner 2009; Momani

2008; Norrlof 2008, 2010]. The Arab Gulf monarchies, due to the boom of the oil export, granted a full

membership to this, so-called, “Bretton Woods II” system [Dooley, Folkerts-Landau and Garber 2004],

which defines them as stakeholders of the stability, the value, and the ongoing international use of the

dollar.

6 Before that date, Oman and Saudi Arabia have been formally pegging to the dollar since 1986. The others had

officially adopted the SDR peg (UAE, Qatar, Bahrain), or a basket of major currency (Kuwait). Currently, except Kuwait, all the countries are pegging their currency to the US dollar.

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Consistently, despite the new condition of large trade surplus (see Figure 1 in appendix), in this

period the GCC central banks did not dismiss the practice of tailoring their benchmark interest rate on the

American Federal Reserve policy. Looking at Figure 27 (appendix), it is observable as the inflation level and

the output cycle does formerly match the trend of the American monetary policy, but as early as mid-2007

the situation got far more unsustainable for the follower countries. In deeds, if initially the average GCC

benchmark rate is tightened when the price of oil pushes price records high, and relaxed in periods of

stagnating export and production, real problems became to arise when the housing bubble burst in the

American Market and spilled-over the banking and financial sector throughput the United States. To

provide more liquidity, the Fed cut inter-bank rates and injected nearly a hundred billion into the banking

system via unconventional tools [Ravenhill 2011]. Meanwhile, the crisis led financial markets to temporary

flee the dollar, pushing its value at the lowest levels in the last decades or so (see Figure 3 in appendix).

Despite all this, for at least one year the ongoing demand expansion and some speculative maneuvers had

raised the price of oil and of other essential commodities for the Gulf’s economy to unexpectedly high

ceilings. Hence, it is during this time window that the economic cycle in the periphery and the center

diverged more significantly, and an implicit bargaining took place to determine whether, and under which

terms, the surplus countries should adjust their domestic economies to keep the currency peg to the US

dollar.

In such a context, the modified MLT predicts that if the global monetary system offers but partial

alternatives to the key currency (as the Euro, the Yen or the Renminbi did not seem to pose a real threat to

the dollar hegemony), this is expected to strengthen the minor follower’s free ride and the major followers’

actions to support the leader currency. Concerning the leader, theory predicts that it will not adjust its

macroeconomic policies to relieve the follower’s difficulties, not even for the main ones. Now, comparing

the real outcome with the base theoretical prediction, it is evident as the leader holds defection as a

dominant strategy. The Fed’s behaviour decisively confirms the theory’s prediction on the leader’s inward-

looking policy setting. As Figure 2 show, the American central bank kept a steady cycle of monetary

expansion, coupled with a massive fiscal stimulus, which was in a strong conflict with the stability of the

dollar. On the contrary, predictions are not entirely respected as far as GCC followers are concerned. On six

countries, just Kuwait de-pegged its dinar from the dollar (adopting a basket-peg of major world

currencies), while its benchmark interest rate was kept to an average 2.5 points differential with respect to

the Fed’s. None of the others either abandoned the fixed rate regime with the dollar, or temporarily

7 The interest rate used in Figure 2 is not the central bank main policy rate. Rather, drawing on the work by Espinoza

and Prasad [Espinoza and Prasad 2012], the 3-Month interbank rate is used as a proxy for assessing the outcome of complementary monetary policy tools (central bank rate, Repo and reverse Repo rates, reserve requirements variation, open market operations etc.). Moreover, the choice of computing an average of the rates for all the five countries available is feasible since the six counties had kept more or less the same interest rate levels until 2009, tracking the Fed’s rate. Nevertheless, given the possible interference by ort-term scapital flows, a second assessment will be made based on the single central bank policy rate of each country. (Figure 5).

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revalued their currency. As regards monetary policy, Figure 5 draws the monthly central bank benchmark

rate against the Fed’s policy rate in the relevant period. As this first graph shows, all the GCC countries

chose to follow the Fed on its expansionary monetary policy except Qatar and Kuwait. Lax credit conditions

fostered investments and raised prices in the housing market, while international causes (included

speculative dynamics) joined the dollar depreciation to increase food prices. In Figure 2, it is shown to what

extent consumer prices augmented in the hottest months of the crisis; moreover, according to some

analyses, data provided by local authorities would be even underestimating the real extent of the

phenomenon8. Such a condition, it must be noted, hit countries that have been used to near-zero inflation

rates throughout the last two decades, with most of the lower classes employed in fixed-income jobs, and

the affluent people who earn much of their income from financial investments, mainly denominated in US

dollar [Luciani 2011]. According to press reports, during this period remarkable societal pressures pushed

on the region’s governments to curb the prices run. Among others, major callings came from the banking

and financial sector, more concerned with the negative yields of real interest rates and the real

depreciation of the financial assets, and from the lower middle class, who suffered above all from the

increases in rents and food [Andrew and Khalaf 2008; Arabnews.com 2008b; Al Asoomi 2011; Drummond

