Pegged at home, exposed abroad: currency risk for Gulf-based investors

How GCC pegs work

Five of the six Gulf Cooperation Council currencies are fixed to the US dollar. The UAE dirham is held at 3.6725 per dollar, the Saudi riyal at 3.75 and the Qatari riyal at 3.64. The Bahraini dinar and Omani rial are fixed at 0.376 and 0.3845 per dollar respectively. The Kuwaiti dinar is the exception: it is managed against an undisclosed basket of currencies in which the dollar is widely understood to carry the largest weight.

A peg is a promise by the central bank to exchange local currency for dollars at the fixed rate, in whatever size the market demands. That promise is backed by foreign-currency reserves, built largely from hydrocarbon revenues. To stop money flowing in or out in search of a better return, local interest rates have to track US rates. When the Federal Reserve moves, most Gulf central banks follow within hours.

These arrangements have lasted a long time. The riyal has been fixed at 3.75 since 1986, and the dirham has been held at its current rate since the late 1990s. Markets do test them occasionally. Forward rates for the riyal and dirham drifted away from the peg during the oil price collapses of 2015–16 and 2020, signalling some demand for protection, but the pegs held. For most investors, the sensible working assumption is that the peg holds, while remembering that a peg is a policy choice and can in principle be changed.

Why GBP and EUR assets move against AED and SAR

Because the dirham is a fixed multiple of the dollar, the dirham value of anything priced in sterling moves exactly as GBP/USD does. A 10% fall in sterling against the dollar is a 10% fall in sterling against the dirham, the riyal and the other pegged currencies. The peg passes every movement straight through.

GBP/USD and EUR/USD are two of the most actively traded exchange rates in the world, driven by interest rate expectations, growth, inflation and global risk appetite. They can move a long way. During 2022, GBP/USD fell from around 1.37 in January to below 1.04 in late September, a fall of roughly a quarter, and EUR/USD dropped below parity for the first time in two decades. A Gulf-based owner of a London property saw its dirham value fall by the same proportion, even if its sterling price did not change at all.

The direction of the risk depends on which side of the balance sheet the exposure sits:

• Assets such as a sterling property, a euro portfolio or a UK business lose value, in dirham terms, when sterling or the euro weakens.
• Commitments such as UK school fees, a future purchase or a sterling mortgage become more expensive when sterling or the euro strengthens.

Many Gulf-based families have both. The two sides offset each other to a degree, but rarely in the right amounts or at the right times.

A worked example

Take a family based in Dubai, paid in dirhams, who have agreed to buy a London flat for £1,000,000, completing in six months. The table shows what the flat costs in dirhams at different GBP/USD rates on completion day.

The gap between the best and worst of these outcomes is AED 550,875, about 12.5% of the lower figure. A 15-cent range in GBP/USD over six months is not unusual.

The same family is also paying UK school fees of £60,000 a year for five years, £300,000 in total. Every five-cent move in GBP/USD changes the dirham cost of those fees by around AED 55,000.

Once the flat is bought, the exposure changes character. The family now owns a sterling asset whose dirham value rises and falls with GBP/USD for as long as they hold it. That calls for a different response from the one-off purchase.

Ways to manage it

The starting point is to separate commitments from holdings. Known future payments, such as a completion date or a schedule of fees, are the strongest case for hedging: the amount and timing are clear, and any move changes the cost directly.

• Forward contracts fix the GBP/USD rate, and therefore the sterling cost in dirhams, for a future date. The forward rate differs from today's rate by an amount that reflects the interest rate gap between the two currencies, not a forecast.
• Staged hedging, such as covering half of a commitment now and more as the date approaches, reduces the regret of being fully right or fully wrong.
• Natural hedges match currencies on both sides. A sterling mortgage on a sterling property means the debt moves with the asset, and sterling rental income can fund sterling costs.
• Currency options, for eligible clients, provide protection while keeping the benefit of favourable moves, in exchange for a premium.
• Shariah-compliant forwards, built on the wa'd (unilateral promise), are available for clients who require them. Their acceptability is a matter for the client's own Shariah advisers.

Long-held assets need a policy rather than a trade. Many Gulf families choose to accept currency risk on long-term property but hedge the moments that crystallise it, such as sale proceeds being brought home. Writing that choice down, with the reasons, is what stops currency decisions being made in a hurry.

The peg gives certainty at home. The work is deciding, deliberately, how much uncertainty to accept abroad.