Time to change monetary policy in UAE

Recently, arguments have been put forward pushing for more deposits in the banking sector. I propose a different approach to addressing the economic crisis. The UAE economy needs an injection of new dirhams in the form of direct spending to support aggregate demand. The injections to date have been aimed at supporting local credit expansion, through loans, deposits, and capital injections into banks. When banks are provided with more liquidity, the injection provides more comfort to the banks, but does not necessarily and immediately become expenditure, and therefore does not provide a boost to aggregate demand.

On the one hand banks have more liquidity, on the other, businesses are struggling and individuals are losing their jobs, leading to an environment where banks are not too quick in lending their cash, and when they do so they do it at a much higher price. Thus, credit expansion does not actually occur as anticipated. Moreover, in such dire economic conditions, those who might have thought about a mortgage or a loan, might postpone their plans for less uncertain times.

The Dh50 billion loan facility provided by the Central Bank, the Dh70bn deposit programme announced by the Cabinet, and the Dh16bn capital injection recently made public by Abu Dhabi, are all geared towards the banking sector. Obviously, this is very important. However, banks lend according to very strict criteria, their lending process takes time, and the interest rates they charge are significantly higher than the UAE benchmark rate.

When banks are provided with more money to lend, in an environment where people are losing jobs and/or are threatened to lose their jobs, the price of loans and the risks associated with lending are very high. This implies that the process of credit expansion slows, making those policy actions relatively ineffective.

The current focus of government policy in reaction to the crisis needs to also include aggregate demand and expenditure. Indeed, additional credit facilities do not necessarily put money in peoples' hands. The solution is to inject new money in the form of direct expenditure, and reverse the downsizing trend across public and private enterprises, which has a direct impact on local activity, real estate, and aggregate demand.

Downsizing in the UAE has a much broader economic impact than in the US or elsewhere. The focus here is on expatriates, which make up the larger proportion of the workforce and population. When an employee is downsized in the US, he or she does not have to leave the country.

When a manager or middle manager loses his or her job in London, they do not have to move out of their house. Quite the contrary, they actually get unemployment benefits.

Indeed, unemployment benefits are called "automatic stabilisers" in macroeconomics, because they increase when people lose their jobs, ie, the decline in income and expenditure is offset with increasing unemployment benefits, at least to a certain extent. There is no such tool in the UAE economy, and the loss in income and expenditure is not offset by any public funds, as expats are not entitled to unemployment benefits.

Moreover, those who are downsized have to find a job or leave. Thus, downsizing in the UAE has a direct impact on the real estate industry as well. Therefore, cost reduction, however necessary, makes the overall scenario worse if offsetting policies are not implemented to support aggregate demand. Indeed, they lead to more defaults, making credit growth even harder, affecting the banking sector as well.

Why have current UAE Government interventions focused on banks and credit expansion? The UAE monetary architecture and the dollar standard lead to an environment where new money injections are dependent on dollar earning/inflows, and thus governments and central banks, can only inject new local currency, if they bring in new dollars. As the illustration shows, all major avenues of USD inflows in the economy have been affected by the crisis, and there has been either a decline in inflows, or actual outflows.

The problem is that there is not enough dollars available in money and credit markets around the world, and with confidence at historical lows in the dollar economy globally, the challenges will be around for some time. Given that on average around 80 per cent of government revenues in the region are petrodollars, and given that petrodollars are used to finance local expenditure, the decline in oil prices has exacerbated the negative impact of foreign capital outflows, and the dramatic reduction in new inflows.

In parallel, the vast majority of foreign investments made by sovereign wealth funds have either lost value or have lost income generating capacity. No one knows exactly how much liquid assets are still available in the hands of SWFs. Indeed, if such savings are still available, spending them locally could also support aggregate demand. In this scenario, however, while the short-term issues could be resolved, the architectural limitations remain.

The bottleneck in the UAE is the dollar standard: the fact that it backs the issuance of local currency with foreign currency, ie, US dollars, rather than domestic government securities. For a dirham standard to replace the existing architecture, the UAE central bank has to manage a floating exchange rate, and needs to engage in open market operations managing the money supply and the monetary base through direct purchases and sales of government securities. If such a change is not undertaken, the fate of the domestic economy would be surrendered to a US and global recovery.

Thus, a lot will depend on the US economic stimulus package of Barack Obama's administration. But even if the new president is successful in changing the trend and bringing back the tide, it will take some time for that liquidity to find its way back into the UAE, and the region. Moreover, if such a turnaround does happen, oil prices will recover only gradually.

Given continuous negative reports in the banking sector, a worldwide decline in manufacturing output, a global freeze or decline in credit expansion, the current recession and global bear market seem to be far away from the bottom.

Monetisation and a change in domestic monetary architecture is the best way to ensure the UAE economy is not dragged down more than it is absolutely necessary or unavoidable.

Global decline in exports from China and India will affect the UAE and Dubai due to the country's role as a major re-exporting hub. The decline in income and wealth experienced in the US, Europe, and elsewhere will affect tourism, FDI, and FPI. The evaporation of large inflows into the economy has already affected local real estate markets, developers and mortgage providers, as most are now faced with falling demand, negative equity, and no money markets where they could easily refinance or finance new or old projects.

The UAE Government and Central Bank can boost aggregate demand and inject new money into the economy through securities issued by the federal government, and bought by the central bank (new money – monetisation). In turn, these cash flows can be spread across emirates, projects, sectors, and public enterprises in order to keep the wheel turning. This will lead to fewer redundancies, fewer business failures, more confidence, and therefore, more growth in credit as well. Otherwise, credit expansion is the only tool against a slowing economy where trust and confidence are low – conditions that constrain credit growth no matter how much liquidity is available.

After all, what are the benefits of the dollar standard? Previously, the dollar standard provided trust and confidence because it backed local money creation with the US dollar. Backing local currency issuance with the US dollar undermines and limits local policy making, and imports the crisis and lack of confidence into the domestic economy.

Moreover, injecting new money and responding to the current woes of the economy through a dirham standard and additional money injection (direct spending) will be applauded by the market.

I propose Islamic monetisation as the way forward. Islamic monetisation is defined as equity-based monetisation. The idea is to back local currency issuance with unique government issued securities which are Islamic in nature, based on risk-sharing and without a predetermined fixed interest rate. They can be called Public Capitalisation Notes, and can be issued by governments and sold to the Central Bank, which in turn can use them to back the currency.

It is my personal opinion that backing local currency issuance with domestic securities is a must – it is time for domestic monetary empowerment, time to manage a floating exchange rate.

It is a managed game, and from time to time, new rules must be designed, if the game is to grow and expand. 


- Armen V. Papazian is an Associate at Judge Business School, University of Cambridge.

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