Global Investment House – UAE Economic & Strategic Outlook – Monetary Policy – UAE’s monetary policy, as implemented by Central Bank of UAE (CBUAE), is primarily to ensure two main goals; the stability of Dirham against the US$ (to which it is pegged at US$1:Dh3.67) and to control inflation through managing liquidity. The CBUAE manages money supply growth by aligning interest rates with that in the US, and by issuing certificates of deposit (CDs) to commercial banks in addition to other tools. The country faced unprecedented higher inflation since 2004 due to high liquidity, increased demand and economic activity as well as booming asset prices. Inflation level more than doubled during the period 2001-05 as it picked up from 2.8% in 2001 to reach 6.2% by the end of 2005. The increased inflation pushed the CBUAE to conduct few modifications in its monetary policy for the last couple of years. The CBUAE increased its issuance of certificate of deposits substantially for 2004 and 2005 to smoothen the fluctuations in domestic liquidity. This was in addition to the successive hikes in interest rates.
The central bank is currently considering a partial conversion of its foreign exchange reserves to the Euro as a first step to peg the Dirham to a basket of currencies rather than to the US$ alone. It is important to note that the IMF called on the UAE to end the decades-old peg between Dirham and US$ to consider pegging it to a basket of currencies including Euro and Yen. The main reason for this is to reflect the fact that around 75% of UAE’s imports are from the Euro zone and Asia that has contributed to a part of imported inflation for the last couple of years.
In 2005, broad money (M2) in the UAE market grew by 33.8% to a new high of AED324.1bn. M2 continued its upward trend since 2001 to register a 19.7% CAGR for the five years period to 2005. Growth in 2005 was primarily due to M1 and Quasi money that reported high growth rates of 29.2% and 36.1% respectively. M1 stood at a new landmark of AED104.4bn representing 32.2% of broad money. More important than M1 was quasi money due to its sheer size 67.8% of M2. Quasi money comprised of savings deposits, time deposits, CDs and foreign currency deposits, reported a record 36.1% growth to record AED219.6bn. Following the same upward trend as M2, the overall broad money M3 increased by 36.6% reaching AED415.4bn.
However, owing to the higher interest rates, and the issuing of CDs by the government, there has been a slowdown in the growth of liquidity in the first half of 2006. Different levels of money supply reported lower growth rates where (M2) grew by just 9.2% over that at the end of 2005 while M3 grew by 5%.
Generally, the most popular method used by the Central Bank of UAE to regulate money supply is issuing and buying back of CDs. By the end of 2005, CDs stood at AED21bn as compared with AED15.6bn in 2000 to report CAGR of 6.1% for the period. Entering 2006 CDs continued picking up to grow by 59.2% reaching AED33.5bn by the end of June 2006.
It is important to note that, interest rates on the UAE Dirham are regulated by the Central Bank using CDs. Banks use this in turn as an indicator for changing their terms on accepting deposits as well as extending loans to customers. Interest rates on CDs normally are in line with the inter-bank interest rates on the dollar deposits in the international markets. Thus, interest rates in the UAE reflect changes in the US, thanks to the currency peg maintained. Moreover, CBUAE governor announced that UAE would continue to match the US move for move without hiking its rates more than the prevailing US levels.
Interest rates in UAE banking system started picking up significantly following a declining trend until 2003. By the end of 2005, average deposit rates more than doubled to stand at 3.563% in 4Q2005. On the other hand, lending rates picked up to resemble 2002 levels. Lending rates grew to reach 8.12% in 1H2006. However, it is important to note that despite this growth in lending rates, its level was not that high to affect credit growth and robust investments.
Entering 2006, almost all rates in the UAE banking system continued picking up following the US Fed. However, they grew at lower rates as compared with 2005. Average 3 months deposit rates reported an all time high of 4.16% by the end of 1H2006. Similarly, 3 months interbank rates stood at 5.17%.
