By Claire Ferris-Lay and Dylan Bowman
US bank says peg not responsible for record inflation, blames rents and international food prices.
Morgan Stanley on Wednesday backed the UAE central bank’s decision to stick with its dollar peg and refuted widespread criticism that the peg was responsible for record inflation in the Gulf state.
The US holding bank said in a report on the UAE economy that the dirham's peg to the US dollar had “generally served the country well", blaming inflation on soaring rents and international food and commodity prices.
Morgan Stanley predicted inflation in the UAE would peak at 12 percent this year before declining to about 9.7 percent in 2009. Inflation in the UAE touched an official rate of 11.1 percent in 2007.
The bank said "the currency peg has generally been a source of stability for an economy that is heavily reliant on export revenues from a highly volatile resource".
"We maintain that inflation in the UAE has essentially been driven by sharp increases in rents and, to a lesser extent, by higher international prices of food and commodities," the bank said.
"Together, these two factors - which have little to do with the dirham’s peg to the dollar - have accounted for over 70 percent of CPI increases over the past two years."
The UAE's peg to the dollar forces the central bank to follow monetary policy set by the US Federal Reserve in order to maintain the relative value of the dirham.
The Fed has been slashing rates since November last year in an effort to stave off recession, at a time when the UAE should be raising rates to rein in spending and fight inflation.
Morgan Stanley said any change in the UAE's exchange rate policy could actually have a negative impact on the economy.
"Although a revaluation may not significantly help to ease inflationary pressures, it will surely lead to a further appreciation in the real exchange rate, which will in turn have an immediate, negative impact on the international competitiveness of the non-oil sector," it said.
"Further, we believe that a change in the existing exchange rate policy - either through a one-time revaluation or the re-pegging to a basket of currencies - would signal to the market that additional revaluations may be forthcoming, which is likely to reignite market speculation against the dirham."
Currencies are supposed to have value. Thatâ€™s why the Gulf Central Banks are buying gold, as Gulf News reported yesterday. The dollar has no value whatsoever. Gold is now a super currency, writes Ambrose Evans-Pritchard in todayâ€™s Daily Telegraph. How can it possibly be argued that the dirham's peg to a currency which has no value whatsoever will continue to serve the country well? And if this can be argued, why is the UAE Central Bank then buying gold?
And the dollar has no value because money supply has been increasing at an extraordinary and ever increasing rate(hence the Fed ceased publishing the M3 figures). This must have a knock on effect in economies pegged to it; indeed UAE money supply increased more than 30% last year I believe. It is a basic rule of economics that monetary inflation leads to price inflation. The Central bank is correct to be stocking up on gold, private citizens would be prudent to do the same.
I agree that there will be a global move towards gold. If you look around the world, stocks are falling, real estate is falling and now even saving money in banks looks risky (and the returns are declining as central banks cut interest rates). As iceland has shown, government guarantees are worth nothing if the states are bankrupt too. It seems likely to me now that the dollar peg will be cut or revalued in 2009, but that it will make the AED *weaker* rather than stronger as most of the speculation of the last few years has expected. Money is flooding out of the UAE and into other currencies, reversing pressure on the dirham to the point where the UAE will have to raise rates to maintain the level and keep foreign investment. This will cripple borrowers in the UAE and exacerbate the decline. The only solution would be to revale the AED to try to encourage foreign money back. This will reduce the attractiveness of working in the UAE, and devalue UAE denominated assets further. So whatever happens, the UAE economy cannot win. There is no easy way out of the mess.