2008; Garnham 2007; Ghafour 2007, 2008; Karam 2008; Mezarban 2007]. For example, reports from Saudi

Arabia related of a group of prominent clerics that blamed the government publicly for the rising prices,

while in 2009 a national TV show joked on the rice shortage and the skyrocketing rents [Ranjan Pradhan

2008; U.S. Department of State 2008c, 2009a]. In order to regain, hopefully, both monetary autonomy and

purchase power, in all these episodes social actors did not just called for a tighter credit policy, but also for

a revaluation or a full-fledged modification of the exchange rate regime. As a last resort, most of the

countries tried to circumvent the causes of inflation and cure its effects by implementing subsidies or

unilaterally raising public-sector wages9. However, on the one hand several burocratic fetters delayed and

diluted the beneficial effects of this policy, making it actually ineffective [U.S. Department of State 2008b].

And on the other hand, those measures injected further liquidity in a saturated market, ending up boosting

inflation in the medium term [Ranjan Pradhan 2008].

In conclusion, proceeding from the modified MLT, all the minor Gulf monarchies were expected to

tackle the situation by at least revaluing their currency (that would have been useful to curb the prices of

imported goods) and tightening the monetary policy (in order to attenuate the housing-real estate market

fever). Plausibly, in that precise moment this would have also taken to a further weakening of the leader

currency, due to the decreasing flow of foreign capital to the US market. However, no definitive collapse of

8 The greatest examples are UAE and Bahrain, whose actual inflation rates soared to nearly 20% in 2008, while official

statistics reported 10% and 5% respectively [Al A’Ali 2008; Looney 2009; Saldhana 2008] 9 In particular, Saudi Arabia’s government paid 1000 Saudi riyals (270$) on each ton of rice imported, Bahrain

established a 100 Billion $ fund to be distributed to poor people for meeting their base needs. Public sector employees were granted with a cost-of-living allowance of 5% in Saudi Arabia, while Oman increased public stipends by 43% and UAE by 70%.

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the greenback was expected, since the other major dollar holders (the east-Asian export-led countries,

China and Japan in particular, and Saudi Arabia) would not have thoroughly diversified their foreign

reserves. Really, five out of six countries maintained the peg without either modifying the exchange rate

parity, or switching to a different regime. Kuwait rests the sole actor to fit the whole model’s prediction for

the entire period covered by this analysis. Further, of the five “loyal” countries, four carried on with the

interest-rate followership in a particularly painful moment for many of their internal constituencies,

whereas Qatar somehow respected the MLT prediction by following a more autonomous monetary policy.

In the next session, the mission will consist in explaining these puzzling choices nesting some new

variables on the base model depicted in section 2. The role of these new variables, coming from both the

agency level and the international structure, will be assessed in their interplay with capital mobility and

balance-of-payment conditions.

4. From Culture to Security: Models of Monetary Followership

In previous sections, a deficiency has been identified in the explanatory power of the Monetary Leadership

Theory. Afterwards, a modified version of the original model has been elaborated in order to deal with the

monetary followership in surplus countries. By employing the same parsimonious set of independent

variables, i.e. capital mobility and the balance-of-payment position, the new model proved itself still

unsatisfactory in explaining the present case study completely. In particular, the modified model failed in

two elements that will be deeper discussed in the following paragraph. Firstly, the modified model, in

opposition to the original one, is no longer able to explain deterministically the necessity of a surplus

country to rule out the floating exchange rate regime and to chase after some form of external monetary

stability. The behaviour of other large surplus countries like Germany, Japan, or Switzerland after the end

of the Bretton Woods system seems to indicate that a floating-rate regime vis à vis the major world

currencies is a plausible choice for a surplus economy. The second reason for which a wider set of

explanatory variables is deemed necessary is the evident failure of the parsimonious base model in

interpreting the behaviour of some of the GCC minor monarchies. Actually, Oman, Bahrain and the UAE

disregarded the model following the Saudi coordinating attitude instead of free-riding on the major dollar

followers. Consequently, in order to account for the outcomes of the monetary system designated as DL-SF

(deficit leader-surplus follower), new variables will be borrowed from economics, the IPE literature on

monetary power, alternative approaches to monetary politics and the theory of International Relations to

produce more effective testable hypotheses.

12

4.1. Constructivist Approach: Cognitive and Cultural Variables

Ideology and economic ideas are powerful drivers for policy change, especially in monetary matters.

