The method of pegging local Gulf Cooperation Council (GCC) currencies to the dollar has been around for a long time. Saudi Arabia and the United Arab Emirates, for example, have been pegged to the US dollar since January 1978 and June 1986. While this has been going on for a long time, the complexities of the UAE's future must be considered, especially in light of the country's growing economy. Some studies in 2018 concluded that it was time to reconsider the dollar's peg, assess the volatility, and move on. The key explanation for the peg is that oil exports are traded in USD, making oil-related transactions more convenient and thus helping to stabilize the UAE economy.
What do you mean by Pegging of Currency?
In order to understand the aforementioned concept, we must first have a clear notion about what does pegging of a currency refers to?
Pegging is the practice of binding a country's currency rate to the currency of another country. Open market operations are used by a country's central bank to stabilize its currency by pegging, or locking, it to the currency of another, theoretically more secure country.
Prior to the expiration of an option, pegging may also refer to the process of manipulating the price of an underlying asset, such as a commodity. Currency pegs are primarily used to promote cross-border trade by lowering foreign exchange risk. Since many companies have thin profit margins, even a minor change in exchange rates will wipe out profits and push businesses to seek new suppliers. This is particularly true in the fiercely competitive retail sector.
What are the Components of Currency Peg?
The Components of Currency Peg are as follows-
Domestic Currency: -
This is described as a legally appropriate unit or tender that is used as a monetary instrument of exchange in one's own or domestic country. This is the only currency that can be used as a medium of trade throughout the country's borders.
Foreign Currency: -
This is a legal and legitimate tender with value outside the country's borders. The domestic country can keep it for the purpose of monetary exchange and recordkeeping.
Exchange Rate: -
This is known as a fixed exchange rate between two countries that is used to complement trade between them. The central bank of such a system aligns its domestic currency with the currency of the other nation. It aids in keeping the exchange rate in a manageable and narrow range.
Which types of Currencies are Pegged?
The following is a list of some of the major national economies and their present exchange rates against the US dollar.
How USD Pegged with Dirham Helps in Exchange Rate Of UAE?
The following are the few major advantages which could supplement the exchange rate of UAE when the US is pegged with Dirham:-
Since oil is sold in dollars, the Gulf Cooperation Council's oil-exporting nations must peg their currencies to the dollar. As a result, their sovereign wealth funds contain vast sums of money. To receive a higher return, these petrodollars are often invested in U.S. companies. The dollar pegs have largely performed well for them as the sole nominal anchor for inflation control.
Officials see it as beneficial to peg the country's currency to the US dollar because of the country's dependence on the oil industry. Keep in mind that oil prices are in US dollars. The UAE government will reduce the volatility of its exports by pegging its currency against the US dollar. To keep the peg, the country's economic indicators and current account should be held at optimum levels. The UAE government, for example, has a current account surplus compared to its GDP as of this writing.
What are the benefits in Banking of USD pegging?
The benefits imposed on the Banking Sector of UAE as a result of pegging of USD with Dirham are as follow:-
Maintenance of Economic Stability:-
The International Monetary Fund (IMF) observed that the resulting stability of the dirham, as a conclusion of USD pegging with Dirham and fixed exchange rate, has benefited and maintained a stable rate in the UAE economy, which has benefited the Banking sector to a great length attracting high numbers of foreign investments which resulted an increase in the revenue of the Banking Sector.
Bolstering Investor’s Confidence:-
As observed by the Central Bank of UAE, the other major advantage of USD pegged with Dirham is that it increases the confidence of the Investors to invest in the Banking as well as other important economic sectors of UAE, because of the thriving benefits which are catered as a result of USD pegged with Dirhams.
How does Fixed Exchange rate works in UAE?
In order to understand the above question, we need to clear our concepts about what Fixed Exchange Rates are:-
A fixed exchange rate is one in which one country's currency is connected to another country's currency or a widely traded commodity such as gold or oil. Countries nowadays typically connect their currencies to their trading partners, such as the US dollar. The United Arab Emirates, for example, pegs its currency, the UAE dirham, to 0.27 US dollar. In other words, you will still get 3.67 dirham for 1 USD which is done to keep the oil trade between the two countries stable.
How does Fixed Exchange rate work in UAE?
A fixed or pegged exchange rate involves harboring the domestic currency to a foreign currency so that a constant exchange rate can be ensured. One of the key facts about the Fixed Exchange Rates is that it promotes international trade by obliterating the exchange rate risks.
The UAE's currency is pegged to the US dollar at a fixed rate of 3.6725 to 1. Since oil and gas products are valued in US dollars, this exchange rate regime has enabled the UAE to reduce the volatility of its hydrocarbon export earnings. Furthermore, by eliminating exchange rate uncertainties, the fixed exchange rate has helped the country boost investor trust. The fixed exchange rate, in particular, forces the UAE to maintain interest rates equivalent to those in the United States in order to avoid speculative capital flows.
Officials see it as beneficial to peg the country's currency to the US dollar because of the country's dependence on the oil industry. Keep in mind that oil prices are in US dollars. The UAE government will reduce the volatility of its exports by pegging its currency against the US dollar. To keep the peg, the country's economic indicators and current account should be held at optimum levels. The UAE government, for example, has a current account surplus compared to its GDP. If you want to know more about this, Contact our Experts at Dhanguard for your Clarification.