UAE Dirham and Exchange Rate Regime - Case Study Example

UAE Dirham and exchange rate regime Name Institution Introduction Every sovereign nation across the globe has adopted a certain exchange rate regime that it utilizes in its trade. The type of exchange rates regime adopted by each nation is dependent mainly upon the economic structure of the nation (Edwards & Savastano 1999, p.75). It is vital to understand here that nations have very diversified economic spectrums and as such, they need to have diversified regimes that fit within these spectrums. Economic development is a factor of how weak or how strong a certain currency is subjected to various parameters such as trade-offs between other nations. Each nation struggles to ensure that its currency is strengthened against other foreign currencies so that it can be able to have a favorable balance of trade. Many of these countries however have not been in existence as sovereign nations for long. For this reason, most of them still find that they are struggling to grow their economy. During this period, their currency is usually very weak and they cannot be able to adopt and develop their own independent exchange rate regime. Because of this reason, many of them get their currencies pegged to a major currency that has strength and worldwide recognition such as the US dollar, Euro or Pound (Ishfaq 2010, p. 13). They relate their currency to these bigger currencies and their trade-off is done with respect to the exchange rate they have with the major currency. They find that they have adopted the exchange rate of the major currency’s nation by pegging their currency to it. Such is a case of the United Arab Emirates (UAE) dirham. However, the UAE are considering adopting another independent exchange rate regime and unpin their UAE dirham from the Dollar pegging. This paper provides an in-depth discourse and analysis into this situation. The paper will look into various exchange rate regimes and assess whether the UAE should change its current exchange rate regime following its current economic structure and economic fundamentals. UAE profile and Economy Before embarking onto the discussion of the exchange rates, it is important to give a brief profile of UAE to be able to understand the economic setup of the country and its economic fundamentals. The UAE is a federation comprised of seven principles with its headquarters in Abu Dhabi. The country boasts as being among the most developed economies in Western Asia. The major export from UAE is oil. The region also exports natural gas, dried fish and dates. From the IMF world economic outlook (2012), UAE economy was ranked at position 30 worldwide. The economy of the UAE started blossoming when the region started exporting crude oil and natural gas. Today, the region is among one of the largest exporters of oil and it is also the largest economy and fastest developing economy in western Asia. The current exchange regime for UAE Since its independence from the United Kingdom, the nation adopted the USA exchange regime. The federal regime entailed pegging their currency (UAE Dirham) to the USA dollar. The implication here is that the strength of the dirham is subject to the strength of the dollar at any given time. Fluctuations in the value of the dollar have a ripple effect to the value of the dirham. The economic structure of UAE UAE operates its economy on a free market basis. There are very minimal restrictions on private-sector activities, capital movements and international trade (UAE interact 2013). The region had a GDP of 1.3 % in 2011 and the estimate was done to place the GDP growth in 2012 at 4.2% following a 6.6% increase in GDP in oil and a further 3.1 % increment in GDP from non-oil products. This prediction is also in line with the UAE maintaining a robust competitiveness as a commercial hub of Western Asia. A further growth of 3.6% was estimated for the year 2013 according to IMF economic outlook (2012), 3.7% in 2014 and 3.8% in 2015. The GDP of UAE is estimated to grow at a factor of 0.1% each year continuously following increased investor confidence in other products from the region such as real estates. In trade, the region enjoys a favorable balance of payments. The value in dollars of the products exported from the region (oil forming the bulk) far exceeds the value of the products that the region imports from other countries. This leads to the nation having a surplus in its GDP and with the reserves held by central bank in foreign nations (UAE interact 2013; IMF world economic outlook 2012). The contention in this case As observed from the above economic structure, UAE considers itself to have one of the world’s largest growing economies. Its vast reserves of oil and natural gas are stated to be in volumes of billions of barrels. For this reason, the region can foresee itself becoming among the major players and key nations and economies in the world. Indeed, the UAE has a 2021 vision, when it reaches its jubilee to provide innovation, science, research and technology as the centers and main drivers of the economy of the region. Its current exchange rate regime where it has been pegged to the dollar is not favorable to the region. For this reason, the country seeks to change the exchange rate and adopt a new one that would be much in tandem with the region’s visions for growth and the current trend in economic growth. The following paragraphs will discuss, in a general format, the various exchange rate regimes that are present and in operation by many nations in