Jerome Powell, testifying at his confirmation hearing on Tuesday, said he wouldn’t hesitate to raise the interest rate to rein in inflation.
A hike in US interest rates will be reflected in the UAE’s lending rates as the Central Bank of UAE (CBUAE) generally adjusts the domestic interest rates in tandem with the US rates to avoid currency market volatility and speculation against the dirham in the context of the UAE currency’s peg to the dollar.
The CBUAE has hinted at the possibility of a rate hike before Powell announced it.
In its latest Quarterly Economic Review, the central bank said that the CPI inflation rate in the UAE turned positive during the third quarter of 2021, for the first time since Q4 2018, at 0.6 per cent year on year. The CBUAE expects that although the domestic inflation is expected to remain moderate, global price pressures and the Fed’s move to rein in US inflation is expected to see interest rates going up.
“Rising inflation is expected to result in an increase in the Federal Funds Rate which would lead to an increase in CBUAE’s base rate applicable to the Overnight Deposit Facility (ODF), which provides an effective interest rate floor for overnight money market rates in the UAE,” the central bank said.
Borrowers face higher cost
An interest rate hike would impact cost of funds of both banks and borrowers translating into higher financing costs at all levels.
Individuals and corporations with fixed-rate loans will benefit if their rates are locked for the entire term of the loan. Those with loans with variable rates will see an immediate jump in their interest costs when the Fed decides to hike rates.
Although the Fed chairman did not give any hint when the rate hikes will start, Investors are betting the Fed will begin raising its benchmark federal funds rate in March up to 4 hikes this year, two years after cutting it to nearly zero at the onset of the pandemic in March 2020. A Fed officials in December said they would accelerate end of their asset purchase programme, and forecast they would raise rates three times this year.
“Powell noted that the Fed could hike rates to rein in inflation. What he didn’t say was also important. He didn’t back four rate hikes in 2022, nor a March start to hikes,” said Jeffrey Halley, Senior Market Analyst, Asia Pacific, OANDA.
UAE banks to benefit
The hike in interest rates will come as a big boost to the UAE’s banking sector’s profitability, which has suffered from prolonged margin squeeze due to low interest rates.
With the rising interest rates, net interest margins (NIMs) of UAE banks are expected to improve. NIM is a measurement comparing the net interest income a bank/financial firm generates from credit products like loans and mortgages, with the outgoing interest it pays to depositors and other sources of its funding.
The higher rates are already reflecting on banking financials. Interest rates will be higher for loans & this may lower deposit rates. However, there is a lag between when these rate changes take effect in the lending category compared to the deposits category.
Funding and liquidity
Although cost of funding of banks are likely to go up, most UAE banks are well capitalized and have adequate funding. Utilising the low interest rates environment during the past two years most banks have front loaded their fund raising activity.
In addition, most UAE banks have a significant share of CASA (current and savings account) in their funding mix and in some cases, it is as high as 50% which gives them a clear hedge against an immediate rise in cost of funds.A lot of UAE banks use a share of funds from current and savings account for their borrowing. This guarantees them liquidity when the rates rise.
The Advances to Stable Resources Ratio (ASRR) of the banking system increased from 77.7 per cent at the end of June 2021 to 77.9 per cent at the end of September 2021, which indicates that the structural funding of the banking sector remains sound. With the loans to deposit r (LTD) ratio for the whole banking system at 91.5 per cent at the end of the third quarter due to the higher growth in deposits compared to loans banks are amply liquid.