Dollar peg spells boom-to-bust

 

It is hardly a matter of economic debate to point out that maintaining the dollar peg to the UAE dirham is going to exaggerate the typical boom-to-bust cycle in this emerging market just as it has everywhere else.

You only have to look back to the Asian financial crisis 10 years ago to see how fixed currency pegs can over-inflate an economic growth and lead to a massive subsequent crash.

Economies as diverse as Hong Kong, Thailand and Indonesia moved quickly from boom to bust.

The root cause of that crisis was the pegging of local currencies to the dollar due to which local businesses thought they could borrow at low cost in dollars and invest locally without any risk.

In theory, the pegging of local currencies to the greenback eliminated exchange rate risk and a stellar economic boom ensued, with overbuilding and over investment.

When the inevitable correction came, it was like jumping from the top of a skyscraper rather than from a garden wall. Giant business empires crashed, construction sites abandoned and millions left impoverished.

It has taken a decade for these former Tiger economies to recover.

It could never happen here. It is different this time. These are the same phrases heard during any economic growth. Usually there is some truth in such statements.

But when Gulf central bank governors sit down for their first of meetings in Doha on April 6 and April 7 perhaps it is Asian crisis they should have keep in mind and not the present United States’ sub-prime credit crisis.

Speculation that the Gulf countries might end their dollar peg or revalue reached its height last November before the central bank governors met, with both the UAE dirham and Saudi riyal being targeted as likely to end this link. But nothing happened. Saudi Foreign Minister Prince Saud Al Faisal has since said the Kingdom does not want to see the dollar collapse. After all, oil revenues are in dollars and two-thirds of GCC state assets are dollar denominated. And it is true that a sudden move by the Gulf would put additional pressure on the greenback, already close to an all-time low of $1.60 to the euro.

It may also be that the US is exerting political pressure on its old allies in the region to support the stumbling dollar at a critical time during its own financial crisis. And yet that did not stop the US ally Kuwait from decoupling last spring and moving to a basket of currencies, easing local inflation rates and bringing its economic growth more under control. Perhaps Kuwait has got it right.

The answer is not for GCC states to act in unison but rather to slowly disentangle themselves one by one from the dollar peg rather than frightening global currency markets with a sudden decoupling.

If the GCC states could in some way co-ordinate this currency realignment then that would be sensible. But of course it needs to be done behind closed doors and we cannot expect to be privy to such information. No central bank in the world operates at that level of transparency or could do.

The risk of being forced into doing nothing is worse than the risk of attempting a co-ordinated policy response. Already Gulf countries have some of the highest inflation rates in the world, and the economics of expatriate labour are being undermined by a combination of dollar devaluation and inflation.

It is no secret that the GCC is highly dependent on expatriate labour, and it increasingly needs skilled, and not unskilled, labour for its advance economies. And that labour is not going to find working in the region attractive if the devaluation of the dollar and high inflation mean they would earn more at home. To put it mildly, this makes recruiting talent hard.

At the same time the GCC states, apart from Kuwait, have to track US interest rates lower and lower.

The Federal Reserve has recently reduced its base rate to 2.25 per cent, a move Saudi Arabia is resisting for the moment. But the trouble is that with the fixed currency peg it is not difficult to borrow dollars cheaply overseas, or even locally, and then invest them in projects, which presently offer a higher return such as GCC real estate sector.

This carry trade is artificially inflating investment in real estate related projects, which is precisely what happened during the Asian financial crisis. But it is not too late for prudent economic management to correct this distortion and to bring the growth under control. The GCC is awash with liquidity from the oil boom and a relatively painless solution is at hand.

That brings us back to revaluation, perhaps first in the countries where inflation and the economic boom are most pronounced, namely the UAE and Qatar, and later by a smaller amount in other countries. And steps should be taken to switch to currency baskets in a controlled, and not overnight, manner.
 
 
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