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Mon 18 Apr 2011 07:15 PM

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The $180bn black hole

Courtesy of currency speculators and $180bn in hot money, UAE banks faced down their own crisis long before the global crash reached Gulf shores

The $180bn black hole
The $180bn black hole
Qatari investor stock exchange
The $180bn black hole
(AFP/Getty Images)

In 2008, the UAE Central Bank was forced to pump billions of dollars into the country’s banking sector in order to get liquidity flowing through the system. Usually when this happens, phrases such as Lehman Brothers, Dubai World debt, Freddie Mac, Fannie Mae, subprime mortgages and the global credit crunch crop up somewhere along the line.

However, the blame for the liquidity squeeze in the UAE’s banks can’t be blamed entirely on the global situation as the problem in the sector actually started a lot closer to home, according to the head of the region’s largest bank.

“In the later part of 2007, probably around $180bn come into the economy on the assumption that the authorities here would delink the currencies [the UAE dirham and the US dollar] and therefore some [investors] could make some quick profits,” says Rick Pudner, CEO of Emirates NBD.

Speculation in 2007 regarding the decoupling of the dirham and the US dollar subsequently proved to be unfounded and — as a result — the billions of dollars of “hot money” flowed back out of the UAE’s banks. All well and good, but Pudner says the problem was that the money had already been used to lend to eager borrowers who wanted quick cash during the boom era.

“Unfortunately, during that period, the banking system used those funds to lend to the economy and again help the aggressive growth rates that were happening at that period… So what you had when the funds left [was] a liquidity crunch and that was slightly independent of the global crisis that was coming in 2008,” says Pudner.

“It was a perfect storm,” says Peter Gotke, Dubai-based vice president of the Bank of New York Mellon Depositary Receipts who recently wrote a white paper on the UAE’s attitude to foreign investors. “The additional factor here was the currency speculation, and the region’s rapidly inflating real estate sector, which was ratcheting up the risks further,” he adds.

As the ‘hot money’ flew out of the banking system, it left the UAE banks “in a very difficult position with degrading liquidity ratios, and a rising interbank offered rate (EIBOR),” says Philippe Dauba-Pantanacce, a Dubai-based senior economist at Standard Chartered Bank.

“Actually not many analysts picked up on that at the time — although we had published a paper quite early on — but this difficult situation for the UAE banks preceded the major crisis that followed when in the fall of 2008 Lehman Brothers collapsed.

“So, in effect, the UAE banking sector was entering the crisis from a position of weakness, for reasons that had nothing to do with the global crisis itself,” Dauba-Pantanacce adds.

With a multi-billion-dollar vacuum opening up in the banking system, the liquidity ratio — otherwise known as the “Loan to Deposit ratio” or “Advance to Deposit” ratio (A/D) —  began to soar above the critical 100 percent regulatory requirement.

This, in effect, meant that the UAE banks were left in a situation where they had more money loaned out to customers than they had available in deposits. Any rush on the banks and a major crisis would have erupted.

“It took years to recover from that and as of today this A/D ratio is barely at equilibrium with the latest central bank data showing an aggregate figure at 97.2 percent,” says Dauba-Pantanacce.

When Lehman Brothers collapsed in September 2008 and the tsunami that was the global credit crunch eventually hit the Middle East, the authorities were forced to inject cash into the already weakened banking system in a bid to close the gap left by the dollar speculators.

“During the economic crisis in September 2008, the central bank created an AED50bn liquidity support facility for banks. In October 2008, the federal government announced and executed the phased transfer of new deposits (AED70bn) into the banking system,” says Shrikanth S, an industry analyst in the business and financial services practice at Frost & Sullivan in Dubai.

Abu Dhabi was also not immune and in February 2009 AED16bn was injected to selected banks in the UAE capital. These measures were designed to improve the loan to deposit ratio, capital adequacy ratio and ensured liquidity in the system, says Shrikanth.

“In effect, this situation has aggravated the crisis in the country when the fallout from the global collapse spread to this part of the world… Where the A/D ratio is at this level, banks only have two choices (often combined): stop lending and/or compete with each other to attract more deposits with ever higher interest rates offered on cash deposits,” adds Dauba-Pantanacce.

