UAE will closely mirror US interest rate hikes. What will this mean for businesses and individuals tapping bank loans and credit? Image Credit: Shutterstock

Dubai: The US Federal Reserve is hinting at sharper increases in interest rates and which will have direct impact on lending rates - and the real effective exchange rate - of the UAE dirham.

On Monday, Fed Chair Jerome Powell said the central bank must move "expeditiously" to raise rates. “The Fed has already signalled a much stronger appetite to combat inflation, indicating a further six rate increases in 2022,” said Fawad Razaqzada, Market Analyst at ThinkMarkets. “But judging by Powell’s latest comments and those from some of the Fed officials, there is a good possibility that we may even see a 50 basis point increase in May.”

A sharper rise could mean a parallel rise in interest rates in the UAE because of the dirham’s dollar peg and the country’s need to keep its currency and economy stable.

Not just funding costs

Any rate increase is expected to see a rise in funding costs for individuals, companies and even banks, affecting disposable incomes and profits, respectively. It also means much more than higher funding costs for individuals and businesses, especially export-driven businesses.

Rising strength of the dirham along the lines of dollar could make UAE exports - including ‘deemed exports’ such as tourism, hospitality, investments in UAE asset classes like property - less attractive to foreign investors because of the inflated valuations resulting from relative currency strength.

Loan growth

The UAE bank lending to individuals and businesses witnessed anemic growth during the past two years following the pandemic. The US rate hike thus has come at a time when loan demand from both retail and corporate borrowers are gradually picking up.

According to data from Alvarez & Marsal Middle East, loans and advances of the UAE’s Top 10 banks that account for nearly 80 per cent of assets grew by a modest 1.7 per cent year-on-year in 2021 at a slower pace than deposits growth of 6.7 per cent.

Analysts expect the nascent recovery in loan demand to moderate because of higher interest costs increasing the risk of loan defaults. “An increase in interest rates would imply a higher debt-service burden for retail and corporate clients,” said a senior director in financial services at S&P Global Ratings. “Depending on the pace and the overall amount of the increase, some clients may experience difficulty and restructure their debt.”

What Is the Real Effective Exchange Rate?
The real effective exchange rate is the weighted average of a country's currency in relation to an index or basket of major currencies. This is determined by comparing the relative trade balance of a country's currency against that of each country in the index.

An increase in a nation's REER is an indication that its exports are becoming more expensive and its imports are becoming cheaper. It is losing its trade competitiveness.

Why keep the peg?

A debate on the rationale of the dirham’s peg to the dollar comes to the fore each time there is a big swing in the real effective exchange rate of the currency. Wild fluctuations in exchange rates have serious consequences for the economy ranging from asset price instability to capital flight. Historically, the UAE’s currency’s anchor to the dollar has largely served the interests of the local economy by protecting it from wild gyrations in global markets.

With the dirham’s exchange rate fixed against the dollar, any move contrary to the US Federal Reserve’s decision to change interest rates can result in speculative pressure on the local currency. In addition, if the dirham keeps a lower interest rates, there could be outflow of capital to dollar deposits and dollar-denominated asset classes.

In its latest move, the US central bank’s rationale to raise interest rates is fundamentally different from that of the UAE. In the US, a big surge inflation in recent months resulting from Covid-related economic stimulus has warranted a policy adjustment to rein in prices.

On the contrary, the UAE is not facing any significant compulsion in terms inflation to increase the lending rates. UAE’s consumer price inflation is projected to hover in the range of 1.8 to 2.4 per cent during the current year.

Widen the currency basket?

Despite the currency stability the dollar peg brings, extreme dollar volatility could raise questions about the need for UAE to peg its currency to a single currency. “While there have been regular calls for the GCC economies to ditch the dollar peg over the years, it can be expected that the current environment will once again reignite the suggestion,” said Scott Livermore, ICAEW Economic Advisor, and Chief Economist and Managing Director, Oxford Economics Middle East.

While a stronger currency erodes competitiveness, a weaker one can hurt economic stability. The UAE with its huge forex reserves and terms of trade tilted in its favour due to high oil prices, the obvious choice is stability and the policy makers are likely to stick to the peg despite its costs.