Questions have been raised on the UAE dirham exchange rate regime, which is currently fixed and pegged to the US dollar.

Two views can be clearly discerned. First, the official UAE monetary authority's view (represented by the Governor of the UAE Central Bank), which is to continue pegging the dirham to the dollar. Second, researchers' views in favour of de-pegging and adopting a flexible exchange rate regime.

Given this difference in opinion, how to choose between fixity or flexibility?

Exchange rate regimes are of two main types: (1) fixed - characterised with exchange rates pegged to a currency or a currency basket, with the possibility of changing the peg if necessary; (2) flexible - with various modalities, such as free-float, where the market determines the exchange rate, or managed float, whereby monetary authorities intervene in the market to influence the exchange rate.

Many studies concerned with the choice between these regimes have concluded the following: (a) In general for all countries, inflation has been lower and less volatile in countries with pegged exchange rates, (b) there does not appear to be a clear relationship between the exchange rate regime and economic growth, (c) the alternative exchange rate regimes on their own do not necessarily lead to better or worse inflation rates, (d) economic growth can be satisfactorily high and inflation desirably low under either exchange rate regime, provided that appropriate macro-economic policies are in place, (e) countries with fixed exchange rates appear to be more exposed to currency and banking crises, (f) during the past decade, the number of countries with flexible exchange rate regime has increased and this trend is expected to continue with an increase in the degree of globalisation of financial markets, (g) neither a rigid fixed exchange rate regime nor a complete flexible exchange rate regime is the optimal regime for achieving macroeconomic stability, (h) Arab countries with flexible exchange rate regimes recorded higher inflation rates than Arab countries with fixed exchange rate regimes.

Appropriate?

Is the UAE choice of exchange rate regime appropriate?

Factors that favour fixed exchange rate are: high inflation, small-size economy, openness, nominal domestic shocks and degree of dollarisation. Factors that favour flexible exchange rate are: high inflation, large external imbalance, low level of international reserves, fiscal inflexibility, financial runs, low flexibility of labour market, internationalisation of own currency, degree of financial development, external nominal shocks, and real external or domestic shocks.

The choice of exchange rate regime on the basis of these factors requires complete information on their status, and does not depend on one factor only.

In addition, it depends on the policymakers' objectives. If the objective is inflation reduction, then usually a fixed rate regime is the choice; however, if the objective is correcting external balances, then exchange rate flexibility is the choice.

Given the features of the UAE economy, three factors - small economy, openness and nominal domestic shocks - call for a fixed exchange rate regime for the dirham. This is because the UAE economy is relatively small, open and is exposed to nominal domestic shocks resulting from large monetary expansion. The inflation factor could favour either fixity or flexibility of the regime.

Imbalances

At the same time, four factors - large external imbalance (the current account surplus was 21 per cent of gross domestic product [GDP] in 2006), capital mobility, external nominal shocks, and real domestic and external shocks which the UAE economy is exposed to - favour a flexible regime.

If all factors were of equal weights, the outcome of choice between fixity and flexibility might be decided in favour of the latter.

Even then, two issues are raised: (a) which modality of flexibility is appropriate for the UAE dirham, and (b) is the UAE economy ready and has it the infrastructure to migrate from a fixed exchange rate regime, that served the economy well for a long time, to a modality of flexible exchange rate regime? That is a topic for another day.

The authors are an economic adviser and corporate finance specialist respectively, based in Dubai.