A couple of weeks ago, before the outbreak of the financial crisis, inflation was the hot topic in the UAE. Today, the major concern is liquidity. Naturally, the international credit crunch has been a trigger behind the UAE's liquidity concerns.

On the one hand, foreign capital has left the country to attend to pressing liquidity issues in home markets, and on the other, the supply of dollar credit to local institutions (banks and other entities) has diminished, and if available, it is so at much higher cost. Moreover, oil prices have fallen, and the threat of a global recession raises further question-marks regarding their future trend.

This article is not about doom and gloom. Although I discuss liquidity, the subject here revolves around the monetary architecture of the country. In other words, I raise issues not from a short-term perspective, but from a structural policy perspective.

The issue rests on the historic evolution of the Central Bank, and the power vested in the institution; and on the nature of fiscal revenue and spending since the inception of the UAE.

On the one hand, the country has had no taxation, and thus government revenue has been derived through oil revenues; on the other, the Central Bank has had limited monetary policy tools due to the dollar peg, which co-opted interest rates, and due to the fact that it has never really had 'monetisation' power.

Monetisation describes the process through which the central bank buys new government bonds, thus injecting new money into the system. When the central bank buys and sells outstanding government bonds, these are referred to as open market purchases and sales, which also affect reserves and the money supply.

There is no active government bond market in the UAE, and the Central Bank of the UAE does none of the above (If monetisation is indeed happening, then there is not enough transparency as to how and through what mechanisms).

Whatever the reasons behind this architectural reality today, it is a fact that the Central Bank has limited avenues of new money injection. Most of the growth in issued currency and money supply are driven by dollar inflows, whether petrodollar inflows (via government spending), or other foreign dollar inflows like foreign portfolio investment, foreign direct investment, tourism, foreign debt, and so on.

New auction system

Given the previously predominant concerns with inflation, the Central Bank launched a new auction system for Certificates of Deposit (CD) in November 2007, which it issues in order to extract liquidity. This system cannot be used to inject liquidity as the Central Bank is the issuer. It could always extract less, or not extract at all, but the Central Bank cannot use this system to inject new money.

Thus the key macro-risk of the UAE is a missing architectural element, i.e., no monetisation of government expenditure, and limited management of the money supply. In other words, money supply changes are very much dependent on new dollar inflows and or outflows, whether they are oil revenues or bank liabilities or inflows generated through tourism, and so on. The exchange rate peg and lack of sterilisation policies are part and parcel of this phenomenon.

Before going further, it is now important to discuss the Dh50 billion credit facility that the Central Bank has recently made available to local banks. This facility can be used by banks to manage their liquidity needs. This is made available through the central bank's discount window. It does impact money supply. However, it does not necessarily end up financing government policy, and therefore, it cannot be targeted to specific expenditures.

Such an injection or facility is very hard to direct, and thus it is mainly beneficial to bank liquidity management. Given that in the UAE the banks were not exposed to the same type of problems as elsewhere, and as the market reports indicated, only 15 per cent of this facility was actually used.

The second effort by the UAE authorities that was announced was the Dh70 billion injection into the banking system by the government, through two-year deposits. While this expands the deposit base of the banking system, and will thus increase money supply, it is again not an example of monetisation unless this is new money. Thus, if the Dh70 billion is fundamentally dollar wealth being transferred to the local banking system, then it depicts the same pattern, subject to the same discussion above. It is not clear as to what the actual source of this injection is, new money or existing wealth transfer. The use of deposits as a method of liquidity injection sheds further light on the arguments made here.

If you were to look at money within the UAE, you could observe a steady increase in the monetary base, in money supply defined as M1, M2, and M3. The definitions and measurements of money vary, and the ones used by the Central Bank of the UAE are well defined in the bank's annual report and the statistical bulletins. It is important to note that credit, loans extended by the banking system, creates money through a process of multiple deposit creation. In other words, every dollar in the monetary base translates into many dollars through the money supply process.

A concept explained by the money multiplier. Figure-1 (Money supply indicators in millions of dirhams) describes these variables in the UAE. All data used in this article is derived from the Central Bank. We notice the increase until 2007. Naturally, 2008 figures are not yet available.

Very illustrative of the above statements regarding the growth of money through credit is Figure-2 where you can see the per cent change in domestic credit and money supply (M1= currency and Monetary Deposits).

The direction and magnitude of quarterly change in these two variables in Figure 2 reveals a relationship which is very well understood by banking and finance professionals (This is not an actual correlation in a statistical sense, but it nevertheless serves the same purpose).

Figure-3 is also revealing, and brings us closer to the above discussion. The figure reveals the percentage change in the monetary base, the percentage change in M1, the per cent change in M2, the percentage change in domestic credit, and the percentage change in Net Foreign Assets (annual figures).

It shows how domestic money supply growth is in fact accompanied by a simultaneous increase in foreign liabilities, which is the reason behind a decline in net foreign assets. In other words, foreign currency positions by banks abroad and loans to local banks have a direct impact on money supply and the monetary base.

Thus, their exit will also have a commensurate decline in the domestic money supply, while reducing the foreign reserves of the Central Bank. This explains the concerns of liquidity, and the determination of UAE authorities to inject liquidity. This is further revealed by Figure-4 depicting the quarterly changes in the monetary base and net foreign assets. (The Central Bank does not have a separate item 'bank reserves' but an account which describes overall deposits without reference to beneficiaries and no distinction between reserves and borrowed reserves.)

The true monetary challenge of the UAE is the build-up of an appropriate monetary infrastructure to ensure domestic money management and domestic money creation mechanisms and policies, which will allow the UAE authorities to deal with a crisis just in case it hits closer to home.

The exchange rate peg, the absence of a government bond market, and the absence of monetisation and open market operations have left the UAE with a dominant fiscal structure, and a monetary architecture lagging behind. The creation of transparent and reliable monetisation mechanisms is crucial. Moreover, appropriate exchange rate, interest rate and sterilization policies are critical in order to shield the economy from potential external shocks.

Thus, the same reasoning behind the diversification of the UAE economy away from oil should also lead to the build-up of independent and self-sufficient monetary structures - more urgently than a monetary union. Indeed, some of the issues raised here are also relevant to other GCC states, which imply that attending to key architectural issues might be more important across the board.

The writer is Associate, University of Cambridge, Judge Business School.