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Monetary Policy in the United Arab Emirates

            Monetary Policy is defined as the process by which the government, central bank, or the authority in charge of the monetary of a country controls the supply, availability, and cost or interest rate of money (Hraiz & Kuwaiti, n.d.). This policy is utilized as a means in order to accomplish certain economic objectives of the country, which are usually focused on the growth and stability of the economy. The United Arab Emirates (UAE) also practiced this aforementioned monetary policy. The country adheres to such policy in order to address particular economic problems as well as the overall goal of developing its economy.

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In order to fully comprehend UAE’s decisions and actions towards their monetary policy as well as its effects to the country, a background of their economic situation is needed. The economy of UAE is heavily dependent on the production of oil and gas as this contributes to a large portion of the country’s revenue. Petroleum production will served as the backbone of its economy up to the foreseeable future as the oil reserves of the country are estimated to be 98.2 billion barrels, which is about more than 8 percent of the world’s oil reserves. On the other hand, the proven reserves for natural gas amounts to about 5.8 billion cubic meters or 3.4 percent of the world total (BP, 2006, quoted from Hraiz & Kuwaiti, n.d.). The proven oil reserves should lasts for over 100 years while the natural gas reserves is sustainable for more than 130 years, with the present rate of consumption taken into consideration. Therefore, UAE ranks third in the west Asian region when it comes to natural gas reserves after Qatar and Saudi Arabia and the fifth largest in the world after the Russian Federation and Iran (Hraiz & Kuwaiti, n.d.).

UAE is considered to be more economically diverse as compared with its other neighboring country. However, its economy is still heavily affected by international oil prices. Based on the data coming from the Arab Monetary Fund, 32 percent of the GDP and 36 percent of the total exports as well as re-exports comes from oil (Hraiz & Kuwaiti, n.d.).

Since 2002, there has been a continuous increase in the oil prices. This long period of high oil prices that rises year after year has had a great effect on UAE’s economy. According to the International Monetary Fund (IMF), in the year 2006 the country’s GDP amounted to AED 399bn ($109bn) that has a very high real growth rate of 11.5 percent. The high rate of real GDP that is happening in the UAE is not common in the economies of other countries around the world. It is also the reason behind why high rates of inflation are observable in the country because of the high rates of GDP that it is experiencing (Hraiz & Kuwaiti, n.d.).

UAE has also exerted efforts to change and improve their economy. They attempted to diversify its economy so that it would not be heavily dependent upon hydrocarbons. The policy of diversification focused on various areas of the service sector namely: tourism, banking and finance, telecommunications, aviation and transportation. Moreover, the production of Petrochemicals has also played an important role in the manufacturing sectors contribution to the GDP. Based on the data of the Central Bank, the improvement in the service sector contributed to the non-oil GDP of the country (Hraiz & Kuwaiti, n.d.).

            The government of UAE has also been very active in pursuing trade agreements and foreign investments among the Gulf region and with other countries in the world. Most importantly, engaging in free trade agreements entails easier access to key markets. This is beneficial to the UAE’s economy because it would allow technology transfer to the private sector of the country that will enhanced domestic industrial growth and contribute to the diversification of the economy (Hraiz & Kuwaiti, n.d.).

            Foreign investors are also lured by the competitive banking and finance sector in the UAE. The banking sector with nearly 50 banks caters to a population of 4.3 million, which makes its contribution to the economy very vital. This is the reason why in 2005 the banking and finance sector contributed 6 percent of the total GDP of the country (Hraiz & Kuwaiti, n.d.).

            The Fiscal Policy of UAE also has its contribution in developing the economy, transferring wealth, as well as promoting and supporting the non-oil sector. Oil receipts and the income coming from foreign reserves in the past oil income constitutes the revenue structure of the country. Taxation in the UAE does not adhere to income and consumption tax, which is why the fiscal performance of the country is still highly reliant on oil prices (Hraiz & Kuwaiti, n.d.). Moreover, UAE has never experience resulting to debt in order to finance deficit in its budget because of the high reserves it has accumulated over the years. Based on official reports, the country has no existing public sector debt. UAE’s Central Bank also does not carry Open Market Operations wherein bonds are sold to the public upon the instructions of the government (Hraiz & Kuwaiti, n.d.).

            The rapid economic growth that UAE is experience also comes with it some economic problems and one of which is inflation. In the past years, inflation has been one of the serious concerns of the UAE citizens, Government, and the Central Bank. The inflation happening in the country is more observable as compared to other oil-dependent Gulf economies. In the recent years, according to official estimates inflation strongly risen reaching 6 percent in 2005 and 7.9 percent in 2006 based on the date given by the IMF.

The increasing inflation rate could be attributed to the following factors: increase in international oil prices that triggers increase in domestic demand, higher government spending, low interest rates in the US which resulted to credit expansion and therefore further in domestic liquidity. The increase in the population due to immigrants entering the country also contributes to inflation. Moreover, this inflation also shows the weakness of the US dollar against the currencies of the other trading partners of UAE that increased the cost of imported goods (Hraiz & Kuwaiti, n.d.).

            Economic problems such as inflation are often resolved by utilizing conventional monetary policy tools. UAE’s monetary policy is always focused on giving the needed liquidity that would sustain a growing and stable economy. The UAE Central Ban k is responsible in doing all the available mechanisms to address the inflation, especially when it comes to using the exchange rate, credit policy, reserve ration requirements as well as other conventional and modern tools (Amazing Growth of Industry, n.d.).

