The CBUAE and SAMA

Two institutions, one anchor 

The two institutions do what central banks generally do. Each issues its country's currency, holds the foreign reserves that stand behind it, supervises the banks operating in its jurisdiction, runs the payment and settlement systems the domestic banking system clears through, and sets a short term policy rate. Neither is the regulator of everything financial in its country: securities markets and the firms that operate in them are supervised by a separate authority in each jurisdiction, so a central bank statement is not the only rulebook a regional market lives under.

The difference from the institutions in the previous two lessons is a single structural commitment that both of them carry. The dirham and the riyal are each held at a fixed published rate against the United States dollar, and each currency is freely convertible into it. Both arrangements have stood for decades and the parities have not moved over that period. That one fact reorganises everything else about how these institutions operate, because a fixed exchange rate is not a description of where a currency happens to sit. It is a standing obligation to exchange at a stated rate whenever anybody asks.

The choice a peg makes in advance 

Consider what would happen if the domestic rate sat well below the anchor's while the exchange rate between the two currencies was fixed and convertible. Money held in the domestic currency would earn less than the same money held in the anchor currency, and moving between them would carry no exchange rate uncertainty at all, because the rate is administered rather than discovered. The usual thing that compensates a holder for accepting a lower return, namely the possibility that the currency appreciates, is absent by construction. What remains is a return difference with almost nothing on the other side of it.

Holders convert. Converting means selling the domestic currency to the central bank, which is obliged to supply anchor currency at the published rate out of its reserves. Reserves fall, and the obligation is only as durable as the reserves standing behind it. The opposite gap produces the mirror image rather than a symmetrical relief: a domestic rate materially above the anchor's draws money in, the central bank takes in anchor currency and issues domestic currency against it, and domestic liquidity expands whether or not domestic conditions called for expansion.

The gap in the block is deliberately wide so that the arithmetic is visible on the page. In practice a much smaller difference is enough to move very large balances, because the sums involved are large and the exchange risk that would ordinarily justify a rate difference has been removed by the peg itself. That is the whole mechanism, and it runs in both directions with equal force.

Economists describe the constraint as a trilemma: a country can hold any two of a fixed exchange rate, free movement of capital across its borders, and a monetary policy set for its own domestic conditions, and it cannot hold all three at once. The United Arab Emirates and Saudi Arabia have both chosen the first two, and the third is the one given up. That is why the announcements arrive within hours of the anchor's and commonly in the same increment. It is a consequence of a decision taken long ago, not a decision taken on the night.

The word commonly is doing real work in that sentence and is not a hedge. The constraint binds over time rather than minute by minute, so an institution can hold its own rate a little above or a little below the anchor's, can move by a different increment, and can move at a different moment, which both have done. What the constraint rules out is a sustained divergence in either direction while the peg and free convertibility are both maintained.

The Central Bank of the UAE 

The Central Bank of the United Arab Emirates issues the dirham, holds the reserves behind it, licenses and supervises the banks, insurers and finance companies operating in the country, and operates the national payment infrastructure. Its stated objectives run to monetary and financial stability rather than to a published inflation target of the kind the institutions in the previous lessons operate under, and the reason is the section above: an institution that has fixed its exchange rate has already delegated the setting that an inflation target would be pursued with.

Its policy instrument is a base rate applied to an overnight deposit facility, which is the rate banks receive on money placed with the central bank overnight. That rate sets the floor of the domestic money market, because a bank with cash has the option of leaving it there and will not lend it out for less. The interbank benchmark that domestic corporate and mortgage lending is priced off, quoted in the local market as EIBOR, sits above that floor and moves with it, which is the path by which a decision taken elsewhere reaches a construction loan in the Emirates.

The base rate is set by explicit reference to the rate the anchor's central bank pays on the reserve balances banks hold with it. This is the point worth pausing on: the mechanism described in the previous section is not an inference a commentator draws about the institution's behaviour. It is written into the operating framework the institution publishes, which is why the announcement can follow the anchor's within hours without a committee debating it.

The Saudi Central Bank 

The Saudi Central Bank performs the same functions for the riyal. It is still generally called SAMA, the abbreviation it carried under its former name as the Saudi Arabian Monetary Agency, and the abbreviation was deliberately retained when the institution was renamed, which is why both names appear in market commentary and refer to one body.

Its policy instruments are a pair of rates rather than a single one. A repurchase rate is the rate at which banks borrow from the central bank against collateral, and a reverse repurchase rate is the rate at which they place funds with it. The pair brackets the domestic money market: the first is the ceiling a bank pays to obtain cash, the second the floor it receives for parting with it, and the local interbank benchmark, quoted as SAIBOR, sits between them. Domestic lending is priced off that benchmark in the same way, so the transmission path is structurally the same as the one described above with a corridor in place of a single floor.

