Pros and cons of dirham’s peg to the dollar

This article appeared originally in Gulf News: link to original article

What does it mean when a currency is pegged to another? Does it mean that every time you check the exchange rate, it will be the same with the change being plus or minus 0.001? Yes, but only partially.

What is normally overlooked is how much it costs to peg a nation’s currency to another. What happens when that other currency goes up and down because of certain monetary measures that may suit that country’s economy, but not yours? And when the other country decides to devalue their currency or deploy tactics to ensure its appreciation, how does it affect your country’s currency and its economy?

I have had people asking about what it means for the UAE to have its dirham pegged to the dollar. That is, knowing almost always that one dollar is equal to Dh3.672, or at least that’s the direct response to anyone asking about any day’s exchange rate. And then, it is this always fixed rate that allows you to quickly multiply the 3.672 by any amount expressed to you in dollars without having to check what the market rate is today.

That’s good, but all good things come at a cost. When the US decides to raise its interest rates; it consequently aims to pave the way for its dollar to appreciate in value. An appreciation of dollar’s value has three main implications: 1. higher purchasing power for US citizens and everyone holding dollars; 2. lower exports for US-based companies; and 3. higher borrowing and refinancing rates.

In a nutshell, anyone holding dollars will benefit from the currency’s appreciation, and anyone who wants to borrow or refinance in dollars is worse off. The second implication is a different case.

The case of US-based companies is a bit different in that regard. When a currency is said to have appreciated or depreciated, that is always expressed against another currency. So when the dollar appreciates, it appreciates against the euro, for instance.

The immediate result would be that US-based companies living off exports would find turbulence in their maneuvers to keep selling their products abroad where currencies have lost value against the dollar. In other words, it would be difficult to sell to citizens of countries who have lost part of their purchasing power.

On the contrary, and as mentioned earlier, US citizens and dollar holders would gain purchasing power. Based on that, US-based companies would find their salvation in increasing their domestic sales.

That being explained, what happens to the UAE when the dollar appreciates in value? Let me assure you, the Dh3.672 (to a dollar) stays almost unchanged with the cost of fluctuation being incurred by the UAE Central Bank, providing a higher purchasing power for those converting dirhams to dollars, and then to euros — as dollar gains value against it.

As for the UAE Central Bank’s assumed costs, assume that today the dollar is implicitly equal to Dh3.972; the cost will be paying or securing Dh0.3 worth of assets for each dollar in the UAE. The other way around would be the dollar depreciating in value which was the case with the quantitative easing (QE) programme.

In such a case, the UAE Central Bank will be buying additional dollars to maintain 1 dollar = Dh3.672. This was the situation the Swiss National Bank (SNB) found itself in to a point where it couldn’t defend the 1 euro = SF1.2 anymore. With the European Central Bank announcing its QE programme, the SNB didn’t want to incur further costs.

The dollar’s fluctuations are milder, which is why many countries peg their currencies to it. With oil prices is a different story altogether. The last thought I want to leave you with is: how about a mix of currencies based on source of imports and UAE’s borrowing?