The United Arab Emirates dirham (AED) is the official currency of the United Arab Emirates (UAE). It was introduced in 1973 to replace the Qatar and Dubai riyal and is pegged to the US dollar. The UAE dirham is subdivided into 100 fils and is issued by the Central Bank of the UAE.

The dirham is an important global reserve currency and has become increasingly prominent in recent years due to the UAE’s robust economic growth and political stability.

Introduction to the UAE Dirham

The UAE dirham was formally established as the national currency of the UAE on 19 May 1973. It replaced the Qatar and Dubai riyal at par and was initially equivalent to one pound sterling.

When the dirham was introduced, 1 dirham equalled 0.287 grams of gold. This peg to gold was abandoned in 1980. Since 1997, the UAE dirham has been pegged to the US dollar at a rate of 3.6725 dirhams to 1 US dollar. This exchange rate has remained fixed.

The dirham is issued in banknotes and coins by the Central Bank of the UAE. The subdivision fils is represented by coins while banknotes are printed in denominations of 5, 10, 20, 50, 100, 200, 500 and 1000 dirhams.

The UAE dirham is an important reserve currency due to the country’s significant oil exports. It is also widely accepted as a trading currency by oil exporters, importers and investors.

History of the Dirham

The history of the UAE dirham traces back to the mid-20th century when the Trucial States – the individual sheikhdoms along the Persian Gulf coast – used the Gulf rupee as a common currency. The Gulf rupee was introduced by the Reserve Bank of India in 1959 at the request of the Trucial States.

In 1966, India devalued the Gulf rupee due to economic pressures. This had major repercussions for the Trucial States whose economies depended on Indian imports.

To address this, the Qatar and Dubai riyal was introduced in May 1966 to replace the Gulf rupee. The new currency was initially equivalent to one pound sterling and was divided into 100 dirhams.

When the United Arab Emirates formed in 1971, the individual Trucial States began the process of monetary unification. In 1973, the UAE created the UAE dirham to replace the Qatar and Dubai riyal as the unified currency across the Emirates.

Since its introduction, the UAE dirham has been issued by the UAE Central Bank and has evolved into a globally traded reserve currency. The exchange rate regime has transitioned over the years, from a gold standard to being pegged to a basket of currencies and finally to a fixed peg against the US dollar in 1997.

Coins and Banknotes

The UAE dirham has both coins and banknotes in circulation. The fils subdivision is represented in 100 fils to the dirham. The coins come in denominations of 1 fil, 5 fils, 10 fils, 25 fils, 50 fils and 1 dirham.

The UAE Central Bank issues dirham banknotes in the following denominations:

  • 5 dirham
  • 10 dirham
  • 20 dirham
  • 50 dirham
  • 100 dirham
  • 200 dirham
  • 500 dirham
  • 1000 dirham

The banknotes contain various designs that draw inspiration from Emirati culture and heritage. They also have features to prevent counterfeiting such as watermarks, threads, holograms and other anti-forgery mechanisms. The banknotes are mostly cotton-based paper.

The size of the banknotes increases with their denomination. The 5 dirham note measures 149 x 66 mm while the largest 1000 dirham note is 158 x 71mm. The banknotes also vary slightly in color – the 5 dirham is predominantly purple while the 1000 note is predominantly brown.

New banknote designs and security features are introduced periodically to maintain anti-counterfeiting effectiveness. The latest redesign was issued in 2018 for the 5 and 10 dirham notes featuring enhanced imaging techniques.

Monetary Policy and Peg to the US Dollar

Monetary policy and exchange rate policy for the UAE dirham are controlled by the Central Bank of the UAE. The stated objective is to maintain the dirham’s long-term stability against major international currencies.

When first introduced, the dirham was pegged to gold similar to other Gulf currencies. However, from the 1970s, global economies began moving away from commodity-based monetary systems.

In the early 1980s, the dirham shifted to being pegged to a trade-weighted basket of currencies including the US dollar and European currencies. But instability in forex markets during this period led to fluctuations in the dirham’s exchange rate.

To improve stability, the UAE government took the decision to formally peg the dirham to the US dollar in November 1997 at a fixed rate. The exchange rate was set at 3.6725 dirhams to 1 US dollar.

This exchange rate peg has remained unchanged for over 25 years granting significant monetary policy credibility. The dirham can fluctuate between 3.6723 and 3.6725 due to market dynamics but trades within this tight band.

The fixed peg provides stability for traders and investors who can rely on the dirham/dollar rate. It also helps control imported inflation given the extensive use of the dollar for global oil and commodity trading.

The Central Bank occasionally intervenes to maintain exchange rate stability and adequate currency reserves. But no currency controls exist on the dirham and it is freely convertible.

Benefits and Drawbacks of Dollar Peg

The UAE’s long-standing US dollar peg has provided major benefits but also some drawbacks for the economy.