Actually, it is widely recognized as economic ideas shape the decision makers’ behaviour precisely by

framing their interpretation of the political and economic incentives of an international (or domestic)

bargaining [Adler and Haas 1992; Eichengreen 2011b; Gavin 2003; Haas 1992; Kirshner 2001, 2003a, 2003b;

McNamara 1998]. As a result, a model failure can be the main cause of the weaknesses in the linear

pattern drawn by the rationalist approach employed so far. Most of the constructivist works on monetary

followership focused on the European area preeminently. For instance, the German-led monetary policy in

surplus countries like Switzerland, Norway and Austria in the 1980’s has been frequently attributed to their

elites’ endorsement to the Bundesbank’s anti-inflationary orthodoxy [McNamara 1998].

Likewise, it is plausible that the Gulf’s absolute monarchs, because of a cultural bias or a peculiar

academic education, may have different assumptions on the tradeoff between inflation, output and

external stability than, for instance, a Japanese or a German central banker. However, the few documents

that may be collected to assess the GCC monetary elites’ attitude towards inflation, output and exchange

rate, do not offer more that mixed results on this perspective. Firstly, an once-over analysis of the central

bank legislation in the six GCC countries reveals that the two objectives of internal and external stability

should be formally pursued with the same zeal. Certainly, this is not sufficient to conclude that monetary

elites in the Persian Gulf assign the same weight to internal price steadiness and exchange rate stability.

Anyhow, it provides some clues about the public discourse attitude that none of the two goals should be

pursued at the detriment of the other. Secondly, the low-inflation history that has characterized the

region’s area as early as the mid-1980’s highlights quite clearly the structure of preferences of the ruling

elite. Furthermore, such an impressive record (i.e. Saudi Arabia scored an average 0.5% in the twenty years

before the crisis) had undoubtedly the effect of freezing a system of interest and social protections that

was caught unprepared against the kind of price instability observed in the last six years. Finally, actions

and statements by most of the region’s government officials seem to indicate that a concern for the rapid

price soaring was not negligible in the worst months of the crisis. Their attempt to handle the problem

through subsidies and wage benefits is symptomatic of how successful societal pressures arrived to be,

even if not enough to threaten the dollar followership. Significantly, the Saudi ministry of Finance Al-Assaf

confided to Treasury Secretary Geithner its concern about an inflation level as “high” as 5% in July 2009.

In conclusion, even those interpretations that seem confirming the existence of a cognitive bias,

which favours exchange stability at the expenses of a low-inflation goal, would need a more robust

empirical support. Actually, the GCC leader’s decisions do not strike as particularly affected by a precise and

identifiable theoretical-interpretive framework from the field of economic science. If anything, a broad

range of societal narrow interests seems to have shaped the elites’ reasoning, although in an often

ambiguous and contradictory way.

13

4.2. Comparative Approach: Domestic Determinants of Followership Policy

According to this theoretical approach, a wide range of variables concerning the domestic characteristic of

both the state’s institutions and the country’s economy would variably affect the bargaining power of the

surplus follower. Some of the proposed variables are well-established controls in comparative political

economy, while others reflect the latest debate on the role of financial markets and monetary institutions

in defining the exchange rate regime. At any rate, so far these variables have been treated predominantly

as determinants of the exchange rate arrangement (hard peg, intermediate regimes, floating regimes).

None of the previous studies though investigated the consequences of such elements on the whole practice

of followership, i.e. the monetary policy pattern with respect to the leadership. It follows a list of such

variables with a brief illustration of their hypothesised causal effect.

4.2.1. Political Regime

The most promising hypothesis in this direction of research is undoubtedly the democracy-autocracy divide,

which could turn out very useful in dealing with the present case study. Surprisingly, there exist just two

studies which use a large panel of countries to test the effect of the political regime on the exchange rate

arrangement [Broz 2002; Leblang 1999; Steinberg and Walter 2012]. From the empirical viewpoint though,

there seems be no doubt that autocratic countries prefer fixed exchange rate regimes, and that the main

reason for this is their need to express credibility. Indeed, autocratic regimes, due to their opaque decision-

making process, would necessitate of an external anchor for inflation control that is more credible and

time-consistent than the Central Bank Independence normally adopted in advanced democracies.

Moreover, the greater insulation of autocrats from the distributive demands coming from multiple

constituencies is deemed to ease the task of maintaining successfully the commitment to external stability

[Bearce 2007; Levy-Yeyati and Sturzenegger 2005; Plümper and Neumayer 2011; Steinberg and Walter

2012].

As to the other face of the followership, the effect of the political regime on monetary policy rests

largely undetermined by existing literature. Thus, it might be hypothesized that, ceteris paribus, the grater

decision-making isolation of the monetary elites tends to incline them toward followership rather than

autonomy in monetary policy setting.

