Nations demonstrate the aspiration to ensure that the living standards of their citizens are appropriate and their capacity to play in the regional and global economic arena remain secure. The United Arabs Emirates is included in this phenomenon with the trade, production, distribution, and consumption of products in the region being a factor of diverse processes (Doyle 2005). Like other regions, UAE operates with an economy that relies on legal structure, customs, technological process, education, politics, and aspects of globalisation like foreign exchange.
With widespread global trade in the contemporary world, the region continues to witness unrelenting business activities across its borders. In facilitating these transactions, the use of foreign exchange regimes has become inevitable in an era where different nations are at liberty to choose from the wide range of foreign exchange structures. The UAE Dirham and the US Dollar Exchange Rate utilise the fixed model (Kennedy 2000). In the recent times, this regime has proved unproductive for the region. As a result, the tying of the currency to the dollar has continually raised questions of whether the regime is worthy. In light of this, various economic researchers recommend that the regions adopt a different foreign exchange regime if its priority is stabilising, or growing the economy (Poirson 2001).
Exchange Rate Regimes
Exchange rates refer to the levels of exchange between different currencies and determine the measure or the value of the currencies of different countries or regions (Jochumzen 2010). These rates vary from countries to countries depending on the regimes that are applicable. The exchanges rates regimes govern the relationship between a currency and others together with the happenings in respective foreign exchange markets. According to Ghosh, Gulde, and Wolf (2002), these structures have vast consequences with the economic systems of the nations and regions using different exchange rate regimes highly dependent on the structures.
In the publication “Exchange, Rate Regimes: Choices and Consequences,” the authors demonstrate that applying rationality in determining the regime to settle on serve to promote the positive implications that the selected structures promise. The reverse is true for choices made out of superficial reasoning processes. As Ishfaq (2010) puts it, the shift from traditional mode of exchange to the modern structures, where nations have to choose their preferred foreign exchange, a regime has to come up with its own complications. However, the advantages of this freedom of choice emerges in the persistence of such regimes and the ease with which the structures consider the populations and income levels of respective nations among other reasons (Rose 2011).
There are three primary categories of exchange rates, which nations can opt to apply in their systems. These are the fixed, floating, and pegged float exchange rates. With the fixed exchange rate regime, a currency ties with another where the latter is among the most common currencies for example the euro or the dollar (Mussa 2000). Floating regime institutes a situation where the market governs the shift of the exchange rates while the pegged float comprises exchange rates under the control of the central bank. In this case, the institution averts extensive deviation of the currencies from the target value or band (Ghosh et al. 2002). Exchange rate systems vary from country to country. Countries can choose to apply one exchange rate system unequivocally or integrate an arrangement that encompasses the two extremes of flexible or fixed exchange rate systems. Additionally, a nation may form a part of a monetary union comprising of nations that share that same currency (Jochumzen 2010). Irrespective of the system a nation utilises, the selection trickles down to the transactions that reduce the volatility of the exchange rates and forego a self-governing monetary policy.
UAE Dirham Exchange Rate Regime
According to Ishfaq (2010), most gulf economies, the UAE included have traditionally pegged their domestic currencies to the US dollar. This traces back to the period that the nation was classified among the poor economies. Initially, UAE seemed to be a merely poor desert void of any possibility for agricultural activities. However, the realisation of oil wealth in the country has transformed this perception over the years. Courtesy of this commodity, the region is equipped with modern infrastructure with the populace enjoying elevated standards of life. Abed and Hellyer (2001) illustrates that the oil exports receives credit for more than 30% of the nation’s GDP coupled with the evident economic growth and performance of the nation. Considering the high levels of oil exports that the nation associates with, discussion of the nation’s foreign exchange in different economic arenas is not astonishing.
Dirham, UAE’s currency started at an equivalent exchange of 3.94737 in 1973 when it first emerged in the markets. In November 1997, the exchange rate between the two currencies witnessed the midpoint trading at 3.6725 dirham per dollar. The currency pegged to the US dollar since November 1980; a feature that officiated in the year 2002 (Ishfaq 2010). Notably, the exchange rate averaged at 3.671 in 2001 and 3.65 in 2007(Survey of economic and social developments 2007). This production structure makes the UAE to rely on its main exports – oil and petroleum products – to sustain its economy. The country has a per capita GDP of 24,000 USD. Tourism, real estate, and construction add to oil and petroleum products in driving the UAE’s economy. Analysis on the current, financial and capital accounts of this country shows a surplus in the Balance of Payment (BOP).
The pegging of dirham to the dollar back in the years emanated from the diverse advantages of the model. Pegging a currency to the US dollar presented advantages not only to the public and private sector of the economies, but also to the citizens of the respective nations. Mussa (2000) points out that the regime benefits nations with remarkable interest in trade and export. This occurs given that the regime aids in the control of a nation’s domestic currency, thus maintaining a low rate of exchange for most parts. Because of this, such a structure promotes the competitiveness of the products that the nation exports to other countries.