On the positive side, the fixed link with the US dollar has:

  • Provided monetary policy stability – The peg anchors inflation expectations and creates confidence in the dirham’s value. This stable platform has helped drive the UAE’s growth.
  • Lowered currency risk – Importers, exporters and investors enjoy reduced exchange rate risk and volatility which supports trade and investment. The fixed rate simplifies financial transactions.
  • Aligned with oil exports – Oil is priced in US dollars so the peg links the dirham to the currency most vital for UAE’s economy. It provides stability and predictability.
  • Prevented imported inflation – Pegging to the dollar has helped insulate the UAE from inflation problems affecting other currencies like the euro. This preserves purchase power and living standards.

However, there are some disadvantages that should be acknowledged:

  • Reduced monetary policy flexibility – The UAE Central Bank cannot set interest rates or influence money supply since the dirham is tied to US policy. Their control over managing the economy is partially ceded.
  • Exposure to US interest rates – When US rates rise, the UAE also feels the impact through higher borrowing costs even if domestic conditions haven’t changed. This external influence can be problematic.
  • Vulnerability to dollar volatility – If the dollar suffers from extended weakness, it drags down the dirham’s exchange rate versus other currencies. This would hurt purchasing power globally.
  • Incentivizes dollar-denominated borrowing – The fixed peg encourages excessive borrowing in US dollars by UAE entities. This can create currency mismatches on balance sheets.

On balance, the consensus suggests the pros of dollar-pegging still outweigh the cons for the UAE’s circumstances. But the drawbacks show the lack of flexibility. The Central Bank monitors the coherence of the peg as conditions evolve.

Exchange Rate Forecasting and Analysis

Given the dirham’s fixed peg to the US dollar, exchange rate forecasting against the greenback is straightforward. The rate is essentially locked at 3.6725 and no major fluctuations are permitted by the Central Bank.

When looking at currency pairs such as EUR/AED or GBP/AED, the dirham rate against them is primarily driven by dollar exchange rate shifts. For instance, if EUR/USD rises then EUR/AED will rise and vice versa.

The key factors to watch for forecasting the dirham versus other major currencies are:

  • Dollar exchange rate forecasts – The main driver of dirham rate movements
  • Relative interest rate differentials – Impacts capital flows and currency demand
  • Oil price outlooks – Influences dollar and UAE growth prospects
  • US monetary policy – Changes in Federal Reserve stance affects dollar
  • Risk appetite – Demand for safe haven dollars versus emerging market dirham
  • Inflation divergence – Real interest rate differentials impact forex

Analysing dirham pairs requires modeling projections for dollar exchange rates along with local UAE economic factors. Over long timeframes, purchasing power parity models can forecast equilibrium exchange rates. But tactical outlooks are dominated by dollar gyrations.

Given the 3.6725 peg, trading the AED/USD pair offers limited opportunity. Some profit can be captured from minor volatility around the fixed rate. But spreads are tight, and any gaps quickly close. Traders instead focus on AED crosses with other major currencies.

Usage as a Reserve Currency

Beyond its domestic usage within the UAE, the dirham has also become an important reserve currency held by central banks and institutional investors globally.

The dirham ranks within the top 20 most traded currencies overall on the forex market in terms of daily turnover. Its prominence reflects the UAE’s rising significance as a trading hub and provider of investment capital.

The International Monetary Fund reported over $80 billion in UAE dirham reserves being held around the world as of Q1 2022. This was up from just $50 billion in 2015 highlighting the dirham’s growth as a reserve asset.

Central banks in neighboring oil-exporting nations have accumulated reserves in dirhams due to the UAE’s entrepôt status and business ties. The dirham is also held by sovereign wealth funds and institutional investors who value its stable dollar-pegged nature.

While not a major global reserve currency like the US dollar, euro or yen, the dirham has become more prominent over recent decades relative to the size of the UAE economy.

Its growth as a reserve asset reflects the country’s rising economic influence and the dirham’s credibility as a stable store of value secured by substantial government assets and oil exports.

Impact of Higher Oil Prices

Oil exports remain the foundation of the UAE economy comprising close to 30% of GDP. As a result, trends in crude oil prices have a major influence on dirham exchange rates and overall economic performance.

Periods of elevated oil prices tend to boost demand for the dirham and strengthen its rate against other currencies. There are several key effects:

  • Improved trade balance – Higher oil export earnings exceed import costs widening the surplus
  • Dollar strength – Oil traded in dollars so crude price rises buoy the greenback
  • Larger current account surplus – More petrodollars boost national savings and investment flows
  • Fiscal boost – Additional oil revenue allows greater government spending which accelerates growth

However, the impact is partially muted by the dirham’s peg to the dollar. As oil rises, dollar strength limits dirham appreciation versus other currencies. Changes in key oil producer policy also influence currency markets.

