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Whither the Monetary Union

Published on: May 2009​
Genre: Economics/Finance​ Category: Op eds​
What are the consequences of the UAE pulling out of the planned common currency? Many proponents of the monetary union have been dismayed by the decision of the UAE government to opt out.

Yet, it is not clear that there should be much cause for dismay. The first argument that has been advanced has to do with the threat a GCC currency would pose to the domestic currency. Since Saudi Arabia is in favour for a common currency being initially pegged to the dollar, the risk of a currency attack on the dirham (once the common currency is formed) is rather muted.

The second argument has to do with the viability of the common currency now that the UAE has stepped out. Making sense of this argument is rather more complicated. First, one should consider the criteria for the creation of a successful monetary union and whether the economies comprising the Gulf fulfil these criteria.

Since a common currency involves a unique monetary authority, any decision made regarding interest rate changes will affect the economies of all countries involved. For example, a decrease in the interest rate by the common central bank would stimulate all of the economies involved in the common currency. Of course, if the business cycles of these economies are not synchronised, this policy instrument will benefit some but hurt others. As it turns out, the economies of the Gulf States do not display much in the way of synchronised business cycles (as measured by correlations of output gaps and CPI-induced inflation).

Therefore the costs of joining this currency area for any given country are rather high.

One of the benefits of forming a common currency is that intra-GCC trade will be stimulated, and as a result all constituent economies will benefit from this increased trade. By not joining the monetary union, the argument goes; the UAE will be missing out on these increased trade opportunities.

It is worth noting here that Gulf States have had pegged currencies since the creation of the Gulf Co-operation Council. This means that there has been little to no fluctuation between any two Gulf currencies for the past 30 years. Yet the amount of trade between Gulf States is rather low, when compared to trade patterns within other currency areas (such as the states comprising the US, or the Eurozone). Any gains to trade have already been realised—as a result, the opportunity cost of not joining is rather small.

Any remaining gains to trade can accrue to the UAE economy after the common currency is formed. Consider for example the case of the Eurozone: despite the UK not joining the European Economic and Monetary Union, it has benefited from increased trade among Euro-partners and its economy has outperformed the economies of many other European countries following its withdrawal from the Exchange Rate Mechanism. Its currency is stronger than the euro, relative to the dollar and it has maintained its monetary autonomy.

"While the common currency would initially be pegged, it would eventually be allowed to float to mitigate the negative impact of inflation"

Finally, another benefit of monetary integration has to do with financial markets: greater deepening, more trade, and greater diversification opportunities.

While monetary integration would certainly help with financial diversification, the latter rests almost exclusively on real economic diversification.

This in turn means that the importance of monetary integration is window-dressing, when compared for the urgent need to create genuinely diversified Gulf economies.

On a slightly different note, one underlying reason for the monetary union has to do with alternative monetary arrangements.

Since the 1980s, inflation and inflation volatility have had a negative impact on growth in the Gulf and this is in part due to the currency pegs.

While the common currency would initially be pegged, it would eventually be allowed to float and this would allow the Gulf States to mitigate the negative impact of inflation. The economics literature has pointed to the importance of operational independence of the central bank from short-term political interference, transparency and accountability in controlling inflation and inflation volatility. It is not clear however the extent to which the new monetary authority will have operational independence, the same way that the Federal Reserve System or the European Central Bank have. This in turn puts into question the credibility of this new common currency, especially if the monetary regime chosen is to allow the currency to float. The UAE Central Bank, on the other hand, is a known quantity to currency traders and private investors. The latter has kept the dirham pegged to the dollar and earned its credibility over many decades. It may be quite some time before the GCC central bank earns its credibility. By not joining, the UAE is ensuring that its economy will not suffer excess volatility due to the creation of the new currency and its association with the common currency.

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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