Should the UAE keep the dirham tied to the dollar?

The US and eurozone debt crises have ushered a new era of the improbable in currency and financial markets. This may be a good time to re-assess the UAE's policy of "pegging" the dirham in a constant relationship of Dh3.67 per US dollar.

Historically, the UAE and most Gulf economies have anchored their domestic currencies to the US dollar. But new uncertainties surrounding the dollar lead many to ask if the UAE should either a) repeg the dirham to a basket of world currencies or b) float the dirham and pursue other monetary objectives.

Let's consider the alternatives.

Repegging would likely involve a range of currencies including the euro and the pound sterling. This might allow the dirham to remain strong against other currencies, but that may not be a desirable policy objective. After all, a weak dirham increases foreign demand for both tourism and real estate - two important pillars of the UAE economy.

In addition, moving to a basket of currencies would introduce uncertainty in budgeting since oil, which is traded in dollars, remains an important part of central and sub-central government revenues.

And including sterling in the currency basket would likely achieve a strong dirham but the euro, just like the dollar, is currently beset by uncertainty - with the added risk of a eurozone break-up.

A strong dirham should not be a policy objective in itself. The positive aspects of a stronger currency have to do with lower imported inflation, but inflation is already at an all time low, below 2 per cent and the UAE's inflation volatility, which is among the highest in the world, will persist.

This has to do with having a fixed exchange rate, rather than with the particular currency or currencies chosen as an anchor.

The other option, allowing the dirham to float against other world currencies, would ostensibly allow the UAE Central Bank to set and pursue a particular inflation-targeting regime - the only viable alternative to a currency peg.

Targeting a given inflation rate essentially allows the Central Bank to set expectations for the private sector on the future rate of inflation. and allows market participants to make more informed decisions: a stable rate of inflation instills confidence in consumers and investors alike.

Inflation in the UAE, however, is largely not under government control: because this is an open economy, inflation volatility is mostly imported, making a more active role for the Central Bank exceedingly difficult.

Under the current monetary regime, the UAE has traded inflation stability for exchange rate stability - this is an additional source of inflation volatility and indeed recent figures show that the UAE has witnessed periods of extremely high inflation followed by single-digit rates of inflation.

A stable inflation rate would benefit UAE residents but economic activity would likely be negatively affected. The UAE benefits from large sums of foreign investment in the real estate sector, the banking sector, and in the form of foreign direct investment. Setting the dirham afloat would make investment returns more difficult to measure, and would remove the existing assurance that investors are not subject to domestic currency risks.

Most UAE residents are foreign and their principal objective in coming to the UAE is to save in their respective currencies. Having a dirham pegged to the dollar ensures that their savings are essentially in the world's reserve currency.

Similarly, international investors are much more interested in a stable exchange rate than in a stable inflation rate - and so should the UAE government.

To put it plainly: a floating exchange rate would encourage foreign residents to put their savings in their respective currencies (the Australian dollar, pound sterling, and so on). That would cause a fall in the value of the dirham.

The central bank, in its effort to prop up consumer confidence, would likely decrease money supply to support the value of the dirham. This would in turn generate higher interest rates and lower levels of domestic investment. The result would be negative consequences for economic growth.

The UAE Central Bank has recently made it clear that it will maintain its current monetary stance. Could the US dollar lose further ground against major currencies? In the short term, investors will be spooked by the ratings downgrade. But the long-term value of the US dollar reflects the purchasing power of the currency.

The US has a nearly $15 trillion economy, which grew at an annual rate of about 1.5 per cent in the first quarter. It is US fiscal policy - not the economy - that is unsound.

The ratings downgrade may well jolt US policy-makers into fiscal discipline, but with jittery financial markets and low investor sentiment, a fiscal remedy may spell another recessionary period.

In improbable times, the steady-as-she-goes stance of the UAE Central Bank remains the right call.

Dr Tarek Coury is an economist at the Dubai School of Government