Exchange rate refers to the “price of one country’s currency expressed in another country’s currency” (Boyes and Melvin 253). The exchange rate is an important macroeconomic variable since it influences the competitiveness of a country’s exports and imports (Boyes and Melvin 156). It also influences the returns on different financial assets. The United Arab Emirate uses a fixed exchange rate regime in which the dirham is anchored to the US dollar. This has enabled the country to maintain a stable currency, thereby attracting foreign direct investments. However, the recent economic crises in the US and Europe have increased the volatility of the US dollar, thereby causing significant fluctuation of UAE’s commodity prices. This paper discusses the alternatives that the UAE has to solve its exchange rate problem.
An Overview of UAE’s Economy
The United Arab Emirates is the second largest economy in the Gulf Cooperation Council (GCC). The real GDP of the UAE grew at a compounded annual growth rate of 4.8% between 2000 and 2008 (Moabi, Thomas and Alexander 1-48). During the 2009 global financial crisis, UAE’s real GDP reduced by 4.8%. This contraction was attributed to the reduction in oil prices and the crash of Dubai’s real estate market. The economy rebound in 2010 by achieving a growth rate of 1.3% due to improved performance in the construction and tourism sectors. In 2011, UAE’s real GDP grew by 4.3% (Moabi, Thomas and Alexander 1-48).
The services sector is the main contributor to UAE’s GDP. The main components of the services sector include wholesale and retail trade; real estate and business services; and logistics and financial services. In 2011, the sector contributed 44% of the country’s GDP (Moabi, Thomas and Alexander 1-48). Overall, the services sector expanded at an average rate of 5% in the last six years. The oil and gas sector is the second largest contributor to UAE’s GDP. The sector’s contribution averaged 33% between 2007 and 2011. The contribution of the oil and gas sector to the GDP declined from 63% in 1980 to 31% in 2010 as the country focused on diversifying its economy. The industry sector is the third largest component of UAE’s GDP. The sector’s contribution averaged 22% between 2007 and 2012 (Moabi, Thomas and Alexander 1-48). The main components of the industry sector include construction and manufacturing. Overall, diversification has been the main economic growth strategy of the UAE since 1975. Additionally, international trade and oil exports are the main drivers of UAE’s economy. Thus, a stable exchange rate is central to the growth of UAE’s economy.
The External Sector
The external sector mainly consists of the balance of payments (BOP), which “Tracks all foreign transactions between a country and all other countries, reflecting all payments and liabilities to foreigners and from foreigners” (Gambler and Colander 163). The BOP has three components namely, the current account, the capital account and the official settlements account. In 2011, UAE’s balance of payments was in surplus to the tune of 1% of its GDP. In addition, the country’s trade surplus averaged 18.4% of its GDP between 2007 and 2011 (Moabi, Thomas and Alexander 1-48). UAE’s capital account deficit averaged -2.9% between 2007 and 2012.
Money and Prices
UAE’s currency is anchored to the US dollar at a constant rate of 3.6725 to 1 US dollar (Moabi, Thomas and Alexander 1-48). This exchange rate regime has enabled the UAE to reduce the volatility of its earnings from hydrocarbon exports because oil and gas products are valued in US dollars. Additionally, the fixed exchange rate has enabled the country to enhance investor confidence by eliminating exchange rate risks. However, pegging the currency to the US dollar has limited the ability of the Central Bank of the UAE to use monetary tools to stabilize the economy. In particular, the fixed exchange rate forces the UAE to maintain interest rates that are comparable to those of the US in order to prevent speculative capital flows.
UAE’s inflation rate averaged 2.4% between 1998 and 2003 (Moabi, Thomas and Alexander 1-48). However, it rose to 8.8% between 2004 and 2008. The increase was attributed to rapid economic growth, increased government expenditure and an increase in oil prices. The inflation reduced to an average rate of 1.1% between 2009 and 2011. The UAE heavily depends on imported consumer goods, which makes it vulnerable to imported inflation.
Exchange Rate Regimes
The fixed arrangements include three exchange rate regimes namely, monetary unions, currency boards, and fixed or pegged exchange rate (Boyes and Melvin 261). A currency board is an exchange rate regime in which a country converts its currency to a foreign currency on demand at a predetermined fixed exchange rate. Currency boards issue domestic currency only if there are adequate foreign exchange reserves to back it. The main advantage of a currency board is that it provides a stable exchange rate, thereby improving trade and investments. Moreover, it promotes fiscal discipline by limiting central bank’s ability to print money in order to finance huge budget deficits. However, governments using currency boards cannot set their own interest rates. Currency boards are also not desirable because they prevent the economy from adjusting to exogenous shocks through variation of the exchange rate (Gambler and Colander 184). Furthermore, they can stifle the development of the banking sector by increasing interest rates and eliminating the central bank’s ability to act as the lender of last resort in order to save distressed commercial banks.
In a monetary union, “a group of countries adopts a single currency” (Gambler and Colander 186). In this case, the countries will have a common central bank that issues the currency and manages the monetary policy (Gambler and Colander 186). A monetary union helps in reducing exchange rate volatility. It also promotes international trade, especially, among the member countries. However, a monetary union exposes its member countries to the shocks within the union. Additionally, the countries lose their control over monetary policy.
