Dubai: As the US Federal Reserve is set to raise rates for the first time in three years and give guidance on future tightening on Wednesday, borrowing rates in the UAE are expected to see a spike almost immediately.
A hike in US interest rates will be reflected in UAE’s lending rates as the Central Bank of UAE (CBUAE) generally adjusts the domestic interest rates in tandem with the US moves to avoid currency market volatility and speculation against the dirham given its peg to the dollar. Although the UAE’s current inflation does not warrant a rate hike, the CBUAE usually follows the Fed's lead in setting domestic rates.
“Rising inflation [in the US] 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.
Impact on banks
The hike will come as a big boost to the UAE’s banking sector’s profitability that suffered prolonged margin squeeze due to low interest rates. Net interest margins (NIMs) 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, while the impact on deposit rates could be lower and comes with a lag. 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.
Analysts see a higher loan charge could push up mortgage, personal-loan rates and rates on funding to small and medium enterprises. This along with the gradual end to the central bank support to banks by June this year is likely to see some increase loan defaults.
“For corporate exposures, we expect banks to adopt a pragmatic approach by not reflecting the full extent of the increase in rates whenever this could dip their clients to non-performance," said Puneet Tuli, an analyst at S&P. "For retail customers, stress tests applied by banks to mortgages at inception in relation to an increase in rates, exposure granularity, and salary assignments will act as mitigant.”