Central banks move to cut rates could aggravate inflation

(FILE)   

 

The UAE Central Bank yesterday cut interest rates by 75 basis points to match a decision by the US to reduce rates – but experts said the move could aggravate inflation and boost pressure for a revaluation.The Central Bank said it had lowered the rate on its repurchase of Certificates of Deposits (repo) from three per cent to 2.25 per cent.

 

It said the decision was “in line with the new level of interest rates on US dollar federal funds” – the short-term dollar interest rate as determined by the US Federal Reserve. And it added in a statement: “The above repo operation conducted by the Central Bank with banks operating in the country is the mechanism through which interest rate on the dirham is changed.”

 

The move came a day after the Fed slashed rates by three-quarters of a percentage point, a substantial cut but smaller than had been expected. The US move was part of an effort to hold off a deep recession and a financial meltdown following the crippling sub-prime crisis.

 

The UAE and other members of the six-nation Gulf Co-operation Council (GCC) were yesterday again forced to match the Fed’s decision to slash interest rates as their currencies remained pegged to the greenback.

 

Experts said the latest cut would increase pressure on regional governments to revalue or depeg their currencies from the dollar.“This measure will only give rise to inflation as it means higher liquidity,” said Gulf economist Mohammed Al Asumi. “It is time for Gulf states to consider ending the link between their currencies and the dollar. I believe it’s their only choice in the present situation.”

 

And the US decision to cut interest rates for the fifth time in less than eight months could push the UAE and other Gulf Arab oil producers to the brink over whether to keep their currencies tied to the dollar, experts said.

 

While the US decision is justified by its slowing economy and the need for a stimulus, the situation in the Gulf is quite different as the GCC’s economies are passing through a boom period that requires an increase in interest rates.

 

“The latest US rate reduction has put regional countries to test as they must match that move,” added Al Asumi. “Cutting rates in the GCC will only aggravate the inflation problem as it will increase liquidity. Rate cuts are not a solution because the economic situation here is quite different from the US, which is suffering from a slowdown.

 

“I think ending the link is an economic, monetary and political decision and should be taken collectively in the GCC. It is time for them to consider this move.”

 

Apart from Kuwait, the currencies of GCC members – the UAE, Qatar, Bahrain, Oman and Saudi Arabia – are effectively pegged to the dollar, which has lost more than 30 per cent of its value over the past two years. Kuwait’s dinar is attached to a basket of currencies in which the dollar has the lion’s share.

 

Speculation has mounted in the past few months on whether GCC nations, which pump nearly a fifth of global oil supplies, would appreciate their currencies against the dollar to offset the decline.
 
But some of them have given indications there are no such plans for the time being, although they have allowed their currencies to rise slightly vis-à-vis the dollar in the past two months.

 

Nazim Al Qudsi, Director of Investment at the government-controlled National Bank of Abu Dhabi, said: “The current value of the GCC currencies do not really match their strong economies at this stage. By following the US, the GCC states are only exacerbating the inflation problem.

 

“I believe the monetary policy should reflect the local economy, not the economy of another country. Here in the UAE and other GCC states we have a state of high economic growth, while in the US there is a slowdown.

 

“How can you take the same measure in quite different economic conditions? I think the right measure that should be taken now is to at least appreciate local currencies against the dollar because this will help ease inflation pressures.”

 

Inflation rates have sharply risen in the GCC over the past two years because of excess liquidity, an economic upsurge, strong domestic demand and other factors. In Saudi Arabia inflation hit a record 4.1 per cent last year, while in the UAE and Qatar it is expected to have exceeded 10 per cent.

 

Excessive domestic liquidity in the UAE was illustrated by a sharp rise in credits, which increased by more than Dh200 billion in 2007 to peak at around Dh722bn at the end of the year compared with Dh515bn at the end of 2006.

Last year’s increase was the highest ever annual credit growth and bankers attributed this to a surge in projects in the country. Saudi Arabia, the world’s oil powerhouse, is also suffering from swelling liquidity and economists said this week its latest decision to force banks to increase reserves to curb credits had failed to stem liquidity.

 

According to Henry Azzam, CEO of Deutsche Bank in Dubai, GCC governments can tackle high liquidity by issuing bonds and certificates of deposits, curbing government spending and raising borrowing costs, along with increasing provision requirements for banks to limit lending potential.


A recent study by the Kuwait Financial Centre (Markaz) deplored the GCC’s current plight of high inflation and the dollar link. “Monetary authorities in the Gulf have never been challenged as much as they are now. The policy is surrounded by various factors, what we call the vicious square, all exerting diverse influence.

 

“Liquidity has experienced very sharp growth during the last few years thanks to high oil prices. The currency peg has led to imported inflation. This is also forcing the authorities to follow monetary policy actions of US, which is completely divorced from that of the local economy.

 

“While the US is on an easing mode in order to ward off recession, GCC economies are experiencing high growth and inflation, which necessitates tight monetary policy. The challenge is to allow a gradual appreciation of the currency without giving in to speculators.”

 

Another study by a Western financial think-tank agreed the dollar peg, which has been in force for more than 20 years, has crippled the region’s ability to deal with inflation.

“The situation is being aggravated by policy shortcomings.

 

The preference for fixed  pegs leaves the region’s central banks with few monetary policy options to stem liquidity growth,” said the Washington-based Institute of International Finance.

 

“In the five states, central banks have been obliged to follow the US Federal Reserve’s recent interest rate cuts at a time when domestic credit growth is rampant.”

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