THE GOVERNOR

Daggers hang on the wall of the UAE Central Bank boardroom. The governor may be excused for thinking a few of them have been pointing towards him these past six months, as the chief guardian of the country's economy has come under repeated pressure to drop the currency peg to the ailing US dollar.

It is a question that has dominated the regional financial press for more than a year as the UAE and its Gulf neighbours have struggled to cope with record inflation without the ability to independently set interest rates because of their pegs to the greenback.

Misinterpreted remarks about the peg could fuel inflation expectations.

It is also the first question that Sultan Bin Nasser Al Suwaidi gets asked by every journalist he comes across, looking to break what would be the economic news story of the year - a definitive decision to drop the peg for a currency basket.

"I think everyone is getting tired of that answer," he says as he trots out the by now well-rehearsed line.

Suwaidi is wise to choose his words carefully. With so much riding on the Gulf's dollar pegged economies, he only has to hint at possible change to move currency markets.

When US Treasury Secretary Henry Paulson said earlier this month that he had been assured Arab Gulf states would maintain their pegs, future contracts to buy dirhams and riyals fell 0.4% against the dollar.

"Misinterpreted remarks about the peg could fuel inflation expectations and make things worse than they are," says Suwaidi.

"It would lead to some other structural imbalances in the economy."

Such market sensitivity around the future of the Gulf currencies explains why Suwaidi takes time to reflect before answering questions, and why his responses seem that much more measured.

The Central Bank boardroom is part office, part art gallery. Along with the daggers on the wall there are models of traditional dhows, multi-coloured vases, paintings from China and wooden elephants from India. There are trophies, awards and oil paintings of ruling families everywhere to be seen.

Sitting in the middle of this eclectic collection, Suwaidi explains why he believes the inflationary pressure facing the UAE is more about ‘bricks and mortar' than ‘pegs' and 'baskets'.

While the US economy battles the threat of a recession and a declining dollar, the same policies used by financial authorities to stimulate the US economy are causing prices to skyrocket in the dollar-pegged Gulf nations.

With oil prices soaring and shortages of basic foods such as rice and sugar as well as materials including steel and cement, there are no signs yet that the inflationary pressure being experienced in the region will ease any time soon.

Suwaidi insists that the local real estate market is the root cause of rising prices."The first chapter of inflation came from local sources, specifically from real estate and the availability of housing units and office space," says Suwaidi.

"Because of these bottlenecks that have developed in the housing market, prices are jumping," he adds.

The soaring cost of construction has also fuelled the problem, increasing the cost of development and therefore the selling prices sought by real estate companies and the rents needed by landlords.

"When prices go up in the real estate market, everything else goes up because this feeds into everything," he says.

Inflation may have hit 14% in Abu Dhabi last year according to the Abu Dhabi Chamber of Commerce - the highest rate in the region.

The chamber, citing government estimates, reported that inflation skyrocketed last year largely due to rising food, fuel and housing costs in the region, which led to a peak inflation rate of 15% last year.

High inflation rates are typically controlled by monetary policy through increased interest rates; however, the UAE's dollar peg restricts the central bank's ability to implement rate hikes because actions must be linked to those taken by the Federal Reserve in the US, which has cut its benchmark lending rate by 3.25% since September 2007, in a bid to stimulate the economy.

Gulf policymakers, though under pressure to move to a basket of currencies, are holding to a steadfast decision to keep the local currency pegged to the dollar.

Instead, the UAE, Qatar and Saudi Arabia have sought to introduce price controls to cope with escalating prices - a strategy that has attracted criticism from many economists.

Suwaidi concedes that price caps are not an answer to inflation, but simply a means to subdue high prices until the problem shortterm inflation diminishes.

"When imported inflation is coming from external sources, price caps are not going to do anything," he says. "It will lead to a lower quality of products and merchants will have to compensate for the loss - which has happened in the region."

Prices may be going up here while the dollar is falling there, but we should know how to deal with these problems when they pop up because that’s the nature of our business.

