Rising cost of funds will not bode well for the nascent private sector recovery. Image Credit: Gulf News Archives

Dubai: UAE borrowers will face another sharp rise in interest rates from June as the US Federal Reserve prepares for a 50 basis point hike. This could be repeated in July as well.

The Fed’s May meeting minutes showed officials are resolved to raising interest rates aggressively to curb inflation despite fears the US may suffer a recession. The minutes show officials willing to lift Fed funds rate by 50 bps in June and July after May’s 50 bps hike.

“We expect Fed will raise (rates) to 2.75-3 per cent by early next year,” said Mansoor Mohiuddin, Chief Economist at Bank of Singapore. “We think it is too soon for Fed to shift from 50 bps to 25 bps hikes.”

The UAE and other GCC countries are likely to follow the Fed’s tightening cycle to maintain exchange rate stability due to the currencies’ peg to the dollar.

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Wider ramifications

Although banks are key beneficiaries of rising interest rates through higher interest margins, bankers agree that rapid rise in interest rates could have wider ramifications for loan growth and asset quality and that could eventually lead to higher loan impairments.

While the UAE economy is on a strong recovery path driven by rising oil prices and pick up in non-oil activities, rising cost of funds will not bode well for the nascent private sector recovery.

“The biggest casualty is going to be capital expenditure,” said an official with an investment bank. “Rising funding costs will be a deterrent to take on debt, and, on the other hand, rising inflation will make the pass-through of interest costs to customers difficult.”

The rate hikes are coming at a time when many firms are either preparing to borrow more funds for expansion or are required to set aside additional funds to address their deferred obligations and/or refinance existing debt.

Most liquidity measures offered by the Central Bank of UAE under its Targeted Economic Support Scheme will come to a close by end June. Analysts expect higher rates combined with deferred/accumulated debt burden during the pandemic to result in defaults.

“There are potential asset quality deterioration risks, in the later half of the year, when the TESS scheme ends,” said Asad Ahmed, Managing Director and Head of Middle East financial services at Alvarez & Marsal.

Weight of dollar

The exchange rate of the dollar has been rising ever since the Fed began rate hikes. The nominal broad dollar index of the Fed shows the dollar has increased about 9 per cent since its low point a year ago while other indexes registered larger gains. The dollar’s safe haven status in the face of geopolitical uncertainties from the war in Ukraine is also contributing to its gains.

Although a stronger dirham will imply lower imported inflation, it would mean exports and deemed exports like travel and tourism and real estate investments by overseas investors become less competitive.

“Rising borrowing rates combined with rising effective exchange rate will be a double-whammy buyers and sellers in the real estate sector,” said a banker.

Policy options

The UAE and Gulf’s pegged exchange rate regime provides certainty about future exchange rates. While the UAE Central Bank has the option to manage liquidity in the banking systems through banks’ reserve requirements, long-term government bonds, and macro-prudential measures, these have a limited impact on interest rates as lending rates will need to converge with US rates to avoid unwarranted speculation resulting in capital flows.