US Fed rate rise a blow for the UAE

Is it time to re-examine the dirham's peg to the dollar?

Federal Reserve Chair Janet Yellen announced a fresh rise in US interest rates on Wednesday, with three more slated for 2018. Jonathan Ernst / Reuters

The UAE’s fiscal and monetary policy needs are in direct opposition to those of the USA. The problem, however, is that since the UAE dirham is pegged to the US dollar, American monetary policy is in effect being imported into the UAE, to the detriment of our economy.

As a reminder, a country’s fiscal policy has to do with government expenditure - which stimulates the economy - and taxes, which rein in the economy. The US government looks like it has come to the conclusion that tax cuts would spur their economy. The US Federal Reserve, which just increased interest rates for the third time this year, has signalled that it would need to counter the expansionary fiscal policy of the US government by increasing interest rates. The Fed’s reasoning is that the US economy is doing well, but because of this any fiscal stimulus will therefore lead to inflation. Hence their conclusion that they will need to aggressively increase interest rates to keep prices in check.

_____________

Read more:

EU's tax blacklist move questionable at the very least

_____________

The situation in the UAE and in the Arabian Gulf is very different. Regional economies have faced challenges due to the depressed state of oil prices relative to their mid-2014 levels. The various governments have, by and large, focused on reducing their fiscal expenditure, via measures such as reducing subsidies and introducing a value added tax so as to help balance their budgets.

I have discussed elsewhere the different approach adopted in the 1980s in the USA by president Ronald Reagan, who introduced a fiscal stimulus to re-ignite the country’s ailing economy. Whichever side of the argument you fall on with regards to fiscal stimulus, I think that we can all agree that the UAE economy would benefit from looser monetary policy, i.e. lower interest rates. But due to the dirham’s peg to the US dollar, the country has little choice but follow the Fed and increase interest rates, which the Central Bank of the UAE has now done.

The interest rate hikes by the Fed in 2017, and the three interest rate hikes it has already signalled for next year, increases the challenges faced by the UAE’s economy. Increased interest rates make it more expensive to borrow, which cuts into corporate profits. Further, increased rates make the debt burden on individuals higher, which cuts into consumer spending. What’s more, increased rates incentivise consumers to save rather than spend, if (and it’s a big if) local banks pass on the rate increase to deposit holders as well as to their lenders.

There is an argument to be made that increased savings rates leads to more money for banks to lend. That may be true in the long run, but in the shorter term banks are unlikely to lend more, and are more likely to opt instead enjoy the free profit increase from moves in interest rates.

From a fiscal policy standpoint, there are two different arguments that can be made for a more effective strategy for the UAE in 2018. First up, given that the forced-replication of the Fed’s monetary policy in the country (due to the dirham’s peg to the dollar) leads to the idea that counteracting the adverse impact of higher interest rates via an expansionist fiscal policy may be the way to proceed.

Secondly, oil prices have risen in recent months, which could fund, at least in part, such an expansionary policy.

But how about monetary policy, is there room to manoeuvre there? Two options are worth examining, even though both appear too challenging to take at this point. The first option would be to simply de-peg the dirham from the dollar, a move that would allow the Central Bank of the UAE Central Bank to set its own monetary policy.  The authorities however have (rightly) made it clear that this is not consider an option, with economists noting that regional currency reverses are sufficiently high to keep pegs in place for the foreseeable future. The second option would be to revise the peg level of the dirham from 3.67 to something lower, such as 4.2 dirhams to the dollar. But that would put those remitting money from the UAE, such as foreign workers and foreign currency debtors, in a much worse position.

For the moment then, it seems as if the UAE will have little option but to follow the US, whatever pain it brings to the country’s economy in the short term.

Sabah al-Binali is an active investor and entrepreneurial leader with a track record of growing companies in the Mena region You can read more of his thoughts at al-binali.com