Reins loosen on Abu Dhabi’s austerity as diversified economy bodes well for UAE

The dollar peg will require the UAE to hike its interest rate at least two further times in line with the US Federal Reserve some time later this year. Andrew Parsons / The National

The UAE's economy is set to perform better in 2017 than the previous year, which proved to be slower and more challenging.
Overall growth will reach 2.8 per cent in 2017 from 2.1 per cent in 2016. The outlook for the UAE is quite positive given its more diversified nature compared to other more oil-dependent economies of the Arabian Gulf.
Oil prices are on the cusp of recovery following last year's Opec accord, which is proving to be reassuring for the UAE as well as the rest of the Gulf economies. Dubai's hosting of Expo 2020 will drive government spending and investment. The event will draw in a large number of visitors, boosting private consumption and services exports.
As oil prices begin to make a more solid recovery above US$55 per barrel, the liquidity situation will continue to ease, reflecting not only local but also regional money supply improvements. Liquidity in the domestic banking system tightened because of falling oil prices and reduced government deposits (although private sector deposits are growing).
With the country facing only a modest refinancing schedule over the coming year, the deterioration in global risk appetite is unlikely to be of significant concern.
The 2017 federal budget represents a cautious reversal of the 2016 budget cuts as spending is slated to rise by 2.5 per cent. Dubai will continue to spend, reflecting its more diversified revenue base. Abu Dhabi has announced new development spending plans that suggest its fiscal austerity drive is weakening.
Fiscal consolidation is an important hallmark of any government that is trying to rationalise and prioritise its expenditures. However, too much belt-tightening does not create necessary domestic demand that leads to consumption.
One of the main ways the government is improving fiscal sustainability is through reductions in fuel, electricity and water subsidies. This is not just a measure that translates to direct fiscal benefits but can transform the UAE economy into a more efficient user of energy that will allow it to become regionally more competitive over the long run. The federal government and individual emirates will also make greater use of international bond issuance to avoid draining liquidity from the domestic banking system.
Manufacturing, trade, transport and tourism dynamics will be affected by the moderation in the regional and global economic recovery and, increasingly, uncertainty in the US and China. The UAE will, however, continue to benefit from its safe-haven status in the region and from the lifting of sanctions on Iran. Despite continuing regional tensions, Dubai will benefit as a commercial hub for doing business in and trading with its regional partners.
The dollar peg will require the UAE to hike its interest rate at least two further times in line with the Fed some time later this year. The UAE Central Bank raised the interest rate on its certificates of deposit by 25 basis points in December, mirroring the increase in the key policy rate of the Fed. As the dollar gains in strength, expect the dirham to continue to gain in real effective exchange rate terms over the year, particularly against other emerging-market currencies.
This will weigh somewhat on competitiveness, making it more difficult for the UAE to attract FDI and be a drag on non-oil exports – a concern for Dubai, much of whose export-orientated service sector is directly exposed to currency moves. However, the peg has provided stability for decades and, despite the lack of monetary flexibility, the authorities seem committed to the system.
Although forward rates have risen in response to lower oil prices, representing the market's assessment that there is a small risk of a devaluation of the dirham against the dollar and an increased risk of capital controls, these are highly unlikely given the government's commitment to the peg and the sizeable pool of foreign assets available to protect it if required.
As a counterweight to a stronger local currency, the business environment will remain very pro-business. Even after the introduction of VAT in 2018, the overall tax burden will remain among the lowest in the world, with no stamp duty, capital gains or corporation tax (banks and oil and gas excepted) applied. More essentially, the restrictions on foreign ownership of companies outside free zones (a maximum of 49 per cent) will be eased and free zones will continue to attract foreign investment.
Bankruptcy legislation comes into effect this year, which, alongside the promotion of improved financing opportunities and higher banking liquidity for small and medium-sized enterprises, should boost entrepreneurship and private-sector employment opportunities.
Downward pressure on asset prices should be watched, particularly in the real estate sector, which has already been subject to declines. The slower demand outlook may also contain returns on investment in the transport, tourism and retail infrastructure that are currently under way.
Fuel prices are now indexed to international prices, which will begin to trend up in 2017, pushing up fuel, transport and utility costs. The removal of other subsidies and new levies on various services will put pressure on prices, although weaker European currencies will tame imported inflation. Inflation in 2017 will not exceed 2 per cent on average.
Overall, the UAE is on a solid path of recovery and is set to be the Gulf's strongest economic performer for 2017.
John Sfakianakis is the director of economic research at the Gulf Research Centre in Riyadh.
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