40% probability of a small (3-5%) AED reval in 2007

As we head towards the GCC central bank governors meeting next week (now scheduled for the 4-5th of April in Medina), speculation of currency revaluations are likely to remain rife. We have long argued that Kuwait will allow a 1% appreciation of the dinar in Q2. For the UAE, the central scenario is it will leave the peg in place at its current level. However, it is clear the central bank is re-examining its FX policy and as such the risks of a move are rising with time. Indeed, we now place the probability of an AED revaluation in 2007 at 40%.

Our view has been that the region should allow managed currency floats in order to grab hold of interest rate settings. However, there are three reasons why this is unlikely to occur in the short term. First, any shift to a managed float is a highly complex system to manage. It would require a firm grasp of the fair value for currencies, which for oil-dependent economies is incredibly difficult to ascertain with any degree of certainty - any serious calculation should take a view on the sustainable level of oil prices and thus current account balances, a highly subjective forecast at best. Meanwhile, significant exchange rate volatility could undermine diversification efforts - although to the degree that low interest rates are fanning inflation, competitiveness is already being eroded via a higher cost base.

Second, the central bank does not have at its disposal tools to manage liquidity in the financial system, an absolute necessity if they are going to manage interest rates effectively.

There is a third consideration and this comes down to what is assumed to be the cause of inflationary pressures. Of course, UAE inflation before this year has largely been pushed higher by capacity constraints in real estate, both residential and commercial. However, by our estimates, if you strip out these costs this year, consumer price inflation in the UAE actually increases from 7.3% to 8.5% due to 1) the 7% residential rent cap in place in Abu Dhabi and 2) changing residential supply-demand dynamics in Dubai, which is likely to soften rents in 2007 - today's news that the 40-tower Jumeriah Beach Residence project will be delayed by at least another three months notwithstanding.

Therefore, something else is at work here. Our view is excessively low real interest rates are the main culprit. However, a view seemingly more prevalent in central bank circles is that inflation is imported. In this case, the simpler solution of a one-off revaluation may appear to make sense. This is the final reason why, if the authorities were to move this year, it would likely be a repegging rather than a managed float. Meanwhile, we would expect any revaluation to be relatively small in size. The authorities would want to balance the need to have an effect on inflation, but not impede diversification efforts. Therefore, the size of any initial move will likely be small (3-5%).