What is Money?

To understand the UAE’s monetary system, it is important first to describe what we mean by ‘money’ and delineate between different types of money. Typically, money can be defined according to its ability to satisfy the following three conditions:

• It is a medium of exchange – it can facilitate the exchange of goods, services, and other assets.
• It is a store of value – its value vis-à-vis goods and services does not fluctuate wildly over time.
• It serves as a unit of account – it is used as a measure of the value of goods and services.

One can consider banknotes and coins – currency in circulation – as meeting these three conditions. However, currency in circulation accounts for a relatively small fraction of the total volume of all money within the UAE’s monetary system. For example, total currency in circulation and physical cash at banks accounted for just 6.3% of all money as at the end of 2020.

Different Types of Money

Rather than its physical form, the digital representations of money (in the form of an IOU) have long accounted for the vast majority of money supply. This includes deposits at commercial banks held by individuals, corporates and governments, as well as commercial bank deposits and related assets held at the Central Bank of the UAE. With this in mind, and for the purposes of explaining the monetary system, it is important to distinguish between central bank money and commercial bank money. To this end, the CBUAE defines the following different types of monetary aggregates:

Monetary Base (MB) – defined in Decretal Law No. 14 of 2018 as the sum of (1) currency issued (currency in circulation outside banks and cash at bank), (2) aggregate balances of current accounts of licensed financial institutions with the CBUAE, including reserve requirements, in addition to any other funds deposited with the CBUAE for the purpose of clearing and settlement operations, and (3) the outstanding balance of securities and financial instruments issued by the CBUAE;

M1 – Consists of currency in circulation outside banks, plus monetary deposits in local currency with banks (all short-term deposits on which bank customers can withdraw without prior notice).

M2 – Consists of Money Supply (M1) plus quasi-monetary deposits (Resident Time and Savings Deposits in Dirhams plus Resident Deposits in foreign currencies).

M3 – Consists of Money Supply (M2) plus government deposits.

Broadly speaking, the Monetary Base can be referred to as ‘central bank money’, such that it is a CBUAE liability. As per the definition above, this includes physical currency issued (notes and coins). It also includes funds held by commercial banks at the CBUAE, which are used as a medium of exchange for transactions between banks, commonly referred to as bank reserves. It also includes any securities or other liabilities issued by the CBUAE, such as Monetary Bills.

Deposits defined under M1, M2 and M3, by contrast, may be referred to commercial bank money. M1, M2 and M3 are also commonly referred to as ‘broad money’. In a modern economy, the stock of commercial bank money exceeds the stock of central bank money by several multiples. For example, as at the end of 2020, the UAE Monetary Base amounted to AED 427 billion, whereas the stock of M3 was close to AED 1.8 trillion. In other words, the stock of money in the form of deposits at commercial banks (whether by individuals, businesses, or government) accounts for the vast majority of money in the UAE economy.

How Money is Created

With the above delineation between central bank and commercial bank money in mind, we can now describe the process of money creation. Commercial bank money, in the form of bank deposits, can be created when an individual or business deposits currency they have earned at a commercial bank. However, this leaves the total stock of money unchanged as the bank customer simply exchanges one type of money for another. However, commercial banks can also create deposits by extending loans. This arises out of a simple accounting identity. When a bank makes a loan, it credits the deposit account of the borrower with an amount corresponding to the loan size. For example, when somebody takes out a car loan of AED 50,000, the impact on the commercial bank’s balance sheet is as follows:

As shown above, when the car loan is made, both the asset (the loan) and the liability (the deposit) side of the bank’s balance sheet increases. As a consequence of this accounting identity, the new loan has therefore increased the total money supply. Even if the deposit is transferred to another bank to facilitate payment of the car, the impact on the aggregate money supply remains. Conversely, when a loan is paid back, this reduces both the liability side in the form of the customer deposit and the asset side in the form of the loan amount outstanding. As a consequence, the process of credit creation and repayments play a very important role in determining the money supply in a modern economy.

