Saturday, September 8, 2007

Sher Value: Inflation Monster

We all, without exception, love growth, it symbolizes that we are doing something positive and the benefits of our policies and hard work are bearing fruit. However, as most economists will tell you, growth comes with its challenges and pitfalls. Some of these can be faced through good fiscal and monetary policy and others can be dealt with in terms of a strategic framework, while not all risks from hyper growth can be mitigated, there is little denying that a good framework is usually a good thing to have.

UAE has been experiencing phenomenal growth, with oil prices having averaged close to US$ 60 per barrel for over a year, a massive expansion in the real estate sector, the growth of banking, hospitality and services all abode well for the future. With growth, usually comes the competition of money seeking those goods and services which become more dear resulting in inflation. Classically, the best way to fight inflation is to have a proactive monetary policy, where indicators are watched and action is taken prior to inflation becoming a chronic problem for growth. Central bank regulators usually balance the needs of economic growth by a variety of measures, the most common and perhaps effective, being the use of interest rates and money supply to either spurt the economy on or rein in too much money supply.

However, for the UAE its linkage to the US dollar creates a unique set of issues, most of which being that while domestic growth has been robust, the UAE Dihram has slid by over 15% last year against the Euro alone on account of the UAE Dihram being pegged to the US Dollar. In addition, while not explicitly stated, UAE interest rate policy closely reflects the movements in the US interest rates creating a dichotomy.

Take the current situation, the US needs to get out of a credit crunch and hence has to make lending easier and provide liquidity to the markets by lowering interest rates. UAE on the other hand had to rein in money supply and curb inflation for which it would typically increase interest rates! While it is commonly stated that a delinking for the US Dollar would reduce the value of UAE’s exports (mostly in dollars) and its investments, (also mostly held in dollars) these adjustments would be notional and allow the UAE to either let its currency float (not recommended by me as it needs active monetary management) or to adjust the peg against the dollar. Ideally, I hae argued that the UAE should create a basket of currencies and adjust its rate against the basket on a regular basis. This will also mean that the UAE Central Bank will have to play a more active part in issuing longer term treasuries to soak in the liquidity and redeem them when it needs to provide liquidity.

UAE, as an economy, is dynamic, robust and becoming more integral to the world capital markets and it has to move away from reactive financial management to a more proactive model. Growth is a great story around the dinner table and something we have to be proud of, but inflation is a pretty stubborn customer that could upset the apple cart.

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