            The main objective of the monetary policy of UAE is to maintain a fixed peg against the dollar, which is at a rate of AED 3.67 per US dollar. Similarly, countries undergoing transitional and developing economies also practiced the same fixed exchange rate in order to protect themselves from unstable currency which can be very detrimental to an emerging economy. It also aid in attracting foreign investment and enhanced the confidence of the private sector. In 1980, UAE succeeded in its adoption of the fixed exchange rate because of its huge foreign reserves (Bolbol and Fathedlin, 2006, quoted in Hraiz and Kuwaiti, n.d.). The currency was officially pegged to International Monetary Fund’s standard drawing rights (SDR). The SDR is at AED 4.7619 per SDR that has a margin of -+2.25 percent together with the US dollar as the intervention currency. In 1997, there have been a slight adjustment to this exchange rate but other than that this fixed rate has not changed for over two decades. During the year 2002, UAE together with other Gulf States have officially moved to a dollar peg (Hraiz & Kuwaiti, n.d.).

            In the past, researchers believe that this monetary policy of linking the dirham to the dollar aided to a low inflation rate. The monetary decisions of the US Federal Reserve Bank that were followed by the Gulf States gave their monetary institutions with credibility and simplified their monetary policy making. However, this decision means that the monetary policy tool of fixed interest rate has not been used. According to the Central Bank economic advisor, whenever the US changes its interest rate the UAE also follows suit by immediately changing their interest rates the next day by giving bank notices. UAE’s monetary policy of fixed exchange rate is not an independent interest rate setting (Hraiz & Kuwaiti, n.d.).

             On the reports of the advisor at the Central Bank, the monetary policy tools enable the bank to use “minimum reserves requirements, interest rates on certificate of deposits, swap operations, foreign exchange rate, loans, advances and overdraft”. But the influence of the Central Bank to the domestic liquidity of the country through these mechanisms are limited (U.S. State Department, 1994, quoted in Hraiz and Kuwaiti, n.d.).

            Based on the study of Hraiz and Kuwaiti, they believed that UAE’s monetary policy is not very effective in addressing the problem of inflation. This is due to the fact that the central bank is not actively using the mechanisms of monetary policy in order to solve inflation. The main factors that constitute to such are the exchange rate policy as well as the lack of effort coming from the government to create a market for public debt. Furthermore, it is also observable that UAE’s monetary policy chose “credibility” over their independence when it comes to the practice of their fixed exchange rate. They tied their exchange rate to US interest rates that is more appropriate US economy’s needs rather than that of UAE.

            However, there have also been positive feedbacks in the monetary policy that UAE adopted. The International Monetary Fund together with the World Bank presented a report on the UAE under the Financial Sector Assessment Program. The report complimented the country’s sound financial system with its banks that are effectively supervised. Due to the effective monetary policy, the banks had an observable amazing growth. The banks in the UAE have accumulated total assets of Dh. 277.2 billion in 2000 as compared to the Dh. 180.9 billion in 1994. The foreign assets of merely the banking sector already reached 33.8 billion dollars (Amazing Growth of the Industry).

            This also facilitates the establishment of free zones also has a vital role in the development policy, liberalization and diversification of the economy that helps in the enhancement of non-oil and non-traditional exports. At present, there are 10 free zones in the UAE wherein numerous companies all over the world have established in. These companies also facilitate numerous economic activities such as: storage, manufacturing, processing, trading, services production and redistribution of goods and commodities. Foreign Direct Investments also increase because of the presence of these free zones. There are about 3000 companies who invested more than 4 billion dollars that are present in these zones. Furthermore, the government vows to continue investing in infrastructure projects that they deem is very beneficial in the country’s economic growth (Amazing Growth of the Industry).

            In the past years there have been studies that are looking on whether UAE is ready to forego its fixed exchange rate and adopt a more flexible one. However, the readiness of the country to do such is being questioned especially after being dependent to this particular monetary policy for a very long time. According to the International Monetary Fund’s literature, there are four necessary components to successfully changed from exchange rate fixity to flexibility and these are: (1) a developed foreign exchange market; (2) a nominal anchor for monetary policy that would take the place of the fixed exchange rate; (3) a policy that would enable the central bank to intervene in the foreign exchange market; and (4) the establishment of an exchange rate risk management that will make sure of the monitoring and managing of both the public and private sectors (Flexing the currency muscle).

            The aforementioned instances are the pre-requisite in order for UAE to shift from a fixed exchange rate to a more flexible one. However, the history of UAE’s economy as well as its present situation show that the country still lacks these necessary requirements in order to change their monetary policy. Thus, being the case, the current monetary policy of the country should still be applied until in such a time that its condition is already suitable to a more flexible exchange rate.

            The monetary policy of UAE that is characterized by its fixed exchange rate could be attributed to the nature of the country’s economy. This policy has its benefits as well as some flaws that need to be addressed. The important idea about this policy is that it prioritized the welfare of its country by giving it the necessary protection as a developing and emerging economy.

Bibliography

Amazing Growth of Industry. (n.d.). <http://www.adcci.gov.ae: 90/public/media

            /Magazines/Dec2001/industry.htm>. {Accessed 27 May 2008}.

Dubai is Pro Dollar Peg. (n.d.). Forex News. <http://www.topforexnews.com

            /2008/01/26/dubais-pro-dollar-peg/>. {Accessed 27 May 2008}.

Flexing the currency muscle. (n.d.). Gulf News. <http://archive.gulfnews.com/articles/print

_friendly_version.jsp?global_name=/channels/gulfnews_com/articles/08/03/08/10195696.html>. {Accessed 27 May 2008}.

Hraiz, A., Kuwaiti, A. (n.d.). Monetary Policy in the UAE: A Means to Combating

            Inflation? <http://sra.uaeu.ac.ae/CURA_2007/Proceedings

/PDF/CBE/CURA_85.pdf>.{Accessed 27 May 2008}.

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