The UAE will stick with its currency peg to the US dollar despite a downgrade of the US credit rating by Standard & Poor's, says a Central Bank official.
"We are pegged to the dollar and will keep it. We don't see the dollar collapse," Mohamed Al Tamimi, the deputy executive director of the UAE Central Bank Treasury Department, was quoted as saying in a report by Reuters yesterday.
Concerns about the US budget deficit has led to a weakening of the dollar in recent weeks. Friday's action by S&P to lower the US long-term credit rating by one notch from "AAA" to "AA plus" could push the dollar further down, say analysts.
Dollar weakness can potentially aggravate GCC inflation by pushing up costs of importing goods to the region. The currencies of the UAE, Saudi Arabia, Qatar, Oman and Bahrain all have exchange rates fixed to the dollar. Kuwait's currency is linked to a basket of international currencies believed to be heavily weighted in dollars. Analysts disagree about the wisdom of regional currency pegs to the greenback.
"The downgrade will undoubtedly increase pressures to de-peg the dirham but it will not be easy to do so," said Ghanem Nuseibeh, the co-founder and director of Cornerstone Global Associates.
"A peg against a balanced currency basket but dominated by the US dollar, reflecting not only oil income, but also the country's trade relations, will give the UAE greater ammunition to weather the storm and be less susceptible to external economic woes."
There are several reasons why dollar pegs make sense for the region. Oil is traded in the currency and much of the region's assets are weighted in dollars.
"There's unlikely to be a change in the currency regime even with the downgrade," said Nancy Fahim, an economist at Standard Chartered in Dubai.
But pegs also mean regional policymakers have limited room to exercise independent monetary policy tools to control inflation in asset prices. Their action has to closely follow the responses of the US Federal Reserve, which is maintaining low interest rates.
A rise in global commodity prices has already pushed up the cost of imported food to the region. In the UAE, overall inflation has remained muted because of a fall in housing rental prices.
Annual inflation in the UAE rose by 1.7 per cent in June, according to official data.
"In terms of foreign exchange pass-through, a weaker US [dollar] on the back of the sovereign downgrade would feed through to higher imported inflation in our region," Khatija Haque, a GCC economist at Emirates NBD, wrote in a research note yesterday.
"For Saudi Arabia, where headline inflation is a tad higher [than in the UAE], a weaker dollar would add to the pressure. We expect the [dollar] pegs in the GCC to remain in place regardless."