Keep the peg and face inflation



The sudden 0.75 per cent cut in US rates last week, and the rising expectation of a further cut soon, will only increase the inflation the UAE will suffer this year as the result of its dollar peg, and the failure to revalue the dirham to compensate for a weak US dollar.

 

It is no good policy makers sticking their heads in the sand. No change to the dollar peg is a policy that says: yes we want higher inflation this year. Just how damaging is that inflation likely to be?

 

High inflation damages the competitiveness of an economy. If salaries of expatriates fall in real terms due to inflation then it is harder to attract the human talent necessary to sustain economic expansion. Most firms have put HR on top of their list of problems this year and the weak dirham compounds this difficulty.

Inflation is also bad for  profits. If costs are rising faster than revenues then profits fall. If company profits fall so will stock markets and investment in new projects. Inflation distorts new investment into non-productive areas of the economy and creates investment bubbles in areas like real estate that are perceived as likely to benefit most from rising prices.

 

Inflation is harmful to economic growth. Indeed, inflation can eliminate economic growth. In 2007 the UAE economy grew by 16.5 per cent and official rates of inflation left real GDP growth at around seven per cent. But most economists reckon inflation was much higher, squeezing economic growth to low single figures.

 

If nominal GDP growth is sustained at this level in 2008 or drops slightly with lower oil prices and inflation surges out of control, then the UAE will go into a recession. That is to say real GDP will be in decline as costs are rising faster than revenues. The Abu Dhabi Chamber of Commerce this week called for a package of measures to tackle inflation.

 

Yet some officials oppose revaluation as a part of such a package. Federal National Council speaker Abdul Aziz Al Ghurair argues revaluing the dirham exchange rate will mean that the government has to change policies every time the dollar falls.

 

He suggests that instead the government should set limits on lending to control inflation. Certainly some additional measures to soak up local liquidity, such as local currency bonds, are required. However, revaluation should be seen in the context of emergency moves to control inflation like the rent cap. It will certainly require government to re-examine the exchange rate on a regular basis, perhaps once a year.

 

But revaluation should be part of a move towards a different kind of monetary regime entirely, a basket of currencies with a floating exchange rate, perhaps based on the very successful Singapore model or Kuwait.

 

Revaluation is a step along the road, but not the final step. A meaningful revaluation should be undertaken very soon to offset the threat of high rates of inflation as the result of wholly unsuitable low interest rates being applied to the already overheating UAE economy, and the maintenance of an artificially depressed dirham.

 

Many of those who oppose revaluation do so for the wholly realistic reason that the value of dollar assets will be lowered in terms of local currency. But this then is a question of self-interest and not national interest, unless the size of overseas assets is perceived as more important than the health of the

local economy.

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