With the steep increases in interest rates proposed by the US Federal Reserve, the UAE banks are continuously increasing the lending rates of the UAE dirham.
On Monday, Fed Chair Jerome Powell said the central bank must move “expeditiously” to raise rates. “The Fed has already signaled a much stronger appetite to combat inflation, indicating a further six rate increases in 2022,” said Fawad Razaqzada, Market Analyst at ThinkMarkets. “But judging by Powell’s latest comments and those from some of the Fed officials, there is a good possibility that we may even see a 50 basis point increase in May.”
A sharper rise could mean a parallel rise in interest rates in the UAE because of the dirham’s dollar peg and the country’s need to keep its currency and economy stable.
Not just funding costs
Any rate increase is expected to see a rise in funding costs for individuals, companies, and even banks, affecting disposable incomes and profits, respectively. It also means much more than higher funding costs for individuals and businesses, especially export-driven businesses.
The rising strength of the dirham along the lines of the dollar could make UAE exports – including ‘deemed exports’ such as tourism, hospitality, investments in UAE asset classes like property – less attractive to foreign investors because of the inflated valuations resulting from relative currency strength.
Loan growth
The UAE bank lending to individuals and businesses witnessed anemic growth during the past two years following the pandemic. The US rate hike thus has come at a time when loan demand from both retail and corporate borrowers is gradually picking up.
According to data from Alvarez & Marsal Middle East, loans and advances of the UAE’s Top 10 banks that account for nearly 80 percent of assets grew by a modest 1.7 percent year-on-year in 2021 at a slower pace than deposits growth of 6.7 percent.
Analysts expect the nascent recovery in loan demand to moderate because of higher interest costs increasing the risk of loan defaults. “An increase in interest rates would imply a higher debt-service burden for retail and corporate clients,” said a senior director in financial services at S&P Global Ratings. “Depending on the pace and the overall amount of the increase, some clients may experience difficulty and restructure their debt.”
Why keep the peg?
A debate on the rationale of the dirham’s peg to the dollar comes to the fore each time there is a big swing in the real effective exchange rate of the currency. Wild fluctuations in exchange rates have serious consequences for the economy ranging from asset price instability to capital flight. Historically, the UAE’s currency’s anchor to the dollar has largely served the interests of the local economy by protecting it from wild gyrations in global markets.
With the dirham’s exchange rate fixed against the dollar, any move contrary to the US Federal Reserve’s decision to change interest rates can result in speculative pressure on the local currency. In addition, if the dirham keeps lower interest rates, there could be an outflow of capital to dollar deposits and dollar-denominated asset classes.
In its latest move, the US central bank’s rationale to raise interest rates is fundamentally different from that of the UAE. In the US, big surge inflation in recent months resulting from Covid-related economic stimulus has warranted a policy adjustment to rein in prices.
On the contrary, the UAE is not facing any significant compulsion in terms of inflation to increase the lending rates. UAE’s consumer price inflation is projected to hover in the range of 1.8 to 2.4 percent during the current year.
Widen the currency basket?
Despite the currency stability, the dollar peg brings, extreme dollar volatility could raise questions about the need for UAE to peg its currency to a single currency. “While there have been regular calls for the GCC economies to ditch the dollar peg over the years, it can be expected that the current environment will once again reignite the suggestion,” said Scott Livermore, ICAEW Economic Advisor, and Chief Economist and Managing Director, Oxford Economics Middle East.
In case of erosion of competitiveness by a stronger currency, a weaker one could disrupt economic stability. Thus, the UAE with its terms of trade and huge forex reserves has decided to stick to the peg despite its costs as it can help maintain stability and also benefit the businesses in the above-mentioned ways.