UAE faces down financial Godzilla

The best news we've had in weeks is that the so-called interbank market appears to be reviving.

Banks are banking with each other again. That's the best news we've had in weeks. The so-called interbank market appears to be reviving, as measured by the rate banks charge each other to borrow money. The interbank market is a complex world filled with strange-sounding names that you'd expect to encounter in an old monster film - Godzilla v Eibor, son of Libor. Suffice to say that if banks don't trust each other, they generally don't trust companies. And if companies can't borrow for short periods of time to pay for supplies and whatnot, they can go bust even when business is good.

Outside the Gulf and some emerging markets, business is not so good. The US, the Godzilla of global economies, is heading into what looks to be a grinding recession that will send shock waves around the world. According to the latest statistics, 6.1 per cent of America's working population is unemployed. The price of the average American home dropped 16 per cent in July. Foreclosures rose in the second quarter at the fastest pace in nearly 30 years. US economist Nouriel Roubini, whose bearish predictions on the US economy have turned out to be eerily prophetic, is now predicting a global recession, with losses to financial institutions exceeding US$3 trillion (Dh11.02 trillion). So far, we're only up to $637 billion in reported losses, which may provide some inkling of how much pain we're still in for.

Because of this, the western financial system is now being partially nationalised. The terms vary, but essentially Europe, the UK and the US are using taxpayers' money to buy up huge chunks of their respective banking systems to keep them alive. For taxpayers, the upside is that pay cheques will continue to arrive and the corner ATM will continue to spit out cash. Here's what this means for the Gulf: oil prices have fallen to below $75 a barrel, back to where they were a year ago. Economists estimate that lower prices could put Bahrain and Oman's governments into deficit, meaning they will have to borrow money or dip into their assets to keep spending as planned. Here in the UAE, though, the Government has a lot more wiggle-room. Oil prices would have to fall to about $31 a barrel before it had to dip into its purse.

In the meantime, Abu Dhabi is still funnelling surplus oil revenues to the Abu Dhabi Investment Authority, the Abu Dhabi Investment Council, the International Petroleum Investment Company and Mubadala Development Company. They now face the unenviable task of trying to find ways to invest that money profitably in today's markets. On paper, banks in the UAE also remain in good shape, even if it doesn't feel like it to the bankers. The flight of foreign funds out of the UAE over the past few months has created a shortage of cash for lending. Domestic deposits, which still account for the lion's share of bank deposits, aren't growing fast enough to make up for the shortfall.

This needs to be put in perspective. The stress in the UAE banking scene is nothing compared to what we've seen overseas. Economists and bankers say some decline in property prices and lending would actually be a good thing for the country. Already, uncertainty about the longevity of the property boom is prompting developers to shift their marketing from uber-luxury down towards mere mortals, addressing an affordability crisis in housing. And Central Bank officials can only be breathing a sigh of relief that higher interbank rates have cooled what was once runaway lending growth.

Still, it doesn't do the UAE any good if funding dries up entirely. There are justified concerns about the ability of local companies to refinance debts in such a tight funding environment. Doubts also persist about just how badly banks might be affected if and when property prices decline. The Central Bank and Government have stepped in to head off trouble, first by offering to lend banks Dh50bn in cash if they need it and then by guaranteeing deposits and interbank lending.

Now the Government is readying an additional Dh70bn to inject into the banking system, though it hasn't yet said precisely how. Economists and bankers say that one way might be simply to raise the amount of money the government keeps deposited at local banks. Others say a more efficient way to increase the amount of funds available for lending would be to lower the reserve requirement - the amount the Central Bank requires banks to keep deposited with it. The Central Bank could also offer banks longer-term, low-cost loans, they say.

Few, however, think the UAE should follow the US, UK and Europe by buying more shares of the country's banks. Most banks still have ample capital, they say, and most are already owned to some extent by the government. The National Bank of Abu Dhabi and Emirates NBD, for example, are both majority-owned by state entities. The only large, private banks are Mashreq and First Gulf Bank. But there are some who think that raising the Government's stake in UAE banks might not be such a bad idea. Qatar announced this week that its sovereign wealth fund, the Qatar Investment Authority, will buy up to 20 per cent of the country's banks on the local stock market.

Using national savings to prop up bank shares might not be the best way for the UAE to go about it, analysts say. Instead, the Government might be better off following the US example, buying preferred shares that pay an interest rate and give the Government the right to convert them into common shares that it can sell for a profit. That gives banks an incentive to perform well enough to raise private capital and buy the Government out.

Given that the UAE's economy is projected to continue growing despite the global slowdown, the odds may be good that such a deal would pay off. It could provide a way to dispel lingering doubts about the health of banks without putting them under Government control. Most importantly, it would ensure that the banks can keep the economy rolling until the rest of the world recovers. [e-mail]