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04 March 2024

Gulf is pegged to inflation

By Staff Writer




The inflation problem that is plaguing the GCC cannot be solved as long as their currencies remain pegged to the dollar, said analysts at investment bank Shuaa Capital.

Calls for dropping the dollar peg have again gained momentum after the UAE’s Central Bank decided to set up a taskforce to study the issue. At the same time the Ministry of Economy has set a task for itself – to keep inflation at five per cent.

Qatar, the fastest growing economy in the world, has seen the highest levels of inflation in the country, most of it imported. Recently, the country’s prime minister said Qatar is seriously considering dropping the peg, though he hopes for “unified action” from GCC countries, he added.

The growing concerns about inflation are not unfounded as both the UAE and Qatar have been the hardest hit among GCC countries. The dollar peg has been hurting GCC countries on two fronts. First, it is forcing GCC central banks (with the exception of Kuwait, which dropped the peg in favour of a currency basket last year) to mimic US monetary policy, or risk speculative pressure on their currencies. The Fed’s adoption of a loosening monetary policy, necessitated by the continuing credit crunch and the looming recessionary fears in its domestic economy, has consistently cornered GCC policy makers, stated the new report by Shuaa Capital.

“The pegged GCC currencies have been left with little option but to decrease interest rates just when their booming economies – and high liquidity levels – warrant tightening. As a consequence, inflation has been exacerbated. As the Fed will continue to adopt a loosening monetary policy, the situation is not likely to improve in the near future. Secondly, as the dollar reaches record lows, the weakening GCC currencies are enhancing imported inflation,” said the report.

For a clearer picture, Shuaa Capital calculated the nominal devaluation of both the UAE dirham and the Qatari riyal. Their estimate is based on a basket of trade currencies, including the euro, Chinese renminbi, Japanese yen, Indian rupee and the US dollar. Since 2006, the dirham has depreciated against the basket of its trade partners between 12 per cent and 17 per cent, while the riyal dropped in value by around 13 per cent to 18 per cent.

However, given the record level of surpluses in the trade balances of GCC countries, Shuaa Capital expect that all GCC currencies are even more undervalued than what estimates reflect.

“Both Qatar and the UAE have been attempting to address inflation through measures such as rent caps and price controls on food items and other basic goods. Qatar recently froze rents for two years.
UAE announced subsidies on basic food items for nationals, and Dubai cancelled all fees and customs on cement and steel to lower construction costs. Though these measures remain popular in countries suffering from inflation, they have limited impact, and in the long term, they end up aggravating inflation by limiting supply.

“As the dollar remains at these low levels and inflation in the GCC countries is at an all- time high, we believe the GCC countries, and especially the UAE and Qatar, have to address their exchange policy soon. At this stage, we reiterate our view Qatar and the UAE remain the two countries most likely to take unilateral action, by undertaking a one-off revaluation in the range of three to five per cent [possibly higher in Qatar’s case] in the first half of this year, followed by a move to a currency basket in the longer term, possibly as part of a common GCC decision,” said the report.

However, the big question remains – will this have an impact on inflation? “In the first instance, a revaluation will directly impact imported inflation, while indirectly affecting such sectors as real estate through factor costs [construction materials and so on]. A revaluation will also moderate other drivers of inflation such as demand for higher wages, as foreign workers see both their purchasing power and the value of their remittances rise. Based on the weights of CPI components in both countries, their trading baskets and the above issues, we estimate a revaluation will dampen inflation by around two to three per cent. Given current inflation rates [and the UAE’s professed target inflation rate], an immediate relief from possible revaluation is becoming increasingly attractive.”

While the real solution would be to adopt a currency basket, a one time revaluation would help both countries reduce inflation temporarily, while allowing monetary authorities time to take necessary steps towards implementing an independent monetary policy. While some initial steps have been taken to create a money market, more is required to build a well-developed monetary market.”