Economic Update

Published 22 Jul 2010

Figures released by the United Arab Emirates (UAE) Central Bank will no doubt further alarm government officials debating the nation’s monetary policy. Year-on-year total liquidity (M3) supply surged 33.8% on the back of rising oil and a weakening dollar. The situation has been exacerbated by hot money flowing into the UAE since late last year. Foreign currency deposits rose 29.7% to $30.7bn as investors anticipated an imminent revaluation of the dirham, or even a dropping of the peg.

The situation is leading to evident disquiet. Speaking earlier this month, Gene Leon, deputy chief of the International Monetary Fund (IMF)’s Gulf Cooperation Council (GCC) division, said GCC countries should tighten their money supply. He added that a revaluation would have only a short-term effect on prices.

Leon’s statement was preceded by a pessimistic Merrill Lynch report published at the end of January. The American financial services giant expects inflation to hit 12% in the UAE this year, driven by strong capital inflows, loose monetary policy and the continuing effects of the dollar.

The government appears to be taking notice. Within the past few days Sheikha Lubna Al Qasimi, head of the UAE’s ministry of economy and planning, questioned whether the current “unbridled growth” within the UAE’s construction sector was sustainable. She pointed in particular to steel demand, which was expected to double to 10m tonnes a year by 2010.

There is little doubt that the UAE’s real estate boom is both contributing to, and in turn suffering from, high inflation. Wages for skilled workers in particular have spiraled, as increasing amounts of liquidity chase scarce resources. OBG reported earlier this month that construction engineers’ salaries in Ras Al Khaimah had doubled during 2007 to over $10,000 a month. The situation has led the authorities to establish price controls in recent months, with concrete restricted to Dh295 a tonne. Sources report a widespread lack of compliance though.

Construction is usually among the first sectors to be hit by high inflation. It affects the ability of developers to accurately predict profit margins, and thus reduces the appetite of firms to bid for tender. Despite fears of inflation, appetite for further construction in Abu Dhabi currently appears firm. Days before the IMF warning, Aldar Properties announced a new contract for Abu Dhabi. A further Dh694m ($189m) shopping mall contract awarded to Arabian Construction Co has taken the combined total for the Central Market Towers to the new record figure of Dh3.4bn ($925m).

If the UAE is to steer through this bout of inflation, maintaining this kind of momentum in the construction sector will be vital. Demand is currently still outstripping supply, although Falah Al Ahbabi, director general of Abu Dhabi’s Urban Planning Council, believes the market will reach balance in the next three to five years. Speaking at the Abu Dhabi Economic Forum, Al Ahbabi added that once equilibrium was reached the council would step in to control future supply.

A soft landing to the current construction boom is vital for Abu Dhabi and the UAE. Indirect measures such as price controls and planning future supply will cushion the effects of inflation, but they will not address its underlying causes. The UAE will always have difficulty absorbing the liquidity generated by its oil exports. Converting petrodollars into real estate is a sensible long-term strategy, but short-term construction booms do not dissipate inflationary pressures.

One viable short-term method of reducing money supply (and thus inflationary pressure) is to convert government reserves into less liquid assets overseas. Sovereign wealth funds – much in the news of late – are one such form of “liquidity sponge”. A recent McKinsey report places oil-exporters alongside East Asia as the world’s largest net suppliers of capital, a position they have not held since the 1970s. Thomson Financial noted that worldwide acquisitions by sovereign wealth funds for January totalled some $20.6bn, or nearly one-third of the total for 2007. In the US, they accounted for 28% of total M&A activity for the month.

This increase in sovereign wealth activity is no doubt a direct corollary to the increase in inflationary pressure within many GCC states. What is less sure is whether sovereign wealth funds alone will be a sufficient “sponge” to soak up all the excess liquidity generated by 33% money supply growth, or whether more aggressive measures will be required.