UAE Foreign Exchange Amongst Covid-19

 

Introduction

Exchange rates are very important in the study of finance and economics since poorly managed exchange rates can have an adverse effect towards the growth of a nation. The main factors are the demand and supply which determine the value of exchange rates. They are done by the companies within the country, financial institutions and other which buy and sell foreign goods and exchange foreign currencies to make payments internationally. In international trade, all businesses focus on the exchange rate since it determines the competitiveness of a country.

Foreign Exchange Rates

Foreign exchange is a major factor and a very important segment while conducting business. This is because any country has the power to bring in income from various resources (VERDELHAN, 2017). In simple words it determines foreign investment. Having said that the exchange rates in various currencies of the world are also important since an unstable and volatile exchange rate discourages foreign investment of any kind, while a stable exchange rate encourages business with that particular country. It may be said that there are various stages of exchange rates which must be discussed first before going into the topic.

Firstly, is the volatile exchange rates which is disastrous to any business! The foreign investors cannot predict their returns and hence withdraw from doing any business whatsoever. An exchange rate can be stable and high. While this stage encourages import, it must be said that it is bad for exports. This is because the investors can increase their ROI or Return On Investment by earning income from parts in their own country (Farhi & Gabaix, 2015). However in exports, the earnings are not much, as they are of less value overseas. Lastly comes exchange rates which is stable but of low value. This encourages exports but not imports. Any business held with this kind of exchange rates are of very high value overseas, but they are of low value within the country. In such cases importers must mark up the goods to recoup on their losses (Thao, 2019).

Relationship between Gross Domestic Product and Exchange Rates

Various scholars (Tang, Bordia, Restubog, & Bordia, 2017) conducted researchers and concluded that as the GDP of the country increases, the appreciation of the real exchange rate occurs. This research was specifically conducted in the Asian countries mainly in China, Singapore, Thailand, Malaysia and Philippines. Another scholar (Chase, 2015) took data from the World Bank between the years 1977 to 2010 and concluded the same. The RID model or the Real Interest Differential model by Keynesian and Chicago was used in the research. The main goal of this study was to analyze the impacts of GDP in the exchange rates. Other researcher (Hussain, 2016) conducted by showed that GDP has a negative coefficient in the RID model. It was also seen that when industrial production increases the GDP of the country appreciates.

A rise in domestic industrial production or the level of output raises the domestic income which demands the leading by the fall of domestic prices in the long run. Scholars (Mariano, Sablan, Sardon, & Paguta, 2016) also conducted a similar study which focused on the Dutch Disease event. They stated that the Real Exchange Rates appreciates when the price of non-tradable goods increases. In this situation, exports tend to decline. The researchers states that when it comes to the case of no remittances, the trading industry sees some sort of decline. In this case, the non-trading industry expands and offers employment to many. The so called imports gain favor. Another study (Button, Martini, & Scotti, 2017) states that the GDP will have a negative impact in the short run, but in long term the real exchange rate is bound to increase. The average changeover time is usually by ten years as observed by various scholars.  

Another model by researchers (Djokic, Grubor, Milićević, & Petrov, 2018) focuses on the Balassa-Samuelson effect. This study focuses on the process of growth on the real cost reduction which comes to trading industry much easier than non-tradable goods. This implies that the value of foreign currency especially the dollar will tend to fall over time. This study was mainly conducted keeping Russia in mind and showed the connection between the GDP and the economic growth of the nation. This study showed that the domestic price levels was adjusted over time in case of any volatile situation. Here the economic growth was expected to face a real appreciation. The researcher in this case made several examples which showed that factors which cause real depreciation are eventually bad since it occurs a reversal of capital inflows. The main positive impact in such situations are that as economy grows it is likely to attract some capital inflows and bring about a real appreciation.