Suwaidi insists that inflation is not necessarily an evil, and even goes as far as presenting it as a positive sign of the economy's potential to grow and expand.

"Inflation is a short-term, temporary issue here because it is derived from the real estate market which must eventually stabilise," he says. "The same goes for food commodities, because supplies will increase since agriculture is of a cyclical nature," continues Suwaidi.

Suwaidi refuses to be drawn on the currency peg issue in the 'here and now', but what possible triggers could there be for a change of heart on the currency peg?

What could happen to make him change his mind?"What other major events could occur?" asks Suwaidi, sardonically. "In the West, there's been a collapse in the real estate market, there have been subprime issues, liquidity problems, a credit crunch - you name it.

"Prices may be going up here while the dollar is falling there, but we should know how to deal with these problems when they pop up because that's the nature of our business, to deal with problems when they come," he adds.

Kuwait broke ranks with the UAE, Saudi Arabia, Qatar, Bahrain and Oman last May by severing its dollar link, saying the US currency's decline on global markets was fuelling inflation by making a number of imports more expensive.

But as the US economy heads toward recession, gripped by a credit squeeze, dollar pegs have restricted Gulf central banks' ability to fight inflation by forcing them to track US monetary policy.

It is a situation that has drawn comment from international figures such as the former US Federal Reserve chairman Alan Greenspan, who said in February that the dollar peg was fuelling inflation in the Gulf.

Suwaidi is dismissive of the comments from the former Fed chairman.

"I don't care about the statements of Greenspan because he's no longer in the government and he's just interested in making interesting speeches," remarks

Suwaidi as he adjusts his glasses.

"But Henry Paulson was very positive. We think most of what he said is accurate."

US Treasury Secretary Henry Paulson made a visit to the Gulf in April, during which he promoted sovereign wealth funds and the inflow of funds from the oil-rich Gulf states to the West.

The weak dollar, he proposed, makes the US an attractive investment platform for foreigners, providing lucrative opportunities for investors from the Gulf.

Sovereign wealth funds from the region have made their mark on Wall Street over the past year, providing funds to financial institutions including Morgan Stanley, Merrill Lynch and Citigroup amid the credit crisis.

"We have a surplus of money from sales of oil and gas. This surplus has to be invested, and the place for it is the US because the market there is cheap, it is liquid, and you have better opportunities than even Europe."

We have a surplus of money from sales of oil and gas... and the place for it to be invested is the United States.

Suwaidi believes that global perceptions of how sovereign wealth funds are managed and run will change once the IMF rolls out the first-ever best practices code for SWFs by the end of this year.

While on tour in the Gulf in April, Paulson suggested that a proposed investment code of conduct for SWFs was designed to appease those in the US calling for greater restrictions, and was not meant to be a restriction on the investment itself.

But Suwaidi believes the net result may be to slow the number of big deals involving SWFs investing in European and US markets."It will reduce the flow [of funds], definitely, and it will work as an impediment on the freedom of these SWFs," says Suwaidi with a nod. "It will affect the volume and the decisions."

Suwaidi shakes his head slowly when speaking about the state of the US economy.

Amid the credit crisis and the collapse of the housing market, he focuses on the devastating social problems created by job losses of more than 83,000 in Tokyo, London and New York since last July.

Since August 2007, Wall Street alone has seen 10,000 job cuts, marking a 3.5% decline in the workforce.

Suwaidi recalls meeting with Federal Reserve chairman Ben Bernanke in April 2007, when subprime losses were estimated to total US$50bn - and how write down figures are now topping US$100bn.

"It surprised everybody," he says with a sigh. "A year ago, just around this time, we were talking about the possibility of something like this but not as drastic, more like a correction."

Yet he maintains that the Gulf remains to a large extent insulated from the impact of the subprime crisis, at least in comparative terms."We don't have the same artificial financial structures here," Suwaidi says confidently. "They kept re-bundling deals and selling them over and over to investors, and it becomes a vicious cycle that turns at a very fast speed.