the world today. It will then discuss the best possible exchange rate regime that the UAE could adopt following a number of factors. The pegged exchange rate system This system (in which the UAE is currently in) is a system where various governments try to maintain the value of their currency subject to the value of another currency (Yevdokimov 2012, p. 12). In other words, the government decides how much their currency is worth in relation to the worth of another currency in the market. In this kind of regimes, nations are required to maintain a certain amount of international reserves to be allowed to be involved in foreign trade. The pegged exchange rate system, also predominantly referred to as the fixed exchange rate system places the value of a currency side by side with another more recognized and more valuable currency. The most common currencies that are used as pegs include the USA dollar, the GBP and the Euro, being the currencies that were recognized in the Breton Woods agreement after the Second World War. Since then, most nations of the world have had to measure the value of their currency in respect to the value of the other currencies, most preferably the USA dollar. UAE has been no exception to this concept. However, this regime allows some controlled levels of currency and capital mobility within the regime. For instance, it could have some relation to a crawling brand or crawling pegs. A crawling brand allows the exchange rate to fluctuate within the band around a central value which is adjusted on a periodic basis. Various economic indicators in a nation are key to influencing this movement. Crawling pegs are normally fixed but they are adjusted accordingly as the pegged system adjusts too. Dollarization This exchange rate is in practice in numerous countries across the globe. The concept shows how many economies across the globe use foreign currency alongside theirs or even on behalf of their own currency (Jochumzen 2010, p.114). The foreign currency used does not necessarily have to be a dollar. Dollarization is just a general concept in this case. Floating exchange rate regimes Floating exchange rate regimes are commonly used the world over. However, the central governments of various nations normally intervene in the market to prevent a situation of depreciation of value or excessive appreciation. This is a situation where the currency is allowed to swing freely through the determinants of market forces (Ishfaq 2010, p. 69). Determinants of exchange rate regimes For a country to adopt a particular exchange rate regime for use within its economic structure, there are a number of factors that need to be looked into to determine whether the regime that they wish to adopt is the best for the economy of particular nation. These factors are discussed here as outlined by Poirson (2001, p.3) in the IMF working paper. One of the determinants of the exchange rate regime is the capital mobility in a particular nation. If a nation has high capital mobility, the tendency to gravitate towards free float and fixed pegs will be higher as these forms of regime are the ones with the capacity to become sustainable in a world of high capital mobility. Pegging and fixed regimes act as guards against excessive depreciation and appreciation resulting from imbalances that could result from this mobility. Another factor that determines the exchange rate regime is the political factors, either stability or instability of the political systems. Political systems are very delicate tools that control the economy of a nation. In a nation where the political system is seen to be faltering, the exchange rate regime that would best suit this economy becomes one that would have the control of the monetary and fiscal policies given to an independent institution like the central banks. Politicians may tend to pas policies that would inflate the economies of their nations, leading to a much-heightened level of inflation in the economic. A case like Zimbabwe is a classical example. The devaluation of the Zimbabwe economy, following excessive inflation resulting from political interference led to the country adopting a new regime, the dollarization. Germany is also another example in this case. Though German later went on to adopt a regime where the central bank was given absolute mandate and responsibility for the control of the economy, the country had undergone a series of economic upheavals when politics intervened in controlling the monetary policies and led to nation into a state of hyperinflation. Un-hedged foreign currency liabilities are also another determinant of exchange rate regime adopted by a nation. Nations that have a high exchange rate risk exposure prefer the pegging exchange rate regimes that will cushion them against this risk. Why UAE should consider changing current exchange rate regimes The UAE should consider changing their current exchange rate regime and adopt a regime that would be best suited to the region following the dynamics of the economic structure and fundamentals of the region. There are several factors that will serve to enrich this consideration as the following paragraphs detail. Political stability in UAE UAE enjoys a relative good political stability than most of its neighbors in the Asian region. The governance and political system of the UAE could be described as a mixture of both federal as well as hereditary. Each of the seven federations that constitute the UAE contributes to the central government. The positions of both the president and the prime