ABU DHABI // Central banks around the world are cutting interest rates to reduce the price of money and soften the impact of the global recession on their economies. But in the UAE, the Central Bank is doing the opposite. Since last month, the Central Bank has stopped matching interest rate cuts by the US Federal Reserve, effectively raising the relative cost of funds even as evidence mounts that the global recession is cooling the country's economic expansion.
It is an unusual policy stance, one normally taken by nations with big trade deficits and bigger debts that lose the faith of foreign investors. That the UAE has chosen to adopt it underscores a structural weakness in the economy, economists say. As the UAE has opened its economy and diversified away from oil, it has become increasingly reliant on borrowing from overseas. That has left its relatively small economy vulnerable to the kind of sudden shifts in foreign investment it has experienced since August.
With foreign funds likely to be in short supply for years, economists say, the country may increasingly need to tap its oil revenues for growth. "Some of the oil proceeds need to stay in the domestic economy," said Marios Maratheftis, an economist at Standard Chartered Bank in Dubai. What that might mean for the goal of Gulf monetary union is unclear. Gulf central bankers have agreed on the need to harmonise interest rates, but since the start of the subprime crisis last year Gulf policy rates have grown farther apart.
Why the Central Bank has taken such an unconventional position remains a mystery: unlike most other central banks, it seldom explains its decisions. Officials at the central bank could not be reached to comment for this article. Normally, the bank does not need to explain its decisions. Because the dirham is pegged to the US dollar, the Central Bank typically adjusts interest rates in sync with the Fed, as do other members of the GCC. "In a normal situation, all of the central banks in the Gulf would be tracking the Fed," said Tristan Cooper, an analyst at Moody's Investors Service in Dubai.
Most Gulf banks are still tracking the Fed - and then some. As falling oil prices and investment sap growth, Saudi Arabia, Kuwait and Bahrain have been cutting even more aggressively than the Fed. That mirrors the response by central banks from China and India to Hungary and Brazil. But not the UAE. When the Fed cut its discount rate by half a percentage point in late October to 1.25 per cent, the Central Bank did nothing. The Fed dropped the discount rate three-quarters of a point to 0.5 per cent this month and, again, the Central Bank has stood pat. For the UAE, doing nothing when the US central bank cuts is tantamount to raising the relative cost of funds to the economy.
The UAE is not alone among GCC members in taking such an unconventional monetary stance. Qatar has also left rates unchanged. It is usually only dire financial circumstances that force countries to raise rates in the face of economic downturns. "In some emerging markets, they don't have much scope to loosen their monetary policy," said Miguel Savastano, an economist at the International Monetary Fund in Washington, DC.
Countries facing balance-of-payments crises, for instance, such as Iceland, the Ukraine and Pakistan, have all been forced to raise interest rates despite the fact that doing so exacerbates the effects of a slowing global economy. The UAE would appear to be a photo-negative of these economies: its oil exports give it a huge trade surplus, current account and accumulated government budget surpluses. The problem is that excluding oil, the UAE's economy is in deficit. And since most oil revenues are channelled into sovereign wealth funds for investment abroad, the non-oil economy is reliant on foreign capital.
According to Global Investment House in Kuwait, the UAE raked in US$33.7 billion (Dh123.7bn) in external financing last year, more than all the other Gulf nations combined. That influx fed an inflationary growth in credit that Standard Chartered estimated at 49 per cent a year. The Central Bank tried to put on the brakes by keeping its rates below the Fed's. That was a controversial policy, too, since low rates also tend to worsen inflation and inflation in the UAE was estimated to be running near 12 per cent.
Much of the money coming into dirham bank deposits at the time was from investors betting that the UAE would revalue the dirham upward to beat back inflation. By August, however, foreign investors had given up on revaluation and started pulling out. "The sudden and fast liquidity outflow was due to the sudden exit of the hot money that was piling up to take advantage of the widely expected UAE dirham revaluation, which was ruled out just before summer," the Central Bank governor Sultan bin Nasser al Suwaidi said at a conference earlier this month.
As foreigners left, banks trying to generate cash to lend had to reach into international credit markets, only to see those lines dry up as the global financial crisis hit. The Government and Central Bank have responded with Dh120bn in liquidity measures. But with the rules on those still unclear, bankers say they have been of limited effectiveness. The lending rate between UAE banks remains near its highest in a year and banks are vying for domestic cash by offering higher and higher deposit rates.
Thus, economists say, the Central Bank is letting its rate float upward to try to lure some of those foreign funds back in, or at least prevent more funds from flowing out. Whether that will work is another question, however. Global investors are still eschewing emerging markets in favour of the safety of the US dollar and US government bonds. To have any real appeal, they say, UAE rates would need to be much, much higher. @Email:firstname.lastname@example.org