Dollar-pegged out

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Published: July 7 2008 19:49 | Last updated: July 7 2008 19:49
An explosion in your US dollar income is not a bad problem to have. The
United Arab Emirates and other Gulf oil exporters, however, have chosen
the wrong way to handle it. Rather than revalue their currencies, and
peg them to something more appropriate than the US dollar, they have
chosen to allow a large domestic inflation. That has unnecessary costs.
A report published by Abu Dhabi’s department of planning and economy says that the United Arab Emirates has floated the idea of tracking a basket of currencies in place of the dollar.
To do so would be a way to reduce inflation, which is measured at 11
per cent in the UAE, 14 per cent in Qatar, and similarly high levels in
other Middle Eastern oil exporters.


The
cause of price rises is simple. Oil used to sell for $20 and now
fetches $145 – so the UAE has got much richer. The domestic economy of
apartments, shops and hairdressers, however, cannot expand so quickly
and that means a choice. The UAE either keeps its currency pegged to
the dollar, in which case too many dirhams will chase too few goods,
and prices will inevitably rise; or else revalue the dirham so each one
is worth more dollars.
Both options achieve the same end result
but inflation has greater drawbacks. First, it is slow, whereas
revaluation is instant. Second, once started, inflation is hard to stop
because workers demand higher wages to compensate. Third, there is a
risk of asset price bubbles in the Gulf nations because high inflation
means that real interest rates are too low. Fourth, inflation hurts the
poor (who do not have direct access to oil revenues), and so harms
political stability.
There is also a specific problem with
pegging to the dollar. Gulf currencies have actually had to depreciate
against the euro in order to follow the dollar, the exact opposite of
what they need, and a shift that will cause even more inflation.Countries
such as the UAE cannot simply adopt a floating exchange rate, however.
They are too small, and dependence on a volatile commodity makes it all
but impossible to predict what their purchasing power will be the year
after next, and what a sensible monetary policy might therefore be.
The
Gulf needs to peg to something. A first step (after revaluation) would
be to peg to a basket of currencies that included the euro and the yen.
A bolder step would be to include the price of oil in that basket, so
that currencies would appreciate when oil is strong, and depreciate
when it is weak. That would make for smoother adjustments than
double-digit inflation.