4.2.2. Dependence on foreign trade

The relationship between foreign trade and exchange rate is one of the best-established research

hypotheses in comparative political economy. For small-open economies, pegging the local currency to the

major trade partner is deemed as natural as breathing. Furthermore, this perspective has received

14

throughout time a robust empirical support [Broz and Frieden 2001, 2012; Calvo and Reinhart 2002; Fischer

2001; Frieden 1991; Meissner 2002; Plümper and Neumayer 2011], and for the oil-export-dependent GCC

monarchies it assumes a special meaning too. It is worth noting indeed that the GCC countries’

predominant export goods, crude oil and natural gas, are paid and traded on international markets only in

US dollars. Hence, the additional problem of a row-material producer country is how to isolate the

international purchasing power of its local currency from the recurrent demand shocks in the world energy

market. A condition that drives straight to the fixed exchange-rate regime and the currency in which the

main export good is priced. Regarding the effect on monetary policy, since trade flows are as well

determinants of the exchange rate pressures as capital movements, a greater trade dependence is

expected, ceteris paribus, to make the surplus country followership more likely.

4.2.3. Net Foreign Asset Position & Currency Composition of Foreign Investments

Generally, a long-term current account surplus is strongly associated with a positive private-sector

exposure in foreign-denominated assets and a high level of central bank foreign reserves. This is due to the

well-observed tendency of the follower to recycle its huge capital surplus in those large and deep foreign

markets that offer the highest guarantee against currency and geopolitical risk. As a result, since the

country with such characteristics is very likely to be the monetary leader, institutional and private financial

actors in the follower country are likely to gain a big stake in the key currency’s future. Consequently, on

the one hand, a strong net foreign asset exposure in a single currency is expected to be significantly related

to the adoption of a rigid exchange rate arrangement, as many recent works confirmed [Arabnews.com

2008a; Bourland 2007; Lane and Shambaugh 2010; Momani 2008; Saeed and Jumean 2011; Steinberg and

Walter 2012; Vipulananda 2011; Woertz 2006]. On the other hand, as far as monetary policy is concerned

this phenomenon results, per se, inconclusive. Indeed, it seems necessary interacting the net financial

exposure with the position of the relevant country within the group of surplus followers. An actor is thus

expected to follow the leader in hard times, ceteris paribus, just when its huge foreign assets holdings are

also a sensible part of the overall key currency liabilities. Otherwise, no significant effect is hypothesized.

Nonetheless , the modified MLT model with the dichotomy between minor and major followers has already

captured this causal effect.

4.2.4. Financial Market Development

It is a widespread opinion within GCC area studies that the dollar peg, inter alia, is a useful tool to provide

these countries with a riskless access to dollar-denominated financial hedging instruments [Bourland 2007;

Khan 2009; Al Khater 2012; Looney 2009]. This strategy would allow financially underdeveloped economies,

namely those that offer mostly illiquid, short-term and unsophisticated investment opportunities, to obtain

the same treatment as more advanced countries by international investors. Namely, trade contracts,

15

included oil-related ones, direct foreign investments and any other cross-border transaction, would gain

enormous price benefits in that “hedgeable” through the wide array of instruments made available by the

dollar-denominated derivatives market (forward contracts, futures, swaps and so on). On this base, it is

simple predicting that underdeveloped countries will be more likely to opt for a fixed exchange rate.

Conversely, since monetary authorities in emerging markets have been found both more likely to, and

more effective in practicing foreign exchange intervention, financially underdeveloped countries should be

less likely to mirror the monetary policy of their currency leaders, and vice versa.

4.2.5. Monetary Policy Effectiveness

This last element has been introduced precisely by the recent studies on the GCC-dollar peg, and it

is appropriate to assess its effects in broader terms. Some authors indeed have argued that the same GCC

monetary authorities, in that aware of the ineffectiveness of their monetary transmission mechanism,

willingly discarded the resort to credit tightening during the inflationary crisis of 2007-2009. In particular, it

has been emphasized as inflationary expectations in the Gulf’s economies tend to react largely to fiscal

policy and international energy prices rather than to central bank interest rates [Basher and Elsamadisy

2012; Looney 2009; Lyons and Maratheftis 2007]. Accordingly, those countries that show a high interest

rate pass-through10, other thing being equal, are supposed to be more likely to let their currency float,

because their opportunity cost of renouncing to monetary autonomy is higher. Likewise, those monetary

authorities with a stronger hold on credit and price conditions will be more prone to defect on the leader’s

monetary policy.

Here below, a table sums up all the causal relationships outlined heretofore concerning the

country-level variables.

10

Interest Rate pass-through is a quantification of the effect that the central bank policy interest rate has over landing and deposit rates in the banking sector. In turn, it could be assessed the effect of monetary policy on prices and output.

