The Federal Open Market Committee (FOMC) of the United States Federal Reserve recently decided not to increase interest rates. This is significant because US interest rates affect not only the economy of the US but every single economy in the world in quite a material way.
Much of the analysis on how the actions of the FOMC will affect the UAE’s economy mirror the analysis for emerging markets as a whole. There is much one can learn by looking at other economies but emerging economies are not identical to each other and each has unique characteristics that simply do not fall within the norms of the emerging markets as a whole.
The first path of influence that a US interest rate rise has on an emerging economy is via the strength of the local currency relative to the dollar. Higher dollar interest rates make the dollar more attractive than the local currency. This would create outward flows of funds from the emerging market to the US economy as investors chased the higher returns on savings and bonds.
The second issue with a weakening of the local currency is that it makes servicing US dollar denominated debt issued by emerging markets more expensive. The math is simple, if you need more local currency to pay off a single dollar then your interest and principal payments go up. But why did these countries issue dollar denominated debt? Imagine you are an Australian wanting to lend money to Argentina. Would you prefer to do it in US dollars or Argentinian pesos?
Both these issues are moot when it comes to the UAE as the dirham is pegged to the dollar and interest rates will mirror those of the dollar. So it would be reasonable to expect that investment flows would increase into the UAE and that dollar and dirham denominated external debt would garner higher demand, as the interest returns would be boosted by the higher foreign exchange returns due to the currency movement.
This brings us to local investments. With higher interest rates demand in the equity and real estate markets would be expected to be under pressure due to a dual action. The first is similar to the effect discussed above, as the safer bank deposits increase their payout investors would be enticed to move some of their funds into savings. The second avenue is that many of these investments are leveraged and as interest rates increase so does the cost of the leverage, thus decreasing the expected return of the investment and making it less attractive.
The good news is that increased rates would increase bank deposits, offsetting expected government withdrawals in a lower oil price environment. However this will be tempered with less consumer spending and corporate investment driven by borrowing. The end results should be stronger banks lending to more viable businesses and households.
Unfortunately a stronger dollar would also impact the tourism sector. A strong dollar/dirham means that citizens from other countries would have to pay more for the same vacations and this would of course create a head wind on the expansion of the tourism sector. Pre-bought packages would mean that this would take some time to materialise. Low fuel costs could also offset the stronger dirham. The flip side is that tourism costs for citizens and residents of the UAE would become cheaper.
More good news. The expat community represents a significant percentage of the UAE’s work force. This community repatriates a significant portion of their wages back to their home countries. A dirham appreciation relative to other currencies will mean that expats will enjoy sending home a larger amount of their local currency for the same amount of dirhams that they are paid. Except for Americans. But after FATCA it really is all downhill for them.
In the words of economists the purchasing power of consumers for the individual suppliers of professional services will increase with respect to their acquisition and retention. In normal language, the cost of employment is cheaper whilst at the same time employees will see an increased benefit. Win — win. The effect that this will have on the economy could be quite significant.
What is the final result? As with anything to do with economics, tea leaves, tarot cards and chicken entrails would probably give a more accurate answer.
But I feel that the overall effect will probably be on the positive side for the UAE.
This article was originally published in The National.