Many SME owners are hopeful that a faster economic recovery supported by higher oil prices will improve their cash flows and debt repayments. Image Credit: Rawpixel on Unsplash

Dubai: A gradual but steady rise in interest rates in the UAE will come as an additional burden on the small and medium enterprises (SMEs) that are yet to recover fully from the impact of COVID-19, according to industry participants and financial experts.

The Central Bank of UAE (CBUAE) raised the interest rates by a quarter of a per cent last week in tandem with the Federal Reserve. The rate hike guidance points to four to six more increases translating to a one per cent to 1.5 per cent increase in the lending rates this year.

Although the central bank has increased only 0.25 per cent in the first hike since 2018, with the prospect of further rate hikes looking real, the net burden of increase in interest rates on SMEs and low rated companies could be much larger as banks have the discretion to set their lending rates based on the credit standing of the company.

Squeeze on margins

“The current lending rates for SMEs range from 12 to 18 per cent, depending on the company’s debt servicing history, cash flow and the bank’s assessment of risk. The new round of rate hikes that started last week is likely to have further increments will be an additional squeeze on margins,” said George Mammen, who runs a steel fabrication unit.

The UAE SME’s had been under significant financial stress since 2014 following the collapse of oil prices that led to a rupture of payment cycle leading to a large number of business owners defaulting their loan obligations.

The rate increase also follows a period of severe margin squeeze following the pandemic that saw SMEs were forced to give significant price discounts on sales to keep up the business volumes.

SME Business in the UAE tends to operate with low liquidity and low margins and with the Central Bank of UAE following Fed’s in a rate hike, the companies who take on debt for working capital may bear higher loan charges which could pressurise their business operations

- Vijay Valecha, Chief Investment Officer, Century Financial

Pandemic hit UAE SMEs at a time they were recovering from the previous shock. Although the loan deferrals allowed under the CBUAE’s Targeted Economic Support Scheme (TESS) prevented loan defaults to a large extent, the debt burdens of deferred loans and accrued interests are weighing on many companies.

“Higher interest rates are certain to add to pressures faced by SMEs. Russia-Ukraine war has resulted in a significant increase in shipping costs and general input costs. More future rate hikes are a matter of serious concern for small businesses,” said Raju Menon, Chairman and Managing Partner of Kreston Menon, a business advisory and accounting firm.

Banks to remain cautious

Banks have remained largely cautious with tighter lending standards in the context of tough business conditions during the pandemic. With a significant chunk of restructured and or deferred loans sitting on their books, an early easing of lending norms are unlikely. This will mean small-business owners will feel the impact of the rate increase with more expensive loans.

Although banks swear by their commitment to SME lending, they are cautious when it comes to lending to the sector.

“Lending to SMEs is a high margin business, but with higher margins come higher risks. In this context banks will be cautious in their risk assessment,” said the Chief Financial Officer of a local bank.

What's next?
Analysts see higher loan charges along with the gradual end to the central bank support to banks by June-end this year is likely to see some increase loan defaults. The UAE banking sector had an aggregate of 6.1 per cent (of total loans) as Stage 3 loans [classified as impaired under IFRS 9 accounting standards]. This is expected to spike to more than 7 per cent this year.

“A higher loan charge could push some mortgage or personal-loan clients to the edge of default, while at the same time pressuring small and midsize enterprises (SMEs) that are still healing from the impact of the COVID-19,” said Puneet Tuli, an analyst at Standard & Poor’s.

Relationships matter

Big corporates are likely to remain largely insulated from the rate hikes as banks tend to be more lenient because of the long term relations, cross-selling opportunities, better credit standings and higher volumes of business they bring.

Banks also will be cautious in pushing large corporates to a crisis because they [banks] have more to lose.

For corporate exposures, we expect banks will adopt a pragmatic approach and would not reflect the full extent of the increase in rates whenever this could push their clients to non-performance

- Puneet Tuli, an analyst at Standard & Poor’s

Clearly, looking ahead, small businesses loans, personal borrowings and mortgages are going to see rates going up as the central bank increases rates. In addition, the guidance on further rate hikes is likely to prompt banks to front-load future hikes into their current lending rates.