Dirham faces fresh pressure

Dubai: The rising money supply, costs associated with inflation and surging speculative investments in domestic markets are putting pressure on the UAE and other GCC countries to adopt more flexible currency policies, according to two international banks.

"We believe there is a significant risk of a change in the policy regimes of either the UAE or Qatar in the coming six months. We continue to hold a long dirham and Kuwaiti dinar versus short dollar in our discretionary portfolio," said Emma Lawson, currency strategist with Merrill Lynch.

'Reforms necessary'

Last week, Standard Chartered said capital inflows generated by investors betting on revaluations of dollar-pegged Gulf currencies and the risk arising from inflationary pressure would necessitate currency reforms.

Although GCC central banks continue to insist on its commitment to the peg, the speculation surrounding the GCC pegs has risen as the Fed has cut interest rates by a total of 75 basis points (0.75 per cent) in the last two months.

" In the case of GCC, the difficult question is how concerned the central banks are with inflation. Given that their mandate is to maintain currency stability rather than price stability, inflation may not matter.

Inflation fears

"However, the reaction of some of the GCC central banks post the Fed's interest rate cut suggests that there is concern over rising domestic inflationary pressure," said the Merrill Lynch report.

Analysts said that attempting to control inflation through monetary policy at the same time as retaining currency stability is not sustainable in the long term.

This is particularly difficult if there is a relatively open capital account and foreign funds can move freely in and out of the economy. If there are higher interest rates in the pegged country then speculative funds will flow in to use the arbitrage opportunities. This is already happening in both equity and currency markets across the GCC and the pace is likely to pick up in the near future.

According to the latest statistics from the UAE central bank, the UAE money supply increased by Dh100 billion during the first half of this year from Dh506 billion at the end of December to Dh600.29 billion at the end of June this year.

Rising speculation about a change in currency peg, as well as easier financing conditions associated with abundant liquidity has been evident in the recent jump in domestic asset prices, especially the stock prices.

"We have already seen that there has been a general rise in prices. Local equity markets, after suffering a significant correction in 2006, have performed strongly in recent months. An increase in liquidity may lead to a rise in bank lending and higher bank profits," said Lawson.

In a move to sterilise the impact of rising money supply Saudi Arabia's central bank raised the reserve requirement for banks last week for the first time in 27 years to prevent lower interest rates from fuelling inflation.