The problem with the peg and what might be done

We heard again last week that pay in the UAE and region is failing to keep pace with bills to be paid. Besides that, for many expats the declining dollar (and automatically dirham) means a further chunk has arguably been taken from their effective income.

Some people could have lost in the range of 10-20 per cent in the past two years in terms of the combination of internal and external purchasing power. They might, then, be interested in revaluation of the dirham.

At the country level the UAE might look at the issue in a similar way. The weaker dollar and dirham have made imports overall more expensive - although the impact on inflation supposedly has been limited - at the same time as diminishing the international value of energy export receipts (priced in dollars).

Reference rate

By discussion with analysts, it seems that, theoretically, the authorities could enact revaluation quite simply if they chose to.

Local currency liquidity is under tight control, unlike the case of many international currencies, and foreign exchange reserve positions are more than ample. Taken together, that means both supply and demand for a given reference rate to the dollar can be managed quite easily.

The prohibitions against the move are broader and economic rather than technical.

The costs associated with the peg and with plans for Gulf monetary union can readily be seen in snapshot in the charts alongside. First, according to these data at least, real interest rates are not high enough, particularly in the UAE, to contain rampant economic growth and inflation (chart 1). Second, both inflation and budget data, which ideally would be roughly in alignment to enable a stable basis for the single currency, show distinct variation between the GCC states (charts 2 and 3).

Latest credit growth data from the UAE Central Bank reflect the astonishing liquidity in the economy which makes continuing inflation pretty much inevitable. The latest figure, an annual 33 per cent to the third quarter last year (and having fallen), is indicative of such monetary momentum as is bound to devalue cash and inflate the price of real assets.

The peg's offsetting benefits, meanwhile, are much-rehearsed: stability against the world's leading currency benchmark (still), regularity in the dollar-denominated oil market, and the high share of dollar-related import costs moderating the effect of the non-dollar account.

Moreover, as the charts also show, real interest rates in both the UAE and Qatar may creep back into positive territory from 2008, albeit only modestly.

None of those planks of policy appear immoveable if the will is there, however. In these pages, we have said before that 2010 is still quite some distance away, yet the problem is here and now, and if oil prices stay high and the dollar low (as most experts seem to expect), it's not going away.

So it is only natural if change might be contemplated, an idea backed by various remarks in the past year by UAE officials suggesting a practical approach towards the spectrum of options. By that reckoning, revaluation against the dollar might be an interim step towards a complete reappraisal of the exchange-rate regime.

Doubt

Most analysts still seriously doubt whether such a move is on the cards soon. In particular, revaluation would mean a portion of exports would effectively be priced higher internationally, which would be damaging for non-oil activities currently being nurtured. So many business assumptions are routinely made at the current dollar rate that there is naturally a hesitance to upset that thinking.

What's more, because inflation is an internally-generated phenomenon relating to structural bottlenecks, rather than externally-sourced, re-fixing the peg higher might not be worth it. Only if the currency were allowed to float (and interest rates set independently) would a real difference be made on that criterion.

A report by Moody's last month laid out further issues. "Pegging to one currency has benefits in terms of transparency and simplicity, and the choice of the US dollar is a natural one," it confirmed.

As for the policy knock-ons, revaluation would lower the value of hydrocarbon exports in local currency terms, with a negative fiscal effect. The balance of payments would also be negatively affected, but it would amount only to the marginal impairment of governmental obligations, given the surpluses in place. Still, "the strong and improving financial strength of GCC governments gives them considerable room for manoeuvre."

In fact, the market movements seen so far have actually been fairly small, although they might reach proportions where the authorities would want to stamp their authority on expectations to damp harmful speculation.

And yet. A decision of some sort is due on the common currency anyway. Could it really be such a surprise if the possibility were being discussed in official circles of revaluation sooner rather than later? This country has demonstrated boldness of vision and vigorous pursuit of the needful in many contexts already. If the balance of the argument tilts far enough, it could do so in monetary policy.