Will the UAE suffer or prosper in the global economic slowdown?

Posted on 08 June 2008 with no comments from readers

Higher oil revenues of $350 million a day mean that the Emirates is prospering while the rest of the world suffers from high oil prices, food price inflation and a slowing economy. The latest MasterCard survey of consumer confidence showed the UAE the only country surveyed to have happier consumers over the past six months.

It is tempting therefore to conclude that the global economic slowdown is going to have no impact on the Emirates. Indeed, the oil boom should be seen largely as a beneficial phenomenon with any problems being those of success and not failure. But beneath the surface there are many issues brewing that could be a source of real difficulty in the future.

The local banking sector has largely escaped from any direct exposure to sub-prime mortgage losses. But the indirect effects of the credit crunch in global markets have had an impact, and the cost of money has gone up. The issuance of commercial sukuks or Islamic bonds is down as a consequence, and the projects they would have financed will probably now be delayed.

Local banks have also not expanded into the mortgage sector as expected and home loan rates remain elevated by global standards. In part this represents a more cautious approach to lending post-crisis, perhaps fearing what might lie ahead. On the other hand, the UAE real estate market is currently so strong that banks can charge what they like for mortgages and banks are restricted in their percentage of lending to real estate.

In fact, as you might expect it is those local sectors that are most exposed to the global economy which are feeling the impact of the slowdown most acutely. Regional airlines are baring the cost of high oil prices, just like their competitors around the world, and this will be hitting their bottom lines at a time when massive fleet expansions are in progress.

For local consumers and business flyers this surely has to mean that significant airfare increases can only be around the corner. You also have to wonder about the price of gasoline and diesel at the pumps. Diesel is half the price of Dubai in Abu Dhabi. Will this differential be maintained if high oil prices continue?

Across the board there is reason to worry about much higher consumer price levels in the UAE. Money supply is growing at a sensational 37 per cent which compares to an estimated 17 per cent in the US, 11 per cent in Europe, and higher in many parts of Asia. This is a highly inflationary environment.

In the short to medium term this kind of velocity of flow of money should also keep oil prices at relatively high levels for longer than most forecasters predict, albeit a summer seasonal dip in prices is likely. It was the same kind of excessive monetary expansion that kept oil prices buoyant in the late 1970s while the world economy was mired in stagflation and grew very little while consumer price inflation roared.

Against this background the UAE will become more and more a text book example of a high inflation economy. That will mean a further surge in real estate prices to levels previously unimaginable to residents but perfectly normal in many wealthy global markets. The Central Bank will have to wrestle with a booming money supply and take steps to reduce liquidity such as imposing a higher reserve ratio on the banks.

And this could yet produce the kind of pressure that will break the dollar peg. Revaluation would provide a valuable pressure valve release for local inflation. Otherwise the dirham is doomed to follow the devaluation of the US dollar – which may well be resumed as a new president finds himself overwhelmed by falling house prices and an economic slump. A $2 euro can not be ruled out.

Interestingly the one point where UAE consumer optimism faltered in the MasterCard survey was on the local stock markets. Here the link with the rest of the world is clearest as participants fear an exit from the local bourses by foreigners who now comprise around a third of investors. For in a synchronized collapse of global financial markets foreign investors would take their money out quickly as they did earlier this year in a market squall.

It is not hard to imagine a scenario under which global capital markets come unstuck. Inflation is going to squeeze US consumer spending and corporate profits at a time of house price falls bigger than during the Great Depression of the 1930s. At some point in the near future share prices will be adjusted to this reality, perhaps once the excitement of the US presidential election has worn off, or just before it as a reassessment of the outlook.

However, we should not forget that stock markets also have a link with reality. If the Emirati markets take a fall this autumn then markets will be taking a forward view of the economic landscape and saying that they do not like what they see ahead. In particular, a renewed economic slowdown in the form of a ‘W’ shaped US economic recession is likely to eventually impact on oil prices, albeit monetary expansion could delay this oil price fall which would actually deepen the economic downturn still further.

All the same, the UAE domestic economy now has such a head of steam in terms of its trillion dollar investment program that any stock market downturn this autumn will probably turn out to largely a false alarm about the strength of the local economy. It could be that this expansion is pruned back a little, with some of the weakest and most extraordinary projects dropped. If nothing else bank credit will become tighter for developers and restrain their expansion plans, and off-plan buyer might become more wary of their promises.

But at a time when the cold winds of recession may be blowing at their fiercest through global markets the Emirates will still appear as an oasis of prosperity in an increasingly troubled world economy. Next year the US presidential election hype will be history and the temptation to get all the bad news over in the first year of the administration means that Wall Street will be left to revalue capital markets to appropriate levels.

Financial crises of the sort we are living through typically take three years to bottom out, and on that reckoning we are not even half way through. The next stage of the cycle is business failures, unemployment, repossessions, and a stock market crash. America is paying for over borrowing and excessive expenditure, and as economies like the UK, Spain, Italy and Japan succumb this is turning into a global slowdown.

Against such a backdrop the Emirates is a wonderful place to be doing business and is relatively insulated from the economic chaos now being thrust upon the rest of the world. But there will be consequences even in the UAE and a little caution in certain sectors is a wise counsel. For one day in the future oil prices will fall, as a world in recession consumes less oil.