16

4.3. International Structural Variables: Security Structure and Monetary Coordination

The last contribution to the puzzle of monetary coordination in DL-SF systems is the so-called security or

geopolitical approach. Within this framework, the support given by a local government to a foreign

currency with a leadership function is embedded primarily in the broader power politics characterizing the

international system. So far, though, the relation between high politics and monetary issues has never been

clearly systematized. First and foremost, a number of clear-cut testable hypotheses has not been precisely

highlighted yet. Therefore, a theoretical hypothesis has been elaborated to substitute the alliance

dilemmas, elaborated within the theory of International Relations, for the generic appeal to “security

linkages” that is found in many preceding works on the subject [Cohen 2010; Eichengreen 2011b; Gilpin

2001; Kirshner 1998; Mastanduno 1998].

The dilemmas identified by the theory of alliances lie on two dimensions. The first dimension,

ranging between entrapment and abandonment, is depicted by the seminal work by Glenn Snyder [Snyder

1984]. In brief, while an “entrapped” actor is about to be dragged into a conflict over the ally's interest, on

the contrary “abandonment” is about the possibility that the ally defects on its original commitments to the

alliance goals. The second dimension, ranging between weakening and strengthening, is described by

17

Marco Cesa [Cesa 2007]. In the first, the author hypothesizes that a weakening ally could bring an

insignificant contribution to the alliance common goals, causing a sort of “unwilling abandonment”. In the

second instance, a strengthening ally would be able to get its own way in any intra-alliance bargaining, a

situation that might be defined as a kind of “structural entrapment”. Accordingly, support or defection are

typical answers to offset the dilemmas illustrated above. On the one hand, a weakening ally is expect to be

rescued by its partners, as well as a defecting one is likely to be incentivized to compliance with a stronger

commitment. On the other hand, a weakened support to the ally’s objectives and a stronger resistance to

its requests are usually adopted to deal with the phenomena of entrapment and strengthening.

To conclude, in this context the phenomenon of monetary followership is seen as a form of support

to a weakening or a defecting ally11. An actor that is concerned either for the explicit threat of

abandonment by an indispensable partner, or by the necessity to relieve the ally’s economic pains, is likely

to manipulate the exchange-rate and the credit conditions in order to incentivize the ally’s compliance or

reinforcing its contribution to the alliance. Moreover, by interacting this hypothesis with the modified MLT

relations, the difference between minor and major followers reemerges again as a cornerstone of the

actor’s decision-making. In deeds, the major follower see its asymmetric vulnerability even worsened by

the security bond to the currency leader, while the minor follower’s situation becomes generally less

advantageous in free-riding on the major actors. Actually, while the bargaining position of a minor ally

apparently keeps equal under the dilemma of weakening, it weakens in case the leader is able to threat

directly the abandonment of the ally in order to force adjustments on it [Zimmerman 2002].

5. A Three-Fold Explanation and the Monetary Policy Conundrum

The initial intention of this work was to challenge the widespread ideas among experts and scholars on the

determinants of the monetary followership in GCC countries during the inflationary crisis of 2007-2009.

According to GCC area experts, the choice of pegging the regional currencies to the dollar reflects some

features of the regional economy and the domestic political system, or alternatively, the security dynamics

linking the greenback to the US military guarantee to the Gulf monarchies. Once the exchange rate link is

established, due to capital mobility, monetary policy would be devoted completely to preserve the parity

against arbitrage opportunities. Instead, the theoretical insight that the present work wants to propose

points to elaborate a multiple-level explanation. The decision to adopt a rigid exchange regime or to anchor

one’s currency to the US-dollar can have a different source compared to the macroeconomic policy

management. The present analysis assesses the effect of both the agency-level and the international-

11

Obviously, this scheme is generalizable only to international situations denotable as a special relationship, an alliance or, at worst, an alignment. It hardly tells anything about strongly conflictual relations and weak or indirect security ties.

18

structural variables on either the economic policy behaviours, assuming, as asserted in section 2, that the

surplus followers are partially able to bypass the capital mobility constraint.

To summarize the intricate overlapping of behaviours, motives and explanatory variables that have been

discussed so far, the table below splits the six countries according to their actual behaviour, testing all the

relevant variables illustrated in the previous sections.

DOMESTIC VARIABLES

COUNTRY Political

Regime*

Trade Dependence

(total trade/GDP)**

Financial Market

Development***

Monetary Policy

Effectiveness****

Net Dollar

Exposure*****

(Dollar assets/GDP, %)

