Towards an Appropriate Foreign Exchange Regime - Example

Name : xxxxxxxxxxx Institution : xxxxxxxxxxx Course : xxxxxxxxxxx Title : Tutor : xxxxxxxxxxx @2013 Introduction In the past decades, the financial system and economy of the United Arab Emirates has been served effectively by an exchange rate regime which pegs its currency, the Dirham to the American dollar at fixed rates. The country’s businesses benefit from easier strategic planning of finances due to a stable rate of currency exchange produced (IMF 2007). According to MacDonald (2010), the economy of the UAE is currently more structurally diversified than it was when the pegging was introduced decades ago. External influences have continued to affect the region, but the demand for oil has been a good source of stability. The UAE is a stronger economy, relying less on the economic cycles of the US. Because of this economic independence, the UAE might need to re-evaluate its monetary policy. This paper discusses the foreign exchange regime options available for the UAE Towards an Appropriate Foreign Exchange Regime An exchange rate refers to the ratio in which one country’s currency can be given out so as to acquire that of another. An exchange rate regime on its part refers to the way in which a country acts in relation to foreign currencies. The regime can take the form of either a pegged or fixed rate. Fixed exchange rate refers to a situation where the exchange rates between countries either varies slightly or does not vary at all. The government adjusts economic policies so that there is maintenance of a stable rate of exchange. There is also the flexible exchange rate system. Here, one currency’s value can freely fluctuate and attain its equilibrium levels depending on forces of supply and demand. No restrictions exist on the selling and buying of currencies and exchange rates can always change (Wang 2009). According to MacDonald (2010), a fixed exchange rate has its strengths, the main of which is creation of a stable pricing and planning framework hence develops international trade and investment. It offers a credible basis for monetary policy, and further establishes direct discipline with regard to monetary policy, for instance through currency boards. Its weaknesses include the fact that the rise in foreign rates of interest creates greater interest rates domestically and a decrease in output levels, and this by extension makes it costlier for authorities to uphold parity. There is in addition an exposure of local industries to excessive competition coming from imports because exports definitely become less competitive. An adjustable peg regime on its part is where authorities specify a fixed parity for the country’s exchange rate, put against one of the world’s major currencies and commit themselves to defend such a parity while offering a small margin. They also have the option of adjusting the parity to some new value in the event of a significant change in the fundamentals (Wang 2009). A floating exchange rate is where there is a periodic intervention by the government to redirect the float through the buying or selling of currencies. According to Kamil (2012), the managed float may also be referred to as a dirty float. A managed Floating Exchange Rate Regime makes it possible for exchange rates to fluctuate every day, with no setting of artificial boundaries. There may however be unofficial boundaries that are set by authorities by means of direct interventions within the foreign exchange markets. Its major strength of this approach is that market forces are the ones that determine what the exchange rate will be. This implies more efficient utilization of financial resources. Speculators do not have the opportunity to seek profits at the central bank’s expense, and monetary independence is also facilitated as domestic currency remains in equilibrium with foreign ones. Under a managed floating system, exchange rate variability is minimal, ensuring there is no fear of major devaluations. In the event of inflationary shock within the economy, there is no transmission to another country as it is absorbed through flexibility. Floating currency is however disadvantageous because high rates of variability lead to uncertainty which ultimately discourages international investment and trade. There is the possibility of a Crawling Pegged Exchange Rate Regime. According to Wang (2009), this is a combination of the pegged and fixed systems. This is because currency ends up being pegged against some other currency, but there is fluctuation allowed in restricted boundaries. The main advantage of this approach is that it offers credibility, in addition to great commitment to monetary policies. There is therefore more financial discipline and provision of a nominal control for disinflation. This is because under a pegged system, there is limited opportunity for the government to implement discretionary monetary policies targeted at the short-term, as pegged rates limit international flows upon domestic money supply There is the option of a linked exchange rate. In this, the country’s exchange rate is managed through linking the currency to some other base currency which is then held in deposits at a fixed ratio in domestic financial institutions. Upon setting of the rate, the government usually does not interfere through policy decisions. Currency is only given out when there is a backup of that currency in the form of the foreign currency (MacDonald 2010). The UAE and its Monetary System The Eurozone debt crisis and the economic crisis in the United States have led to the creation of a difficult world financial climate. In this, financial and currency markets have become unpredictable. The challenges in the world economy necessitate a rethinking of monetary strategy, considering that the UAE pegs its dirham at the rate of about 3.67 per American dollar. The UAE and a majority of countries in the gulf have traditionally pegged their currencies