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Forex Trading and the Value of the Dirham

Published on: February 2009​
Genre: Economics/Finance​ Category: Op eds​

What determines the value of a currency? If you hold a bank account denominated in British pounds, you may have been recently pondering this question.

For a number of years before its recent collapse, the pound was worth about two dollars, until mid-2008. It has since lost 25 per cent of its value and is currently trading at around 1.45 dollars. Many pundits believe that the pound will lose further value but according to at least one measure, the pound should stabilise around its current value. The measure, purchasing power parity (PPP), values a currency according to what it can buy. For example, if one can purchase a representative basket of goods in the US for say, $150 and this same basket costs £100 in the UK then the implied PPP exchange rate is 1.5 dollars to the pound. Anyone living in the UK knows that prices for most consumer goods are much higher than their US counterpart and that, accordingly, the exchange rate that prevailed between the dollar and the pound until the summer of 2008 implied that the pound was overvalued relative to its long-run PPP value. According to the most recent IMF estimate, the PPP exchange rate stands at 1.55 dollars to the pound. While the long-run beckons for the sterling pound, what do PPP exchange rate data tell us about the actual value of the Dirham?

According to the October 2008 IMF World Economic Outlook, the most recently available database since the onset of the financial crisis, the current PPP value of the dirham stands at Dh5.326 to the dollar. According to the Fund’s predictions, the PPP exchange rate is set to deteriorate in the next five years to Dh5.958 to the dollar. The currency peg therefore overvalues the dirham by about 45 per cent and if the peg is maintained at current levels, the dirham will be overvalued by about 62 per cent in 2013, relative to its PPP exchange value. Interestingly, the same dataset reveals that between 1983 and 2003, the pegged rate was about 20 per cent under the value of the PPP exchange rate, on average.

What do these numbers reveal about a possible future course for the dirham? While the PPP exchange rate is a sensible long-run valuation of a currency, most currencies do not trade at this value.

There is, however, a large econometric literature that points to a long-run disciplining effect of the PPP valuation on floating currencies. This in turn suggests that if the dirham was de-pegged against the dollar, the long-run valuation would point to a potential depreciation of the domestic currency. Of course, this measure is but one determining factor: in the short-run, the valuation of a currency is notoriously difficult to pin down.

For example, trade in goods and services should influence the value of a currency in a natural way: greater demand for domestic goods and services should put an upward pressure on the value of the domestic currency.

And yet, the total value of goods and services traded accounts for only about 5 per cent of the overall daily forex trading volume, estimated to be well over a trillion dollars, and has no predictive power in the short-run. Another factor that should influence the value of a currency is the difference in interest rates between say, the US and the UAE: a higher interest rate in the UAE should put an upward pressure on the value of the dirham. Disconcertingly, a vast econometric literature points to the failure of this hypothesis: the so-called uncovered interest rate parity condition does not predict movements of currency values. Instead, the literature points to the importance of differences in beliefs, asymmetric information and different motives for trading as proximate factors in determining currency values.

Self-fulfilling beliefs in currency movements, and in particular devaluations, have a powerful short-run impact. In a famous example, the UK had to withdraw from the European Exchange Rate Mechanism following an attack by currency speculators who shorted $10 billion worth of the then-pegged pound sterling. The attack cost the UK government over £30 billion pounds. The speculative nature of most forex trading points to the difficulty of choosing the right currency peg: a devaluation may signal weakness on the part of the monetary authority while a revaluation makes the currency more expensive to defend. In either case, the probability of a currency attack may well rise.

Cutting the Gordian knot of an optimal exchange rate regime will therefore come through a better understanding of economic and institutional fundamentals in the UAE. After all, the devaluation of the pound following "Black Wednesday" spurred greater economic growth in the UK relative to the Euro area.

This was driven, in part, by greater currency competitiveness and increased exports.

Tarek Coury is an Assistant Professor at the Dubai School of Government.

This article was originally printed in The Khaleej Times. It can be accessed here.

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