"We don't have this mechanism here," he adds. "We stood against these products three years ago because it was easy to see how the market would misuse them."

Suwaidi has spent 30 years in the finance industry and has seen recessions come and go.

While the impact of surging inflation has become one of the biggest threats to regional economies, Suwaidi gives the impression that he doesn't think rising prices represent a long-term problem.

With the oil price expected to continue its climb and regional economies enjoying the benefits of that advance in the form of record budget surpluses and rising incomes, the daggers are unlikely to be out for the governor just yet.

Monetary plan moves closer Central bank governors from each of the Gulf states met early last week to discuss pertinent issues including the status for plans for the creation of a monetary union, high inflation rates, anti-terrorist financing and antimoney laundering.

An agreement was reached to develop a common governing body for the GCC in 2009, which is the initial phase leading towards the establishment of a common currency.

However, the central bankers indicated at the meeting that the common currency would not be implemented by the proposed target in three years' time (end-2010).

The process would involve a central bank draft proposal that would be ratified by each member of the GCC and approved by finance ministers before the monetary council can start implementing rules.

Currency speculation ran high at the end of last year when a revaluation of the dollardirham peg seemed possible for many of the Gulf states; however, the GCC members agreed to maintain the peg, at least until monetary union was established.

Inflation was one of the main concerns discussed during the meeting. The central bankers suggested that alarming inflation rates are among the main reasons for the delay in finalising monetary union by 2010.

Record inflation rates, though forecasted to be a short-term phenomena, have reached levels as high as 14% in the UAE. It was highlighted during the meeting as a main problem that needs to be resolved before the monetary council can begin operations.

Prices are rising largely due to the booming real estate market in the UAE, flowing oil revenues and shortages on basic commodities.

The peg to the weakening dollar for all the Gulf states, with the exception of Kuwait, is also pushing the cost of imports higher.

An inflation target of a maximum of 2% above the original regional average was one of the most controversial points touched upon by the GCC members at the meeting.

The soaring prices have often caused disagreements about the launch of a common currency, and plans were tested when Oman opted not to join in 2006 and Kuwait dropped its dollar peg in the Spring of 2007.

The soaring price problem Gulf Arab states have launched a series of emergency efforts to control soaring prices, as inflation in Egypt hit a 19-year peak last week. Qatar is to freeze the price of steel and cement for three years and extend a diesel subsidy, while Kuwait is set to unveil a plan to battle inflation, which hit 10.1% in the latest measure, driven by housing and food costs.

Record inflation poses huge challenges to the Middle East as governments struggle to manage creaky or overstretched economies and head off the discontent that has led to strikes and protests in some parts of Europe.

Ironically, the oil-exporting countries of the Gulf who are benefiting the most from high oil prices are also suffering from inflation.

They import most of their food and roaring economic growth drives up costs for concrete, steel and housing. "Inflation remains a problem for macroeconomic stability and a problem that needs to be addressed," Marios Maratheftis, regional head of research at bank Standard Chartered in Dubai, told Reuters last week. "On the positive side, it is now widely acknowledged by all the authorities that this is indeed a problem." Gulf states are hampered in their fight against inflation by currency pegs to the ailing dollar, which have driven up import costs and forced them to track US interest rate cuts even as their economies boom.Yet even Kuwait, which de-linked from the dollar a year ago, is battling inflation that topped 10% in February, highlighting the complexity of the problem olicymakers face.

"The Kuwaiti experience has shown that just de-linking the currencies to the US dollar is not sufficient to do away with inflation," said Jasim Ali, a member of the Bahraini parliament's finance and economic committee. "Currency link is one element. We have to liberalise the economies, possibly curb governmental spending, curb the growth of money supply, and think of new measures such as value added tax (VAT)." Consumer prices in Iran, the world's fourth-largest oil producer, have risen steadily, fuelled by profligate spending of petrodollars combined with interest rates well below inflation. The year-on-year rate reached 25.3% up to May 20, up from 16.6% one year ago.