minister of the UAE are hereditary even though the supreme council usually elects them. The coordination in the region is such that the emirs of the region’s two great cities, the emir of Abu Dhabi are the president of UAE, the emir of Dubai the prime minister. The other federations have their representatives in the council. This form of government ensures that power is consolidated in the region and political stability is maintained. Stability politically is a huge determinant of the exchange regime as this offers security and minimizes some of the risks that other nations have due to their instability status. Low capital mobility Even though the region does not inhibit or restrict the movement of capital within and out of its boundaries, the mobility of capital in the UAE region is low. This is a very important factor in the determination of exchange rate regimes. It has been observed from a previous section that a nation that has high capital mobility tends to adopt the pegged exchange rate regimes so that they can be guarded against instances of excessive depreciation and excessive appreciation. The UAE’s current exchange rate regime is pegs the dirham to the dollar, implying a pegged exchange rate regime. However, because of the fact that the region does not have a high capital mobility, it can afford to shift to another form of exchange rate regime without the fear of unchecked depreciation and appreciation that could emanate from shifts and balances in capital. Un-hedged foreign currency liabilities This is also another factor that could be used to determine whether the UAE region should adopt a new exchange rate regime. When nations have high-risk exposure to the exchange rate in the market, they tend to gravitate their exchange regimes towards the pegged and fixed regimes so that they can be shielded from the risk in the market. However, the UAE does not have much of such un-hedged foreign currency liabilities. For this reason, the region does not have to worry much about the risk attached to their foreign currency liabilities. They have much of their liabilities and interests in other foreign nations. The region has very vast resources in other foreign banks of other countries. This shields the UAE from the threat and possibility of risk from un-hedged foreign liabilities. The region has posted surplus in its GDP for a consistent period. Strong economy The strength of the UAE federations’ economy is increasingly emerging to become one of the world’s largest growing economies. A previous section that highlights this strength has been discussed in this paper. Because of this, it would be important to have the region expand and grow without having to peg the value and the strength of the dirham to the dollar. The fluctuations in the dollar value may lead to imbalances and fluctuations in the value of the dirham too. If the region adopted a different regime, they would have a chance at becoming stronger and being on the path to be an economic super power. Conclusion The above discussion has looked into a number of issues along the concept of exchange rate regimes. Various exchange rates regimes have been discussed in this paper. They are namely pegged exchange rate regime, dollarization exchange rate regime, fixed exchange rate regime and floating exchange rate regime. Discussion into the UAE as an economic nation and as a region has also been carried out to determine whether the region should change from the current regime to a new exchange rate regime has been done. The determinants of exchange rate regimes have been discussed too. This paper concludes by arguing that indeed, UAE should consider going ahead and changing their exchange rate regimes so that they can continue, as a region, to grow as phenomenally as they have been doing in the past couple decades economically. It has been observed that factors such as political stability, low mobility of capital in the region and low risk resulting from un-hedged foreign currencies liabilities are the major factors that have been considered in determination of whether the UAE should change their current exchange rate regime and adopt another form of regime. References Poirson, H 2001, ‘How do countries choose their exchange rate regime?’ IMF Working Paper, Viewed 5 November 2013, http://www.imf.org/external/pubs/ft/wp/2001/wp0146.pdf Edwards, S & Savastano, M. A 1999, ‘Exchange rates in emerging economies: What do we know? What do we need to know?’ NBER Working Paper 7228, Viewed 5 November 2013, http://www.nber.org/papers/w7228. IMF world economic outlook 2012, Global Recovery Stalls, Downside Risks Intensify, viewed 5 November 2013, http://www.imf.org/external/pubs/ft/weo/2012/update/01/pdf/0112.pdf Ishfaq, M 2010, ‘Overview of Different Exchange Rate Regimes and Preferred Choice for UAE’, Economic Papers Series, Government of Dubai, Viewed 5 November 2013, http://www.dof.gov.ae/en-us/publications/Lists/ContentListing/Attachments/55/Overview%20of%20Different%20Exchange%20Rate%20Regimes%20and%20Preferred%20Choice%20for%20UAE1.pdf Ishfaq, M 2010, ‘To peg or not to peg? A quantitative analysis of the UAE Dirham’, Economic Papers Series, Government of Dubai, Viewed 5 November 2013, http://www.dof.gov.ae/en-us/publications/Lists/ContentListing/Attachments/53/1.pdf Jochumzen, P 2010, Essentials of Macroeconomics, Ventus, Frederiksberg. UAE interact 2013, The Economy, Viewed 5 November 2013, http://www.uaeinteract.com/business/economy.asp Yevdokimov, Y 2012, Practical Guide to Contemporary Economics, Ventus, Frederiksberg Read More