Given the above, it may be tempting to think that commercial banks can create money out of thin air and there is some truth to this notion. However, in practice there are a number of factors that limit the extent to which banks can lend and therefore create money. Such factors include:

• Market forces preventing banks from extending additional loans profitably.
• Banks’ considerations regarding the riskiness of extending additional loans.
• Regulatory constraints such as the liquidity ratios imposed by the CBUAE.
• Demand for loans by the public and governments.
• Changes in interest rates.

The CBUAE, in its analysis of domestic markets, keeps track of these various factors. One example of this includes developments in credit conditions covered in the CBUAE’s Credit Sentiment Survey.

The process by which central bank money supply – the Monetary Base – changes is different. As per its monetary policy objective, the CBUAE maintains a fixed exchange rate of the UAE Dirham against the US Dollar. In practice, this means that the CBUAE must intervene in the foreign exchange market in order to maintain parity of the UAE Dirham against the US Dollar. To that end, the CBUAE commits to buy UAE Dirhams against US Dollars from the market at a rate of 3.673, and sell UAE Dirhams against US Dollars at a rate of 3.672 with eligible market counterparties. For this to be credible, the CBUAE requires a stock of liquid foreign currency reserves with which to intervene. Decretal Federal Law No. (14) of 2018 imposes a “Monetary Base Cover” requirement. This requires that the market value of the CBUAE’s foreign reserves shall not, at any time, be less than 70% of the Monetary Base, thereby ensuring credibility of the exchange rate regime.

As a result of its monetary policy objective, the CBUAE’s balance sheet is mainly US Dollar ‘asset-driven’. That is, most changes in the Monetary Base are fully matched by a corresponding change in foreign reserves. For example, consider what happens when capital inflows increase due to speculation on the property market. In order to prevent the UAE Dirham appreciating, the CBUAE will sell UAE Dirhams for US Dollar at a fixed rate of 3.672, with the UAE Dirham funds deposited at the CBUAE in the form of reserve balances. In doing so, the asset side of the CBUAE’s balance sheet expands in the form of foreign reserves while the liabilities side expands in the form of bank deposits (bank reserves). As a consequence of this intervention, the UAE’s Monetary Base expands.

What about interest rates?

As noted above, most of the money supply is created in the form of commercial bank money arising whenever a commercial bank makes a loan. The Monetary Base, however, can exert a powerful influence over broader forms of money due to its effect on market interest rates. Recall that the Monetary Base includes funds that commercial banks have deposited at the CBUAE. Such funds, known as bank reserves, are used to facilitate payments in the broader economy. For example, when you make a payment for a coffee via a debit card and the café owner’s bank is different to that of yours, such funds are settled between banks via their reserve (settlement) accounts at the CBUAE. In order to facilitate such payments and to meet regulatory obligations, banks therefore need to maintain some volume of funds in their reserve accounts at the CBUAE. When a bank requires additional funds to meet such obligations, it will go to the interbank market to borrow funds from another bank. The rates charged on interbank borrowing then determine interest rates across a broader set of products for individuals and corporates. In the event that a bank is unable to borrow from another bank, the bank may borrow from the CBUAE at an above-market rate.

In the UAE, the supply of bank reserves are significantly greater than needed to facilitate payments and meet regulatory obligations. This is referred to as “structural excess liquidity”, and arises in large part due to the UAE maintaining a large current account surplus over time. As a result of this, supply of reserves exceeds demand by a sizeable margin. Under such a monetary system, it is necessary for the CBUAE to place a floor under which interest rates can fall no further. The CBUAE achieves this by operating an Overnight Deposit Facility (ODF), whereby banks can deposit their excess reserves at the end of each business day. The rate paid on the ODF, the Base Rate, is the key CBUAE monetary policy rate, and is a key determinant of all interest rates in the UAE. It is the rate at which banks, having exhausted all options to lend in the interbank market, will receive a minimum interest rate at the CBUAE for their surplus reserves. In the absence of such a floor, interbank interest rates would likely fall to zero.

