There is a pattern of relationship between the financial markets of the US and the UAE. Presently, the UAE holds a position of one of the most perspective trade and investment partners for the world’s largest and strongest economy. Its financial market is considered one of the healthiest and most liberalized structures among the international and regional players. The country holds this unique position due to the continuous commitment to building a safe and attractive investment environment, adopting progressive economic reforms, maintaining political consistency, respecting investors’ confidence, and granting equal treatment for all financial inflows (UAE Embassy, n.d.).
In 2012, the US and the UAE became partners within the framework of an Economic Policy Dialogue. This program envisioned the strategic development of economic, financial, and business ties between these two successful entities. Following this initiative, the reciprocal investment capacity increased exponentially. In addition to the physical presence of thousands of American firms and numerous joint ventures with mutual funds in the UAE market, the country has also conducted extensive investment activities in the US market for three decades. Particularly, the UAE enterprises invested cash in the largest American business groups, such as Boeing, General Electric, Carlyle Group, and Hyatt Hotels Group, among others (UAE Embassy, n.d.).
Even though the UAE has operated as a generous and dependable source contributing to the liquidity and sustainability of the US financial markets, accumulation of national wealth, and employment coverage, its financial market remained in the dependent position ever since it pegged its national currency, the dirham, to the US dollar. This step was taken to secure exchange rate stability of dirham to facilitate and expand trade relations with the major importer of oil, which is the country’s chief product. Since a significant amount of US dollars was infused in the UAE economy in exchange for petrol on a regular basis, it was logical at some point to peg AED to the US dollar. Even though a significant scope of current UAE-US economic relationship lies outside oil exports, the dollar peg lingers. Under healthy economic conditions, it protects the national currency of a smaller economy. However, the weakening of the US dollar immediately jeopardizes the stability of dirham and shatters the UAE financial market (Khamis & Senhadji, 2010).
The UAE belongs to a dozen of countries that still have their national currencies pegged to the US dollar. In 1997, the dollar-peg decision was made in the conditions of a thriving economy, abundance of oil profits, and the need to boost investment activity both in and outside the country. The pegging implies that the UAE central bank is committed to undertaking measures to keep the permanent exchange rate regardless of the real market fluctuations in the basket of currencies. Up until 2007, the strategy proved cost-efficient and justified by the soaring domestic demand for real estate and investment inflows. Notably, despite the fact that the cost of maintaining the equilibrium has been growing for eight years, the UAE is determined to maintain the dollar peg. There is much discussion about the chances of escaping AED devaluation under the pressure of skyrocketing inflation and a landslide in oil prices (Coppola, 2016).
In the scenario where a global demand for USD increases, there are two options to satisfy the vacuum and bring the world’s economy to the new equilibrium. On the one hand, the Federal Reserve can print more dollars to increase the supply of the currency. However, in this case, it risks provoking the devaluation of USD and triggering increased domestic inflation rates. On the other hand, the combination of the deficit and growing demand are likely to cause the rise of the dollar value against other currencies in the currency bucket. Other currencies will devalue against dollar and countries will have to pay more to buy the traditional amount of USD. However, they will be forced to buy USD regardless of the cost to conduct trade deals. In turn, the international demand for AED will decrease because dirham will become stronger and more expensive against other currencies due to the dollar peg. Since it is not a reserve currency, other countries will not be compelled to buy it. At this point, it is necessary to look into the primary reason for pegging dirham in an economy striving for export-oriented growth, namely the intention to devalue its national currency and make domestic exports more attractive for global trade partners. In case AED becomes stronger, UAE exports and investment opportunities will become less attractive.
If the UAE and other GCC economies do not learn from the recent global financial crisis of 2008 and incorporate proper decisions and mechanisms in the governance of their financial markets, then the effect of the next crisis will be similar. As the US is the world’s largest economy and a lender of last resort and the US dollar is a peg currency for most of the UAE investment partners, unhealthy fluctuations in the US markets inevitably have a negative effect on the UAE financial system. The fact that the crisis forecast was soaring a year before and it actually crushed the Wall Street proved that the financiers did not learn from historical stock market collapses. No matter how devastating the aftermath of the financial shock is for the national economy and the world, they refuse to curb their greed and change the moral connotation of conventional practices. The recent liquidity and mortgage crises in the US emerged from the fraudulent activities in the sub-prime mortgage market that connived at the violation of common sense by granting loans to the borrowers with compromised credit histories (Bernanke, 2007). The bubble of fictional profits fueled the creation of an alternative financial market of $55 trillion gambling on a new artificial instrument, the Credit Default Swaps. Despite their obvious financial inconsistency, derivatives were used to satisfy the global demand for investment and housing. As the property prices melted a large scale, hedge funds collapsed, and American financial moguls filed bankruptcy, the international panic and frantic call for cash could not be satisfied (Morgenson, 2007).
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Even though the UAE economy received a fairly minor direct damage due to its isolated position and relatively little exposure to global capital shocks, it could not ultimately avoid the credit deficit, the crisis of confidence, the devaluation of investment portfolios, and the general panic caused by the so-called “financial weapons of mass destruction” (Rahman, 2008). The fact that, unlike European and Asian economies, more than 95% of the UAE business environment comprises small and medium-sized family companies adds to its financial sustainability. Operations based on family equity relieve from the exposure to international financial risks (Khamis & Senhadji, 2010).
Furthermore, the orientation toward its GCC and Asian partners also minimizes the vulnerability of the UAE small financial market. However, the country cannot escape overall deterioration of financial activities, contamination of investor credit, the decline in international demand for re-export, bankruptcies, and panic among minority shareholders. The UAE financial market maintained healthy operations and achieved smooth recovery due to sufficient assets and reserves, as well as the involvement that the national government had in the financial sector through co-owned equity in the largest banks. The UAE bailout plan worked because it was tasked to cover less than 10% of external assets with about 13% of the UAE-owned deposits. The fact that national bank capital reserves are required to keep more than 11% of reserves secures solid resilience against future shocks in the US financial market (Habibi, 2009). However, the introduction of additional regulative measures and a common currency within the framework of a monetary union among the GCC countries could strengthen sustainability and control of the UAE financial system.