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A hike in interest US interest rates will be reflected in the UAE’s lending rates as the Central Bank of UAE (CBUAE) generally adjusts the domestic interest rates in tandem with the US rates. Image Credit: Supplied

Dubai: The Federal Reserve Chairman Jerome Powell, testifying at his confirmation hearing on Tuesday said he wouldn’t hesitate to raise the interest rates to rein in inflation.

A hike in US interest rates will be reflected in the UAE’s lending rates as the Central Bank of UAE (CBUAE) generally adjusts the domestic interest rates in tandem with the US rates to avoid currency market volatility and speculation against the dirham in the context of the UAE currency’s peg to the dollar.

Even ahead of Powell’s confirmation that the Fed is going ahead with a rate hike plan, the CBUAE had hinted that a rate hike could be imminent.

In its latest Quarterly Economic Review, the central bank said that the CPI inflation rate in the UAE turned positive during the third quarter of 2021, for the first time since Q4 2018, at 0.6 per cent year on year. The CBUAE expects that although the domestic inflation is expected to remain moderate, global price pressures and the Fed’s move to rein in US inflation is expected to see interest rates going up.

“Rising inflation is expected to result in an increase in the Federal Funds Rate which would lead to an increase in CBUAE’s base rate applicable to the Overnight Deposit Facility (ODF), which provides an effective interest rate floor for overnight money market rates in the UAE,” the central bank said.

Borrowers face higher cost

An interest rate hike would impact cost of funds of both banks and borrowers translating into higher financing costs at all levels.

Individuals and corporates who have fixed rate loans will stand to benefit if their rates are locked for the entire term of the loan. Those who have loans with flexible rates will see an immediate jump in their interest costs as and when the Fed decides to hike the rates.

Although the Fed chairman did not give any hint when the rate hikes will start, Investors are betting the Fed will begin raising its benchmark federal funds rate in March up to 4 hikes this year, two years after cutting it to nearly zero at the onset of the pandemic in March 2020. A Fed officials in December said they would accelerate end of their asset purchase programme, and forecast they would raise rates three times this year.

“Powell noted that the Fed could hike rates to rein in inflation. What he didn’t say was also important. He didn’t back four rate hikes in 2022, nor a March start to hikes,” said Jeffrey Halley, Senior Market Analyst, Asia Pacific, OANDA.

UAE banks to benefit

The hike in interest rates will come as a big boost to the UAE’s banking sector’s profitability that suffered prolonged margin squeeze due to low interest rates.

With the rising interest rates, net interest margins (NIMs) of UAE banks are expected to improve.  NIM is a measurement comparing the net interest income a bank/financial firm generates from credit products like loans and mortgages, with the outgoing interest it pays to depositors and other sources of its funding.

The impact of higher interest will be reflected on the profit and loss accounts of banks fairly quickly as the rate hikes take effect almost immediately on loans and the impact on deposit rates could be lower and comes with a lag.

Funding and liquidity

Although cost of funding of banks are likely to go up, most UAE banks are well capitalized and have adequate funding. Utilising the low interest rates environment during the past two years most banks have front loaded their fund raising activity.

In addition, most UAE banks have a significant share of CASA (current and savings account) in their funding mix and in some cases it is as high as 50 per cent, giving them a clear hedge against an immediate rise in cost of funds.

The Advances to Stable Resources Ratio (ASRR) of the banking system increased from 77.7 per cent at the end of June 2021 to 77.9 per cent at the end of September 2021, which indicates that the structural funding of the banking sector remains sound. With the loans to deposit r (LTD) ratio for the whole banking system at 91.5 per cent at the end of the third quarter due to the higher growth in deposits compared to loans banks are amply liquid.

In addition, the central bank has assured that it will be monitoring economic and financial developments and the liquidity situation of banks operating in the UAE to support the financing needs of the private sector. CBUAE reaffirmed in Q3 2021 its continued commitment to supporting the economic recovery through the Targeted Economic Support Scheme (TESS) and confirmed that withdrawal of emergency measures introduced in response to the pandemic will be gradual and appropriately timed.