Relationship between Volume of Money Flows and Exchange Rates

Various scholars (Basher, A.Haug, & Sadorsky, 2016) have conducted studies which states that there is a connection between the Real Exchange Rates and the Stock Prices. This study used various casualty tests and co-integration processes to get valuable insights on the relationship. The finding also explores the relationship between REX (Registered Exporter System) and the stock market. In the recent years many of the foreign businesses with Europe demand a REX number and is importer for the valuation of the foreign exchange currency. Many scholars (Sui & Sun, 2016) say that there are to theories with respect to the relationship between these two elements. One is the Traditional Approach, in which the exchange rate affects the stock prices and the other one is called Portfolio Balance Model. These theories explain in a simple way that if stock prices increase, they will attract more foreign investment and the exchange rate will be higher. On the other hand, if the stock prices fall, the market will become unstable leading to the fall in the currency value. Researchers (Bahmani-Oskooee & Saha, 2017) states that this may also lead to fall in the demand of money and various monetary authorities, which are susceptible to decrease the interest rates.

Various other researchers (Roubaud & Arouri, 2018) explored these theories and conducted study in the Asian nations which indicated that the results were impacted by the market which is further influenced by phenomenon used in these theories. In this study most countries showed a negative correlation and while others showed a positive impacts. A very important test known as the Johansen-Juselius co-integration test was used which proved the in the long run the impacts are always positive. The final conclusion that was reached was that a balanced approached was required influenced by various pre and post conditions of the market. Stock prices are a determinant factor in influencing the exchange rates. Economists and the country advocates must implement effective strategies to balance the relationship between the two.

Factors Affecting Foreign Exchange Rates

When discussing the influencing factors, there may be several factors which any country might take into consideration while making economic policies related to international trade. Although there are many factors, the report will attempt to state the major ones that will be impacted on the foreign exchange rates. They are outlined as follows:

Inflation Rates

One of the major factors are the changes in the market inflation. It means that in a country with a lower inflation rate is more like to see appreciation with respect to the value of its currency. The costs and prices of goods and services will also increase gradually. If the inflation rates are lower over a considerable period of time, then there is always a rise in the currency value of any country, which is again further influenced by the rise in the interest rates (Schmidt-Hebbel & Carrasco, 2016).

Interest Rates

Changes in the interest rates also impact the foreign exchange amount. Forex rates are always taken into consideration before doing any kind of foreign financial transactions. Researchers (Dumrongrittikul & M.Anderson, 2016) state that increase in the interest rate may cause the currency of a particular country to appreciate in value. This is because high interest rates can be provided to lenders thereby attracting more foreign investments.

Current Account of a Country

A current account reflects the transactions taken place in trade and the foreign investments earned by a particular country. The balance in the account is usually comprised of exports, imports and debts and various other transactions. A deficit in the account will show if the spending is more than the earning, which means that the import is more than the export (Ahmed, Liu, & Valente, 2016). As discussed earlier, an overall a balance needs to be achieved between the domestic currency and the foreign exchange rates. As per 2017 data, UAE holds a gross amount of USD 26.47 billion in its current account (CIA, 2020).

Debts of a Country

Debt of the government is a major factor that influences exchange rates. National debts also impact the domestic affairs and the public affairs. A country with huge debts is less likely to attract foreign investment, which in turn can lead to inflation of prices. Investors also can sell their bonds in the foreign marker if debt rises (Paula, Echeveste, Silveira, & Caten, 2016). This can cause a decrease in the exchange value of the currency of that particular nation. UAE currently holds a gross external debt of USD 237.6 billion and public debt of 20%, as per the data of 2017 (CIA, 2020).

Terms of Trade

Terms of trade is always related to the current account and the balance of payments. This reflects the changes in the import and export prices of goods. When export prices rise, it means that the country has improved its terms of trade and when import prices rise, then the country needs to focus on the terms. Often during the earlier case, higher revenue is earned by a nation which increases its currency value over a period of time. Thus an appreciation in the exchange rate occurs (Dallmann, Phillips, Li, Arnon, & Packman, 2018).

