Those lessons about interest rates need reworking
When the Federal Reserve start a gradual hike in interest rates this week, it will have its impact on cost of funds for individuals, banks and businesses in the UAE. Image Credit: Gulf News

Dubai: The Federal Reserve is set start a gradual hike in interest rates this week that will have its impact on cost of funds for individuals, banks and businesses in the UAE.

The Fed is widely anticipated to hike interest rates by 25 basis points on next Wednesday. A resetting of monetary policy from the historically low interest rates introduced to fight economic contraction from the pandemic has been on cards. While most economies around are on a recovery path with prices on the rise, central banks are forced to tighten interest rates to rein in inflation.

War complicates policy

Markets had been widely anticipating a US interest rate hike in the first quarter of 2022, largely driven by spike in inflation. Price increases in the US continued to surge in February, pushing the annual inflation rate up 7.9 per cent. That is the biggest year-on-year leap since 1982 and up from the 7.5 per cent rate reported in January.

Under normal circumstances, a rate hike to cool inflation is seen as usual policy action. However, the war in Ukraine has complicated the decision as wide-ranging sanctions imposed on Russia will disrupt trade flows resulting in a surge in input costs ultimately undermining the post-Covid economic recovery in the US and economies around the world.

On Wednesday when the Fed is poised to begin raising the benchmark lending rate that was cut to zero at the start of the Covid-19 pandemic in March 2020, it could mark the beginning of a policy tightening cycle that will have consequences for economies around the world.

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.

- Central Bank of UAE

Impact on UAE, GCC

An increase in US interest rates will be immediately reflected in the interest rates across the GCC countries that have their currencies pegged to the US dollar with the exception of Kuwait. In Kuwait too, the dinar is pegged to a basket of currencies dominated by dollar.

In the UAE, lending rates move in tandem with the Fed rates as the Central Bank of UAE (CBUAE) generally mirrors US rates to avoid currency market volatility and speculation against the dirham in the context of the UAE currency’s peg to the dollar.

In its latest Quarterly Economic Review, the CBUAE had hinted at a rate hike in the UAE along the US lines. “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.

Squeeze on borrowers

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.

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 nonperformance. 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,” said Puneet Tuli, an analyst at S&P.

UAE banks to benefit as rates go up
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.
“Broader profitability is expected to be driven by net-interest income (NII) growth as interest rates in the UAE are expected to increase in tandem with rate hikes by the US Federal Reserve,” said Asad Ahmed, Managing Director and Head of Middle East financial services at Alvarez & Marsal.
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.
“On average, banks in the UAE will benefit from the planned increase in interest rates. We calculate a 15 per cent increase in net income and 1.4 percentage-point rise in return on equity for every 100-basis-points increase,” said Mohamed Damak is a Senior Director within the Financial Services at S&P Global Ratings.

Cost of funds, liquidity

The cost of funds will inevitably rise as some deposits migrate to interest-bearing products from no-or low-interest-bearing products. The higher interest rate environment means a higher return on deposits, which could further accelerate deposit growth and relatively cheaper funds for banks compared to capital markets.

Although cost funds of banks are likely to go up, its largely mitigated because most UAE banks are well capitalized and have adequate funding. Utilising the low interest rates environment during the past two years many banks had 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.