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The Dollar Peg Advantage

Bank runs coupled with financial crises are a rare occurrence but they tend to have devastating effects on real economic activity.

The 1997 Asian financial crisis, which began with the precipitous fall of the Thai baht, is an important case in point. Recent action by world governments and in the past few days by the UAE federal cabinet, to provide deposit insurance is good economic policy.

This is especially true for our economy: Arabian Gulf States may face a greater risk of bank runs as their workforce comprises a greater proportion of foreign workers with access to bank accounts denominated in other currencies. In light of this and of greater financial volatility stemming from the ebb and flow of hot money in the UAE, the government’s decision to extend these guarantees is both timely and prudent.

In addition, the government’s recent decision to inject money into the banking sector will decrease the likelihood of a precautionary hoarding of cash: as lending between investment banks is typically a matter of relationships of trust, this move should begin to restore confidence between lenders and, depending on the terms of the liquidity injection, may reap a tidy profit for the government.

These measures however are likely to have limited effects in protecting our economy from demand-side risks associated with the global slowdown in real economic activity.

Ironically, the much maligned currency peg of the dirham to the dollar is likely to limit downside risk to economic activity in the UAE.

Indeed, in a recent announcement, the US Federal Reserve System cut the intended federal funds rate along with the discount rate.This action, coupled with the recent bailout plan voted by Congress to ensure the provision of liquidity in the banking sector, is intended to counter the below-trend performance in US economic activity.

The UAE Central Bank has followed with its own cut on the repo rate, guaranteeing the viability of the currency peg to dollar at the current nominal rate.

This access to cheaper money is likely to stimulate economic activity in the UAE but will also increase the staggering inflationary pressures already experienced in recent times.

One should expect however that the appreciation of the Dollar against major world currencies along with reduced natural resources revenues stemming from the recent fall in the price of oil (and the attendant slowdown in fiscal spending) will stem somewhat these inflationary pressures.

Cheap money stimulates greater investment and economic activity, but the likely effects on equity markets are ambiguous: the Dubai stock market saw a dramatic fall in its value since the beginning of the year, while the real estate sector has been more resilient.

The fall in value of the Dubai stock market and greater volatility relative to markets in developed economies signal challenges that monetary policy in the form of an interest rate cut are unlikely to remedy.

Structural changes, including greater market depth are likely to reduce stock market volatility while continued policies by the UAE government to aggressively diversify the economy away from natural resources revenue will allow financial markets to optimally allocate risk to real economic activities that promote sustainable economic growth.

The challenges facing monetary authorities in stemming financial market fears in the current climate are equally formidable: as recent years have demonstrated, the fall in the value of the dollar coupled with strong fiscal spending spurred by natural resources revenues have accelerated the rate of inflation growth.

In addition, speculative money flows in currency markets have created volatility as currency arbitrageurs bet on a revaluation of the dirham or a new monetary arrangement that more accurately reflects the higher value of our currency relative to world currencies.

And yet, the UAE central bank has maintained the currency peg to the dollar, perhaps the least financially disruptive arrangement currently available.

Currency revaluation runs the risk of creating speculative flows in the opposite direction and may exacerbate the effects of the current global credit crunch on the domestic economy: indeed, such a move would increase the risk of a currency crisis, as a more expensive currency requires more reserves to defend.

Greater monetary autonomy in the form of a currency float, on the other hand, requires a more active participation on the part of the central bank to control inflation and presents institutional challenges that may well add to investor uncertainty in all equity markets.

As the UAE faces the real economic fallout of the global financial crisis, continued prudent monetary policy in the form of a currency peg along with government protection against a systemic breakdown of the domestic banking sector may well be the monetary arrangement most conducive to minimising further financial and monetary risks.

(Dr Tarek Coury is currently assistant professor of public policy at the Dubai School of Government and an associate of the Kennedy School‚at Harvard University.)