Saturday, Apr 21, 2007

Gulf News

What would be the impact if the UAE dirham were revalued? With talks on GCC monetary union in 2010 apparently stalled, the possibility of currency adjustments ahead of that date has provoked market conjecture in recent months.

It is a discussion which entails matters of economic principle but also likely consequences in practice.

Among the most common arguments against currency appreciation are that exports are hurt. If the dirham appreciates, it takes more units of a foreign currency to buy a dirham, thus UAE-made goods become more expensive to the rest of the world and UAE exports fall.

Another argument against currency appreciation is its impact on remittances, repatriated profits, and foreign direct investment (FDI). UAE nationals working abroad and UAE investments abroad generate profits that once repatriated to the UAE will buy fewer dirhams. FDI would also be affected in a very similar way. In other words, FDI could get hurt if, for example, it takes more euros to buy a dirham to be invested in the UAE.

Appreciation

On the other side of the coin is that as the dirham appreciates it takes fewer dirhams to buy a given unit of a foreign currency, thus goods made in the rest of world become cheaper to the UAE and imports increase. Also, the appreciation of the dirham could help reduce the inflationary pressure that has eroded real wages in the country in the last few years.

Gulf News reported in April that UAE exports in 2006 reached $139 billion, significant but below IMF projections of $155 billion for 2006. Of total exports, about 65 per cent is oil, gas, and oil related products.

The IMF also reports that the projected current account balance for the UAE in 2006 is $35.5 billion, about 20 per cent of GDP and the largest since 2002.

If we take into consideration that most UAE exports, especially those related to the oil sector, are made in US dollars, the appreciation of the dirham will not a have a significant effect on a large share of the UAE export sector.

In fact, because the UAE is a net importer of capital from abroad (machinery and equipment) used in the production process of exported goods, the UAE could be viewed as a country that needs to import in order to export.

The appreciation of the dirham will also benefit consumers because as consumer goods produced elsewhere become cheaper to us, the inflationary pressure in the UAE could fall. Given this argument, the appreciation of the dirham could bring more benefits than costs in the external sector of the UAE economy.

With regard to how remittances, repatriation of profits, and FDI will be affected, note the following: remittances to the UAE is a non-issue. There are simply not so many UAE nationals working abroad who send money to the UAE on a regular basis.

Repatriation of profits is a more interesting case. The largest UAE institutional investor abroad is the Abu Dhabi Investment Authority (Adia), which is also the second largest in the world, after the Bank of Japan, according to the Oxford Business Group.

In 2006 Euromoney reported that Adia holds investments of as much as $500 billion in a portfolio that grows at an annual compounded rate of 10 per cent per year. Put in a simple number, this return on investment represents about $50 billion per year. Because of investment diversification, it is unlikely that Adia or any other large UAE institutional investor like for example, Dubai Holding, will repatriate profits back to the UAE, thus the appreciation of the dirham is unlikely to have a significant negative effect on UAE repatriated profits.

A reason for not repatriating profits, other than investment diversification, is the large current account balance the UAE has as reported by the IMF for 2006. The surplus in the current account would support about three months worth of imports, but given the daily cash flow of the UAE, rather than keeping the surplus idle in order to support imports in case of a sudden stop of the cash flow into the country, the surplus has been invested in major projects throughout the country, contributing to the rapid increase in inflation.

FDI will be affected only to the extent that expected returns on investment in the UAE fall below that expected in the rest of the world. It is true that the appreciation of the dirham will raise the cost of investing in the UAE, but if expected returns on investment remain attractive, FDI will still flow into the country.

How to deal with the inflationary pressure in the UAE?

Pressure

For the most part, the source of the inflationary pressure in the UAE is the rapid increase in investment spending, especially in the real estate sector, which in turn generates higher level of personal income, and since consumption is a positive function of income, consumption spending is also high. That rapid increase in investment has been attributed mainly to the extra revenue generated by the sale of oil at current prices. This is reflected in the country's large current account balance.

To slow down the rate of investment to the point that inflationary pressure is minimised, some economists would advocate fiscal policy such as increased taxation, and/or monetary policy to tighter credit, something difficult to accomplish in the UAE mainly because of the absence of personal income tax (in the case of fiscal policy) and the abundant liquidity in UAE banks which make difficult any monetary policy designed to tighter credit.

It appears, then, that in order to deal with inflationary pressure the appreciation of the dirham could be an interesting policy device because it will decrease the value of the surplus in the current account which in turn, could affect the rate of investment spending in the country. A slowdown in investment spending is needed in order to reduce inflation.

As a disclaimer, no effort is made here to pass judgment on whether the appreciation of the dirham is the correct course of action to deal with the inflationary pressure in the UAE. There are simply too many loose ends which require additional information and analysis in order to come up with a recommendation. But at least we have here some reflection on the points to bear in mind when considering the UAE's current monetary challenge.

- The writer is Associate Professor of Economics, American University of Sharjah.

Gulf News 2007. All rights reserved.