Nonetheless, higher crude prices historically support the UAE’s growth outlook and confidence in the dirham. It allows fiscal loosening and more public investment in infrastructure. This energy-led growth typically outweighs shifts in the currency itself.

But if oil spikes well above budgets, it can pressure the dirham peg and may necessitate tightening by the Central Bank to restrain inflation. Managing oil volatility is an ongoing priority for UAE policymakers.

Effects of Rising Interest Rates

With the dirham pegged to the US dollar, changes in Federal Reserve policy and US interest rates have a direct impact on UAE monetary conditions.

When the Fed hikes interest rates, borrowing costs also rise for lenders and consumers in the Emirates despite no action by the UAE Central Bank. This external influence can restrain economic growth.

Higher US rates also affect capital flows. Rising yields on dollar assets increase their attractiveness to global investors. This spurs dollar demand and leads some investment funds to transfer out of dirhams into greenbacks.

Efforts by the UAE Central Bank to maintain the peg in these conditions drain liquidity from the banking system. Increased dirham borrowing costs may be necessary even without domestic inflation.

On the positive side, higher US rates strengthen the dollar which provides some stability for the dirham’s rate against other currencies like the euro. But fundamentally, Fed tightening cycles create headwinds for the UAE economy.

If US interest rates eventually peak and move downward again, it would provide monetary policy relief. But while rising, tightening by the Fed requires vigilance from UAE regulators to prevent instability in financial markets tied to the dirham.

Risks and Challenges for the Dirham

Despite the dirham’s long track record of stability, some risks and challenges persist that could test the currency regime in future:

  • Dollar over-reliance – Dependence on the dollar leaves the dirham exposed if the peg were abandoned due to hyperinflation or other crises. More flexibility could be beneficial.
  • Asset bubbles – Prolonged low US interest rates may have fueled excessive risk-taking and asset price bubbles in UAE real estate and stocks. A correction could destabilize markets.
  • Fiscal loosening – Heavy stimulus spending during the pandemic may have stretched government finances. Returning to austerity post-crisis will require discipline.
  • Oil volatility – Major swings in oil revenues make fiscal planning difficult and drain reserves if crude prices fall. Continued economic diversification is needed.
  • Geopolitical tensions – Ongoing turmoil in the Middle East and potential flareups with Iran contribute uncertainty over regional stability.
  • Dollar overvaluation – Some analysts feel the dollar is fundamentally overvalued. A future rebalancing could pressure the dirham peg if a realignment becomes necessary.

These threats require prudent economic and currency management by the UAE government and Central Bank. But the dirham’s successful track record suggests policymakers have the tools to maintain stability barring serious global crises.

Outlook for the UAE Dirham

The fundamental outlook for the UAE dirham remains steady given the longevity of the dollar peg and the country’s substantial assets backing the currency regime.

Assuming oil prices avoid major plunges, the dirham is expected to see minimal exchange rate movements versus the greenback over coming years. The peg has become entrenched since its 1997 introduction.

Against other major currencies, the path of the dirham will follow dollar exchange rate shifts. If strong US growth lifts the greenback, the dirham would strengthen accordingly versus pairs like EUR/AED.

Inflation may edge up in the UAE as global commodity prices rise but should remain manageable given the Federal Reserve’s tightening cycle to restrain prices. This will help maintain dirham stability.

Fiscal policy will need to normalize following the surge in spending through the pandemic. But the government still has ample reserves and assets to smooth this adjustment.

Geopolitics and oil supply factors inject some uncertainty. But the dirham’s durable dollar peg should ensure it remains an attractive regional haven and reserve currency over the medium term.

Key Takeaways

The UAE dirham has cemented its status as an important global currency due to its stability, full convertibility and the country’s strength as a safe haven for capital flows to the Middle East.

Pegging to the US dollar for over 25 years has been crucial for macroeconomic stability. It has instilled confidence in the dirham for international trade and investments despite various global crises over recent decades.

Looking ahead, the UAE’s significant hydrocarbons reserves, influence as a regional financial center and diversification efforts should help maintain the dirham as a haven even as monetary policy normalizes post-pandemic.

While risks exist, the dirham looks well placed to sustain its credibility and usage for years to come both within the UAE and globally as a cross-border investment and reserve asset.

Conclusion

In this comprehensive guide, we have explored all aspects of the UAE dirham from its origins and development to monetary policy, outlook, and role as a reserve currency. Despite its short history, the dirham has rapidly grown in significance due to the UAE’s stability and increasing importance in the global economy.

While the long-running peg to the US dollar presents some constraints, the overall benefits have clearly outweighed the costs over recent decades. This regime is set to remain entrenched barring a substantial negative shock.

Traders and investors globally should closely follow dirham forex trends as an indicator of Middle East monetary conditions and oil market dynamics. Within its neighborhood, the sturdy dirham serves as a beacon of stability and a trusted store of value.