The riyal is held at a fixed published rate against the dollar and has been for decades. There is a straightforward budgetary logic to the arrangement in an economy whose principal export receipts arrive in dollars while its spending is domestic, because fixing the rate between the two removes the exchange rate from the government's own arithmetic. A lesson later in this module deals with what a dollar priced export does to a regional economy more broadly, and that part is left there.

The regional pattern is a norm rather than a rule, and the exception is worth knowing because it is the counterexample any argument about pegs reaches for. The Kuwaiti dinar is managed against an undisclosed basket of currencies rather than against the dollar alone, which is why it moves in small amounts against the dollar where the dirham and the riyal do not. Gulf currency arrangements are therefore several arrangements with a family resemblance, not one system.

What the peg does not fix 

A fixed rate against one currency is not a fixed rate against all of them. The rate between a pegged currency and the euro, the yen or the pound is the anchor's rate against those currencies, converted through the parity. A pegged currency is therefore stable against exactly one thing and inherits every movement the anchor makes against everything else, including movements caused by decisions taken for reasons that have nothing to do with the region.

The parity is identical in both cases, and the price of the third currency in domestic terms differs by half as much again between them. The peg did not stop the domestic currency moving. It determined what it moves with, which is a narrower claim than it is usually given credit for.

The same limit applies to prices. Goods invoiced in the anchor currency arrive at a fixed conversion, so the peg genuinely removes one source of imported price variation. A substantial part of a domestic price index is not tradable at all: rents, schooling, healthcare and local services respond to domestic conditions, to population flows and to local supply, none of which the anchor's committee is looking at. A peg imports a policy rate. It does not import an inflation rate, and the two economies can sit at different points of a cycle while sharing the rate that is supposed to address it. That gap is the standing criticism of the arrangement and it is dealt with directly in the disagreement section below.

Dollar denominated exposure, seen from here 

Two consequences follow for an account held in the region, and they are consequences of arithmetic rather than of anybody's opinion. The first concerns conversion. An account denominated in dirhams or riyals that holds a position denominated in dollars carries a conversion step at the end of the calculation, and while the peg holds, that step is a multiplication by a constant. The result in domestic currency tracks the result in dollars. The same account holding a position denominated in a floating currency carries a conversion that is a live variable, and the two components of the outcome, the position and the currency, have to be read separately because they can point in opposite directions.

The second concerns where the movement is. A pegged pair has, by construction, almost no movement to observe: an instrument whose price is administered has no discovery process to follow, and market practitioners describe such pairs as thinly quoted and as wide relative to any distance they travel. What the anchor's decisions do reach in this region is not the exchange rate but the domestic cost of money, and it shows up in the interbank benchmarks named above, in bank funding costs, in the terms of domestic borrowing and in the valuation of domestically listed companies. A reader who concludes that Gulf monetary policy is uneventful because the currency does not move has looked at the one variable the arrangement was designed to hold still.

Where practitioners disagree 

The first argument is whether the peg is the right regime for these economies at all. One position holds that it imports monetary credibility at very low cost, removes the exchange rate from a budget whose receipts are denominated in the anchor currency, and gives domestic and foreign investors a currency they do not need to form a view on. Another position holds that it imports a policy cycle calibrated for a different economy, and that the calibration can arrive backwards: a period of weak domestic activity in the region can coincide with tightening at the anchor, so rates rise locally at the point domestic conditions would have argued for the opposite. Both descriptions are of the same arrangement, and the disagreement is about how often the second case occurs and how much it costs when it does.

The second argument concerns how much independence these institutions actually retain. One view treats them as policy takers, on the grounds that the headline rate is effectively determined elsewhere and the announcement is a formality. Another points out that the headline rate is not the whole of policy: reserve requirements, liquidity operations, the size of the gap held against the anchor's rate, and macroprudential tools such as limits on how much of a property's value may be borrowed are all set domestically, are used, and reach the domestic economy without touching the exchange rate. The honest reading is that the exchange rate instrument has been spent and the balance sheet and prudential instruments have not.

The third argument runs about the regional calendar. One tradition holds that Gulf policy announcements carry little information, because the content of the decision was determined by the anchor's meeting hours earlier and the local statement is arithmetic. Another holds that the interesting information in a regional announcement is precisely what is not mechanical: whether the gap to the anchor was held constant, what was done to liquidity operations, and what the accompanying prudential measures were, none of which follows automatically from the anchor's decision. Neither tradition disputes the facts. They disagree about where in a published statement the information sits, and that disagreement is genuinely unresolved.