Saudi Arabia -10 0,787855 0,459097 / 46,70%

UAE -8 1,120968 -0,30464 / 8,24%

Bahrain -7 1,77766 -0,47092 high 10,14%

Oman -8 0,476829 -0,64493 low 11,41%

Qatar -9 1,467199 -0,30433 high 6,72%

Kuwait -7 0,664782 0,111267 high 7,59%

* Based on Polity IV score during the crisis. Democratic States are considered those above -6. ** Source: Correlates of War Project’s Trade Data Set, Version 3.0 & World Bank – Global Development Index *** Based on the capital markets development composite index elaborated in [Naceur and Ghazouani 2007], standardized including the high-income OECD average as benchmark (1,15 points) (see Figure 10 in appendix for a detailed description) **** Based on measures performed in [Espinoza and Prasad 2012] (co-integrated VAR estimates of the long-term sensitivity of deposit and lending rates to the 3-M interbank rate). Expressed Dichotomously (High/Low) when interest rate pass-through is above 30% ***** Based on absolute net foreign assets and official reserves, considering an average 50% of dollar holdings on total foreign assets in GCC countries, as assessed by [Samba Financial Group 2008] (see Figure 11)

STRUCTURAL VARIABLES COUNTRY Modified MLT

Position

Modified MLT Prediction

(assuming no alternatives

to key currency)

Dilemma of

Alliances

Real Outcome

(exchange rate-

monetary policy

Saudi Arabia Major holder Coordination Weakening Fixed-Follower

UAE Minor holder Defection Weakening Fixed-Follower

Bahrain Minor holder Defection Weakening Fixed-Follower

Oman Minor holder Defection Weakening Fixed-Follower

Qatar Minor holder Defection Weakening Fixed-Defector

Kuwait Minor holder Defection Weakening Flexible-Defector

The first table represents a set of indicators for the domestic variables that have been hypothesized in

section 4. Qatar and Kuwait (coloured in light and dark grey respectively) are the two defecting actors,

although in a different way. Looking solely at their international position in the world monetary game, the

monetary policy stance is consistent with the base MLT model. Conversely, their exchange rate choice is

19

affected by some domestic characteristics: both present a low asset exposure to a single currency and an

autocratic political system, but the trade dependence is below the regional average for Kuwait and

relatively high for Qatar. The monetary policy effectiveness turns out high on the interest rate channel for

either countries. Considering these data, a preliminary conclusion could be that both have a strong

incentive to deviate from the Fed’s policy, but Kuwait, because of a more developed capital market, had to

couple the monetary policy autonomy with a more flexible exchange-rate solution, made less painful by the

weaker trade constraints. A second conundrum is Bahrain’s policy. Despite presenting similar values to

Qatar in many variables, the little kingdom consistently maintained the dollar peg but did not defect on

monetary policy. In this case, the royal family’s limited autonomy in foreign policy is much more likely to

offer a credible picture than any country-level characteristic. The weakness of the isolated Sunni monarchs,

under the constant threat of the country’s Shiite majority, has made the dynasty a de-facto protectorate of

Saudi Arabia, as testified by the pro-status-quo military intervention carried out during the spring 2011

uprisings. Furthermore, the little kingdom is the seat of the NSA Bahrain, the home base of the US Navy 5th

fleet, by far the largest and most important American military facility in the area, both from the numerical

and strategic point of view12. It is plausible thus that the value of the national currency both in dollars and

Saudi riyals cannot be called into question. As regards Oman, data point decisively towards a rigid peg and

the maintenance of the parity as long as possible. Despite having the less developed capital market in the

region, the positive effect that this element could have on monetary policy autonomy is compensated by

the scarce effectiveness of the transmission mechanism, explaining why the Kingdom did not exploit the

possibility to free-ride on monetary policy. Finally, for the United Arab Emirates data on the effectiveness

of monetary policy are unfortunately unavailable. Without this element, it seems as the financial market

conditions, the political system and the foreign trade volumes play a forthright role with respect to the

currency regime and the exchange rate management, while offering nothing more that an ambiguous

indication as regards monetary policy. Overall, a richer dataset and the employment of more complex

statistical tools could be helpful in future research.

Finally, for the available data, the geopolitical/security approach can hardly play a role in explaining

any single country’s choice during the crisis. Actually, it is worth remembering that the capacity to project

the American power overseas, that guarantees the Gulf monarchies’ security against regional threats, is

known to be deeply intertwined both with a strong dollar and a refinanced federal budget deficit

[Eichengreen 2011a; Helleiner and Kirshner 2009; Kirshner 2008]. Both factors themselves are deeply

affected by the monetary policy and exchange rate choices made by the world major surplus economies. In

fact, the story of the inflationary peg coincides with the first months of the subprime crisis in the United

12

The US military personnel deployed in Bahrain ranges between 1500 (considering just permanent ground forces) and over six thousand people considering the whole NSA Bahrain program (ground+afloat) [U.S. Department of Defense 2008]. Considering an overall population of 1.3 million inhabitants, the US presence in Bahrain is the more numerous among GCC allies, both in absolute and relative terms.