A fixed or pegged exchange rate involves anchoring the domestic currency to a foreign currency in order to ensure a constant exchange rate. It promotes international trade by eliminating exchange rate risks (Boyes and Melvin 263). A fixed exchange rate regime also enhances fiscal discipline since the government has to avoid inflationary policies in order to reduce unemployment and balance of payment deficits. Furthermore, a fixed exchange rate regime eliminates speculative capital flows that usually destabilize developing economies. However, a fixed exchange rate regime makes monetary policy ineffective. It can also lead to balance of payment deficits, which in turn causes recession.
Intermediate Exchange Rate Regimes
Intermediate exchange rate regimes include “crawling peg, basket peg, and target zones or bands” (Gambler and Colander 192). A crawling peg regime involves pegging the local currency to a foreign currency. However, the exchange rate is adjusted periodically in response to inflationary pressures. The crawling peg enables countries to enhance both stability and flexibility of their exchange rates. It also helps in preventing high inflation. However, a crawling peg encourages speculative capital flows that can lead to economic instability. In a target zone or band system, the exchange rate is allowed to fluctuate around a central rate. For instance, it can be allowed to increase or decrease by one percent. The target zone system improves the stability of the exchange rate. However, it limits the use of monetary policy to stabilize the economy. In a basket peg system, the domestic currency is anchored to several foreign currencies. This helps in avoiding the risks associated with the fluctuation of the value of the anchor currency.
The flexible arrangements include managed float and pure float. In a pure floating exchange rate regime, the forces of demand and supply in the foreign exchange market determine the value of the domestic currency. This enables the economy to adjust to exogenous shocks through changes in the exchange rate (Gambler and Colander 210). Unlike the fixed exchange rate, the float exchange regime does not require the central bank to hold large foreign reserves. Furthermore, it does not restrict the use of fiscal and monetary policies to stabilize the economy. However, it leads to high exchange rate volatility, which can lead to inflation and loss of the competitiveness of exports.
In a managed float exchange regime, the value of the domestic currency is determined by the demand and supply dynamics in the foreign exchange market (Boyes and Melvin 267). However, the central bank intervenes periodically to minimize volatile fluctuations of the exchange rate. In this regard, it promotes flexibility and stability of the exchange rate. However, a managed float exchange regime may not ensure fiscal discipline since it does not cause severe restrictions on the application of monetary and fiscal policies.
Dollarization is a system in which a country adopts the currency of a foreign country as its legal tender. In most countries, dollarization involves adoption of the US dollar as the local currency. Under dollarization, monetary policy has to be delegated to the country whose currency has been adopted. The benefits of dollarization include the following. First, it promotes trade and financial integration between the local economy and the rest of the world (Boyes and Melvin 274). Second, it promotes fiscal discipline in the local economy. Third, dollarization leads to institutional reforms and improvements of the efficiency of the financial system. However, dollarization increases the risk of real and financial shocks by limiting the use monetary policy tools.
Determinates of Exchange Rate Regime Choice
Countries that are highly integrated to the word economy through trade relationships should use a fixed exchange rate. This argument is based on the perspective that strong trade relationships can be maintained by eliminating exchange rate volatilities through a fixed exchange regime (Ishfaq 1-21). In the last decade, the UAE has emerged as a major trade hub in the Middle East. The UAE is the financial services and re-exportation center in the Middle East. Additionally, the UAE is a leading exporter of oil and natural gas. These factors have significantly improved the level of trade integration between the UAE and the world economy. UAE’s trade orientation can be measured by the ratio of its exports plus imports to its GDP (trade ratio).
In the last 25 years, UAE’s trade ratio averaged 1.25 (Ishfaq 1-21). Given the large size of this ratio, the UAE is likely to benefit from large transaction cost savings by maintaining a stable exchange rate. In this context, the UAE should maintain a fixed exchange regime in order to stabilize its exchange rate. However, the UAE may only realize a reduction in transaction costs when trading with its main trade partner since a fixed exchange regime reduces exchange rate fluctuations attributed only to the anchor currency. Furthermore, maintaining a fixed exchange rate may reduce the competitiveness of UAE’s exports if its business cycle is not aligned to those of its major trading partners
The disadvantages of a fixed exchange rate increases as an economy’s integration to the world financial markets increases (Ishfaq 1-21). Empirical studies have shown that emerging market economies with fixed exchange rates such as the UAE are likely to experience banking or currency crises since they are exposed to high international financial capital flows. Financial integration can be measured by the level of financial development (ratio of money to GDP). In this case, a low money to GDP ratio suggests that the country has limited access to global financial capital. Thus, it is less vulnerable to financial crisis under a fixed exchange rate. In the last decade, UAE’s money to GDP ratio has remained below 0.25 (Ishfaq 1-21). This suggests that it is less vulnerable to financial crisis under a fixed exchange regime.
