First with Financial Comment from Arabia

Maintaining the UAE dollar peg has boom-to-bust risk

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It is hardly a matter of economic debate to point out that maintaining the dollar peg to the UAE dirham is going to exaggerate the typical boom-to-bust cycle in this emerging market just has it has everywhere else.

This option has been ruled out now by Vice President and Prime Minister General Sheikh Mohammed bin Rashid Al Maktoum. But a committee is reviewing the situation and currency revaluation remains a possible option, while retaining the peg.

Fixed peg problems

You only have to look back to the Asian Financial Crisis ten years ago to see how fixed currency pegs can over-inflate an economic boom and lead to a massive subsequent crash. Economies as diverse as Hong Kong, Thailand and Indonesia moved quickly from boom to bust.

The root cause of the Asian Financial Crisis was the pegging of local currencies to the US dollar so that local business thought it could borrow at low cost in US dollars and invest locally, without any risk.

In theory the pegging of local currencies to the greenback eliminated exchange rate risk and so a furious economic boom ensued, with overbuilding and overinvestment. When the inevitable correction came it was like jumping from the top of a skyscraper rather than from a garden wall. Formerly giant business empires were toppled, construction sites abandoned and millions left impoverished. It has taken a decade for these former Tiger economies to recover.

It could never happen here. It is different this time. These are the mantras heard in any economic boom. Usually there is some truth in such statements.But when Gulf central bank governors sit down for their first of two meetings this year in Doha from 6-7 April perhaps it is the Asian Financial Crisis that they should have uppermost in their minds and not the present US sub-prime credit crisis.

Speculation that the Gulf countries might end their dollar peg or revalue reached its height last November before the central bank governors met, with both the UAE dirham and Saudi riyal being targeted as likely to end this link. In the event nothing happened. Saudi Foreign Minister Prince Saud Al Faisal has since said that the kingdom does not want to see the dollar ‘collapse’.

After all oil revenues are in dollars and two-thirds of GCC state assets are dollar denominated. And it is true that a sudden move by the Gulf States would put additional pressure on the greenback, already close to a life-time low of $1.60 to the euro.

It may also be that the US is exerting political pressure on its old allies in the region to support the stumbling dollar at a critical time during its own financial crisis. And yet that did not stop US ally Kuwait decoupling last spring and moving to a basket of currencies, easing local inflation rates and bringing its economic boom more under control. Perhaps Kuwait has got it right.

The answer is not for GCC states to act in unison but rather to slowly disentangle themselves one by one from the dollar peg rather than frightening global currency markets with a sudden decoupling. If the GCC states could in some sense coordinate this currency realignment then that would be only sensible. But of course it needs to be done behind closed doors and we can not expect to be privy to such information. No central bank in the world operates at that level of transparency or could do.

The risk of being forced into doing nothing is worse than the risk of attempting a coordinated policy response. Already Gulf States have some of the highest inflation rates in the world, and the economics of expatriate labor are being undermined by a combination of dollar devaluation and inflation. For it is no secret that the GCC is highly dependent on expatriate labor, and increasingly needs skilled and not unskilled labor for its sophisticated economies.

Now that labor is not going to find working in the region attractive if the devaluation of the dollar and high inflation mean that they would earn more at home. To put it mildly this makes recruiting talent difficult. At the same time the GCC states, apart from Kuwait, have to track US interest rates lower and lower.

The Federal Reserve has recently slashed its base rate to 2.25 per cent, a move Saudi Arabia is resisting for the moment. But the trouble is that with the fixed currency peg it is not difficult to borrow dollars cheaply overseas, or even locally, and then invest them in projects which presently offer a higher return such as GCC real estate.

This ‘carry trade’ is artificially inflating investment in real estate related projects which is precisely what happened in the Asian Financial Crisis. But it is not too late for prudent economic management to correct this distortion and to bring the boom under control.

The GCC is awash with liquidity from the oil boom and a relatively painless solution is at hand. That brings us back to revaluation, perhaps first in the countries where inflation and the economic boom are most pronounced – namely the UAE and Qatar – and later by a smaller amount in other countries. And at the same time work should be in hand to switch to currency baskets in a controlled manner but not over night.

Dollar excesses

The alternative approach of just hoping that the US dollar will one day recover just does not seem to be working, and the liquidity that the Federal Reserve is now pumping into the US banking system can only make dollar devaluation worse and not better. Indeed, the Fed is repeating its error of excess liquidity and you have to wonder how this can strengthen the dollar. Is it not using dollar devaluation to bail out its own sinking economy?

This is certainly a tough time for GCC central bankers and the weight of responsibility on their shoulders is enormous. But ultimately it will be for the most senior political figures to decide on the future on the basis of their recommendations. Perhaps the dollar peg will stay but revaluation might be considered necessary and wise to head off economic overheating.


Written by Peter Cooper

April 4, 2008 at 4:38 am

Posted in Banking, US Dollar

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