Low interest rate policy is how the US defends its economy from an economic downturn. But this is also the cause of all recent major economic bubbles, or inflations. First came the US dotcom stock market bubble, then the US and global house price bubble; now food, energy and real estate in the Gulf states.
The UAE Central Bank moved quickly last week to match US base rates of just two per cent, a level appropriate for an economy in recession such as the US but not for the booming Emirates. This lowering of interest rates is most immediately felt in the already overheated real estate sector.
Both local developers and property investors can now borrow at incredibly low interest rates to fund projects. Nakheel's sukuk last week raised money at an effective 4.3 per cent profit rate. With local inflation estimated at running anywhere between 11 per cent and 15 per cent that means real interest rates are sharply negative, and the economy is paying a profit on borrowed money.
The lower the Federal Reserve takes interest rates the stronger this effect becomes. It encourages UAE developers to borrow money to build and sell property; and it encourages local investors to borrow money at cheap interest rates, especially as rental yields of six to eight per cent in Dubai give an instant positive return on that investment.
In the short term, everybody wins. The problem is that the risk of a US-style real estate bust is increased. For let us not forget that it was the low interest rates after the dotcom crash in 2000 that brought on the US house price crash and the sub-prime mortgage crisis, which the IMF says may cost the banks $1 trillion (Dh3.67trn) in write-downs.
If a real estate market is over-stimulated then an excess supply of property is generated – as in the US where stocks of unsold homes actually rose to a new high last month – and the forces of supply and demand eventually implode with drastic implications for prices and volumes, and overstretched developers and investors.
However, the current shortfall of property in Dubai should delay that day of reckoning until at least 2010, according to a report from Swiss bank UBS last week. There is also a shortage of property lending available from local banks, many of which are already at the ceiling of their 20 per cent of capital cap on property lending for 2008. But the risk of the UAE Central Bank pumping up a real estate bubble with ultra-low interest rates is significant, and funds can be borrowed in dollars and switched into dirhams at no risk due to the currency peg.
Perhaps this is one reason why Mohammed Alabbar, Emaar Properties' Chairman, told the Arabian Hotel Investment Conference yesterday that he would like to see Gulf currencies eventually moving to valuation against a basket of currencies rather than being pegged to the US dollar. Alabbar knows how best to preserve a stable property market and not create a bubble.
Inflation is, and always will be a monetary phenomenon. And real estate inflation is only one unwelcome side-effect of the Fed's monetary policy. The same policy is driving food price inflation all over the world. You can certainly point at underinvestment in agriculture – mainly due to the subsidies given to farmers in rich countries – as a contributory factor to food shortages and food price inflation. But it is not the core reason.
We have had bad harvests and poor weather many times in the past without the price of staples such as rice and wheat doubling in a year. It is again the Fed's policy of loose money to save the US economy from its overspending and over-borrowing that is to blame. Hedge funds and other speculators are siphoning this cheap cash into investments in food and energy and forcing prices up, and when they get on a trend they stick with it. The Asian Development Bank says one billion people are going hungry because of recent food price inflation. That is the 600 million who live on less than one dollar a day, and 400 million who have only a little more. When you live on that budget, food is your main expense, and if food prices go up then you starve.
So the rich in the US are offloading their housing crisis on to the poorest of the world. But then you have to ask would it now be better for the Fed to raise interest rates and let the US economy collapse? No, but something radical needs to be done to solve the world food crisis.
How about rebuilding Russian agriculture as a new bread basket for the world? It lags the US in productivity by 80 per cent and a massive investment in modern technology would produce a second green revolution. Arab investors should be looking at redirecting oil revenues into Russian agricultural production, which would be an excellent investment as well as a humanitarian act.
In the meantime, expect to see more social unrest in the Middle East as a result of food price rises. People just refuse to take starvation lying down. Meanwhile, the real estate boom will rage in the Gulf states and another group of people will get even richer. Strange really, the side-effects of US monetary policy.