The pegged regime had the capacity to work well in increasing the competitiveness of the oil products that the UAE sold to other nations of the world (Ishfaq 2010). In addition, this structure of exchange encouraged a low cost of production for the nations that applied the system. This provided a much greater basis for the incorporation of the system into a myriad of economies. As Mussa (2000) points out, the feature aids countries in protecting their economies aside from increasing the earning outlook of their organisation. This translates to improved earning, national development and, therefore, improved living standards for citizens.
Like expected the pegging of the dirham to the dollar brought the UAE massive benefits. First, the US dollar dominates oil prices. This made the system the most convenient for the oil transactions allowing it to compete at an appropriate level with other oil producing nations (United Nations 2008). This regime aided the nation in diminishing the risks that associate with international trade. This is due to the elimination of fear on the part of potential customers on the possibility of price changes. This created a sense of assurance for customers who not only purchased the products, but also invested in the nation. These investments partially contributed to the stable economic condition that UAE prides itself in (Ishfaq 2010).
Markedly, the regime’s achievement from the fixed tax regime also established the capacity for managing the economy cushioning the government from inflationary policies within the country. Moreover, the pegged rate not only enhanced the nation’s financial stability, but also eliminated the speculations for destabilising thus providing an increased potential for investment and subsequent economic growth. Fixed exchange rates instil confidence in investors, as there is certainty on foreign payments. Unlike in the flexible exchange rates where there are high liquidity preferences due to windfall gains, this system favours economic stabilisation by checking unwarranted changes within the economy of a country.
Problems of the Current Exchange Rate to UAE Economy
Although the fixed exchange rates present a number of advantages, recognising the possibility of the feature in countering positive economic development efforts is imperative. According to various economic experts, the downside of this kind of exchange structure comes in its vulnerability instabilities making it cause economic failures in unfavourable conditions. Instead of being a tool for enhancing economic growth, the fixed regime can end up as a liability to a nations’ economic system (Jochumzen 2010). It is essential that economies that apply this model maintain a fixed rate of exchange to avoid negative consequences (Doyle 2005). Subsequently, large amounts of financial reserves come in handy for the nations to maintain such conditions. This will have to coincide with the constant purchasing and selling of domestic currency. Undoubtedly, the problem of maintaining such reserves sometimes translates to importing inflation.
This is due to the rise in prices of commodities emanating from the enhanced supply of money in the economy. The economic shock that the United States experienced in the wake of the 2008 financial crisis followed massive economic difficulties, some of which the nation is yet to recover from (Ltaifa, Kaendera, & Dixit 2009). The instability that this caused to the dollar is evident. The fixed exchange rate system also does not encourage long-term foreign investments given that it is not actually rigid or permanent. It leaves foreign investors uncertain on the next changes in the domestic currency. This system presents complications in deciding when to alter the external value of the currency. At the same time, it presents challenges in determining the acceptable criteria for devaluation, and the amount of devaluation required to establish equilibrium in the BOP of a country.
The financial crisis in the United States, coupled with the debt crises in the Euro Zone served to introduce a new period of the questionable in the financial and currency markets. The challenges have made the requirement for the reassessment of the foreign exchange regimes in some nations indispensible. For instance, the UAE is finding of maintaining the dirham’s tie to the US dollar at a constant of AED 3.67 per $1 is not practical. Because of this, consideration of dropping the peg to the dollar continues with the view of switching to another regime of foreign exchange.
Among the contemplations include floating the currency independently, or changing to another currency. As Ishfaq (2010) explains, the currency’s tie to the US dollar pressurizes the UAE’s central bank to adhere to the monetary policy that the US Federal Reserve establishes. This is in the bid to maintain the comparative value of the currency. The effort of the federal government to stave off recession since 2008 is apparent (Ltaifa et al. 2009). Unfortunately, this is countering the UAE’s effort of raising rates with the view of fighting inflation in its economy. The disposition of the nation’s domestic policy for becoming inoperative owing to the attachment of the reserve currencies to the interest rates in the United States makes the US responsible (Doyle 2005).
According to Ishfaq (2010), the fixed rate of exchange rate regime has become a real liability to the dirham as opposed to initial expectations. With the present financial regime, the country tends to consider exchange rates stability at the expense of inflation stability. This is a further trigger for inflation volatility. Evidently, this is in line with the latest financial figures, which indicate that the country has experienced instances of tremendously high inflation that the single-digit inflation rates succeeded. Moreover, the fear of foreign investors is already affecting the nation whose economic potential relies considerably on such investments. Economic researchers suggest that a stable rate of inflation would be advantageous to the nation’s populace. Making the dirham stronger and safe from the potential influence of the high inflation rate ought to be a priority for the government. This will cushion the nation from suffering the possible consequences of inflation due to the pegging the dirham to the US dollar.
