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UAE businesses must balance as bank lending begins to rise with US rate hikes

By on March 23, 2022 0

Dubai: The US Federal Reserve is hinting at larger interest rate hikes that will have a direct impact on lending rates – and the real effective exchange rate – of the UAE dirham.

On Monday, Fed Chairman Jerome Powell said the central bank needed to move “quickly” to raise rates. “The Fed has already signaled a much stronger appetite to fight inflation, indicating six more rate hikes in 2022,” said Fawad Razaqzada, market analyst at ThinkMarkets. “But judging by Powell’s latest comments and those of some Fed officials, there’s a good chance we’ll even see a 50 basis point increase in May.”

A bigger rise could mean a parallel rise in interest rates in the UAE due to the dirham’s peg to the dollar and the country’s need to maintain stability in its currency and economy.

Not just financing costs

Any increase in rates should lead to higher financing costs for individuals, businesses and even banks, affecting disposable income and profits respectively. It also means much more than higher financing costs for individuals and businesses, especially export-oriented companies.

The rise of the dirham in the direction of the dollar could make UAE exports – including “famous exports” such as tourism, hospitality, investment in UAE asset classes like real estate – less attractive to foreign investors due to inflated valuations resulting from the relative strength of the currency.

Loan growth

UAE bank lending to individuals and businesses has seen anemic growth over the past two years following the pandemic. The rise in US rates therefore came at a time when demand for loans from individuals and businesses is gradually accelerating.

According to data from Alvarez & Marsal Middle East, loans and advances from the top 10 UAE banks, which account for nearly 80% of assets, grew from a modest 1.7% year-on-year in 2021 to a slower pace than deposit growth of 6.7 percent.

Analysts expect the nascent recovery in loan demand to moderate as rising interest costs increase the risk of default. “A rise in interest rates would imply a higher debt service burden for individuals and businesses,” said a senior director of financial services at S&P Global Ratings. “Depending on the pace and overall amount of the increase, some customers may run into difficulty and restructure their debt.”

What is the real effective exchange rate?

The real effective exchange rate is the weighted average of a country’s currency against an index or a basket of major currencies. This is determined by comparing the relative trade balance of a country’s currency to that of each country in the index.

An increase in a country’s REER indicates that its exports are becoming more expensive and its imports are becoming cheaper. It loses its commercial competitiveness.

Why keep the ankle?

A debate on the logic of the pegging of the dirham to the dollar comes to the fore every time there is a big swing in the real effective exchange rate of the currency. Sudden fluctuations in exchange rates have serious consequences for the economy, ranging from instability of asset prices to capital flight. Historically, the peg of the UAE currency to the dollar has largely served the interests of the local economy by protecting it from the wild swings of global markets.

As the dirham exchange rate is fixed against the dollar, any decision contrary to the decision of the US Federal Reserve to change interest rates can lead to speculative pressure on the local currency. Also, if the dirham keeps interest rates lower, there could be an outflow of capital into dollar deposits and dollar-denominated asset classes.

In its latest decision, the US central bank‘s rationale for raising interest rates is fundamentally different from that of the UAE. In the US, a sharp surge in inflation in recent months resulting from the Covid-related economic stimulus has warranted a policy adjustment to rein in prices.

On the contrary, the UAE does not face any significant constraint in terms of inflation to raise lending rates. Consumer price inflation in the UAE is expected to hover between 1.8 and 2.4 percent in the current year.

Expand the basket of currencies?

Despite the monetary stability provided by the peg to the dollar, the extreme volatility of the dollar could raise questions about the need for the United Arab Emirates to peg its currency to a single currency. “While there have been regular calls for GCC economies to abandon the dollar peg over the years, the current environment can be expected to reinvigorate the suggestion again,” Scott said. Livermore, ICAEW Economic Advisor, Chief Economist and Managing Director. , Oxford Economics Middle East.

While a stronger currency erodes competitiveness, a weaker currency can harm economic stability. The United Arab Emirates, with its huge foreign exchange reserves and terms of trade tilted in its favor due to high oil prices, the obvious choice is stability and policymakers are likely to stick with it. anchoring despite its costs.