One of the main advantages of a floating exchange rate regime is that it enables the economy to absorb internal and external shocks. In particular, it cushions the economy from adverse effects of shocks such as deterioration of terms of trade, decline of world demand, and reversal of capital flows (Poirson 1-28). By contrast, a fixed exchange rate has a limited capacity to absorb shocks. Since nominal “exchange rate is fixed, shocks are largely absorbed by changes in economic activity and employment, which may cause economic and political instability” (Boyes and Melvin 266). Thus, countries that depend on the export of a few commodities should adopt a flexible exchange rate to absorb external and internal shocks. By contrast, diversified economies do not need a flexible exchange rate to cushion themselves from shocks. This provides a case for a fixed exchange rate for the UAE since its economy and exports are highly diversified.
A fixed exchange rate “provides better insulation to demand shocks than a flexible regime in a country with low capital mobility” (Gambler and Colander 164). In a fixed regime, a positive aggregate demand shock will cause an increase in imports and a decrease in foreign reserves. This leads to a reduction in money supply, which in turn offsets the positive demand shock. In a floating regime, a positive demand shock leads to the depreciation of the currency, which in turn worsens the impact of the initial shock.
However, in a country whose capital mobility is high, a flexible exchange regime provides better protection against demand shocks than a pegged regime. In a pegged regime, a positive demand shock will raise interest rates and capital inflow. Thus, the money supply increases, thereby worsening the effect of the positive demand shock (Boyes and Melvin 271). In a flexible exchange regime, a positive demand shock leads to strengthening of the domestic currency, thereby reducing the impacts of the shock. In this regard, a floating exchange rate will be preferable in the UAE since it has high capital mobility.
Empirical studies indicate that maintaining the credibility of monetary and fiscal policies under soft peg regimes is often difficult. This can be illustrated by the failure of soft peg exchange systems in several developing countries in the last two decades. In this regard, an emerging market economy should adopt either a hard peg or a floating exchange regime (Gambler and Colander 181). A hard peg forces the government to commit itself to provide fixed rates and maximum credibility. Similarly, a flexible exchange regime can ensure credibility if the monetary authorities avoid creating expectations concerning future exchange rate. This suggests that the UAE can maintain its pegged regime in order to ensure credibility.
The Right Exchange Rate for the UAE
The choice of the right exchange rate for the UAE depends on the structure of its economy. The country’s economy can be characterized as small, open, and vulnerable to domestic shocks. In this context, a fixed exchange rate will be the best regime for the UAE. However, UAE’s economy is also characterized with large external imbalances, high capital mobility, exposure to external nominal shocks, as well as, vulnerability to real domestic and external shocks (Ishfaq To Peg or not to Peg 1-23). These factors suggest that a floating exchange rate is the right regime for the UAE. Given the characteristics of the country’s economy, the choice of the right exchange regime depends on its macroeconomic policy objective. In this regard, a fixed exchange regime will be appropriate if the macroeconomic objective is to maintain low inflation. A floating exchange regime will be appropriate if the objective is to reduce external imbalances. Overall, the floating exchange regime will be appropriate if all the characteristics of the economy are taken into account.
The United Arab Emirates’ current account has always been in a large surplus in the last ten years. This can lead to strengthening of UAE’s currency against those of its major trading partners such as Japan (Gambler and Colander 356). This will reduce UAE’s exports and increase its imports, thereby destabilizing the economy. In this case, a basket peg will be appropriate for the UAE because it will allow international trade to continue being the main driver of the country’s economic growth. Additionally, it will enable the country to prevent imported inflation and to form a monetary union with its major trading partners (Ishfaq To Peg or not to Peg 1-23).
Currently, the UAE has to follow the USA’s monetary policy in order to stabilize the value of its currency (Moabi, Thomas and Alexander 1-48). This has led to policy mismatch since the US has focused on reducing its interest rates in order to stimulate economic growth, whereas the UAE should be increasing its interest rates in order to maintain low inflation. Under a floating exchange regime, the UAE would be able to increase its interest rates, which in turn leads to appreciation of its currency. Consequently, the high interest rate would reduce domestic demand, whereas the high value of the dirham would reduce external demand. However, a floating exchange regime is not desirable because it will increase the volatility of the dirham, thereby stifling growth in key sectors such as tourism.
Given the advantages and the disadvantages of the various exchange rate regimes, there is no perfect solution to UAE’s exchange rate problem. However, the structure of UAE’s economy provides a strong case for a fixed exchange rate. The main challenge in anchoring the dirham against the dollar is that the latter has been fluctuating in recent years. Thus, the UAE can adopt a basket peg by anchoring its currency to currencies that are more stable than the dollar (Gambler and Colander 266).
This paper has discussed the alternatives that the United Arab Emirates has to solve its exchange rate problem. The alternatives that are available to the UAE include adopting a floating exchange rate regime or maintaining its fixed exchange rate regime. Moreover, the country can adopt intermediate arrangements that combine the features of both fixed and floating exchange regimes. The analysis of the effectiveness of these alternatives indicates that none of them provides a perfect solution to UAE’s exchange rate problem. However, the structure of the UAE’s economy suggests that maintaining the fixed exchange rate will be the best solution. In addition, the UAE can respond to the fluctuation of the US dollar by adopting a basket peg.
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