20

States, when many international investor were fleeing the dollar-denominated securities, included the

Treasury Bill, and consequently dragging the US dollar to its lowest levels. According to the weakening

dilemma hypothesis, the major follower among GCC countries, that is, Saudi Arabia, was expected to lower

its interest rates to the Fed’s level, in order to prevent capitals from flying to the local markets, and

encouraging instead carry trades13 to take place at the advantage of the falling dollar. Empirically, in Figure

9, the average GCC market interest rate is compared with the annual trend of the dollar-denominated

claims purchased from all the Persian Gulf countries14. Although disaggregated data are unfortunately

unavailable, it is shows as in a period of run on the dollar, the GCC actors really countertrended, buying US-

based assets more in 2008 than in 2007 despite the huge financial turbulence they were experiencing.

Definitively, this picture highlights to what extent the move of lowering interest rate pro cyclically was truly

intended to preserve the trend of “petrodollar recycling”. However, basing the explanation entirely on the

security linkage raises at least two remarkable problems. On the one hand, the base modified MLT model

already provides a very good reason for the major dollar holder, Saudi Arabia, to follow the leader’s

monetary policy, even without resorting to the security linkage. Thus, the bargaining related to the

wakening dilemma would be, at best, an epistemologically superfluous addiction. On the other hand, the

interaction between the modified MLT and the theory of alliance does not expect small allies to respond to

the weakening dilemma. The stake of Oman, Bahrain and UAE in absence of an explicit abandonment

threats by the leader-hegemon (which did not take place according to available documents) is thus less

evident, because if their single contribution is negligible, they could still free-ride on the major dollar holder

and security partner, Saudi Arabia. For them, the previously assessed domestic variables strike as offering a

better interpretation.

6. Conclusions: regional politics as main perspectives for future research

The previous section indubitably left an open-ended research path that will be outlined in the paragraphs

below. Yet, even some conclusive words can be said about the US dollar followership of the six GCC

countries. First and foremost, the analysis of the data largely confirmed the correctness of the rational

choice modelization of the relation between a deficit monetary leader and its surplus followers. The core of

the bargaining is the determination of the major follower to support the declining leader’s currency, even

in times of distress for the local economy. The Saudi behaviour during the whole period of the crisis fits all

the predictions provided by the modified MLT as well as by the geopolitical approach to the problem of

monetary coordination. Two countries instead did not coordinate to relieve pressure on the dollar, Kuwait

13

These trades occurs when international investors take advantage of low interest rates in one country to borrow cheap currency in that market and investing in a foreign market that offers higher yields on bonds or deposits. 14

The assessment by the US Treasury International Capital System includes Iran and Iraq as well. However, their contribution is evidently negligible.

21

and Qatar, respecting the theoretical predictions in so far as minor holders of dollar liabilities. For the three

little monarchies that apparently behaved as major holders, Oman, UAE and Bahrain, some agent-level

variables has been identified which weakened their bargaining position concerning monetary policy

autonomy and exchange rate behaviour. However, just for Oman this mixed approach offered clear

indications, while for the UAE and Bahrain, the domestic variables turned out as inconclusive at best.

Indeed, even though the latter’s behaviour has been somehow interpreted within IR theory as a

manifestation of alliance engagement, the UAE’s choice remains a real open question. Although some of

the actor-level data are still missing for this country, filling those gaps shall hardly be sufficient to unravel

the knot. In this case, the alliance bargaining with both Saudi Arabia and the United States is more likely to

provide interpretive tools, since the federal monarchy is both a strategic US partner and the second most

important regional actor. The UAE is seat of some of the largest US military facilities in the area, stations

like the Jabel Ali harbor or the Al Dhafra air base are fundamental bricks of the US posture in the Persian

Gulf, especially for their position at the access to the Gulf of Hormuz. Further, the UAE is by far the biggest

financial player after the Saudis in terms of dollar assets, holding alone half of the entire minor monarchies’

holdings (see figure 11). Relative to Qatar, for example, whose financial standing was significant but much

more diversified [Tétreault 2011; Woertz 2007], the Saudi concern for UAE’s coordination was

understandably higher.

The second consideration concerns the neglected importance of regional politics in shaping

monetary outcomes in the area. Especially, little attention has been paid to Saudi Arabia as a mediator

between the American monetary interests and the little Gulf monarchies. Alliance and security is not the

only institutional background of regional politics, and monetary cooperation or other economically relevant

issues constitute important issue–linkage opportunities too. The periodic meetings to discuss the Gulf

single currency for instance, have been the main framework where the problem of the dollar peg and its

consequences has been openly discussed by the six countries. In this context, it is relevant noting to what

extent Saudi Arabia, probably the only country enjoying a de-facto veto power on the negotiating currency

union, systematically defended a pro-American stance. It is plausible thinking that if the powerful

neighbour had agreed to carry part of its major holder responsibility, the little followers like Bahrain and

the UAE would have gained some room for maneuver in macroeconomic policy setting. This hypothesis is

consistent with the greater autonomy shown by an actor as interested as the others in the prospected

currency union, but remarkably less central for the Saudi policy, like Qatar. Presumably, the decision by

Oman (in 2006), Kuwait (in 2007) and finally the UAE in 2009 to get out of the single currency project

cannot be interpreted without looking at this apparently contested view of what the GCC monetary union

would have stood for. It was actually intended by a country like Saudi Arabia as an instrument to better

subordinate macroeconomic and monetary issues to the alliance with the United States while for the other

minor monarchies it was rather a way to gain somehow a greater isolation from the dollar’s destiny.