“In turn, banks had to raise their lending rates in order to still be able to turn a profit, stifling private sector credit growth which has been completely muted for over two years now,” he adds.

But how did the dollar speculation begin and how did the UAE banking sector find itself in this situation? As the dollar declined in 2007, as a result of the subprime crisis, currency speculators began selling the American currency and looking for safer havens. This mounted pressure on the Gulf countries to depeg their currencies from the dollar. The impact was strongest in the UAE as it was grappling with rising inflation and the majority of its imports were from Europe and Asia, whose currencies appreciated against the dollar and dirham.

In May 2007, Kuwait depegged from the dollar and by November speculation reached fever point when the UAE Central Bank governor Sultan Nasser Al Suwaidi said the UAE was “at a crossroads” over the dirham’s peg to the sliding US dollar.

“2007 was rife with speculation of a currency revaluation for the dirham,” says Chris Canning, head market analyst at London-based currency exchange specialists First Rate FX.

“The possible revaluation of the dirham was of great interest to currency speculators as it created an ideal opportunity to generate quick returns. If the peg was to be re-valued the dirham would have immediately strengthened. In the build-up to the decision of the peg revaluation, many currency exchange houses were so confident that the peg would change that they pre-empted the decision and moved their rates from 3.65 to 3.3,” says Canning.

Some observers believed that a depegged dirham could surge as much as five percent — which would have given speculators a $9 billion pay day on the back of $180bn injected into UAE banks.

“To investors, they could have immediately sold out of the currency at a profit following the depeg, and this presented an almost-risk free investment,” says Canning. It is fair to say that speculators were probably not best pleased when UAE authorities eventually opted to back the dollar and refused to follow their Kuwaiti counterparts.

Fast forward to 2011 and the ill effects of the hot money currency speculation are still being felt. Last week, Standard Chartered Bank announced a plan to target small and medium-sized enterprise (SME) customers in the UAE over the next three years, in a bid to improve the liquidity situation for companies that are the backbone of the economy.

Despite the fact that Standard Chartered claims that SMEs account for 95 percent of firms trading out of Dubai alone, and that companies in the sector have an average of up to 75 employees plus a maximum turnover of around AED250m ($68m), the sector still receives very little support from the banking sector.

In hindsight, Pudner believes one of the challenges faced by the UAE banks during the 2007 depegging speculation and one of the main reasons it was difficult to manage the inflow and outflow of hot money was because “identifying it was not straightforward.”

“It was just speculation that something was going to happen and you know what the capital markets are like, waves of money fly around the world looking at opportunities to make quick profits,” he says.

Since 2007, however, Pudner believes “all the banks have learnt a lot of lessons and there is a lot more monitoring of foreign assets that are coming in now.” In fact, Pudner believes the sector has weathered the worst of the storm. “The liquidity situation has been positively evolving over the last eighteen months. February seems to have been quite reasonable… The liquidity in the banking sector is fine, it is not an issue now. Going forward the capacity is there to lend,” he says.

This growing enthusiasm has also been observed by mortgage advisors in Dubai, with Jean-Luc Desbois, managing director of Home Matters Mortgage Consultants reporting that February and March have proven to be the company’s best two months since it began operations five years ago.

“We had our two best months in five years in February and March. The 20 or so banks we work with [are] massively busy right now in terms of clients applying for pre-approval.”

Desbois said HMMC reported a 760 percent rise in the number of mortgages processed during February, compared to the year-earlier period, and in March it saw a 300 percent year-on-year rise in transactions.

However, not everyone is convinced. “The situation as far I am concerned is not resolved and it is still difficult to get a loan,” says Craig Holding, associate director at Acuma Wealth Management.

Holding, who is also treasurer of the Australian Business Council in Dubai, believes that “the business community realises that you still can’t get loans. It is almost impossible. The fact it is they can’t loan the money and their terms aren’t very good.”

While the currency speculation may have not been the sole cause of the liquidity issues in the UAE, they certainly helped to weaken the sector. Simply put, it was one of the first dominoes to fall in a long sequence of events that has left the finance industry in the precarious state in which it finds itself today.

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