UAE shock absorbers can handle hard hits

Strong links here with the US mean any major economic upheaval there will be felt to some extent in the Emirates. Yet there are good reasons to feel relatively safe.

Any change in the direction of the US stock markets would directly affect local bourses. Above, traders work on Wall Street. Scott Eells / Bloomberg News

Every year the World Economic Forum publishes its Global Risk report to highlight the perils as it sees them for the next decade.

These are classified into five categories: economic; environmental; geopolitical; societal; and technological. This year, economic risks have gained prominence and, in particular, the forum identifies the threat of "chronic fiscal imbalances".

These arise when there is a sustained mismatch between revenue powers and expenditure responsibilities of a government.

Today, the euro zone and the United States are two epicentres of chronic fiscal imbalances. Causes for the euro-zone crisis abound but fiscal profligacy is not the least of them. The consolidation facing the European periphery weighs heavily on their growth.

While the euro crisis continues to take a toll on global growth, the US has its own fiscal woes. According to the IMF, if the US fails to avert a fiscal crisis - by enacting a bundle of tax increases and spending cuts at the end of this year and early next year - the economic effects would be severe.

The US economy could contract early next year and the negative spillovers would be felt around the world.

From the UAE's perspective, chronic fiscal imbalances are an external risk - one that emanates from outside the country. Nonetheless, the UAE - because of its global linkages and relatively open economy - is more vulnerable than any other country in the GCC.

Let us now see how these imbalances can spill over, or have probably already spilt over, to the UAE. A recent IMF paper calculates this on the basis of a spillover coefficient (SC) - a measure of distress dependence, which captures the chances of distress of a country as it is affected by conditions in other economies.

Greece contributed more than 60 per cent to changes in Dubai's SC from July last year to January this year. And, along with Italy, Portugal and Spain, it accounted for almost 80 per cent of the contagion risk to Dubai.

Clearly, financial contagion to Dubai from the euro crisis cannot be ignored. In addition to the implications for sovereign risk, there is a clear link of risk to the tourism, services, manufacturing and trading segments - the key drivers of the UAE's non-oil economy - with what happens in Europe.

As far as direct exposure of UAE banks to Europe is concerned, foreign liabilities are less than 20 per cent of total liabilities, not a worryingly high figure.

However, lending by banks from the leading parts of Europe cannot be ignored.

Now European banks - in an effort to deleverage - have started to retrench from non-core markets, including the UAE, it could make it difficult to roll over the maturing debt of government-related entities, resulting in a rise in the overall cost of their borrowing from international markets.

The jury is still out on whether local banks have filled the gap left by European banks. But the direct impact on the UAE's financial system should be manageable, save for the event of a chaotic disintegration leading to a post-Lehman Brothers kind of liquidity freeze.

Imbalances in the US, in particular a failure to avert a fiscal crisis, could have profound spillover effects. Some equity strategists believe that could lead to a 15 to 20 per cent drop in US stock prices.

Now here's the thing: of all the GCC markets, UAE stocks are the ones most likely to be affected by changes in direction of the US stock markets. To put it another way, the correlation of shocks between S&P 500 and UAE stocks is the largest among the GCC markets.

Not only will this linkage be transmitted to the wider economy by means of the "wealth effect" - the hit on consumption from reduced stock market wealth - but it will also affect the quality of the UAE's banking assets, a good part of which is backed by local equities.

A slowdown in the US will exert downward pressure on oil prices and with a break-even oil price of about US$100, the UAE's revenues and export earnings could suffer a setback.

This in turn would reduce government spending and ultimately slow growth in non-oil GDP. The asset quality of UAE banks - which move in lockstep with oil prices - could also be adversely affected.

So what can be done about these spillover effects? Not much can be done to prevent them, for they do not emanate from within the country.

However, much can be done to mitigate the impact. The UAE already has the advantage of a well-capitalised banking sector. The Government has sufficient resources to inject liquidity into the financial system, which it could do if the need arises.

And, more importantly, if required, a temporary expansionary fiscal stance at home can also be an effective antidote.

Amit Tyagi is the vice president of the risk management division at National Bank of Abu Dhabi. The views expressed are solely of the author and not of the bank.