Pegging the UAE Dirham to the US Dollar, Research Paper Example

As the Dirham is currently pegged or fixed to the US dollar (USD) the United Arab Emirates (UAE) as well as several other Arabian nations are strongly compelled to pursue the US monetary policy. The notion of pursuing the US monetary policy has the betterment of giving the UAE Dirham the power and balance of keeping track of the world’s most popular de facto currency which is the US dollar. This is especially significant as the US dollar based firms adjacent to other currencies such as the Euro or the Japanese yen are continuing to make cheaper imports from European countries as well as Japan. Ever since 1997, the UAE Dirham has been pegged or fixed in foreign trade to the US dollar with a fixed ratio of exactly 3.6725 Dirham being the equivalent of a single US dollar. (Adballa 2012)

With the pegging of the UAE Dirham to the US dollar, it helps to promote and maintain currency stabilization. Furthermore, the power of the US dollar can moderately assist in maintaining the international purchasing power of the UAE during the fall back of decreased prices of oil, along with sustaining weak import inflation. The position of the UAE’s power in crude oil exportations also benefits the pegged Dirham to the USD. (Karnik 2005)

The primary export asset is priced in USD and is accordingly practical to set the currency of the UAE Dirham pegged to the USD. If the UAE’s oil exports were priced in any other currency, there most likely would be a case for a currency pool. A minor nation can always maintain a fixed exchange rate system substantially better than a greater nation economically. This can be especially true for the UAE as nearly 60% of their GDP revenues come from their oil exports. (Al-mulali 2011)

Fixing as well as safe guarding the formal exchange rate of the UAE Dirham is well within the laws of the acumen of the Board of Directors for the Central Bank. The policy concerning the fixed pegging of the UAE Dirham to the USD will remain in place for a while. However, consider that this discontinued, and that the UAE Dirham was no longer fixed to the USD. The UAE Dirham would fluctuate in the international market against the USD as most other currencies do. Depending on the assets that the Central Bank owns as well as the import and export market of the local economy, various impacts concerning the UAE government would begin to occur. (Adballa 2012)

A trade deficit refers to the concept of any domestic economy, such as the UAE, spending more money on foreign exchange goods, products, or services than they are spending on domestic goods, products, or services. This can also mean that the nation is spending more than it is able to produce because the domestic savings are not substantial enough to fund domestic investments on top of the government’s fiscal financial balance. A trade deficit must be financed by borrowing assets from other nations in the world through the source of financial markets. Other nations throughout the rest of the world outside of the UAE are able to provide such finance due to the fact that they are operating a corresponding international trade surplus and are spending less than they produce. (Al-mulali 2011)

This concept of the UAE’s trade deficit holds emphasis that trade as well as capital flows between the economy and the rest of the global economies must sustain balance. One area of the UAE’s trade deficit is another area’s surplus and vice versa. This is an element of accounting that must be upheld. In effect, having allowed the UAE to run a trade deficit through the unpegged Dirham to the USD, foreigners must finance it. However, depending on the fluctuating exchange rates, the terms may be favorable or unfavorable. (Adballa 2012)

If the UAE were to discontinue pegging the Dirham to the USD, then it would be easier for their Central Bank to set a monetary policy. Monetary policy is the system of a centralized bank or financial institution of a nation’s monetary government controls the flows of currency throughout the economy. This control over the supply of currency is maintained through establishing interest rates or economic inflation. The objectives of monetary policy are to cultivate price stability and obtain increased economic development. Monetary policy considers macroeconomic objectives such as lowering the unemployment rate, reducing poverty, and establishing federal minimum wage. The economic outcome of monetary policy sets the bar for what strategies should be set in place in order to create the most economically effective monetary policy. (Perkins 2012)

A monetary policy in the UAE would result in two specific outcomes. The outcomes of monetary policy in the UAE can lead to economic expansion. In this scenario, the monetary policy drives up the total supply of the Dirham throughout the economy at a faster rate than how it is normally distributed; in such a way that would not be possible if it were still fixed to the USD. This form of monetary policy is primarily used to help reduce the unemployment rates during an economic recession or depression. This is done by reducing interest rates for businesses. When interest rates are reduced, businesses are more likely to finance their operations through loans or credit which gives them the opportunity for business expansion. This can open up new jobs and contribute to lowering the unemployment line throughout the UAE. (Istaitieh 2007)