Recommendations on the Exchange Rate Regimes
Choosing an exchange rate, especially in the face of uncertainty as in the case of the UAE requires the incorporation of well thought out considerations. Ishfaq (2010) points out that selecting an exchange rate regime requires the acquisition of adequate information on the nation’s economic status and policymaking goals among other factors. It is imperative to note that the nation enjoys massive investments in the banking and real estate sectors together with the foreign direct investments. Therefore, ensuring the stability of the currency would go a long way in facilitating the capacity for measuring investment returns and sustaining the existing assurance that investors are not vulnerable to any currency risk at the domestic level (Abed & Hellyer 2001).
Additionally, the descriptions of the country’s economy include the openness, small size, and ostensible domestic shocks ensuing from huge monetary expansion. Consequently, the implementation of the pegged regime of exchange rates is applicable in this system. However, the high inflation factor makes the system inapt with the consideration for a substantially flexible approach commendable (Ishfaq 2010). Flexible exchange rate system may cause speculation in capital movement, which may result in challenges of exceptionally high liquidity preference and inflationary effect.
The fact that fixed rate regimes serve to avert instances where domestic currencies gain in value considerably above major trading partners is not new in the exchange systems (Ishfaq 2010). This is justifiably significant in ensuring that such situations neither stifle exports nor suck in exports (Doyle 2005). However, this is a situation more critical for economies operating on deficit. The fact that the UAE runs on massive surpluses makes this form of foreign exchange rate not as critical as it was in the first place. Taking into account the technical part, the pegging approach would aid in substantially matching UAE’s trade profile. Further, the regime would be in a better position of protecting the nation from the experience of imported inflation it is currently struggling to counter.
On the other hand, the fixed regime would dispose the country to loss of simplicity. Considering the merits and demerits of the two key exchange rate systems, the UAE being a developed nation ought to use the flexible exchange rate system in managing its dirham, as this will enable them to develop independent policies to manage the economy. Further, this option easily helps in establishing equilibrium in the BOP. Beside the use of the flexible exchange rate system in place of the pegged system, the UAE can use the pegging to a currency basket as in the case of Kuwait. This option will extend advantages by creating an increased potential in the ultimate currency union (Ishfaq 2010). In addition, this region would present incessant cushion against the pressure of inflation while sustaining the peg factor.
The globalisation of trade has made Foreign exchange an inevitable process in the society. The significance of this feature in facilitating the movement of products and revenues across the globe is beyond doubt and its effort in enhancing the growth of global economies remains substantial. However, this process occurs not in a vacuum as the existence of various regimes governs different operations. The flexible, fixed, and pegged regimes of foreign exchange rates govern the phenomenon with the UAE applying the pegged approach. This regime constitutes a number of advantages in the form of increased chances for economic stability and improved living standards among other benefits. The inability of the regime to function properly in unstable economies and unfavourable conditions is evident from the three regimes.
Given that the UAE, has been experiencing a favourable BOP, it ought to contemplate on using flexible exchange rate systems. It can give the UAE freedom to adopt a policy that encourages autonomy in conducting domestic economic matters. The objective of any foreign exchange program for this nature should focus on both correcting external balances and reducing inflation. As a domestic shock absorber, this system helps in protecting the internal economy from international disturbances. The UAE will easily maintain its favourable balance of trade and surplus BOP using the flexible exchange rate systems. The fact that it triggered imported inflation in the UAE besides continually threatening investment environment in the region attests to the continuous use of the system. The calls for a change in the approach are widespread with the choice of the flexible rate regime in a currency basket being suitable for both the small and open economy.
Abed, I., & Hellyer, P 2001, United Arab Emirates: A new perspective, Trident Press, London.
Doyle, E 2005, The economic system, John Wiley & Sons, Hoboken, NJ.
Ghosh, A. R., Gulde, A. M., & Wolf, H. C 2002, Exchange rate regimes choices and consequences, MIT Press, Cambridge, Mass.
Ishfaq, I 2010, Overview of Different Exchange Rate Regimes and Preferred Choice for UAE, Economic Papers Series. Web.
Jochumzen, P 2010, Essentials of Macroeconomics, Research and Education Association, Piscataway, N.J.
Kennedy, P. E 2000, Macroeconomic essentials: Understanding economics in the news, MIT Press, Cambridge, Mass.
Ltaifa, N. B., Kaendera, S., & Dixit, S. V. S 2009, Impact of the Global Financial Crisis on Exchange Rates and Policies in Sub-Saharan Africa, International Monetary Fund. Web.
Mussa, M 2000, Exchange rate regimes in an increasingly integrated world economy, International Monetary Fund, Washington, DC.
Poirson, H 2001, How do countries choose their exchange rate regime?, International Monetary Fund. Web.
Rose, S. K 2011, Exchange Rate Regimes in the Modern Era: Fixed, Floating, and Flaky, Journal of Economic Literature, vol. 49, no. 3, pp. 652-672.
Survey of economic and social developments in the escwa region 2006-2007 2007, United Nations Publication, New York.