Dirham sticks to the greenback

The currency peg is set to stay, with the Central Bank welcoming a strong US dollar. But there are arguments for change.

United States of America dollars with UAE dirhams. Ryan Carter / The National

With the Central Bank governor Mubarak Al Mansoori stating that the rising US dollar was good news for this country, it may be unlikely that the UAE will revisit the dirham’s peg anytime soon.

“We are fortunate in the UAE to have pegged the dirham to the US dollar,” Mr Al Mansoori told the seventh Global Financial Markets Forum in Abu Dhabi this month.

“A strong dollar offsets some of our losses as part of oil exports. As an oil producer, we export oil and other services to neighbouring countries whose local currencies are also pegged to the dollar.”

But the arguments in favour of adjusting the peg, or floating the dirham altogether, deserve a fair hearing – especially since the fall in oil and the rise in the dollar have changed the cost-benefit calculus for the UAE’s policymakers.

“Following the plunge in oil prices since the middle of last year, the sustainability of dollar pegs in the [Arabian] Gulf has come under increasing scrutiny,” says Jason Tuvey, an emerging markets economist at Capital Economics. “Some have even suggested that the Gulf countries should ditch their dollar pegs altogether and move to floating exchange rate regimes.”

The fall in oil prices cuts the value of exports, making a current account deficit more likely: Capital Economics thinks the UAE will run a trade deficit of about 2 per cent this year. Low oil prices mean the country will face a fiscal budget deficit of 3.7 per cent in 2015, the IMF says.

In the background, rumblings of the beginnings of a global currency war can be heard.

In January, the president of the European Central Bank Mario Draghi fired the starting gun on a second wave of competitive currency devaluations. By pledging to boost the supply of euros, Mr Draghi guaranteed a lower price for the currency. The repercussions were immediate.

Devaluations in Singapore, Egypt, Venezuela, Nigeria, Ukraine and Azerbaijan followed. China’s currency continues to fall, driven by net capital outflows, while Japanese quantitative easing has been depressing the yen against the dollar, and its regional trading partners, since the re-election of Shinzo Abe as the prime minister in 2012.

“An unspoken currency war has broken out,” says David Woo and Vadim Iaralov of Bank of America Merrill Lynch in a recent research report. “For many countries ... the only policy tool left at their disposal to stimulate growth is a weaker exchange rate.”

This, in combination with expectations of the US Fed interest rate rises, means the dollar has risen. The Bloomberg Dollar Spot Index is up 20 per cent on the middle of 2014, indicating that it has appreciated against a basket of 10 major currencies.

Devaluation becomes more attractive when the dollar is high. Oil exports are priced in dollars, which means dollar-revenues from sales would be unaffected.

If the UAE sells $100 of oil at the current rate of Dh3.67 to $1, the country earns Dh367. However, if it sells the same amount of oil with a weaker dirham, at, say Dh4 to $1, it will earn Dh400 for the same quantity of exports. So a weaker currency would boost oil and export revenues. Since the fiscal and current accounts are priced in dirhams and not dollars, devaluation could help to plug the gaps in the fiscal deficit and the central bank’s vaults.

“Given that government spending is denominated in local currency, what matters from the perspective of the public finances is the local currency value of government revenues,” says Mr Tuvey.

Current account deficits pose an existential threat to the UAE’s economic plan. The country’s status as a net creditor is vital to its economic strategy.

The economic model sees oil wealth swapped for inflows of capital and labour. This takes the form of expatriate workers, new factories and new firms.

In short, the UAE needs to continue to run current account surpluses if it is to continue to transform wealth into growth – and increasing the dirham-value of barrels of oil through devaluation would help to reduce the pressure on the balance of payments.

Mr Al Mansoori had emphasised that the UAE economy is less vulnerable to low world oil prices due to the fact that oil revenues constitute 30 per cent of the country’s GDP. “We have strong financial abilities, sovereign wealth funds and banks having high ratio of liquidity. Our banks have huge reserves to handle bad debts and any possible challenges facing the global economy,” he told the forum this month.

Indeed, foreign currency reserves plus foreign asset holdings are equal to about 275 per cent of GDP. The UAE has oil reserves of upwards of 90 billion barrels, which, even at a price of $50 per barrel, is equal to about 10 years’ worth of GDP.

That is a lot of ammunition with which to plug a gap in the current account.

What is more, the UAE’s sizeable foreign assets are likely to increase the country’s wealth further.

Gulf investors are fond of buying up swathes of London’s fancier districts

This is not just idle consumption spending. Investing in markets such as these helps to put the UAE’s money to work by making sure that the country’s stock of foreign holdings keeps growing.

Modern portfolio theory tells us something crucial: it is easier to make more money when you already have a lot of it.

As the UAE’s wealth stock increases, the country can continue to accumulate claims on economic factors of production in other countries.

How financial policy works

The Central Bank of the UAE sets the country’s interest rate. According to the bank, it does this through two types of operation.

The Marginal Lending Facility allows financial institutions to swap securities for overnight liquidity at the Central Bank. The price of parking securities at the Central Bank is the interest rate. This sets the minimum domestic price of borrowing funds for financial institutions. The bank also auctions Certificates of Deposit to financial institutions on a daily basis. These are usually very short-term papers that pay the bearer the principal plus the interest rate over the relevant time period. This sets the minimum rate of return for banks in the UAE.

By changing the price of money (the interest rate), the Central Bank can control the minimum borrowing price, and the minimum real rate of return on assets, that prevail in domestic financial markets. This filters through to the real economy, as banks then buy and sell funds to each other at a higher interest rate – the Emirates Interbank Offer Rate. Assuming a no-arbitrage condition, no bank has an incentive to invest at a rate lower than the interest rate, because they will earn the interest rate simply by parking funds at the Central Bank. Similarly, the interest rate determines the price of loans, because the cost of borrowing is always equal to or greater than the interest rate. The Central Bank sets the lower bounds for the rate of return, and the cost of borrowing.

It can defend the exchange rate peg in three major ways.

Firstly, the bank promises to buy and sell unlimited quantities of dollars at prices just above and below the peg. If the dirham falls below Dh3.67 to $1, the bank will offer to buy dirhams at Dh3.67, causing it to rise. If it rises above Dh3.67 to $1, the UAE will sell an unlimited amount of dirhams at Dh3.67, and the value falls.

Secondly, the interest rate affects the availability of lending and consumer demand – and the demand for imports. If consumers spend a lot of money on imports, this should cause the value of the dirham to fall, as consumers sell domestic currency.

The Central Bank can raise interest rates in order to depress consumer demand for imports, which could reduce the rate at which consumers sell the dirham, causing the currency to rise.

Thirdly, the interest rate affects hot money flows – short-term capital movements designed to take advantage of differential interest rates across countries. Higher interest rates increase hot money flows, which increases demand for the dirham, causing its value to rise.