Thursday, 6 January 2011

The UAE Dirham, currency politics and monetary policy

Currencies are a prized symbol of national sovereignty. As countries regained their independence in the decades following World War Two, the number of currencies in existence jumped dramatically. Newly independent countries jettisoned the currencies of former colonial masters and proudly unveiled their own currency notes and coins.

The emblem of the UAE
In the 1970s, the Gulf emirates also embarked on a nation building process, including economic reform and development. A national currency was introduced in 1973, when the United Arab Emirates (UAE) dirham began circulating. The dirham replaced the Qatari Riyal, Dubai Riyal and Bahraini Dinar, which were variously used as legal tender in the several emirates until that date.
Initially, the dirham was issued by the UAE Currency Board. The Board was not authorized to conduct monetary policy for the union. Instead, the Board's functions were "to issue the dirham and ensure full coverage in gold and foreign currencies." 
Monetary policy is the process by which a country's central bank manages the supply of money to achieve a balance between growth and stability within the economy, including stable prices and low unemployment. Typically, monetary policy is conducted by targeting a level of interest rates within the economy.
For national economic managers, monetary policy is a powerful tool, especially when used in coordination with fiscal policy. Within the UAE, monetary policy is the preserve of the UAE Central Bank. The Central Bank is tasked with the "organization of the monetary, credit and banking policy and the supervision of its implementation [within the UAE]." 
The Central Bank replaced the Currency Board in 1980.
During the last several decades, the UAE's economy and financial system have been served well by maintaining an exchange rate regime which pegs the dirham's value to the US dollar at a fixed rate. The business community comprising of traders, industrialists and entrepreneurs has the benefit of strategic financial planning in the context of a stable currency exchange rate.
Undoubtedly, the UAE's exchange rate regime is one of the crucial factors which helped engineer the rapid development of the UAE economy into a regional trading and financial powerhouse. However, the UAE's fixed exchange rate regime has the side effect of abdicating the country's monetary policy to US policymakers.
US policymakers, by definition, are concerned mainly with the vagaries of the US domestic economy. The UAE economy is far from their minds when devising and implementing US monetary policy.
The historical US dominance of the international economic stage meant that in the past US monetary policy generally fit the UAE economic environment. However, the world economy has changed in many ways during the last few years.  
For starters, the US dollar's role as the world's paramount reserve currency is eroding. The proportion of international reserves held by national governments' in US dollars has been in steady decline for years.
Which currency replaces the US dollar is an open question. The Euro is certainly not an ideal candidate, especially given the woes surrounding members like Greece and Ireland.
Indeed, it may be due to a lack of credible alternatives that the World Bank President, Mr. Robert Zoellick, recently suggested that a new international monetary system involving multiple reserve currencies with a role for gold as a reference point for market expectations of inflation and future currency values be given serious thought.
Today's UAE economy is structurally more diversified than when the exchange rate peg was established a few decades ago. Certainly, external influences continue to play a major role, but sources of global demand for the UAE's prime export commodity, i.e. oil, have shifted towards rapidly growing emerging markets.  
The result is a stronger UAE economy, less reliant upon the ups and downs of US economic cycles. It is because of this reduced dependence of the UAE economy that a comprehensive analysis regarding an independent UAE monetary policy is necessary.
Surely, an independent monetary policy cannot be wished into existence overnight. Policymakers must have appropriate interest rate management tools at their disposal. The financial infrastructure ought to include a yield curve across a range of maturities. A robust data gathering, analysis and dissemination system is called for. Key decision makers require timely and credible information to formulate optimal monetary policy.
Delinking the UAE's interest rate policies from the US will necessitate a shift from the US dollar – dirham peg. Otherwise, the UAE currency may become a tool for interest rate arbitrageurs; a development which could have adverse long term economic implications.
Clearly, achieving monetary independence might exact a short term economic price. Significant policy alterations are disruptive to any economy. However, as the UAE economy matures so too must the instruments available to manage the country's continued development. For the UAE, monetary policy flexibility may well become an essential requirement in the years to come.


Imran is a business and management consultant. Through his work at Deodar Advisors, Imran improves the profitability of small and medium sized businesses. He can be reached at

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