Middle East lenders will benefit from rate cut

(FILE)   

The UAE’s dollar peg forced the Central Bank to mirror the US Federal Reserve’s massive 1.25 per cent interest rate cut over the past 10 days, which has many in the region worried about a rise in inflation. Experts in the UAE disagree whether the cuts will lead to a marked increase in money supply or fuel inflation, but it seems bank profits will rise due to increasing spreads as lower borrowing costs are not passed on to consumers and corporates.

Abdul Kadir Hussain, Chief Executive of Mashreq Capital, said the rate cuts in the GCC were necessary to avoid pressures on currencies, but the countries “don’t want the domestic economy heating up either”. So the common practice deployed, given the absence of monetary policy tools, is that central banks “try to immunise the impact of lower rates by essentially increasing reserve requirements so banks do not lend very aggressively”.

Consumer and corporate borrowers are unlikely to find cheaper money following the drop in interest rates in the GCC, in sharp contrast to the expected flow of liquidity that is now available in the US. “Banks in the region do not immediately pass these cuts on to consumers,” said Hussain. “The mechanism of increased liquidity and increased money supply is not as automatic as it would be in the US.”

It seems once again banks in the UAE and across the Gulf will benefit from a widening spread between borrowing and lending rates, and can also expect an increase in profits.

But some economists argue mirroring the Fed is increasing money supply and fuelling inflation. Mary Nicola, economist at Standard Chartered in Dubai, said there is “ample liquidity in the market, and lending rates are lower than policy rates, so the problem is that the economy is still being stimulated” in an inflationary environment.

As for increasing reserve requirements, Nicola said these measures have proven to be ineffective in absorbing excess liquidity in developed markets, and will not perform as intended in the Gulf.

“Inflation will rise throughout the region as a result of this cut. The remedy is dropping the peg or currency revaluation, which will absorb some of the liquidity in the market,” said Nicola.

Given the impotent monetary policy tools available to regulators in the region, Hussain believes a government bond market that conducts more expansive open market operations should emerge to soak up excess liquidity and combat inflation. But “for now, the reserve requirement is the biggest tool they have and that is probably what will be used”.

The rate cuts in the US were not followed by similar reductions in the European Union, which will lead to further dollar (and dirham) depreciation. Hussain said in the short term the euro may further appreciate, however by the second quarter this year the dollar should reverse its downward spiral.

If this dynamic materialises, and the dollar’s woes do subside, the rigid peg policy in the GCC may pay off. “I think the dollar has gotten beaten up enough that I would probably be more comfortable in dollars at this point,” said Hussain.