Dubai: The UAE Central Bank has raised the base rate on the Overnight Deposit Facility (ODF) by 5 basis points from Thursday (June 17). This decision was taken following the US Federal Reserve Board’s announcement to increase the Interest on Excess Reserves (IOER) by 5 basis points.
The new base rate set by the CBUAE is 15 basis points. The UAE regulator also decided to maintain the rate applicable to borrowing short-term liquidity from the CBUAE through all standing credit facilities at 50 basis points above the base rate.
“The base rate, which is anchored to the US Federal Reserve’s IOER, signals the general stance of the CBUAE’s monetary policy," the Bank said in a statement. "It also provides an effective interest rate floor for overnight money market rates.”
Guidance on rate hikes
The Federal Reserve kept its benchmark interest rates unchanged at near zero as economic recovery continues amid growing concerns over an inflation surge. "Progress on vaccinations has reduced the spread of COVID-19 in the US," the Fed said in a statement. "Amid this progress and strong policy support, indicators of economic activity and employment have strengthened."
It came days after the Labour Department reported that US consumer prices rose 0.6 per cent in May, with a 12-month increase of 5 per cent, marking the largest 12-month increase since the period ending August 2008. Excluding the volatile food and energy categories, the so-called core consumer price index (CPI), the Fed's preferred inflation measure, rose 0.7 per cent in May, following a 0.9 per cent increase in April.
Although the recent spike in inflation is termed by the Fed as transitory, the hawkish stance on earlier than anticipated rate hike in 2023 is likely to have deep impact on global interest rates, capital flows, liquidity and exchange rates.
GCC interest rate outlook
All GCC currencies, with the exception of Kuwaiti dinar, are pegged to the dollar. Interest rates across GCC track US rate movements to avoid speculation and pressure on local currencies that could trigger capital outflows. Although the Fed is unlikely to increase rates before 2023, the hawkish tone of the latest Fed meeting points to at least two hikes in 2023 that will be reflected on GCC interest rates.
Impact on GCC
The Fed has pledged to continue its asset purchase programme at least at the current pace of $120 billion per month until economic recovery makes substantial progress. There is speculation that the tapering (gradual reduction in bond purchases by the Fed) could begin as early as mid-2021, adding to the pressure on emerging market currencies and equities.
Higher US yields and a stronger dollar are likely to reduce the popularity of carry trades, which had bolstered demand for regional debt. “The prospects of a calm carry collection summer seem to be somewhat challenged,” Citigroup Inc. strategists wrote in a note. "Even as Asia is in a better position compared to that last episode of taper chatter in 2013, it is not immune to spillovers from higher US rates and stronger US dollar."
An earlier than anticipated tapering is unlikely to impact GCC’s dollar pegged currencies or result in capital flight as could be the case in many emerging markets.
Emerging market equties
Almost all developing Asian currencies were lower against the greenback after the Fed released forecasts that showed officials anticipate two interest rate increases by the end of 2023 - sooner than many thought. An earlier than anticipated rate hike and pull-back from bond purchase could keep US Treasury yields elevated and weigh on Asian currencies in the near term, particularly those that benefited from large portfolio capital inflows.
Large capital outflows could mean rapid decline in exchange rates of these currencies against the dollar.
Indian rupee outlook
The rupee slipped 33 paise to 73.65 against the dollar in early trade on Thursday, amid strengthening of the greenback. It hints at further pressure on the rupee and India's equity markets amid strengthening dollar and rising US Treasury yields.
Asian currencies started weaker against the greenback this Thursday morning and will weigh on sentiments. The South Korean won fell as much as 1.5 per cent to pace declines in the region, while the Chinese yuan, Indian rupee and Indonesian rupiah each dropped at least 0.5 per cent. Analysts see these losses could mark the start of a new era of declines in emerging Asian exchange rates.