Big opportunities with lower interest rates

Bringing down the cost of borrowing encourages investment and spreads liquidity. The signs are good that this will continue, giving the UAE economy a welcome boost.

Central Bank data show deposits rose by 14.3 per cent in March compared with the same month last year to Dh1.1 trillion. Andrew Parsons / The National
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After remaining stubbornly high over the past two years, interest rates in the UAE are finally beginning to come down and the lower cost of borrowing should ultimately contribute to strengthening growth in the economy.

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Last Updated: May 17, 2011

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The financial system has notably received substantial inflows of liquidity in the first part of this year, which have served to push interest rates and credit spreads down.

One of the most visible signs of this has been the easing in Emirates interbank offered rates (Eibor), which serve as an important benchmark for pricing many corporate loans, funding operations and other borrowings.

The three-month Eibor began to head lower early last month. After remaining largely unchanged since October at about 2.13 per cent, it finished last month below 2 per cent.

Many observers follow the spread between Eibor and US dollar London interbank offered rates (Libor) as a gauge of local money market conditions.

Since the dirham is pegged to the dollar, economic theory says the interest rates for these two countries should be linked as well, with any difference representing idiosyncratic local market conditions.

Thus the difference between Eibor and US dollar Libor can be seen as a measure of the liquidity/credit premium in the local interbank market compared with the dollar funding market in the US.

The spread between these two benchmark rates in the three-month tenor has fallen from 185 basis points earlier in the year to less than 170 points in the early part of this month, and has plenty of room to fall further.

It is useful to examine the broader monetary backdrop. Increased liquidity in the banking system has been the primary driver of changing conditions, with strong growth in bank deposits.

Central Bank data show deposits rose by 14.3 per cent to Dh1.1 trillion (US$300.85bn) in March compared with March last year. Deposits were up 5.3 per cent in the first three months of the year alone.

This has helped to push banks' loan-to-deposit (LTD) ratios lower. The ratio for the banking sector as a whole fell below 100 per cent in October for the first time since 2007, meeting the target threshold set by the Central Bank.

Continued improvement in this measure over the following months has helped to restore confidence in the development of a sustainable trend, and the LTD ratio fell further in March to 94.8 per cent.

As the supply of deposit funding demonstrated sustained gains, this put downward pressure on the market price for deposits (that is, interest rates paid), and banks began lowering rates they pay on deposits from the early part of this year.

By mid-March, the lower rates gave investors incentive to look elsewhere to generate higher yields. About the same time consensus built regional political unrest had stabilised. These conditions created demand for local bonds. Ample liquidity from local investors, improving liquidity ratios in banks and a rally in local credit all set the stage for the drop in Eibor last month. Continued pressure from these factors should sustain the downward momentum in interbank rates over the coming months.

At the same time, the supply of funds available and an improving economic backdrop should spur businesses to raise funds in the local market to finance expansion.

So far this year, there have been three large bond issues in the UAE.

Emaar raised $500 million in a sukuk sale announced in January. The International Petroleum Investment Company successfully sold €2.5bn (Dh12.97bn) and £550m (Dh3.27bn) during challenging market conditions in early March, and Mubadala Development, a strategic investment company owned by the Abu Dhabi Government, sold $1.5bn last month.

Conditions appear optimal for further issuances, with credit spreads much tighter than a couple of months ago and US dollar interest rates near their lows for the year.

Despite rising liquidity and an increase in money supply, growth in bank loans and advances has been slow and has remained subdued since in late 2008. After some signs of a gradual pickup in bank credit last year, loan growth stagnated towards the end of it.

There have been green shoots in the first couple of months of this year, although loans were still up only 2.5 per cent in March compared with March last year.

But continued downward pressure on Eibor should eventually feed into stronger credit growth. At a sector level, a few areas have recently demonstrated growth.

Increases in credit to heavy industry and personal loans for business purposes have shown signs of nascent growth, according to recent data from the Central Bank.

The latter augurs well for optimism among small and medium-sized businesses, an important engine of economic growth. In short, recent moves in Eibor and bond yields are a reflection of opportunities to earn relatively high rates of return in local fixed income markets.

The scope for further falls in rates should reveal itself in greater opportunities for companies to raise money more cheaply, and for these benefits to filter through to consumers and businesses.

Tim Fox is the head of research and chief economist at the global markets and treasury division of Emirates NBD, but is writing here in a personal capacity