Dollar fall may lead to dirham revaluation

While the UAE is making serious efforts to stem soaring liquidity and tackle inflation, such measures have been complicated by the sharp drop in the US dollar, to which the dirham and other Gulf currencies, except Kuwait, are pegged.

“The government is making sincere and serious efforts to control inflation… but due to the peg, the central bank is unable to stem monetary growth by adjusting interest rates independently of the US Federal Reserve. Also the currency weakness has pushed up the import costs leading to a substantial increase in construction costs as well as consumer price inflation,” the Kuwaiti-based Global Investment House (GIH) said in a report about the UAE economy yesterday.

“The UAE Central Bank persists on continuing with the peg stating that it has served the country well for so many years.

“However, going forward, much would depend on the direction of the US dollar movement. A prolonged and steady decline would make the case for revaluation difficult to ignore.”

The Central Bank has repeatedly ruled out an appreciation of the UAE dirham against the US dollar for the time being despite a surge in the cost of imports from major non-dollar exporting countries.

The link between the dirham and the greenback has forced the UAE and other Gulf states to match a series of US Federal Reserve interest rate cuts over the past few months, putting further pressure on their desperate bid to ease inflation.

“Cutting rates to match similar US moves would only aggravate inflation in the UAE and other Gulf countries,” said Mohammed Al Asumi, a well-known Gulf economist.

“The economic situation in the Gulf is quite different from the economic downturn experienced by the United States for the past couple of months, and this should prompt Gulf states to seriously consider revaluating or detaching their currencies from the dollar.”

GIH, a prominent regional financial and investment consulting centre, said it saw loopholes in the UAE’s efforts to fight inflation, including what it called non-compliance by the recent government decision to impose a five per cent cap on rents of residential properties to prevent a spiralling from stoking inflation.

It said the move, first introduced in Dubai, had been only partially successful as it reduced annual rents. “However, the rate of increase is still significantly higher than the cap, suggesting widespread non-compliance.

“Furthermore, there is no protection for newcomers or those changing accommodation as the rent cap, even when enforced, is only applicable to renewals. Other efforts of the government include building affordable housing to the labour population at large.”

But it noted other measures taken by the government or under consideration could help curb inflation, which it put at a record 9.3 per cent in 2006.

They include more certificates of deposits by the Central Bank and an Abu Dhabi Government decision in January to issue bonds to absorb liquidity and tighten money supply. The government is also looking at other means such as providing subsidies for UAE nationals and more wage increases.

“Debate is currently on whether the country should de-peg its currency from the dollar… the US and the GCC economies are at very different stages in their respective economic cycles.

“On one hand, the US is facing a sharp economic slowdown and declining housing demand… on the other hand, the GCC is awash with liquidity and experiencing a period of strong growth.”

GIH said high inflation in the UAE was reflected in a surge in credit, which was a direct result of an economic boom caused by strong oil prices across the world.

“The healthy credit growth contributed to the expansionary trend in the market. A review of the factors influencing broad money [M2] shows that the effect of net foreign assets was contractionary, as they dropped by 6.7 per cent in 2006 over 2005 and again dropped further by 2.4 per cent in the first nine months of 2007.

“However, the effect of net domestic credit on broad money [M2] was expansionary, as it first increased by 55.0 per cent in 2006 and then again a further 45.7 per cent in the first nine months of 2007. Claims of the banks on private sector grew rapidly by 32.9 per cent in 2006 to reach Dh385.8bn and then a further increase of 22.7 per cent to reach Dh473.4bn at the end of Q3-2007.”

The Global Investment House said such a high growth, which has come on top of the double-digit growth rates in the previous two years, points at both the demand in the economy and the rapid development of the private sector.

Beside bonds, the Central Bank has also sharply boosted its certificates of deposits to banks to absorb part of the swelling domestic liquidity. This is in contrast with previous years, when there was a large decline in the Central Bank’s liabilities corresponding to CDs.

“There has been a change in the policy lately, with the economy facing inflationary pressures. With the Central Bank persisting on the dollar peg, and accordingly its need to bring down the interest rates in line with Fed, it had to rely on issuing certificates of deposit in order to mop up the excess liquidity,” said the Kuwait-based group.

“This is one of the effective measures to tighten liquidity in the fight against rising inflation, which has continued to be a concern, and also a hurdle, for the UAE economic progress and was at all time high of 9.3 per cent in 2006 as recorded by Consumer Price Index.”