Conversely, a monetary policy in the UAE would lead to economic contradiction. In this scenario, the supply of the Dirham is distributed at a much slower rate than normal and sometimes is even drawn back negatively. This form of monetary policy is usually used to reduce economic inflation. To sum it up, if the power of the Dirham rises too quickly, then it leads to excessive economic inflation. On the other hand, if the power of the Dirham rises too slowly, then this slows down the rate of economic growth. This is why a monetary policy would be necessary should the Dirham be unpegged from the USD. (Istaitieh 2007)

Financial stability would heavily be based on the methods of accounting should the Dirham discontinue to be pegged to the USD. This is because without a fixed exchange rate, the Dirham would continue to fluctuate and foreign exchanges with the US would become more difficult in methods of accounting. (Epstein 2011)

Foreign currency translations in international finance are primarily governed under two comparable yet contrasting concepts, International Financial Reporting Standards (IFRS) and US Generally Accepted Accounting Principles (GAAP).  There is an ever increasing drive for the globalization of a single set of universal accounting and financial reporting regulations, otherwise known as convergence. Over 100 countries currently translate foreign currencies under the guidance of IFRS. This is why it is important for any business desiring global expansion to learn how IFRS will impact their business. (Perkins 2012)

Should the Dirham break away from being pegged to the USD, U.S. companies and investors would have to decide if they want to continue to trade with the UAE. If US investor parties decided that they wanted to continue to trade with the UAE, they would then need to conform to the fluctuating rates of the Dirham as it is no longer fixed at 3.6725 to the USD. This means that US investors must decide if they are going to follow the GAAP or the IFRS accounting standards when trading the USD with the Dirham. This is where financial stability falls on the set of accounting standards for the UAE as different approaches can have different effects on their exchange market. (Epstein 2011)(Perkins 2012)

Foreign currency matters related to GAAP are guided primarily guided under the Financial Accounting Standards Board’s (FASB) Accounting Standards Codification (ASC) Topic 830, titled Foreign Currency Matters. The IFRS issues guidance for foreign currency matters under its’ International Accounting Standards (IAS) 21 and 29. IAS 21 deals with the effects of changes in foreign exchange rates concerning the Dirham, while IAS 29 deals with the financial reporting in hyper-inflation of the UAE. (Epstein 2011)

Hyperinflationary economies carry other major differences under GAAP versus IFRS. Under GAAP, the financial statements of hyperinflationary economies are pre-measured as if the parent company’s reporting currency was considered the functional currency. Any differences resulting from exchange rates are reported as income. Under IFRS however, the Dirham would be retained in a hyperinflationary UAE. If there are any amounts in the financial statements that were not pre-measured using the current rate at the end of the reporting period, then those amounts are indexed under a general pricing index, which are then converted into the reporting currency at the current rate; unlike the fixed rate of the Dirham to the USD from before. (Perkins 2012)

Bibliography

Abdalla, Suliman Zakaria Suliman. “Modelling exchange rate volatility using garch models: Empirical evidence from arab countries.” International Journal of Economics and Finance 4.3 (2012): p216.

Al?mulali, Usama, Che Sab, and Che Normee Binti. “The impact of oil prices on the real exchange rate of the dirham: a case study of the United Arab Emirates (UAE).” OPEC Energy Review 35.4 (2011): 384-399.

Epstein, Barry Jay, and Lawrence G. Macy. “Differential Influence of US GAAP and IFRS on Corporations’ Decisions to Repatriate Earnings of Foreign Subsidiaries, The.” Int’l Tax J. 37 (2011): 25.

Istaitieh, Abdulaziz, Sarah Hugo, and Natasha Husain. “UAE macroeconomic report.” Macroeconomic Report Series, Dubai Chamber of Commerce and Industries, Data Management and Business Research Department (2007): 1-52.

Karnik, Ajit, and Cedwyn Fernandes. “Macro-econometric modeling for an oil dependent economy: an instruments-targets approach for the UAE economy.” (2005).

Perkins, Dwight H., et al. “Economics of development.” (2012).