to the dollar. However, the uncertainties that now exist raise the question of whether the approach should be thought out afresh. There are two alternatives that may be pursued in this regard. One of them is floating the Dirham while pursuing other kinds of monetary objectives, and the other is re-pegging the currency to various world currencies (MacDonald 2010). The choice of allowing the floating of the Dirham against the other currencies is viable. IMF (2007) explains that this is because it will enable the country’s Central Bank to impose and seek a single regime to deal with inflation. This is the only relevant alternative to having the peg to some currency. The floating of the Dirham will be likely to make foreigners save in terms of their home currencies, and this will cause a decline in the Dirham’s value. If the central bank continues boosting consumer confidence, it will probably reduce money supply in order to stabilize the Dirham. This will raise interest rates and decrease investment. Re-pegging can consider several currencies, top of which is the Sterling Pound and the Euro. This will enable the Dirham to maintain its stability against others. However, this will not be the most viable policy, because it is the weakening of the Dirham which raises the demand for real estate and tourism in the UAE. Considering that these are major components of the economy pegging becomes a delicate option. The measure will also lead to the creation of considerable uncertainty as oil is a commodity traded in US dollars, and is a major source of revenues for the government at all levels. If the Sterling pound is used, then there is the possibility of the local currency becoming stronger. However, if the Euro is adopted, there is a risk as it is also facing challenges in the wake of the crisis in Europe (Sabri 2008). According to Kamil (2009), having a strengthened Dirham needs not be the policy objective to be pursued. The benefit of having a stronger currency is usually reduced inflation brought from outside. However, the UAE is facing a low rate of inflation currently, with its inflation volatility likely to continue. The UAE has among the highest levels of volatility in inflation globally. What will need to be considered is establishment of a fixed rate of forex exchange instead of choosing particular currencies to be used as an anchor. Seeking to deal with the inflation rate will enable the government to set targets for the country’s private sector in relation to future inflation rates. It will also allow players in the market to arrive at informed decisions. When the inflation rate is made stable, then there will be an increased level of confidence among both investors and domestic consumers. Sabri (2008) explains that the open nature of the economy ensures that the UAE’s inflation does not fall under the control of the government. The high volatility arises from international trade. As a result, the role of the central bank becomes quite limited. In the present monetary regime, the country has opted to forego inflation stability and remain with stability in its exchange rate. Having a stable inflation rate assists the country’s citizens but will affect economic activity in a negative way. The nation gains from massive real estate investments, some Foreign Direct Investment and banking business. Having the Dirham floating will make investment return measurement harder and eliminate the current levels of assurance which ensure that investors do not face currency risks. A large number of people who come into the UAE do so in order to make savings on their home currencies. If the Dirham remains pegged to the dollar, the savings remain within the world's reserve of currency. In the same way, investors will be more drawn to stability in exchange rates than they would to stability in inflation rates. According to Ishfaq (2010), the nature of the UAE economy determines the likely approaches to fiscal policy. Its small economy, occurrence of nominal shocks due to extensive monetary expansion and openness make it necessary for the country to take up a fixed exchange rate system. The country is characterized by a massive external imbalance. There is also a high rate of capital mobility, frequent shocks, both external and real domestic and nominal shocks from outside. If the economy seeks inflation reduction, then a fixed system will work best. If the objective is however dealing with external imbalances, flexibility becomes better. A flexible regime is generally the best for the country. Conclusion Ensuring that the country’s interest rate policies are delinked from the American system will require a shift from the pegging of the Dirham to the US dollar. An Exchange Rate Regime provides an essential tool for the improvement of economic performance. This is because it has a direct impact on a country’s competitiveness and macroeconomic stability. In the case of the United Arab Emirates therefore, the choice of exchange rate system is a considerable challenge which greatly depends on ensuring consistency in macroeconomic policies, and the country’s general economic state. There is the need to adopt a flexible approach in its foreign exchange regime. Bibliography International Monetary Fund (2007), United Arab Emirates: Financial System Stability Assessment, International Monetary Fund: Washington DC Ishfaq, M (2010), Economic Papers Series: Overview of Different Exchange Rate Regimes and Preferred Choice for UAE, Government of Dubai: UAE Kamil, H (2012), How Do Exchange Rate Regimes Affect Firms' Incentives to Hedge Currency Risk? Micro Evidence for Latin America, International Monetary Fund: Washington DC MacDonald, R (2010), Currency Union and Exchange Rate Issues, Edward Elgar Publishers: Cheltenham Wang, P (2009), The Economics of Foreign Exchange and Global Finance, Springer-Verlag: Berlin Sabri, N (2008), Financial Markets and Institutions in the Arab Economy, Nova Science Publishers: New York Read More