By Andrew Torchia, Reuters
A narrowing of interest rates has cushioned Gulf economies. What now? asks Andrew Torchia
A dramatic narrowing of spreads between interest rates in the United States and the Gulf might have cushioned the region’s economies last year, but the trend may be close to ending as demand for loans picks up and monetary policy tightens further. And any move towards significantly higher regional rates – those in Saudi Arabia have actually fallen in the past year, against the US tide – could weigh on the modest acceleration of economic growth expected in 2018.
In theory, short-term money rates in the United States and the Gulf should move in similar ways as the region’s currencies are closely linked to the US dollar, leaving central banks little room to conduct independent monetary policies. But in the last couple of years, theory has gone out the window and spreads have fluctuated wildly as Gulf economies struggle under the impact of low oil prices.
On Monday, February 12, the three-month Saudi interbank offered rate was just eight basis points above its US dollar equivalent – the smallest gap since mid-2009, when rates were distorted by the global financial crisis – compared with 104bps at the end of 2016.
Meanwhile, the spread of three-month money in the UAE has, on occasion, shrunk to zero in the last few weeks, the lowest since late 2008. It stood at 6bps on February 12.
Narrowing spreads have been good news for businessmen and consumers in the Gulf, shielding them from some of the pain of the Federal Reserve’s five increases in US rates since late 2015. In particular, declining real estate markets in Dubai and elsewhere in the region, deflated by low oil prices, have been spared a significant rise in loan costs.
While the three-month US dollar London interbank offered rate has surged 82bps in absolute terms since the end of 2016, the three-month Saudi rate is down slightly and the UAE rate has edged up only gradually.
That pattern may change in the coming months as the US central bank continues to raise rates. Markets expect between two and four more Fed hikes of 25bps each in 2018, and this time the conditions that insulated the Gulf from US policy may change.
“Spreads have narrowed so much that it’s difficult for them to narrow more. The feed-through from higher US rates might be more this year, more of a headwind for the economy,” said Monica Malik, chief economist at Abu Dhabi Commercial Bank, said of the outlook in the UAE.
Economic growth in the Gulf oil exporters is expected to pick up a little this year; analysts predicted in a Reuters poll last month that Saudi gross domestic product would expand 1.5 percent, after contracting 0.5 percent in 2017.
But growth looks likely to stay far below the pace of around five percent early this decade, and real estate markets are in poor shape to cope with higher interest rates. Dubai property prices are estimated to be down as much as 16 to 19 percent from peaks hit several years ago.
Olivier Panis, senior regional credit officer at Moody’s Investors Service in Dubai, said Saudi spreads narrowed for two main reasons last year: less demand for loans due to the weak economy, and lower domestic borrowing by the government.
Bank lending to the Saudi private sector shrank 0.8 percent from a year earlier in December. However, Panis expects overall loan growth to pick up this year because of greater government spending and a slightly stronger economy.
Loan growth could reach four or five percent in 2018 and eight to ten percent in 2019. That would not be enough to tighten the money market significantly, Panis said, but it could prevent a further loosening and start to change the outlook for rates. Similarly, annual bank lending growth in the UAE sank to 0.4 percent in December, the lowest in at least three years. Panis said growth could rebound to around five percent in 2018. Another factor pushing down Gulf spreads, bankers say, is increased confidence about the stability of the region’s financial system after last year’s recovery in oil prices.
Governments now have more money to support banks if needed, so banks demand less of a risk premium in lending to each other. But that trend may have run its course; Brent crude has dropped back to around $64 a barrel from above $70 last month.
In Saudi Arabia, the central bank, keen to protect the economy, kept money rates low last year by adjusting the way in which it responded to each US rate rise. It increased its reverse repo rate, at which commercial banks deposit money with the central bank, by 25bps each time but did not move its repo rate, used to lend money to banks.
That strategy cannot continue much longer, however, because the corridor between the rates has narrowed to just 50bps. Too narrow a corridor would remove the incentive among banks to lend among themselves, damaging the money market.
A Saudi commercial banker predicted the central bank would have to raise the repo rate after the next US rise, expected in March; Malik said the corridor might conceivably narrow to 25bps. Either way, the repo rate looks set to begin climbing sometime in 2018, pulling the money market with it.
History shows it is not impossible for Gulf spreads to continue tightening into negative territory; the Saudi-US spread reached almost minus 100 bps in 2008.
But that was during the global crisis, when emergency measures by central banks and a freezing up of money markets influenced rates. In more normal times, banks are unlikely to lend more cheaply in the Gulf than in the United States.
“Spreads have sometimes been negative in the past but this has been very rare and unsustainable,” said one Gulf banker. “Markets will tend to demand some kind of premium for the risk of lending in the Gulf versus the US.”
Saudi banks’ domestic liquid assets ended 2017 at a record high of $122bn, despite subdued deposit growth and challenging business conditions, according to a report by Moody’s.
Overall, banks’ domestic liquid assets grew 11 percent in 2017 and equalled 20 per cent of banks’ assets at year-end 2017 versus 14 percent at year-end 2015. Saudi banks’ ratio of reserves to total deposits was 14.8 percent as of year-end 2017, its highest since year-end 2012.
The positive trends were despite a 0.1 percent deposit growth in 2017 and were driven by a one percent contraction in loans and a 43 per increase in the banks’ holdings of domestic government bonds. Sukuk issuance allowed banks to transfer their excess liquidity into high-quality government investments.