Predicting United Arab Emirates' real effective exchange rates using oil prices

• Author: Bassam AbuAl‐Foul,Hamid Baghestani
• Published date: 01 December 2019
• Date: 01 December 2019
• DOI: http://doi.org/10.1111/opec.12166

Predicting United Arab Emirates’ real

effective exchange rates using oil prices

Hamid Baghestani and Bassam AbuAl-Foul

Department of Economics, School of Business Administration, American University of Sharjah, P.O.

Box 26666, Sharjah, UAE. Email: baghesta@msn.com

Abstract

We examine whether oil prices help produce accurate forecasts of the real broad effective

exchange rate of the United Arab Emirates (UAE). Using monthly data for 1994–1999, we

formulate a univariate moving average (MA) and an augmented moving average (A-MA) model to

generate multi-period forecasts of UAE real exchange rates for 2000–2019. The MA model utilises

past information in real exchange rates, while the A-MA model utilises past information in both

real exchange rates and oil prices. Our results indicate that oil prices help produce accurate

forecasts of UAE real exchange rates only for 2000–2009; that is, for this period, the A-MA

forecasts are unbiased, outperform the MA forecasts and are directionally accurate. As for 2009–

2019, we take a non-parametric approach and show that oil price changes accurately predict

directional change in UAE real effective exchange rates.

1. Introduction

As one of the most closely watched indicators, crude oil prices play a major role in both

oil-exporting and oil-importing economies. Numerous studies have examined the impact

of oil price shocks on such important macroeconomic indicators as output, inflation,

employment, terms of trade and exchange rates. Focusing on the latter indicator, we

investigate whether oil prices have predictive power for the real effective exchange rate

of the United Arab Emirates (UAE). Over the last few decades, the UAE has experienced

remarkable economic growth and tremendous transformation from an underdeveloped to

a modern economy. Contributing factors include greater participation in international

trade, attracting foreign direct investment and a high level of financial development .

However, as a major oil exporter with a free-market economy, the UAE faces significant

long-term economic challenges due to heavy dependence on oil revenue. In order to

reduce this dependence, various economic diversification plans have been put in place

with the goal of positioning the UAE as a global trade and tourism hub. The recent

success of these plans can be attributed, among others, to the distinct geographical

location that has made the UAE a transit route for many goods and attracting foreign

©2020 Organization of the Petroleum Exporting Countries. Published by John Wiley & Sons Ltd, 9600 Garsington

Road, Oxford OX4 2DQ, UK and 350 Main Street, Malden, MA 02148, USA.

492

direct investment (FDI). Free-trade zones, established across the country, offer zero taxes

(in addition to full ownership) to foreign companies that have chosen the UAE as a

regional base.

Our emphasis on effective exchange rates in this study follows the notion that such

rates provide a better indicator of the macroeconomic effects of exchange rates than any

single bilateral rate (Klau and Fung, 2006, p. 51). The UAE has a floating exchange rate

with many trading partners, but not with the United States. In particular, the UAE dirham

has been pegged to the US dollar at a fixed rate of $1–3.67 dirhams since 1997, and

before then, it was pegged to the International Monetary Fund’s special drawing rights.

In addition, we focus on the real (not nominal) effective exchange rate, since it accounts

for the relative price of domestic and foreign goods and, thus, helps assess the UAE’s

trade competitiveness in the world economy. The literature points to the real exchange

rate as one of the key drivers of economic growth and employment through its influence

on both trade and FDI (Goldberg and Klein, 1997; Villavicencio and Bara, 2008; Al-

Abri and Baghestani, 2015; Guzman et al., 2018). In particular, Guzman et al. (2018)

emphasise the importance of a stable and competitive real exchange rate poli cy for both

macro-stability and economic development.

Research indicates that oil prices contain useful information for predicting various

real exchange rates (Amano and Van Norden, 1998a, 1998b; Chen and Chen, 2007;

Lizardo and Mollick, 2010). Motivated by such evidence, and given the importance of

real effective exchange rates as an indicator of competitiveness in the world economy,

we examine whether oil prices help predict the UAE real effective exchange rate for

2000–2019. Specifically, we employ the monthly data for 1994–1999 to formulate two

forecasting models for generating the multi-period forecasts of the UAE real exchange

rate for 2000–2019. The first model is a univariate moving average (MA) that utilises

past information in real exchange rates, and the second one is an augmented moving

average (A-MA) model that utilises past information in both real exchange rates and oil

prices.

1

We show that the A-MA forecasts for 2000–2009 are unbiased, outperform the

MA forecasts and are directionally accurate. For 2009–2019, however, the A-MA

forecasts fail to outperform the MA forecasts and are directionally inaccurate, meaning

that the A-MA model loses its ability to accurately predict the UAE real effective

exchange rate soon after the 2008 global financial crisis. This is not surprising due to the

structural change in the relationship between the UAE real effective exchange rate and

oil prices around 2008.

More specifically, as shown in Figure 1, this relationship appears to be positive up to

2008 but negative afterwards. The theoretical transmission channels, including the

wealth transfer (Golub, 1983; Krugman, 1983a, 1983b) and terms of trade (Amano and

Van Norden, 1998a, 1998b; Chen and Chen, 2007), describe why and how oil price

fluctuations influence a country’s exchange rate. A common conclusion is that a rise in

©2020 Organization of the Petroleum Exporting Countries OPEC Energy Review December 2019

Predicting UAE real effective exchange rates 493