Gulf states should consider dropping their pegs to the US dollar to have more tools to control inflation and achieve single currency criteria, a key report said.

Targetting inflation should be the top priority of the Gulf central bank to be set up by the GCC states as they roll out a single currency, the Dubai International Financial Centre (DIFC) said in a report.

’Pegging to the US dollar is not the best policy to control inflation,’ said Nasser Al-Saidi, chief economist of the DIFC, a financial free zone in regional business hub Dubai.

’The central policy issue is to gear monetary policy toward controlling inflation. A Gulf monetary authority should put its priority to targetting inflation.’    

Dollar pegs have forced Gulf central banks to track seven US interest rate cuts in the past year, driving real interest rates into negative territory and stoking inflation to records.

Gulf states agreed in 2001 on European Union-style convergence criteria toward achieving a single currency by 2010, including an inflation target of no more than 2 percent above the regional average.

In 2007, the weighted average Gulf inflation rate was 6.9 percent, a level exceeded by the UAE and Qatar, the DIFC said.

While inflation has converged this year, and will probably average 9 percent in five of the six Gulf Arab states according to a Reuters poll, it will be difficult to keep them in sync without more monetary flexibility, Al-Saidi said.

’They need to have independent monetary tools to intervene in the money markets, buy and sell treasury bills to affect interest rates, and target inflation and be accountable for those targets,’ he said.

The DIFC is the latest body to urge Gulf states to reconsider currency policy as they prepare for a 2010 deadline that policymakers have conceded is very difficult to meet.

The Abu Dhabi Department of Planning and Economy called on Gulf states to consider a currency basket in a report in July, shortly before the Saudi shura advisory body said it was studying a proposal to revalue the riyal.

The International Monetary Fund (IMF) said earlier this month Gulf states should consider alternative exchange rate regimes if the monetary union is delayed.

Al-Saidi said he was not an official adviser to governor of the DIFC Authority, Omar bin Sulaiman, who sits on the board of the UAE central bank.

As of now, there is no Gulf authority charged with deciding a common monetary policy, but central bankers in June approved a draft of the union deal and a set of rules governing a monetary council that will form the first leg of a common central bank.

Other than inflation, the six convergence criteria -- such as keeping annual fiscal deficits below 3 percent of gross domestic product and achieving a public debt ratio of less than 60 percent -- have mainly been met, the DIFC said in the report.

’The Gulf countries have much fewer differences among them than the European countries,’ Al-Saidi said.

With adequate political will, Gulf states could announce a common currency by 2010, and issue the banknotes later, the DIFC said. Euro banknotes were issued three years after its launch.

Gulf states must also improve statistics and invest in infrastructure and payment systems, Al-Saidi said.

The Gulf monetary union project was pushed off the rails after Oman decided in 2006 it would not join, and Kuwait severed its dollar peg intended to remain intact until monetary union. - Reuters