Tool in Reserve?

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The growth of the country's banking sector is indicative of the strong economic growth Abu Dhabi has been experiencing of late, but the positive outlook is being overshadowed by the spectre of rising inflation. With relatively few options for tackling price increases, Abu Dhabi may follow some of its neighbours in increasing banks' minimum reserve requirement (MRR). This, however, may not prove to be the answer.

In June, the UAE Central Bank said inflation had reached a 20-year high of 11.1% in 2007. With the market awash with liquidity derived from soaring oil incomes and investment inflows, the money supply has continued to grow this year, putting a further demand pull on inflation. The M2 (broad) money supply grew some 8.37% in the first quarter of 2008 alone.

A report published last month by US banking firm Citigroup said that whilst the short-term outlook for banks was positive, given "the combination of surplus liquidity and strong investment demand amidst a negative real interest rate", in the medium term, the same factors could lead to the authorities moving to trim their lending.

"The substantial over-heating of regional economies could prompt regulators to adopt other measures to potentially dampen credit growth," the report warned.
But it is not just the glut of money flooding into Abu Dhabi that has driven inflation, there are a number of other factors at play.

On the demand side, a fast-growing population has put pressure on scarce resources, including property. And, in terms of supply, global food prices have been driven up by changing consumption trends and poor harvests in several key food-producing countries. Abu Dhabi, which imports most of its agricultural produce, has been hit particularly hard. Rising commodity costs worldwide have also added to the problems of bottlenecks in many sectors and lead to further inflationary pressure.

The bulk of the blame has often been attributed to the Emirates' dollar peg, which obliges the central bank to follow the Federal Reserve's policy of cutting interest rates, just at the time when the UAE is looking to keep its spending in check. Furthermore, the falling value of the dollar has pushed up the price of non-dollar denominated imports, a factor compounded by the strengthening value of the Euro. Many imports are from eurozone countries and this in turn has placed further pressure on prices.

So in terms of policy Abu Dhabi is in something of a tight spot and is being forced to pursue a fiscal policy against its better interest. One tool available might be the introduction of direct income taxation, but this could erode the emirate's competitiveness and be counterproductive by increasing wage demands.
There are other monetary policy tools available though, and this is where Citi's warnings about constraints on banking growth come in.

A handful of countries in the region have been using the MRR to constrain lending. The rule obliges banks to store a proportion of their deposits in a non interest-bearing account with the central bank, therefore putting a limit on how much of their deposits they can lend.

The MRR strategy has been deployed by many central banks across the world, and they tend to vary widely in terms of application. The UAE's MRR is 14% on current, savings and call accounts, while China's is 16%, the United States' 10% and the Eurozone's 2%.

Having an MRR is considered beneficial for several reasons. It acts as a form of insurance in the case of a bank's default, smoothes overnight interest rate fluctuations and helps to create steady demand for a central bank's notes. It can, therefore, contribute to the overall banking system's stability.
Increasingly, MRRs are being used as a tool to rein in credit growth, primarily to curtail inflation. In June, Oman hiked its MRR from 5% - 8%, and Saudi Arabia increased its minimum to 12% from 10% in April. It is often more appealing as a monetary tool than a pure credit growth cap as it does not put an artificial limit on banking expansion, but merely seeks to slow it.

However, increasing the MRR as a disinflationary tool is questionable. It does not prevent liquidity from entering the market, or from directly increasing the cost of borrowing. Foreign banks in particular can find ways to access and extend credit lines that circumvent the regulation by borrowing from their mother institutions. With Abu Dhabi eager to establish its name as a banking centre, it wants to avoid being seen as penalising domestic players.
Banks also complain that the requirement puts an unnecessary brake on their growth, and discourages saving. Some argue that the MRR actually causes institutions to lend more recklessly, in an attempt to make up for losses caused by regulation.

With inflation high and few other tools available, cranking up the MRR certainly seems to be an appealing policy option. Given the banking sector's stellar performance and bright prospects, tightening the regulatory framework is unlikely to be damaging long-term. Of greater concern is how effective increases in the reserve requirement can be in combating rising prices.

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