UAE raises expectations it will drop dollar peg

Central bank revamps monetary policy tools, take first euro deposits from local banks.

The UAE central bank on Tuesday revamped its monetary policy tools and said it would take its first euro deposits from local banks, after raising market expectations it could swap its dollar peg for a currency basket.

The central bank will replace its daily sale of fixed-rate certificates of deposit from Wednesday with an auction that will determine interbank lending rates. The bank will allow the UAE's first repurchase agreements, it said in a statement.

The UAE has no benchmark interest rate. The central bank has guided interbank borrowing costs by selling dirhams denominated certificates, cutting them by much as 20 basis points last week to deter bets on a dirham appreciation.

The maturity of the longest-dated certificate will be extended from 18 months to five years, a statement on the central bank website said.

"Banks are allowed to enter into a repurchase agreement with the central bank or among themselves," the central bank said on its website. Repo rates, from overnight to three months, will be determined by demand, it said.

Banks will be allowed to hold certificates in euro and dollars as well as dirhams, it said.

"This is a formal introduction of the euro in the whole system," said Marios Maratheftis, regional head of research at Standard Chartered in Dubai.

"If we are talking about moving to a currency basket in the future, this probably suggests the composition of a future basket," he said.

UAE Central Bank Governor Sultan Nasser Al-Suweidi said this month he was under growing social and economic pressure to drop the dirham's peg to contain inflation.

The dirham could track a currency basket including the euro, although any move would only be made in concert with Gulf Arab neighbours preparing for monetary union as early as 2010, he said.

The dirham hit a five-year high last week on his remarks and forward rates showed investors expecting a appreciation of as much as 3.1% in a year in a currency which has been fixed at 3.6725 per dollar since 1997.

The central bank will hold daily auctions for one-week to 12-month CDs and monthly auctions for CDs of two, three, four and five-year terms, it said.

"This will assist in the development of a dirham yield curve," said John Eldredge, treasurer at Emirates Bank International (EBI), part of Emirates NBD, the Gulf's biggest lender by assets.

"It is a good move and something that banks have been looking for a long time," he said.

Currency reform

To deter bets on currency appreciation, the central bank cut its six-month to 18-month certificate of deposit rates by between 10 basis points and 20 basis points on Thursday.

In his call for currency reform in the Gulf, Al-Suweidi complained that the dollar pegs force regional central banks to track US monetary policy when their booming economies are out of step with the US.

With the Federal Reserve cutting US interest rates to contain the fall-out from a mortgage market crisis, Gulf central banks have been forced to follow suit and ignore the risk of stoking inflation which is at decade-highs across the region.

The Fed has reduced rates by 75 basis points since September 18. None of the UAE's certificate rates has fallen by as much, encouraging investors to pour money into dirham deposits in anticipation of a revaluation.

By switching to an auction, the central bank will let demand determine interest rates. Strong demand for dirham deposits will cut the yield on certificates, making bets on dirham appreciation less attractive. (Reuters)

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