Global Investment House –Kuwait – UAE Economic and Strategic Outlook – Monetary Policy – UAE’s currency continues to remain pegged to the US$. The Central Bank (CBUAE) manages money supply growth by aligning interest rates with that in the US, and by issuing certificates of deposit (CDs) to commercial banks in addition to other tools.
With the US$ peg and complete capital mobility, nominal interest rates in the domestic market have tracked corresponding US rates closely. Accordingly, interest on 3 months interbank deposits increased from 4.8% in Q1-2006 to 5.5% by the end of 2006. However, since then interest rates are on a declining trend and have come down to 5.2% by the end of Q3-2007. Following the same trend the deposit rates for the 3 months period also inched up sharply from 3.9% in Q1-2006 to 4.4% by the end of 2006 and then gradually coming down to 4.2% at the end of Q3-2007 which is in line with the declining interest rate scenario in US. Following the Fed’s cut of interest rates in January 2008, CBUAE also cut its repo rates by 0.75% to 3.5% on 22nd January 2008 and again followed the US at the end of January by lowering its repo rates by a further 50 bps. Fed has again cut the rates by another 75 bps to 2.25% on 18th March 2008 with CBUAE following suit and cutting its deposit rate to 2.25% but has left its discount, or lending, rate unchanged.
Interest rates in UAE
2006 2007
(in %) Q1 Q2 Q3 Q4 Q1 Q2 Q3
3 Month Inter-bank Rate (average) 4.81 5.17 5.48 5.38 5.38 5.26 5.17
Lending rate to business (average) 7.93 8.12 8.02 8.05 8.14 7.47 7.77
3 month AED Deposit Rate 3.91 4.16 4.44 4.43 4.34 4.30 4.22
Source: CBUAE
The interest rates for business loans, that had increased from 7.9% in Q1-2006 to a high of 8.1% by the end of Q1-2007, decreased sharply to 7.5% in Q2-2007. However, the interest rates increased again to 7.8% by the end of Q3-2007.
The high inflation and low interest rate environment resulted in increasingly negative real interest rates. This coupled with expansionary fiscal stance have added to the upsurge in credit growth and increased development activity leading to high inflationary pressure.
The broad money supply, as measured by M2, has exhibited consistent positive trend during the past few years. M2 has grown at an exceptionally high rate in the first nine months of 2007, which is primarily attributed to the increase in private sector time and savings deposits (Quasi Money) as well as monetary deposits. The currency in circulation remained constant in Q1-2007 compared to Q4-2006 but then increased from Q2-2007 onwards and stood at AED29.0bn at the end of Q3-2007. Mostly keeping in line with the rising demand deposits, the money (M1) increased by almost 31.0% in the first nine months of 2007 compared to year ending 2006 figure and stood at AED157.2bn.
In the first nine months of 2007, the quasi money witnessed an increase of 25.2% compared to the 2006 ending level. The broad money supply (M2) increased from AED399.3bn at the end of 2006 to AED507.0bn at the end of Q3-2007, an increase of 27.0%. There has also been a consistent rise in the money supply as measured by M3, which was primarily due to a substantial rise witnessed in deposits from the Money supply (M2) in the first nine months of the 2007. However, deposits from the government slightly dropped in Q1-2007 but it rebounded from there and M3 recorded 23.0% growth compared to end figures of 2006.
Major growth in bank credit points to steady demand in the economy….
The healthy credit growth contributed to the expansionary trend in the market. A review of the factors influencing broad money (M2) shows that the effect of net foreign assets was contractionary, as they dropped by 6.7% in 2006 over 2005 and again dropped further by 2.4% in the first nine months of 2007. However, the effect of net domestic credit on broad money (M2) was expansionary, as it first increased by 55.0% in 2006 and then again a further 45.7% in the first nine months of 2007. Claims of the banks on private sector grew rapidly by 32.9% in 2006 to reach AED385.8bn and then a further increase of 22.7% to reach AED473.4bn at the end of Q3-2007. This growth, which has come on top of the double digit growth rates in the previous two years, points at both the demand in the economy and the rapid development of the private sector.
Outstanding CDs continue picking up to control liquidity….
The most popular method used by the CBUAE to regulate money supply is issuing and buying back of CDs. Previously, there had been a major reduction in the liabilities corresponding to CDs of the Central Bank. This shows that either the Central Bank was issuing fewer CDs, or was buying them back from the market, in turn increasing the money supply.
However, there has been a change in the policy lately, with the economy facing inflationary pressures. With the CBUAE persisting on the US$ peg, and accordingly its need to bring down the interest rates in line with Fed, CBUAE had to rely on issuing CDs in order to mop up the excess liquidity. During the first nine months of 2007, a significant amount of CDs amounting to AED58.7bn were issued, compared to AED11.3bn in 2006 as a whole, with the total outstanding reaching AED91bn at the end of Q3-2007.
