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Wed 23 Jan 2008 01:47 PM

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Gulf slashes rates to keep pace with US

Kuwait cuts benchmark interest rate for first time in 18 months, Saudi, Bahrain and UAE also lower rates.

Gulf states lowered interest rates on Wednesday, with Kuwait reducing its benchmark for the first time in 18 months, after an emergency US cut forced them to defend dollar-linked currencies and yield ground to surging prices.

It was the Gulf's most cautious response yet to the US Federal Reserve. Only the UAE matched Tuesday's 75 basis point Fed cut. Kuwait, Qatar, Saudi Arabia and Bahrain opted for reductions of half a percentage point.

Saudi Arabia and Bahrain, the largest and smallest of six economies preparing for monetary union, raised reserve requirements, forcing banks to keep more money in their vaults to prevent lower borrowing costs from stoking inflation.

Investors maintained bets on currency appreciation, expecting the growing divergence between booming oil producers and a US economy reeling from a credit crisis to eventually sever the Gulf's ties to the dollar.

"The region's problem is that its economies have decoupled from the US, but economic policy is still tied because of the dollar peg," said Simon Williams, regional economist at HSBC.

Bankers signalled just how difficult it was becoming for central banks to have their cake and eat it.

National Bank of Abu Dhabi (NBAD) said lower rates would allow it to lend 20% more this year in a country where inflation hit a 19-year high of 9.3% in 2006 on surging credit growth.

Banque Saudi Fransi complained that tumbling deposit rates had hurt profits by slashing returns from the money market, where banks were struggling to place funds as record oil revenues poured into the economy.

Kuwait's Central Bank governor Sheikh Salem Abdul-Aziz Al-Sabah acknowledged the dilemma, but said the gap between interest rates on dinar deposits and those of other currencies including the dollar had grown "unjustifiably high".

Kuwait's 50 basis point cut came as a surprise. Unlike its neighbours, which maintain fixed dollar pegs, the country tracks a currency basket dominated by the dollar, which tumbled to a record low against the euro last year.

The basket gives Kuwait more flexibility on interest rates and the central bank has left the benchmark discount rate steady since July 2006, fearing lower borrowing costs would fuel inflation which hit a record high of 6.2% in September.

The central bank had lowered the repo rate by 100 basis points since September 12 to deter bets on an appreciation of the dinar.

On Wednesday it cut the discount rate and the repo by 50 basis points each, to 5.75% and 4%.

Other Gulf central banks avoided reducing lending rates at a time when record oil revenues are flooding banks with cash.

Saudi Arabia, where inflation hit a 16-year high of 6.5% in December, cut its reverse repo, which guides bank deposit rates, to 3.5% from 4%. It left the benchmark lending rate, the repo, at 5.5%.

The world's largest oil exporter also raised the reserve requirement for banks to 10% of deposits from 9%. Bahrain raised its reserve ratio by 2 percentage points.

Both Bahrain and Qatar cut their deposit rates and left the lending benchmarks unchanged. Oman sets monetary policy at a weekly auction and kept rates below the Fed's benchmark.

Most Gulf states have negative interest rates, making it cheaper for people to borrow than to keep money in a bank deposit. "Negative interest rates have a tendency to support asset price inflation," John Sfakianakis, chief economist at SABB bank in Riyadh.

Property prices are the main driver of inflation in much of the Gulf. Qatar, Oman and the UAE have imposed curbs on rent rises, but loan growth is driving demand.

"The appetite in the market for borrowing is huge and the effect of lower interest rates will make the appetite larger," Saif Ali Al-Shehi, NBAD's senior general manager domestic banking, told reporters.

"To bring down inflation, the value of the dirham should increase by at least 30% gradually," he said.

UAE dirham forwards widened after the cuts, with investors betting the currency will rise 2% in a year, compared with 1.7% on Tuesday. (Reuters)

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