After the Federal Reserve raised interest rates this month, most GCC central banks followed quickly by raising interest rates in the hours that followed, consistent with the operation of their currency pegs to the US dollar.
One main exception was the Saudi Arabian Monetary Authority (SAMA) in Saudi Arabia, which had already tightened its monetary policy the week before.
This was widely seen as a pre-emptive move on the part of SAMA to get ahead of the game in the hope of restoring normality to local interest rate markets, which had seen negative spreads develop between the SAR and AED three-month interbank rates and three-month USD Libor.
While the higher three-month USD Libor has contributed to this phenomenon, the growth in deposits and slowdown in lending in the region’s two largest economies has also been a factor, creating some concerns about the potential for capital flight if this situation deepens or persists.
In theory, the spread between the interbank rates of pegged currencies should be minimal in a free market. However, in practice, it is frequently not. This is because the ability to arbitrage between the different rates on pegged currencies requires the existence of liquid rates and FX markets.
The GCC markets are not liquid enough for this arbitrage to be exploited and to then exert pressure on rates to revert to median. Therefore the Saudi Arabian Interbank Offered Rate (Saibor) and Emirates Interbank Offered Rate (Eibor) rates can often reflect local situations rather than mirror exactly the movements in Libor rates.
Usually, local interest rates trade at a small premium to Libor, reflecting the different dynamics within the region compared to the economic situation in the US. Recently, however, Saibor and Eibor have been trading at a discount to Libor due to a number of special factors.
After touching a premium of 156 basis point (bps) in mid-2016, the three-month Saibor spread over Libor turned negative in February this year, with a similar situation in the UAE.
The last time that the Saibor and Eibor spreads had fallen below the USD Libor was in 2006/2007. Although a fast pace of rate hikes in the US in 2005 caused Libor to rise faster than Saibor and Eibor then, the main factor causing negative Saibor/Libor spreads was the speculative inflow of foreign capital triggered by anticipation of currency revaluation.
The negative spreads reversed in late 2008 as Libor spreads spiked during the financial crisis, from which they only gradually declined before turning negative again last month. This time around, however, the explanation for these developments is more domestic in nature, as the following explanation of the situations in Saudi and the UAE highlights.
Following the sharp decline in oil prices in 2015-16, governments in the region drew down their deposits in domestic banks to meet their expenses. In Saudi Arabia, government deposits in commercial banks declined by nearly one percent every month in 2016 and 10 percent over the year. The trend was exacerbated by declining business and individuals’ deposits as well.
At the same time, Saudi began issuing domestic bonds to help finance the budget deficit, which contributed to tightening liquidity conditions as private sector credit growth also remained relatively robust through Q3 2016.
As oil prices recovered to touch $70 over the course of last year, government deposits at commercial banks also recovered, as did private-sector deposits. The government issued less domestic debt and supplemented this with external debt issuance. Importantly, private sector credit growth slowed sharply in 2017, reaching -0.8 percent year-on-year in December 2017 compared with 2.4 percent in December 2016.
In short, liquidity conditions in the domestic banking system have improved sharply in recent months.
The story is similar in the UAE, with government deposits rebounding strongly in 2017 while private-sector credit growth slowed dramatically. After declining sharply in Q1 2016, government deposits in the domestic banking system started to recover from May 2016 and growth in government deposits accelerated in 2017, peaking at 41.9 percent year-on-year last November.
Regardless of the reason, the consequence of solid deposit growth and weaker lending growth has been an increase in liquidity in the domestic banking systems. This has been reinforced by an influx of foreign funding through new bond issuances. And these factors have contributed to the tighter riyal and dirham spreads over USD Libor, and recently small discounts.
The interest rate increases seen in the UAE following the Fed’s rate hike, and in the KSA before it, meanwhile, have still not resulted in the recent compression of spreads being reversed.
For the situation to correct itself, and for normal interest rate margins to re-emerge, private-sector credit growth will need to recover as non-oil economic growth accelerates in 2018. Until then, and against a background of rising interest rates in the US, this is a development that should cushion the impact of higher US rates on the region’s economies.
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