No 'magical' cure for UAE inflation

The UAE Central Bank does not have a magic solution to soaring inflation in the country and any sudden currency changes could trigger monetary turmoil in the short term, a government report said yesterday.

Revaluing or de-pegging the dirham from the ailing US dollar remains a very difficult decision and such a move will not alone tackle inflation, which surged above 11 per cent last year from 9.5 per cent in 2006 and less than five per cent in previous years, the Department of Planning and Economy (DPE) said in its weekly report on the dirham peg and inflation in the UAE.

While stemming inflation requires a set of measures, changes in the UAE monetary policies appear to be more complex than any other country in the six-nation Gulf Co-operation Council (GCC), the report said.

It said the Central Bank had already made clear that there are no plans at present to unpeg the dirham from the dollar on the grounds that about 70 per cent of the country's foreign trade is in the US currency, a large part of the UAE's foreign assets are in dollar, more than 95 per cent of its official reserves are in dollar and the peg has long been a factor of stability.


MAGIC SOLUTION

"Therefore, it should be said in conclusion that the UAE Central Bank does not possess the magical stick to stop inflation. Rather, it is a problem that should be tackled by more than one institution at the federal and local levels. Even the private sector and individual consumers have a role to play," it said.

According to the report, pegging the dirham to the dollar has been justified by many internal and external factors and that any decision to end the link requires alternative monetary policies that would curb inflation. But it warned:"Any major change in the exchange rate will cause financial and monetary unrest in the short term… available options do not seem attractive for the time being and changes of the monetary policies in the country look more complex than any other country of the GCC."

The report said the role of the UAE Central Bank, like any central bank in the world, is to preserve the value of the national currency and keep inflation in check. However, the roles of central national banks are being curtailed by the assertive influences of globalisation sweeping across the world, it added.


CURRENCY PRESSURE

It noted that the UAE dirham has come under increased pressure as a result of the flow of oil revenues, adding that inflation has been partly fuelled by the high cost of imports from non-dollar markets.

While this imported inflation can best be reduced either by scaling down imports or by diversifying sources, such a decision requires well-thought out and long-term strategies, DPE said.

Moreover, the report believes any inflation ensuing from devaluation of local currency can only be redressed through adoption of a basket of alternative world currencies, but at carefully studied and fixed rates.

"More importantly, it should be said that despite the enormous pressures put on the UAE economy by the dollar woes, any abrupt change in monetary policies will not suffice in itself to bring down inflation," it said. "On the contrary, such a haphazard move would affect the competitive edge of the UAE's non-oil exports. At the same time, such a decision will affect the overall productivity and would touch on salaries and remittances."


DEVALUATION

According to DPE, oil revenues will remain unaffected as they are valued in dollars but under this scenario, a decision to devalue the dirham by little less than its current value would seem a good option as this would boost the competitiveness of the country's exports and re-exports.

"De-valuation of the dirham would not entirely be woesome because many sectors of the local economy will stand to benefit from such a decision.

"Having said that, it remains to be mentioned that any decision to change the monetary policies or even devalue the dirham, no matter how little that devaluation might be, would require a comprehensive and technical studies that encompass the pros and cons… an attempt to decide the future of the UAE's national currency will remain a complex task. "

The report, citing official comments, said a close look at the UAE's monetary and financial experience during the past three years would reveal that the dollar pegging policy has had some positive impacts.


NOT EASY

"Thus, to drop the dollar would not be so easy a decision to take because it would require some robust alternative policies aimed at curbing inflation and volatility in exchange rate… this dilemma, however, does not mean that the UAE Central Bank would sit by idly while inflation continues to rip local markets apart. While remaining pegged to the dollar, there are financial and monetary policies that the UAE could adopt. One of them is to set a limit for liquidity growth as per the needs of local economy."

It recalled that when the UAE decided to peg the dirham to the dollar more than two decades ago, there were a host of economic, and financial and monetary justifications.

The pegging proved to be a safe haven for a long time, ensuring credibility, stability and boosting investments and investor confidence, it said.

"Furthermore, a review of these justifications will show that the argument to retain the pegging at fixed rate was fuelled by some objectives conditions. Prime among these conditions was the pricing of oil and other essential commodities in dollar. Indeed, 60 per cent of dollar reserves are outside the US.

Additionally, UAE cash surplus and financial accounts are all in dollars.

"What is important in the complex issue of whether or not to de-peg is the position of the UAE Central Bank, which maintains that de-pegging will have adverse consequences that the national economy would not afford.

"The Central Bank maintains that monetary stability, which has long been the UAE's strength, will be tampered with, at least for the time being, if de-pegging is adopted."


BASKET OF CURRENCIES

Despite the positive aspects of the link to the dollar, the pegging of any national currency against a foreign basket is a double-edged sword, DPE said, citing recent Central Bank remarks. It noted that the decline in the US dollar benefited UAE non-oil exports but made the country's imports from other markets costlier.