22

A third consideration is needed to include an often neglected element of analysis in the politics of

monetary leadership and followership (a relevant exception is Kaelberer’s study on the EMS [Kaelberer

2001]), namely, the issue of side-payments. For example, Saudi Arabia never subordinated its coordination

to a specific quid pro quo. Nonetheless, it tried to extort side-payments successively as a reward to its

efforts in favour of the dollar and the global economic recovery. Prevalently, as diplomatic cables reveal,

Saudi authorities were more interested in security agreements and military deliveries, in a free trade

agreement with the US, and above all in countering the prospective weakening of the Saudi position inside

the IMF and the G20. Indeed, a structural reform was about to be discussed in those months in order to

turn the IMF quota system from a contribution-based into a GDP-based one [Haider 2009; Schreck 2009;

U.S. Department of State 2008a, 2009b, 2010]. Especially, this tells a lot about the capacity of the

hegemonic power to hold “bargaining chips” to be used in order to gain the compliance of its followers.

Saudi Arabia behaved as it did with the expectation of getting something in return that only the United

States were able to provide.

Finally, it is worth noting that in the minor Gulf monarchies the political economy of the overseas

military bases can be a fruitful and underestimated constraint to the exchange-rate policy choices. As the

case of Bahrain testifies (and may examples from the past as well), the maintenance costs and the daily

expenses of a great military facility significantly affect the local exchange rate policy.

23

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Appendix

Figure 1 - Current Account/GDP ratio in GCC countries (except Qatar & UAE) and United States 2000-2010 Source: IMF – International Financial Statistics

Figure 2 – Comparison between monthly average Inflation (%Cpi change), 3-Month Interbank Rate (in % change), Us Federal Fund Rate (in % change) and Oil Price (average spot Wti/Brent, in Dollars per Barrel) in GCC countries (2000-2013). Note: for Oman, the data is the Overnight Central Bank Deposit Rate. Source: IMF-International Financial Statistics, Haver analytics, US Energy Information Organization (EIA)

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Figure 3 – DXY Index 2000-2013. Source: www.tradingeconomics.com

Figure 4 – Monthly 3-Month Interbank Rate (in %) in GCC countries (for Oman, overnight deposit rate), & US Federal Fund Rate (in %). Source: IMF – International Financial Statistics, Haver Analytics

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Figure 5 - Central Bank policy interest rate in GCC countries (except UAE) plus US Fed, in % (monthly data) Source: IMF – International Financial Statistics

Figure 6 Source: Samba Financial Group (2008), “Tracking GCC Foreign Investments: How the Strategies are Changing with Markets in Turmoil”, in Report Series

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Figure 7 Source: Samba Financial Group (2008), “Tracking GCC Foreign Investments: How the Strategies are Changing with Markets in Turmoil”, in Report Series

Figure 8 – Saudi Riyal against US dollar. International monthly spot price. Source: www.tradingeconomics.com

34

Figure 9 – Portfolio Holdings of US in million dollars (GCC countries + Iran & Iraq, right axis) against average 3-M interbank rate in GCC countries and Us Federal Fund Rate (in %, left axis)

Figure 10 – Standardized index of financial market development (SMINDEX) for GCC countries against High-Income OECD average. Source: World Bank – Global Development Index The index employs three key stock markets indicators in measuring its size, activity and efficiency. «Stock markets capitalization to GDP ratio (MC) measures the size of stock markets as it aggregates the value of all listed shares in the stock markets. […] To measure stock markets liquidity, [the index uses] value traded variable (VT), which equals the value of the trades of domestic stocks divided by GDP. […] [The index uses] also the turnover ratio (TR), which equals the value of trades of shares on national stock markets, divided by market capitalization to capture the efficiency of the domestic stock markets. More efficient stock markets can foster better resource allocation […]). Thus, taken together, these three measures of stock markets development provide more information about a nation’s stock markets than if one uses only a single indicator.» [Naceur and Ghazouani 2007]. The SMINDEX index for the years 2007-2009 is the average of the standardized value of each of the three indicators for each country. The three indicators has been separately standardized relative to the mean of the single indicator on the whole pane of countries. The formula is the following:

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Figure 11 – Gross dollar-denominated foreign assets in GCC countries (estimate, in million dollars), average 2007-2009. Source: IMF – International Financial Statistics

2003,941413

9059,001365

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192379,5556

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