Banks in the UAE pay 1.25 per cent on time deposits with a maturity of one year. While this may look measly, two things matter for consideration here.
First, interest rates are still positive in the UAE, unlike Europe where they turned negative. (Yes, some European banks demand interest from depositors.)
Second, while the interest received by UAE depositors is positive, this is technically termed as nominal rate. When adjusted for inflation, the real rate of interest gives a different picture. UAE inflation (CPI) is running at 1.8 per cent. After adjusting for inflation, the real rate of interest in the UAE is minus 0.5 per cent.
This matters because negative real rates are good news for borrowers and bad news for lenders. From individual customers’ point of view, as depositors they lose out. As borrowers (especially consumer loans), they benefit. For corporates, it presents a great opportunity to clean up the balance sheet, reduce leverage or refinance high- cost loans with low-cost loans.
The UAE’s real rates have been negative since 2009, apart from a brief period between August 2011 and August 2012 when they turned positive. However, what is noticeable is the sharp and continuous descent in the rates since then.
For rates to turn positive, either nominal interest rates should move up or inflation should move down, or a combination of both. Given the US dollar peg to the dirham, UAE interest rates will mirror that of the US Fed. The Fed has now started raising rates but is finding the going tough. While the expectation is that the rates will rise from here, analysts are confused about the speed.
Regarding UAE inflation, the possibility of reduced rates can be debated owing to commodity price softening, although a reduction in subsidies can be inflationary. Average inflation since 2009 has been reined in at 1.7 per cent. Hence the UAE should brace for negative real rates of interest for some time to come.
But why should negative real rates of interest be problematic?
There are three reasons.
- First, negative real rates would discourage savings, as they would depreciate customer deposits. In simple terms, money deposited today will be worth less in the future, in real terms.
- Consequently, preference for long-term deposits among customers has fallen and deposits at banking institutions, at best, are skewed towards the short end of the curve, a maturity period of one year or less. Time deposits, which accounted for 52 per cent of private deposits in 2007, now account for only 28 per cent.
- As a result, funding profiles of the banks are increasingly short-term in nature, which could constrain their ability to fund projects that are long term in nature owing to duration mismatches. The problem is exacerbated as banks have been the primary suppliers of capital in the region because of a lack of bond markets.
- Second, lower lending rates could distort the “hurdle rate” or “break-even rate” by which project investments are evaluated. By holding interest rates artificially low owing to the need to maintain the currency peg, capital might be misallocated. A fall in overall financing costs would tempt borrowers to ignore existing balance sheet problems. If left to persist and prevail, problems such as higher debt would make it hard for central banks to normalize interest rates in the future, for the fear of damage it could inflict.
- Finally, low interest rates have contributed to increased capital outflows from the country. Prolonged lower rates would drag down the yield on domestic assets. A hunt for yields in a low-interest environment could pave the way for speculative activities that could fuel asset bubbles. Further, distortions in asset prices could push investors (both domestic and foreigner) to hunt for higher yields elsewhere, encouraging a flight of capital.
Stay Tuned To Marmore MENA Insights!
Never miss a patch or an update with Marmore's Newsletter. Subscribe now!
Related Article
The Dynamic Rise of Fintech in the GCC
The convergence of technology and finance is reshaping the GCC Financial Ecosystem. The blog explores key players, regulatory framework and market dynamics of Fintech in the GCC region.
Read MoreHow secure are GCC banks compared to their global counterparts?
The blog examines the impact of cyber attacks on financial institutions and the resiliency of GCC banks compared to their global counterparts
Read More2024 Kuwait Banking: Interest Rates and NIM Trend Analysis
The blog discusses how net interest margin of Kuwaits banks has moved across interest rate cycles, in light of awaited policy rate cuts.
Read More
