Inflation increases pressure to revalue UAE dirham

14 December 2007
With real wage levels falling due to soaring inflation and the declining value of the dirham, expatriates are threatening to leave the UAE, putting further pressure on the government to drop the dollar peg

Labourers working for the UAE’s largest building contractor, Arabtec Construction, went on strike in November. Their grievances would be familiar to the majority of expatriates working in the emirates: the declining value of the UAE dirham and the US dollar compared with other currencies, and the spiralling cost of living.

Falling exchange rates and near double-digit inflation have greatly reduced the amount of money that expatriate labourers can afford to send home. And for some, returning home to work has become a better option.
The falling dirham is also having an impact further up the income scale, with many professionals and business people now reconsidering their positions.

“If the exchange rate does not improve by February, I will go home,” says a UK-based project manager. “It just is not worth staying here if you cannot save money.”

For labourers in Dubai, the strikes had a positive outcome. Contractors agreed to increase labourers’ wages by up to 20 per cent after repeated calls for the government to impose a minimum wage were ignored. “We assessed the rate of inflation and exchange rate fluctuations,” says a contractor working in Dubai. “We took the decision to raise wages by 20 per cent with immediate affect.”

Construction workers are not the only people who have received substantial pay increases. The federal budget for 2008, approved in mid-November, will be the largest ever. It totals $9.5bn and includes a provision for a 70 per cent increase in the salaries of federal government employees and retired civilian and military personnel.

Wage rises

The decision is expected to fuel further inflationary pressures in 2008. “Federal government employees are not as well paid as their counterparts working in other government organisations at the emirate level, so a correction was due” an analyst tells MEED. “The question is, what impact will a 70 per cent increase have on other public and private sector employees, who will now feel entitled to a similar pay rise?”

The broader concern is that these wage rises will further increase inflation and push up the cost of living. The Economy & Planning Ministry was immediately on the defensive and publicly warned suppliers against raising the prices of goods and services to take advantage of pay increases. Despite the warnings, local newspapers reported in early December that prices for essential food items had already increased by nearly 30 per cent in some stores.

In 2006, the official rate of inflation was under 10 per cent, but unofficially the rate was even higher. Standard Chartered Bank estimates it was 13.8 per cent.

According to the ministry, rapid population growth has stretched local supplies of consumer goods and housing. The population increased from 2.4 million in 1995 to 4.1 million in 2005.

Rent impact

Soaring rental prices are listed as the main contributing factor. The rush by non-residents to buy homes, taking advantage of new freehold ownership laws, reduced the number of available housing units in the rental market, and many residents experienced rental increases of up to 40 per cent in 2005 and 2006.

According to the ministry, inflation in the UAE reached 9.3 per cent in 2006, driven by the price of housing units and services, which increased by up to 15.3 per cent.

The solution for the individual emirates has been to impose rent caps. Dubai was the first to act in late 2005 when the government capped the annual rent increases at 15 per cent. Fearing similar inflationary trends, Abu Dhabi followed Dubai’s lead, capping rents at 7 per cent in 2006. Dubai then lowered its cap for 2007 to 7 per cent.

With rent caps in the two largest emirates, analysts predicted at the start of 2007 that inflation would fall to 7-8 per cent. But by early summer, there were few signs that it was slowing. In June, the Abu Dhabi Chamber of Commerce & Industry (ADCCI) reported that the rate of inflation in Abu Dhabi was 11.3 per cent.

In August, Standard Chartered reacted by raising its 2007 inflation forecast to 9.3 per cent, as it believed the law capping rent increases was failing to protect new tenants. In November 2006, the bank had cut its original UAE inflation forecast from 9.6 per cent to 7.3 per cent, after Abu Dhabi decided to limit residential and commercial rent rises to 7 per cent a year. In 2007, the bank expects rents in Abu Dhabi to rise by 12 per cent, compared with a predicted 4 per cent increase in Dubai.

Many observers say the solution to rising inflation is revaluing the dirham against the dollar. The currency peg to the dollar, which has seen the dirham pegged at 3.6725 to the dollar since 1997, means the central bank is unable to use interest rates to take inflationary pressure out of the market. “The reason you will continue to see inflation is that you cannot control interest rates to control demand,” says Kito de Boer, managing director, Middle East, at US management consultant McKinsey & Company.

Ahead of the GCC summit in early December, pressure was mounting on the government to act. In mid-November, the ADCCI urged the government to drop the dollar peg. It cited concerns that the UAE was following US monetary policy, which was set for an economy facing the prospect of recession, not an economy free from current account deficits, external debts and with strong economic growth.

The ministry admitted the peg was adding to inflationary pressure, while some senior government officials hinted at the possibility that the UAE would take a unilateral decision on the peg. At the end of November, central bank governor Sultan bin Nasser al-Suwaidi spoke of the social and economic pressures to give up the dollar peg in favour of a basket of currencies.

In the days preceding the summit, many analysts predicted an announcement either revaluing or depegging the GCC currencies from the dollar. In preparation for an announcement, money changers in Dubai changed their rates, and some were offering as little as AED3.03 a dollar, almost 20 per cent lower than the official rate.

Split opinion

Delegates at the summit appeared to be divided. The UAE and Qatar were thought to favour prompt action to prevent any further decline, whereas Saudi Arabia preferred to maintain its peg. For the UAE, this leaves the option of unilaterally revaluing the dirham against the dollar. “From what I understand, the UAE and Qatar now have licence from the GCC to revalue their currencies unilaterally,” says Eckart Woertz, programme manager at the Gulf Research Centre.

But revaluation may not be a quick solution. “The jury is still out on whether inflation is tied to exchange rates,” says Youssef Nasr, chief executive officer, HSBC Middle East. “There are other factors. Exchange rates are not the panacea.”
Although a revaluation will reduce imported inflation, it will have little effect on the principle cause of inflation: excess liquidity. It may even heighten inflationary pressure as those paid in dirhams will feel better off, which could drive up prices even further.

“The impact of a revaluation on inflation should not be exaggerated,” says Woertz. “Open-market policies to soak up liquidity and ceilings on lending are more important in the absence of interest rate sovereignty because of the peg.”

Key challenge

Making adjustments to control and mitigate inflation without adding to the problem by increasing spending.

UAE Economy: GDP Contribution by Emirates

  • Abu Dhabi: 60%

  • Ajman: 1.3%

  • Dubai: 28%

  • Fujairah: 1.2%

  • Ras al-Khaimah: 1.9%

  • Sharjah: 7.2%

  • Umm al-Qaiwain: 0.4%

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