Dabbling with Danger

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In line with the US Federal Reserve (Fed), Abu Dhabi has once again cut its interest rates, spurring further concerns about inflation and raising questions about maintaining the dollar peg.

The Central Bank of the United Arab Emirates (UAE) responded almost immediately to the US Federal Reserve's rate cut on April 30 by lowering its own repo rate to 2%. The 25-basis point cut was the first response by any of the dollar-pegged Gulf Cooperation Council (GCC) states to the latest round of easing from the Fed.

Analysts have interpreted the Fed's accompanying press statement as hinting that this latest cut will be the last in the current cycle of easing. If so, this would prove a relief to the UAE. The central bank has been forced to cut rates by 325 basis points since last September in imitation of the Federal Reserve's policy, at precisely the time rising inflationary pressures would ordinarily counsel fiscal tightening.

Independent estimates of the current level of inflation in the UAE have varied from anywhere between 8% and 14% and the latest rate cut is likely to have exacerbated the situation even further. The Dubai Chamber of Commerce and Industry currently argues that 18% of the UAE's current inflationary pressure is the result of the dollar peg, while independent analysts have claim the figure for imported inflation may be as high as 30%.

Currently, transparency regarding the true level of inflation in the UAE is limited. In February the government announced that it intended to bow to long-term pressure from the International Monetary Fund and publish a monthly consumer price index (CPI) rating. However, there is some debate as to whether the CPI basket currently used will give an accurate reflection of the true picture for UAE residents. Economists say up to 50% of local inflation is directly attributable to increases in rents, whereas the basket allocates only 36%.

The UAE's move was followed the next day by Bahrain and Qatar, who dropped their deposit rates while holding central bank lending rates level, in the hope of slowing credit growth. The UAE's central bank has only limited motivation for delaying a cut in the central bank lending rate: the three-month Emirates Interbank Offered Rate (EIBOR) was around 8 basis points lower than the central bank repo rate even after the cut, meaning commercial banks have little reason to borrow from the central institution.

The GCC currencies have been pegged to the dollar since 2003 as part of plans for an eventual common currency in 2010. This effectively forces the GCC's central banks to mirror the Federal Reserve's policy, at a time when the US economy's fundamentals are precisely the opposite of the Gulf's.

The long decline of the greenback has placed the ambition of a GCC monetary union in some jeopardy of late, as the varying effects of the weak dollar and the high price of oil have strained solidarity among the organisation's members. Last year Kuwait took the first step to regaining control of its monetary policy by unilaterally leaving the peg and switching to a basket of currencies. The Kuwait central bank has so far left its rates unchanged following this latest cut by the Fed.

For the remaining GCC states wishing to maintain a unified front, the only monetary policy available is a simultaneous revaluation. This option has been much discussed of late, yet it would now appear to be off the table, as members fear eroding market confidence in the dollar further and jeopardising an eventual monetary union.

If the latest cut does prove to be the last, it is possible that the UAE may be able to weather its current inflationary storm. However, the government's target of 5% inflation for 2008 will now be extremely difficult to meet. Next year's broad money figures will also make interesting reading. In February, the central bank revealed annual M3 money supply growth for 2007 had hit the worrisome level of 33.8%. Figures for 2008 will probably be higher, given the buoyant price of oil and the effect of the past six months' rate cuts.

Short of raising minimum reserve requirements still further (a difficult proposition given the presence of foreign banks in the UAE's financial sector), the UAE will essentially be limited to protecting its residents' purchasing power through direct market intervention. Ultimately, the government perhaps reasons that the UAE's rapidly emerging economy is better served by maintaining growth, even at the price of relatively high inflation.

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