Written by Jameel Ahmad, Global Head of Currency Strategy and Market Research at FXTM
Countries with their currencies pegged to the USD are potentially set for increased buying power and higher bond yields as their central banks track Federal Reserve’s interest rate hikes.
One example is the UAE, where the central bank recently raised its key rate by 0.25% in line with the Federal Reserve, further strengthening the Dirham. There’s an indirect benefit for emerging economies like India, which have a large expatriate population in the UAE who send their earnings home to support the family and make investments. India’s households, real estate, equities, and bank accounts receive an estimated $69 billion annually in remittances from the UAE. As the Dirham appreciates against the Rupee, Indian expatriates have higher spending power and the UAE can attract more skilled workers needed for the Oil industry.
In addition, profitability may improve in the banking sector, encouraging more lending and investment to other sectors of the economy. Higher deposit rates would likely attract foreign investment inflows into the UAE, lifting foreign currency deposits and adding to bank assets. The likelihood of this happening was increased in May when the UAE approved incentives for foreign investors, allowing them 100 percent ownership in business ventures and 10-year residencies for them and their families.
A significant challenge is to overcome GDP growth issues and diversify the economy, so a rise in foreign investment from the current level of three percent could be one way of accomplishing this. While the IMF has raised its 2019 growth forecast for the UAE to 3.9% on the back of increased Oil revenues and state spending, it’s been proven that the Oil markets can be a double-edged sword for an economy. Strengthening other sectors could mean more resilience during Oil market shocks.
Consumers are likely to feel the benefits of cheaper travel and savings on imported goods due to the stronger Dirham. Locally, higher prices are expected because inflation is likely to rise to 3.5% this year on the back of the introduction of VAT and the stronger USD. However, the IMF forecasts CPI will ease to 1.9% in 2019.
Looking at the bigger picture, risks and opportunities may lie ahead for pegged currencies as a result of an uneven global interest rate environment. Unlike the Federal Reserve and UAE Central Bank, the European Central Bank and the Bank of England are relatively dovish, keeping rates on hold. Logically, this would trigger a flow of capital to the higher-yielding territories, potentially encouraging central banks in weaker economies to increase rates out-of-step with GDP growth in order to compete and creating a global credit bubble. As long as the US economy keeps growing, the opportunities described earlier should exceed the risks for countries with USD-pegged currencies. If there are any signs of a slowdown, however, the balance could tip towards risk rather than opportunities.
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