Printer Friendly

A Dollar De-peg Do-over.

Summary: As the UAE rides the financial crisis, we are again hearing calls for de-pegging the dirham to the dollar. Currently, the only alternative being discussed is re-pegging the dirham to a stronger basket of currencies.

Kuwait, which re-pegged its currency to a basket in 2003, is an example of a Gulf state which took the jump off the US bandwagon.

From 2003 until 2007, the Kuwaiti Dinar was allowed to float within a 3.5 per cent band against the dollar and has since then become pegged against a basket of currencies.

While the precise composition of this basket is unknown, exchange rate movements of the KD against other currencies suggest that this basket is heavily dominated by the US dollar.

Has Kuwait experienced lower rates of inflation than the UAE? Yes, in the past few years, inflation (as measured by changes in the Consumer Price Index) in Kuwait was about half that of the UAE. The lower inflation was not however driven by the difference in currency pegs.

First, Kuwait's rates of growth are lower than those in the UAE, the UAE has a far more diversified economy with greater inflationary demand for goods and services (driven in part by government spending on infrastructure) than that of Kuwait and the real estate market in the UAE has experienced far greater gains in valuations than its Kuwaiti counterpart. The latter explains much of the difference in inflation performance between the UAE and its GCC neighbours. The trade-off between output growth and inflation means that high inflation in the UAE is the price to pay for high rates of growth.

The decision to re-peg the dirham should therefore be taken with due consideration to the exceptional characteristics of the UAE economy. Differences in the composition of populations should for example guide a decision to re-peg the dirham.

While the UAE and Kuwait have a high share of expatriates in their total workforce (90 per cent for the UAE and 80 per cent for Kuwait), the share of expats in the total population is much lower in Kuwait (around half) versus the UAE (around 80 per cent), according to the IMF.

This means that the population in the UAE is far more transient than the population in Kuwait. De-pegging the currency may result in much greater capital flight in UAE banks toward foreign-denominated accounts.

This would cause much trouble for local banks reeling from the financial crisis: as they try to meet capital adequacy ratios mandated by the UAE Central Bank, a flight of currency would mean unnecessary disruption and volatility in a time when the country is weathering the consequences of the financial crisis.

To assume that the private sector will maintain its savings in dirhams if the dirham is de-pegged to the dollar is to ignore an important source of potential disruption to the economy.

In addition, the financial crisis has modified a number of factors relating to inflation performance in the UAE. Slower worldwide economic growth mean lower exports for the UAE, in particular: lower hydrocarbon exports. The UAE economy is predicted to grow in 2009 but not nearly as much as it did in the past few years. This will in turn slow down inflation and make a discussion of de-pegging seem much less urgent than it did in the past few years.

The recent rise of the dollar against major world currencies, like the pound sterling, mean that imported inflation will be less pronounced than in the recent past. As economic growth slows and property prices align closer with fundamentals, a major source of inflation will be tamed. As a result, the current dollar peg will at the very least not contribute as much to inflation as it has in 2008.

A re-pegging to a stronger basket of currencies presents a few additional challenges. First, it is very difficult to foresee the movement of major currencies in the next few years and today's strong basket may in the future go the way of the pound sterling.

Second, a re-pegging to a strong basket will not resolve the fundamental source of inflation dynamics in the UAE: a country with a currency peg cannot at the same time control its inflation.

This is because one instrument (setting the repo rate) cannot be used to accomplish two different objectives: both keeping the currency stable and the inflation rate stable.

The choice is therefore to either tame exchange rate volatility or inflation volatility. For the past few decades, the UAE has chosen to keep the exchange rate fixed and the private sector has adapted to this economic environment.

The Central Bank's insistence on keeping the dollar peg is therefore the right position to take in these difficult times.

Aa

Dr Tarek Coury is an economist at the Dubai School of Government and the Harvard Kennedy School.

Aa

Copyright 2009 Khaleej Times. All Rights Reserved.

Provided by Syndigate.info an Albawaba.com company
COPYRIGHT 2009 Al Bawaba (Middle East) Ltd.
No portion of this article can be reproduced without the express written permission from the copyright holder.
Copyright 2009 Gale, Cengage Learning. All rights reserved.

Article Details
Printer friendly Cite/link Email Feedback
Publication:Khaleej Times (Dubai, United Arab Emirates)
Date:Mar 29, 2009
Words:822
Previous Article:MGM Mirage Covers CityCenter JV Financing Payment.
Next Article:Rain, Thunderstorms Expected.
Topics:


Related Articles
H.K. injects money into banking system to defend U.S. dollar peg.
Unravelling the myths of the GCC dollar peg.
Expats must watch dollar to rupee rate.
Outgoing central banker warns against changing H.K. currency peg.
Cashing in on foreign currency.
Bahrain denies secret talks on dollar peg.
Bahrain denies secret talks on dollar peg.
Death of the dollar.
Gulf to decide on FX reform says UAE cbank chief.

Terms of use | Privacy policy | Copyright © 2019 Farlex, Inc. | Feedback | For webmasters