Flexing the currency muscle.
The choice of the dirham exchange rate regime between fixity and flexibility may favour the latter, as was discussed in an earlier article (Gulf News, February 2, 2008) concerning the net impact of the factors involved.
But, two issues arise. Firstly, which modality, or type, of flexibility is appropriate, and secondly, is the UAE economy ready with the infrastructure to migrate from the fixed exchange rate regime that has served the economy well for a long time?
No theory is available to assist in assessing the UAE case. However, according to the International Monetary Fund's literature, country experiences reveal that four components are necessary for a successful migration from exchange rate fixity to flexibility.
They are as follows: (a) a well-developed foreign exchange market; (b) a nominal anchor for monetary policy to replace the fixed exchange rate; (c) policy for central bank intervention in the foreign exchange market, that is the practice of buying or selling the local currency to influence its exchange rate; and (d) an exchange rate risk management mechanism for monitoring and managing both public and private sectors exposure.
The sequence and speed assigned to each of these four components are to a great extent country-specific and depend on a country's economic structure. These components are not yet in place in the UAE. But UAE monetary authorities can, if they wish, work towards establishing them.
We can elaborate on each in turn.
First, the foreign exchange market.
A foreign exchange market consists of both a wholesale inter-bank market and a retail market where licensed brokers trade with each other and with individuals and firms. Such a market is necessary to operate a flexible exchange regime. However, the market has to be liquid and efficient to allow the exchange rate to respond to market forces and limit deviations from an equilibrium exchange rate that is consistent with a country's economic characteristics. Given the relatively large external current account surplus of the UAE, the exchange rate of the dirham that would be determined in the market would most likely be higher than the theoretical equilibrium, as market-determined exchange rates tend to over- and undershoot.
Owing to the fact that the dirham exchange rate is fixed, there has been no attempt to develop a foreign exchange market that would determine the exchange rate. Thus, if the UAE monetary authorities decide to adopt such a regime, they need to establish an efficient and deep foreign exchange market gradually. The following steps would help.
(a) Allow some flexibility in the dirham exchange rate within a band around the dollar peg. For example, allow it to fluctuate between 3. 674 +/- 0.367, that is 10 per cent above or below the current rate per US dollar. Such a measure could stimulate foreign exchange activity and foster an understanding of exchange rate risk - that is, a currency may either appreciate or depreciate, and help create future and forward foreign exchange markets.
(b) Limit the UAE Central Bank's trade with banks and interventions gradually, to reduce its role in the foreign exchange market.
(c) The UAE Central Bank could provide complete information on the sources and uses of foreign exchange, and on UAE balance of payments trends, to assist foreign exchange market participants to take a view on the exchange rate. Also, it is important that information systems and trading facilities give real-time bid and offer quotations in the market.
Second, central bank intervention.
Under a fixed exchange rate regime, a central bank buys and sells foreign currency to bridge the gap between its supply and demand. In contrast, under a flexible regime, the central bank is not obligated to intervene in the market. However, it can intervene, buying or selling, to correct or limit deviations from a desired exchange rate, limit volatility of disorderly markets, supply foreign exchange and accumulate foreign reserves.
Currently, the UAE Central Bank intervenes to buy or sell dollars in order to balance the supply of and demand for dollars at the fixed dirham exchange rate. Moving to a flexible exchange rate regime would relieve the UAE Central Bank from selling or buying dollars at the fixed rate, while presuming the readiness of the UAE Central Bank to intervene in the foreign exchange market when the dirham exchange rate against the dollar is misaligned with the economic fundamentals of the UAE, as is the current situation.
Third, an alternative nominal anchor.
A country migrating from a fixed exchange rate regime to a flexible one needs to adopt a new nominal anchor in place of the peg, such as an inflation target, to be used as a framework for its monetary policy.
The switch from fixity to flexibility of exchange rate entails the shift of liquidity management from intervention in the foreign exchange market to other monetary policy instruments such as open market operations. Many countries that shifted from fixity to flexibility adopted inflation targets as their alternative nominal anchors. Such a move could be explicit and transparent, or implicit without announcing the target.
Fourth, exchange rate risk management.
Moving from exchange-rate fixity to flexibility shifts exchange rate risk from the central bank to the foreign exchange market participants, because the former will not be obliged to intervene at a fixed rate. However, for a successful shift a central bank needs to establish a framework for managing exchange rate risk.
Such a framework is made up of four elements: (a) an information system to monitor the various sources of exchange rate risk, (b) techniques to measure exchange rate risk, such as value at risk, (c) internal risk policies and procedures, and (d) prudential regulation and supervision of foreign exchange rate risk.
Taking all together, the necessary components for a successful shift from a fixed dirham exchange rate to a flexible one are not currently available in the UAE. In light of the preceding elaboration, and given the weak and declining dollar, the authorities have several options to align the dirham exchange rate to the UAE economic and financial fundamentals.
One option is to keep the peg to the dollar, but revalue by an amount equivalent to the depreciation of the dollar against the euro.
Another option is to peg the dirham to a basket of currencies of the UAE's major trade partners, or revalue and adopt a gradual path to put in place the required components to move from fixity to flexibility.
In other words, it does not mean that the UAE monetary authorities must stick to the fixed dollar peg.
- The writer is a former director of the Economic Policy Institute, Arab Monetary Fund, Abu Dhabi.
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