The UAE economy today is better prepared for the new world order of lower oil prices versus the previous oil price shock in 2008-09. To withstand this shock better, not only has it built in sufficient economic buffers (IMF estimates low external debt level of 49 per cent of GDP in 2014 and reserves exceeding standard adequacy levels) but has also taken decisive steps towards diversifying its economy. High capital expenditure towards building infrastructure to promote trade, tourism and construction has had a multiplier effect on growth. These steps have been vital in making the much needed structural changes to the economy that are crucial towards diversifying away from heavy hydrocarbon dependence. These government measures to bring in structural changes have been viewed positively by markets, as it signals decisive political will for reforms.

In addition to high capital expenditure, the government has launched radical fiscal reforms on both the expenditure and revenue sides. On the one hand, subsidies on water, electricity and fuel have been cut and on the other, implementation of value added tax (VAT) as well as corporation tax is expected sooner rather than later.

Looking ahead we expect three themes to dominate news flow in 2016 in the UAE; a) sovereign bond issuance/s; b) currency peg and c) sovereign rating implication with persistently low crude. We believe that stronger dollar returns on foreign assets held by sovereign wealth funds (SWF) will likely partially offset the implication on the fiscal and external position of the UAE due to lower crude price and rising US interest rate.

Reduction in subsidy, likely implementation of VAT

In terms of fiscal reforms, the two-pronged approach to maintaining strong fiscal position included a) reduction in subsidy to cut wasteful expenditure; and b) introduction of taxes to diversify sources of government revenue. While the first has already been executed, the second is being discussed on a GCC-wide basis.

Subsidies on water and electricity were reduced not only for expats but also for nationals from January 2015, in a radical move towards expenditure reforms. In another major policy shift, diesel and gasoline prices in the UAE have been linked to global market price. The IMF estimates this reduction in subsidy to be around Dh6.8 billion (0.3 per cent of estimated GDP in 2015).

The other pillar of this two-pronged approach is the diversification of revenue sources through the introduction of taxes – potentially on personal or corporation or both. Introduction of taxes in the GCC has been debated and speculated for a long time. But the announcement of timeframe (of about 18 months) as well as indications that food, education and health care will be exempt from VAT, all point towards a high degree of certainty around its implementation sooner rather than later. This also signals that the UAE/GCC no longer need to attract expat workforce as a tax-free country to work in, as it has become an employer of choice offering world class amenities and infrastructure.

UAE: Key themes for 2016

1. Sovereign bond issues likely in 2016

Looking ahead in 2016, crucial to the continuation of the investment programme will be to plug in possible gaps that may be financial and could possibly involve technical capabilities.

With the drawdown of fiscal and financial buffers the money markets have already begun to indicate tighter liquidity in the banking sector all across the GCC. While Saudi, Oman, Bahrain have already tapped the debt market, UAE has been able to stay away owing to sound buffers and fiscal reforms discussed above. Looking ahead in 2016, we expect the UAE to issue sovereign bonds, possibly more than once. We see this as an opportunity to develop and deepen the local bond markets that are still in nebulous stage. Undoubtedly, capital raised will play a critical role in the continuation of UAE’s investment program that saw delays in projects in non-focus areas in 2015. However, key sectors such as oil and gas, and infrastructure sectors, continue to receive focus. Historical data suggests that investments in oil and gas sector in the UAE have always peaked when oil prices have bottomed. This indicates counter cyclical fiscal loosening pivotal for supporting growth. We believe that government spending will support activity in the oil and gas sector with major projects in this sector likely seeing continued support. In terms of filling in the gap with technical and operational efficiency, passing of the much anticipated PPP law will also play an important role.

2. Currency peg to remain unchanged

Undoubtedly with current account running a deficit on lower oil and rising interest rates in the US, there has been pressure on the dollar-dirham peg. As lower oil persists through 2016 and news flow worsens on liquidity situation owing to falling government deposits, there will be renewed speculation on the peg. We believe that the peg will stay in place helped significantly by better dollar returns on assets held by sovereign wealth funds abroad.

For the peg to stay in place will be beneficial for the economy. This is because upward inflationary pressures caused with the removal of subsidies on water, electricity and diesel and petrol will be partially offset by smaller dollar import bill on food and other necessities. Thus no change in the peg will help keep inflationary pressures in check.

3. Bad news flow to likely not affect sovereign rating

All major ratings agencies place the UAE as high investment grade sovereign backed by largely sound fiscal and external position. Persistently lower crude prices and Fed rate hikes will undoubtedly make policy management challenging. We do not expect news flow to be positive as liquidity tightens and Eibor rises. However, a spate of fiscal reforms in 2015 as well as higher returns from assets held by sovereign wealth funds (SWF) will help the fiscal as well as external positions. With concrete signals on the implementation of VAT and corporation tax in the GCC, the ratings agencies would likely adopt a wait and watch approach.

— Ketaki K. Sharma, Independent Economist – Mena & India