While the CBUAE can set a Base Rate, it cannot do so independently. Recall that the CBUAE maintains a fixed exchange rate of the UAE Dirham against the US Dollar. For this arrangement to remain stable, it requires that interest rates are closely aligned with US interest rates. If interest rates in the UAE are too high relative to the US, this will encourage speculative inflows. Conversely, if interest rates in the UAE are too low, capital outflows may arise. To that end, the Base Rate is closely aligned with US interest rates. Specifically, the Base Rate is aligned to the US Federal Reserve’s Interest on Reserve Balances (IORB) rate, though the CBUAE may adjust this alignment on occasion depending on market conditions. The CBUAE also monitors flows of funds closely to ensure that monetary policy settings do not inadvertently encourage speculative flows.

The means by which the CBUAE manages its monetary policy is referred to as a “floor system.” That is, structural excess liquidity is maintained as a policy choice, as the CBUAE seeks to target a level of structural excess liquidity. This is known as the CBUAE’s excess reserves target, whose purpose is to ensure that overnight interbank interest rates are consistent with the Base Rate, while at the same time ensuring that commercial bank reserves are not sufficiently large that they impede capital market development. The CBUAE intervenes in the domestic market to meet its excess reserves target. Such intervention is known as ‘Open Market Operations’.

To demonstrate how this works, we can consider an example of capital outflows from the UAE. In this example, AED 5 billion flows out of the UAE via a foreign exchange transaction with the CBUAE. This reduces the CBUAE’s Net Foreign Assets and the reserves balances of banks at the CBUAE, resulting in a contraction of the monetary base by AED 5 billion.

In such an example, we can then consider that excess reserves held by banks falls below the CBUAE’s excess reserves target. Consequently, this scarcity of reserves may cause interbank interest rates to spike well above the Base Rate. The CBUAE, seeking to ensure both excess reserves and interest rates are in line with its target, therefore needs to intervene in the domestic market. There are a number of tools available to the CBUAE to intervene, though for the purpose of simplification we consider an outright purchase of domestic assets. In such an example, the CBUAE purchases AED 5 billion in securities denominated in UAE Dirham from the banks. In such transactions, the CBUAE’s net domestic assets increase by AED 5 billion, while bank’s reserve accounts are credited with AED 5 billion.  Such transactions, therefore, offset the impact of currency flows on banks’ reserve accounts, and thereby ensure overnight interbank rates remain in line with the CBUAE’s target.

To recap:

• Most money in the monetary system is created by commercial banks lending money.
• Central bank money, on the other hand, is largely created by foreign currency flows, but central bank money can influence money supply via interest rates.
• The CBUAE sets interest rates via its Base Rate, which is closely aligned with US interest rates. This rate sets a floor for the interbank market.
• The CBUAE intervenes on the domestic market to ensure that overnight interbank rates align with its Base Rate and so that excess bank reserves are consistent with its targeted level.

What impact does the currency have?

As noted above, the CBUAE operates a fixed exchange rate regime against the US Dollar. This imposes some limitations on the independence of the CBUAE in setting monetary policy. This arises because of what is referred to as the ’Impossible Trinity’, which states that it is impossible to achieve all three policy options simultaneously: a stable exchange rate, free capital movement, and independent monetary policy. As a consequence, policy makers can only choose two out of the three policy options:

To understand why the impossible trinity is impossible, we can consider what would likely occur should the CBUAE attempt to implement all three options simultaneously. In such an example, the CBUAE may decide to implement an expansionary monetary policy by lowering interest rates. In doing so, this lowers UAE interest rates relative to those prevailing in the US, resulting in an outflow of funds, as participants in the local market are able to make risk-free profits by borrowing in UAE Dirhams and depositing at a higher rate in the US.

This form of carry-trade will eventually increase the supply of UAE Dirhams, pushing downward pressure on the currency and prompting the CBUAE to sell its foreign reserves in order to intervene in the market. If such a condition were to persist indefinitely, the CBUAE will eventually exhaust its stock of foreign reserves, resulting in an abandonment of the fixed exchange rate. Overall, any of the three policies listed in the Impossible Trinity will eventually break, should a policy maker attempt to implement all three at once.