"Thus, the most dangerous impact of the dollar decline is imported inflation that comes with it as a result of huge fall in the dollar exchange rate against other currencies. Imported inflation terribly affects economic activities and the gross domestic product. This is not to mention the spiralling prices of consumer goods that are purchased with other major currencies," DPE said.

"In short, it is difficult to claim that any one particular monetary policy would be ideal for the UAE. However, if the US dollar continues to decline, the UAE's economy will continue to pay the price as a result of continued dirham pegging with the weakening dollar." It stressed that such a scenario might require certain practical measures to mitigate the negative impact.

"One way of tacking such a situation would be to tie the dirham to a basket of major currencies, including the dollar. This step would boost the international market value of the dirham. Such a decision would, of course, have some short-term effects. Nevertheless, it would achieve a better economic stability. However, it should be acknowledged that such a decision would be one of the most difficult and complex economic decisions to take. "As mentioned earlier, the decision to de-peg the dollar is not an easy one. It requires a set of alterative monetary policies to check inflation and exchange rate. Similarly, it is hard to assert categorically that a single currency anchor is the best system for the UAE."

DOLLAR HAS SERVED GCC WELL

In its comment on the GCC as a whole, the report considered that the dollar pegging had served member states well for decades.

But it also noted that the pegging was adopted when oil prices were low and the greenback still at the height of its strength.

"Today, the dollar is falling relentlessly and oil prices are skyrocketing. This new reality calls for a rethink of monetary policies. GCC states need to peg against a basket of world currencies, taking into account the latest trading patterns which tend to be bent towards the euro zone and Asia.

"With oil windfall entering its fifth year in a row, and with the dollar continuing to decline, it is clear that GCC's monetary polices will face a problem of policy alignment. This problem will definitely affect the single currency union." It warned that a single GCC currency could not be without a decision by the six members to align their monetary, financial, and banking policies.

"This is the single most important objective that needs to be attained now. This alignment may require certain standards in the long-term. These standards include, among others, keeping inflation rate below two per cent at the average, maintaining budget deficit at not more than three per cent of the GDP and keeping the general GCC credit at 60 per cent," it said.

"The wider interest of the GCC countries necessitates amendments in key aspects of economic policies, including adjustment of exchange rates against local currencies. …as the dollar continues to fall, the GCC states need to face the repercussion by adopting a unified stand. It should be noted that these states pegged their currencies to the dollar for objectives reasons."



The Dirham peg: Reasons and motives

OBJECTIVES AND SPECIAL REASONS

- Dirham peg has been the bedrock of a stable monetary stability. The economy enjoyed long credibility as a result.

- Investor confidence in the local currency maintained

- UAE's financial assets in dollars

- 70 per cent of foreign trade is in dollars

- More than 95 of reserves is in dollar

- International oil trade is priced in dollars


GENERAL MOTIVES

- The dollar remains the single most important hard currency in the world

- It is the currency of international trade

- It is the currency of the US, which accounts for about 27 per cent of the world trade 

- 66 per cent of world reserves are in dollars

- 60 per cent of the greenback is outside the US



Side effects of dollar peg

- In view of US economic woes, dirham exchange rate is loosing some of its credibility, a trend that might have negative impact on monetary stability (As in 1977-1976)

- That the dirham exchange rate has remained fixed against the dollar will require the Central Bank to be continually ready to intervene in the exchange market. This will require huge foreign assets reserves.

- With the dollar continuing to decline, future exchanges rate trends will continue to be uncertain. This will cause problems to economic planning

- Euro has begun to compete with the dollar at the global level. It is a force to reckon with when considering the exchange rate



De-pegging or no de-pegging?

REASONS FOR TAKING THE DECISION

- Enhancing the efficiency of monetary policy to regulate economic activities

- Curbing inflation and mitigating its effects at the domestic level

- Mitigating the effects of dollar depreciation on domestic conditions.

REASONS FOR DEFERRING THE DECISION

- Pegging is justified by many internal and external factors

- De-pegging requires alternative monetary policies, which would curb inflation and check exchange rates

- Changes in UAE's foreign trade, which helped to contain inflation

- Taking risk by adjusting exchange rate is one of the tools for monetary policy

- Any major change in the exchange rate will cause financial and monetary unrest in the short term

- Available options do not seem attractive (currencies basket/floating, etc)

- Difficulty in managing exchange rates in the context of other option

- De-pegging requires regional and international consensus (GCC single currency)

- De-pegging requires delicate balances

- Changes of monetary policies in the UAE look more complex than any other country in the GCC



Future of dollar: further depreciation predicted

- The dollar lost 40 per cent of its value since 2000

- US monetary policy welcomes more reduction

- Dollar weakness reduces cost of US exports

- Dollar weakness helps US trade balance

- Weakening dollar reduces cost of US assets

- There is a global tendency to get rid of the dollar in favour of other currencies