UAE and Qatar likely to revalue currencies

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Merrill Lynch believes the UAE and Qatar will revalue their currencies by 5 per cent “in the near term”. The prediction comes despite vociferous denials from the UAE Central Bank that a change to the dirham’s existing dollar peg is even under consideration.

However, analysts say the Bank would not want to offer any indication a currency change was imminent for fear of creating a run on the dirham. This happened in December last year, when fervent speculation led Dubai hotels to reduce their dollar exchange rates from 3.72 dirhams to 3.1 dirhams, while others refused to even accept the US currency.

The revaluation rumours will not go away, providing a boon for the domestic equity markets as foreign institutions snap up UAE stocks in the hope of a double gain – that these shares will increase anyway, while their value relative to other currencies will also rise following a change to the peg.

“Strongly growing GCC countries with currencies pegged to the US dollar are faced with rising inflation against a background of increasingly accommodative interest rates,” a Merrill Lynch report states. “We believe this makes a currency regime change more likely.”

Merrill acknowledges imported inflation from the declining value of the dollar is not a primary driver of inflation, but says a stronger dirham would tighten monetary conditions and switching to a basket of currencies would provide greater flexibility for policy makers.

As previously reported, US, and therefore UAE, interest rates have been reduced from 5.25 per cent to three per cent in less than six months. Such a move has swelled the money supply in the UAE.

“If the UAE and Qatar follow the Fed instead of revaluing, monetary easing is likely to lead to even higher inflation – real interest rates are already deeply negative,” the report states.

Imported loose money controls are massively exacerbating growth-related price pressure, with some GCC states experiencing money supply growth of 30 per cent year-on-year.

The dollar peg has provided stability and reassurance to investors. A sudden abandonment or change of the dollar’s peg would place the beleaguered US currency under further pressure, therefore reducing the value of the GCC’s dollar-denominated reserves.

However, Merrill believes the benefits of currency reform outweigh the costs.

“If these countries wish to diversify into financial services they must open the capital account, which is harder to do with a fixed currency and would require greater intervention.”

Some observers claim adjusting the dollar peg would discourage foreign investment, with overseas investors getting less for their money. This would hamper efforts to diversify the economy away from oil, but Merrill says this is argument is basically flawed.

“Most diversification is either through domestic demand [real estate, housing, transport services etc] or exports in sectors that reflect supply bottlenecks [refineries, petrochemicals, liquefied natural gas, metals, etc] or tourism.

“We argue this does not have much to do with price competitiveness,” the bank said.

Inflationary Causes

There is a high correlation between rent and inflation in the UAE, according to data from the Dubai Chamber of Commerce, with a 0.96 correlation between the two. Wages are another factor driving inflation, providing a correlation of 0.76.

This has led to productivity – the value of GDP divided by total wages – to fall by 0.7 per cent over the past 10 years. The public sector has driven wage rises. Government expenditure is a small contributor to UAE inflation.