Honey, who shrank my dirham?

The recent sharp fall of the dirham's exchange rate against all leading international currencies was triggered by a 50-basis-point (0.5 per cent) interest cut by the US Federal Reserve.

Due to the growing pressure of the global credit crunch arising out of the US mortgage market turmoil and sagging economic growth, the Fed was forced to cut interest rates.

The lowering of interest rates and the growing prospects of future interest rate cuts in the US has driven the currency markets to dump the dollar in favour of other currencies such as the euro, sterling, the Canadian dollar and a host of Asian currencies such as the Indian rupee and the Chinese yuan.

Purchasing power

While the dollar's decline was proportionately reflected in the dirham's exchange rate against other currencies due to the dirham's peg to the dollar, a big surge in domestic prices (inflation) in recent years has seen the dirham's purchasing power shrink rapidly.

In the UAE, strong econ-omic expansion in the recent years has fuelled a big surge in domestic demand, causing supply shortages and upward pressure on prices.

While domestic inflation is estimated at 9.3 per cent, the UAE's money supply (M2) rose 23.2 per cent to Dh399.3 billion in December 2006 against Dh324.1 billion in December 2005, largely due to high oil prices and repatriated Arab investments.

Although the housing shortage, rising rents and food prices and supply shortages contribute to a major share of inflation in the UAE, the falling exchange rate of the dollar is fast being reflected in the UAE's domestic prices of imported goods.

More than 70 per cent of the UAE's imports are from Europe, the UK and Asia where currencies have appreciated against the dollar. The decline of the dollar has added to imported inflation.