Dollar peg under scrutiny

Pressure could return for a review of the dirham's peg to the US dollar next year as the UAE economy recovers from the global recession. The shortcomings of mirroring US monetary policy under the fixed exchange rate are likely to be exposed if accelerating inflation returns to haunt consumers, economists and analysts say.

A convergence on monetary policy with the US suits the UAE at the moment, with both countries looking to keep interest rates low to spur economic recovery. But as the UAE's economy emerges from the financial crisis at its own pace, the need for the Central Bank to diverge from Federal Reserve policy by raising interest rates to keep a lid on rising inflation may become greater. The Fed will keep interest rates at low levels for the remainder of this year.

Dr Nasser Saidi, the chief economist at the Dubai International Financial Centre (DIFC), said: "Now is not the time to do so but as soon as we are in recovery the UAE and the Gulf should review the strong dollar peg policy, which has led to a perverse monetary policy." Among GCC states, only Kuwait has dropped the dollar peg. It moved in 2007 to pegging the dinar against a basket of other currencies.

Last year, a rapid appreciation of the dollar stoked inflation throughout the Gulf as prices escalated for property and consumer goods. Future inflationary pressures could rise if high oil prices return, driving up costs of imported goods The Saudi Arabian oil minister, Ali al Naimi, said on Friday that he did not rule out another crude shock. "Anything is possible," Mr al Naimi said. "We will do our best to avoid that because I don't believe high prices are good nor too low prices."

The dollar fell close to a one-year low against the euro on Wednesday and to a seven-month low versus the Japanese yen on Friday. The fall came after signs that the economic recovery was gathering momentum, prompting investors to sell the US currency and buy assets offering higher yields. Investors had fled to dollar-denominated assets as a safe haven during the financial crisis. The dollar's drift lower against other leading world currencies has also pushed up the price of oil because it is denominated in the US currency.

The dollar could be weakened further after last week's summit of the Group of 20 leading and emerging economies, where leaders discussed the need to rebalance the global economy. Simon Williams, HSBC's chief economist in Dubai, said: "Through 2010 and longer, growth in the UAE will pick up earlier and more rapidly than in the US and with it will come upward pressure on prices. "But the monetary policy for the pegged currency may mean we find ourselves with a weak currency and weak interest rates when what we need is tighter monetary policy."

The boom years of the Gulf were fuelled in part by policy makers in the region following the lead of the Federal Reserve in the US by lowering interest rates, Dr Saidi said. Eric Swats, a partner at Rasmala Investments in Dubai, said the current dollar weakness would help the UAE economy stabilise in the short-term. "The weak currency is what the UAE needs," Mr Swats said. "We know that there's been a huge deflation in the property sector. I think a weaker currency will help to bring foreign direct investment back to the sector."

The UAE has maintained a fixed exchange rate with the US currency since 1997, although its currency has tracked the dollar since 1978. An alternative to the dollar peg could be the currency basket system adopted by Kuwait, although that is believed to be heavily weighted in dollars. Jane Kinninmont, an economist at the Economist Intelligence Unit in London, said: "If they want more interest rate flexibility a stronger move would be towards a currency basket like in Kuwait."

Analysts see little chance of the dirham being cut loose from the dollar peg any time soon, but some can see discussions on the subject. "I think it's highly unlikely," said Robert McKinnon, the managing director of equity research at Al Mal Capital. "I do anticipate a discussion among policy makers, but the perception among them is that the dollar peg adds stability in the region, although I think that's a misconception."

Tim Fox, the chief economist at Emirates NBD, also believes the peg to the dollar is here to stay in the medium term. "The fact that the UAE resisted when inflation was much higher in 2008 when there was pressure to revaluate makes me think it will not be the case," he said. "The message has been strongly supportive of the dollar as a peg." Sultan al Suwaidi, the Governor of the Central Bank, said in May that the UAE had no intention of diversifying its foreign currency reserves away from the dollar. Most Gulf nations, with their currencies pegged to the greenback, have to recycle surplus oil revenues into dollar-denominated assets. As a result, the region is among the world's largest buyers of US government bonds and corporate shares.

Previous speculation about a review of the currency peg has had an impact on UAE markets. Last year saw the withdrawal of an estimated Dh180 billion (US$49bn) in "hot money" invested in local markets on the expectation of a dirham revaluation, after it became clear that the currency peg would be maintained. * additional reporting by Tamsin Carlisle @Email:[e-mail]