Figure 2: Factors affecting the foreign exchange rate of a country

Political Stability

A country’s political state is always looked on while making foreign investments. This is the strength of any country which impacts trade to a major extent. A glaring example is the recent Hong Kong protests, which caused huge disturbances in trading and foreign businesses. Various industries suffered a depreciation in its value due to the political turmoil (Rapoza, 2019). A country with sound financial and trade policy however, will attract more foreign investments. UAE in this case is a leading example attracting foreign investments across the globe. Below few recent policies of the government will also be discussed to further clarify the issue.

Recession

When a country experiences recession, the government likely falls under debts causing a fall in the interest rates. As a result of which foreign capital is decreased causing a weakening in the currency value. The world has been going through a period of recession since the 2000s. Europe and USA was the most affected. However economists say that UAE can face recent periods of recession at any time, as a global recession is on the rise (Wardeh, 2020).

Speculation

Scholars say that if the currency value of a country rises, then investors will automatically be more in demand of the currency value in order to make a profit for the future. With this, the exchange rates will also increase causing foreign value to inflow. However, if the value decreases then the opposite will take place (Greenaway‐McGrevy, Mark, Sul, & Wu, 2018).

Prospects of AED in Exchange Rates

The United Arab Foreign Exchange Rate was measured at 107.4 billion USD in January 2020. In the reports it showed that the Foreign Exchange Reserves comprised of 5.6 months of Import from the year of 2017 and since then there has been an increase of 9.3% YoY in 2020.

The most recent step that was taken by the Government of UAE was to raise the standard of the money exchange houses. This was a direct order of the Central Bank, due to fear of illicit financial transactions. This was done keeping in mind the diverse businesses from various sectors with Asia, Africa and parts of Europe. More than 125 money exchange houses were targeted who in the earlier years relied on middlemen, foreign exchange dealers and tenders who affected the exchange rate of the nation. This major step proved to be highly effective in ensuring that financial errors were less and money laundering is reduced. These exchange houses now have strict compliance rules and appoints compliance officers so that all the records and identification of exchanged accounts are checked and re-checked. Currently, the houses can only do a transaction of more than USD 545 in a single unit (Arnold, 2020). Moreover to improve the rates and the financial problems in the sector the FERG (Foreign Exchange and Remittance Group) introduced several policies to curb its negative effects. This also includes the decree under Article (69) of the Federal Decree Law No. 8 of 2017 on Value Added Tax. The Federal Tax Authorities also made it mandatory to declare the gross amount of VAT, together with the exchange rate that was published by the Central Bank (EY Global, 2018).

Can the UAE authorities maintain the USD peg?

The gross domestic product of UAE is about USD 382.6 billion as per the data in 2017, making the nation the 30^th largest economy in the world and the 2^nd largest economy in the Gulf Cooperative Council (GCC). The nation has now many diversified means of economy bringing in foreign money from across the globe. Foreign investors consider the UAE Dirham to be one of the most stable currencies, when it comes to the exchange rates. The International Institute of Management Development or the IMD in Switzerland, considers the UAE dirham to be the 24^th most stable currency globally (Augustine, 2019).

However because the country is related to the oil industry, the government see it an advantage to peg its currency to the US dollar. It is therefore always seen that the oil prices are noted in US dollars throughout the globe. By doing so, the UAE government can reduce the volatile effects of its exports. But, this comes with maintenance at some level, since the current account and the economic indicators must be improved at all levels. This is one of the reason why the UAE government is running a surplus in the current account against its GDP. At times of need, the government can also work against the peg. This mainly occurs when oil prices fall, especially in 2015 where all the GCC countries suffered a reduction in revenue in foreign investments (Alkhareif, Barnett, & Qualls, 2017).

Conclusion

There are many factors that the economist and the Government of UAE needs to consider because making any change to the economy. However foreign exchange is a crucial part and all is interlinked and must be kept in balance for a sound and secure revenue.

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

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