Four ways QEII benefits the UAE but why it is still dangerous

Posted on 30 October 2010 with 2 comments from readers

Next week Fed chairman Ben Bernanke is set to announce QEII, the second round of quantitative easing by the US central bank. That means money printing or more literally raising the quantity of money in circulation.

Printing money is what governments do in dire circumstances like wars when they need to raise money and cannot raise taxes or borrow more money. For instance by the end of the First World War the US and UK had doubled their money supply, France had trebled and Germany quadrupled.

Inflation trap

Money printing eventually produces inflation, unless you have massive spending cuts and reduce the money supply through high interest rates, and in some cases physically remove cash from circulation. But there is no sign from the Fed that it has reached this point. Indeed, QEII is the opposite.

The US thinks it can grow its economy out of the slump, despite the evidence that this simply is not happening. The UK by contrast is going for austerity but perversely says it may undo this with money printing of its own.

So the US dollar is inflating in terms of supply. That means it is deflating in terms of value, and if the supply keeps on increasing through QEII then the dollar will devalue against other currencies. How will that benefit the UAE?

Four benefits

First, the price of oil will go up as a consequence of inflation and devaluation of the dollar, so oil revenues will rise. Secondly, the $109 billion debt mountain accumulated by Dubai during the 2003-8 boom will quickly be eroded in value in real terms.

Thirdly, the UAE will become more globally competitive as its dollar-linked currency will fall in value alongside the US dollar. And finally there is the carry trade of investors borrowing dollars cheaply and investing them in emerging markets like the UAE where equity and real estate prices are depressed after the recent boom.

This is the sort of positive impact for QEII that the US would like to see for its own economy. Thus far the results of this drastic policy have been to halt a deep depression but to leave the US economy in a deep slump with high unemployment, auto sales at two-thirds of boom levels and the housing market and mortgage banks in crisis.

Will QEII work?

More of the same medicine is not necessarily going to work. Indeed, the risks are high that it will kill the patient. The so far orderly exit of investors from the US bond market may become a rush, and leave financial markets in turmoil again, this time without the Fed as a backstop.

How long that might take is hard to guess: weeks, months, a couple of years? In the meantime, dollar-linked economies like the oil rich UAE have to live with the impact of policy choices not of its making.

If this inflation rumbles on for a few years the UAE will largely gain from higher oil revenues, the erosion of the Dubai debt and higher tourism income. Of course, there will be a downside with food costs rising along with the cost of many other basic necessities.

Financial crisis part II?

But if the US monetary system blows up quickly then the world economy will return to the kind of turmoil witnessed two years ago and a lot of business in the UAE would grind to a halt with the interruption to credit. That said life would still go on and the world would still need its oil supply. But this would hardly be an easy time for anybody.

Being an investor during this period would also be extremely difficult as financial markets will be subject to violent fluctuations. Bonds would definitely not be the place to be invested. Even commodities could fall and rise dramatically. Equities might keep pace with inflation or fall badly behind. Cash would be devalued although interest rates would rocket. Real estate prices would stay depressed or go lower.

This kind of wealth destruction is what follows a credit driven boom. The Fed and global central banks are trying to make this as painless as possible. We can only hope that QEII is indeed the cure and not the final stage of a credit induced madness that ends in disaster. There is no historical precedent to suggest it will work, sadly.

Low-risk investment, diversification and caution is the watchword. But at the right moments some speculation should pay off handsomely. Fortunes are quickly made and lost in such turmoil.