Much has been made regarding the UAE Central Bank's directive for local banks to limit their exposure to state-linked enterprises. The lending limit is capped at a 100 per cent of a financial institution's capital base. While some banks will find it relatively easy to comply, others with an exposure of nearly 200 per cent of capital are asking for more time to implement the directive.
While the process of compliance presents short-term risks, the rewards will probably result in more credit for the private sector and may spur local equity valuations in the long term.
Local banks worry about the speed with which they will have to divest of their assets to meet Central Bank targets. This concern is certainly valid in light of the events that precipitated the US financial crisis: an important mechanism in the "disorderly deleveraging" that took place in the United States shortly after Lehman Brothers' collapse was the so-called "balance sheet effect", whereby eroding capital valuations led financial institutions to sell off assets en masse, further eroding the value of assets that were traded perhaps below their fair value.
This points to the importance of further consultation with financial institutions in the UAE to avoid a similar outcome and perhaps to adopt a more staggered approach to achieve regulatory requirements.
The Central Bank may however be equally worried by the price of inaction. The new regulations also limit lending to a private-sector commercial enterprise to 25 per cent of banks' capital. Non-performing loans (NPLs) held by UAE banks have nearly tripled since the onset of the local financial crisis in 2009 and accounted for 4.6 per cent of total loans in Abu Dhabi banks and 10.6 per cent of total loans for Dubai banks by the end of 2011, according to a recent study by the IMF.
With a significant proportion of Dubai debt set to mature in the next few years, NPLs are expected to rise further, according to the same study. Given the importance of retail investors' perceptions of bank stability and solvency, Central Bank efforts to limit lending may therefore have short-term salutary effects in reducing capital flight and increasing economic stability.
But what of the long-term benefits of obeying these new lending limits? The Central Bank directive was adopted in part to comply with tougher capital adequacy standards as set forth in Basel III. It was also designed to avoid a repeat of the debt crisis that gripped Dubai in 2009: excessive exposure to the property sector by financial institutions is a systemic risk and therefore has wider macroeconomic implications.
However, the effect of limiting local banks' exposure to state-related entities may have longer reaching consequences than simply limiting systemic risk. A parallel with Japan's experience in the 1990s provides some interesting similarities: the low-interest rate environment of the late 1980s resulted in over-investment that pushed up asset valuations to unsustainable proportions.
Recognising this, the Bank of Japan aggressively raised interest rates and burst the bubble. The following "lost decade" was characterised by a period of financial stagnation with banks saddled with bad debt, and reluctant to increase lending to the private sector. While the economy grew on the back of massive government spending, the local equity market (as measured by the MSCI Japan index) lost over 60 per cent of its value from 1989 to present day.
Similarly, the UAE witnessed an investment boom in an environment of low interest rates with nominal rates and credit default swaps increasing as investors sought to reduce their risk. Local stock markets and property valuations plummeted by over 40 per cent following the onset of the crisis.
Looking at Japan's example, the long-term worry now isn't so much the quality of the legacy property portfolio held by local banks as much as it is their capacity to undertake new loans to the private sector. The back story to Japan's capital market underperformance was local banks' lack of willingness and capacity to help spur economic activity in the private sector.
The hope is that UAE Central Bank regulations on lending limits to state-related entities will open up opportunities for the private sector to borrow from local markets. Recent surveys show that the private sector perceives problems with financing to be the biggest impediment to business activity.
The Central Bank regulation may therefore help spur investment activity by small and medium-sized enterprises and in the process boost long-run valuations in local equity markets.
Dr Tarek Coury is the chief economist at Tanween, a property firm based in Doha