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Mon 11 Feb 2008 08:21 AM

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Inflation and the dollar peg

Authorities need to take action to stem imbalances as real income for the majority of the UAE's inhabitants continues to fall.

Hard evidence abounds that life is not very tolerable for many in the UAE at present. A fact to which we will all bear increasing witness in the months to come as real income, for the majority of inhabitants, continues to fall.

My calculation though is that contrary to popular opinion, the Utopian dream will go into reverse and the authorities will have to take action to stem the imbalances. Why? Because as we enter the third consecutive year of rampant inflation, individuals and institutions will begin to vote with their feet as Dubai increasingly becomes an unattractive place from which to conduct a life or a business. Inflation has killed many a golden goose and there is no such thing as a special case, despite what the Versace suited property tells you. If the government doesn't act, then watch what happens.

Two years ago in Arabian Business, I wrote that supply side economics in the UAE need to be addressed more urgently than anything else or inflation would follow. The UAE is beset by significant asset price inflation that borders on a price bubble. And although the nation seems full of armchair economists blaming the currency peg for every conceivable ill, and confusing the drop off in their foreign currency remittances with the evidence of economic extravagance here, it is inconceivable that the relentless suggestion of a one off revaluation will do much to counteract the inflationary spiral.

In the spirit of free speech, it's a point worth considering but frankly, as any undergraduate economics student will tell you, it doesn't work. Not at least if it isn't addressing the root cause. Inflation in the UAE and the wider GGC comes as a result of massive expansion of the money supply caused by trade surplus, imported inflation caused by higher global commodity prices and domestic demand inflation, particularly for property. As there is no possibility of a monetary policy solution, given that a Government facing the exact opposite of the UAE's attendant problems dictates local policy, then the inevitability of supply side economics must come into play.

Fiscal policy as a method of demand management has been seen for years to be limited so governments have turned to using it to improve aggregate supply to maintain stable economic growth. If a greater output can be produced at a lower cost per unit, then the economy can achieve sustained economic growth without inflation. An increase in aggregate supply should be the key long-term objective of Government economic policy.

One off revaluations will do nothing to restore order, as we remain tied to an interest rate structure set by a US government currently stretching the phrase "moral hazard" to new depths. The feel good factor is irrelevant in a country such as this one not inclined towards elections and besides the effect would be short lived if the dollar continued its decline. Far better that the authorities drain liquidity out of the economy by sovereign bond issuance, or by increasing bank deposit ratios. Better still; just ask the banks to stop lending so much.

To a great extent these things are self limiting and cyclical. In recent weeks the Greenback has risen against the UK currency by $0.14c from its low - a move of 7%- more than the level by which most pundits were suggesting the Central Bank revalue the dirham in the first place! And the US Dollar index fluctuates wildly over the long term, dropping to its current levels twice during the 1990s without dramatically importing inflation to the GCC.

Despite the pessimistic forecasts of everyone from disaster scenario lover Jim Sinclair, the noted gold bull, to Jim Rogers, the foreteller of the current commodity boom, there is a real possibility that the US Dollar will increase in value, particularly against Sterling & the Euro. HSBC expects the pound to fall to $1.76 against the dollar over the next eighteen months, even though the dollar itself is in danger of losing its status as the world's "anchor currency".

It is a strange world that we live in. As economic conditions in the US worsen, especially in the real estate market, that it is possible to look for Dollar strength will surprise many traders and most certainly confound many analysts, much to the delight of those sending money home from the GCC.

Arabian Business: why we're going behind a paywall