• UAE banks need to be in step with Fed hikes

      March 4, 2018    

    Nation's banks record improved earnings in 2017The US federal funds rate, which saw only two hikes between 2009 and 2016, witnessed a dramatic change in trend during 2017. The rates were increased on three separate occasions owing to the strengthening economic growth in the United States. As the UAE dirham is pegged to the US dollar, the change in Fed rates translated to a proportional increase in the country's policy rates.

    The hike in Fed rates will have repercussions across most GCC states as the consequent escalation in bank finance rates will likely stoke up cost of living and doing business. Change in rates is expected to play a major role in the UAE banking sector as it would impact credit disbursal and deposits.

    As the UAE's currency is pegged to the dollar, they will need to mimic the policy path followed by the US Fed in terms of interest rate movements. The UAE hiked its key interest rates on all three occasions when the Federal Reserve announced an increase on their Fed funds rate in 2017. As a result, UAE repo rates saw a cumulative increase of 75bps in 2017, increasing it from one per cent to 1.75 per cent.

    Majority of the Federal Open Markets Committee participants have projected three or more interest rate hikes in 2018 which would see the interest rates move to a range of two per cent to 2.25 per cent from the current range of 1.25 per cent to 1.5 per cent, implying a change of 75bps. This would translate into an increase in the UAE repo rate to 2.50 per cent by the end of 2018 from the current 1.75 per cent, if they follow the Fed's interest rates.

    UAE banks, after the rate hike and with improved credit conditions, witnessed a marginal expansion in interest margins, resulting in improved earnings in 2017. The relatively stable performance can be attributed to growth in the non-oil economy, improved liquidity and stable funding conditions.

    The UAE banking sector is expected to benefit from interest rate increase as a higher interest rate environment results in expanding net interest margins for banks as a result of a large share of non-interest bearing deposits, creating significant upside potential.

    UAE banks have maintained a healthy loans-to-deposit ratio of above 95 per cent in the past two years. Accumulation of deposits outpaced loan disbursals in the third quarter of 2017, leading to a fall in the loan-to-deposit ratio to 99 per cent from the 103.8 per cent witnessed in the same period during 2016. Rise in interest rates have triggered a decline in credit growth in 2017 owing to the increased cost of borrowing.

    The year-on-year credit growth in during the period fell to 0.9 per cent from 5.9 per cent seen in the third quarter of 2016. Deposits however, saw an increase in 2017 staying above five per cent in the first three quarters of 2017. UAE banks' deposits stood at $434 billion at the end of third quarter of 2017, against $411 billion at the end of third quarter of 2016, easing the liquidity crunch in the domestic banking system.

    However, this is not good news for customers as the increase in burden for banks would be passed on to them in the form of higher loan rates. Though the central bank's rate hike is on short-term interest rates, it is expected to trickle down to medium- and long-term rates, affecting personal, auto and home loans. The rate at which banks charge for consumer loans including that of credit card is usually pegged to repo rate.

    An increase in repo rates would be passed on to customers in the form of a higher annual percentage rate for variable rate credit cards. Those who have availed floating rate housing/mortgage loans would have to face higher EMIs.

    While banks are quick to increase the rates they charge for lending money (loans), they often take the opposite approach for paying interest in savings accounts. From the perspective of banks, a higher interest rate would help them increase their net interest margin. However, it could also deter credit offtake thereby reducing their profitability.

    In the case of manufacturing companies and other non-banking institutions and services, cost of borrowing funds would rise with an increase in interest rate and reducing their profits. The case is similar for equity investors whose returns would diminish if there is a reduction in earnings of the companies. Higher interest rates would be beneficial for households as it would increase the returns on their savings triggering an increase in deposits.

    The UAE from an economic viewpoint is in the need to reduce its interest rates in order to encourage borrowings and subsequently aid in fostering economic growth and diversification. However, they are expected to rely on fiscal consolidation measures to protect their balance of payments as they run the risk of having fluctuations in oil revenue if they take the de-pegging route to have greater control over their interest rates.

    The increase in borrowing rates would help the UAE banks increase their net interest margins. However it does not necessarily increase their profitability as the slowdown in credit offtake would result in the reduction of their income from interest on loans. The scenario is set to continue into the end of 2018 due to the expectation of further hikes in UAE repo rates.

    The UAE will need to improve its credit conditions in order to promote corporates to increase borrowings and improve their productivity. UAE banks will also need to adopt consolidation measures and take proactive steps to make borrowing more attractive for corporates in order to achieve better cost efficiency and profitability amidst rising interest rates.

    Source>>>

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