An Unexpected Decision
October 31, 2008
By Mohamed Jaber | London
The UAE Central Bank has decided against reducing its policy rate following Wednesday’s cut in the US fed funds rate: The US policy rate was lowered by 50bp to 1%. The UAE authorities’ move is at odds with their previous practice of mirroring changes in the US policy rate, which has dropped by 4.25% since September 2007. The general assumption has so far been that monetary policy independence in the UAE is constrained by the dirham’s peg to the US dollar and by the absence of restrictions on capital flows. Over the past year, market speculation hoping for a revaluation of the dirham has also put additional pressure on the UAE monetary authorities to mirror US monetary policy. Despite lower domestic rates, substantial speculative inflows resulted in an accumulation of about US$50 billion in additional foreign currency reserves during the 18 months ending in March 2008. Since then, however, the momentum seems to have turned, with the banking system’s total foreign assets decreasing by about US$18 billion during 2Q08.
In the absence of an official statement from the central bank, we conjecture that the decision not to lower rates may have been partly based on: 1. Concerns over potential excess liquidity: Over the past month, the authorities have introduced a number of measures to increase liquidity in the banking system. The government has announced that it will increase its deposits in the banking system by about US$19 billion for a period of two years (a third of those funds have already been disbursed). Moreover, the central bank has established a US$13.6 billion liquidity facility and has recently eased the borrowing costs to banks for accessing this facility. It is notable that only 15% of these funds have been tapped so far and that the interest rates paid by banks for accessing these facilities are linked to the repo rate. As such, the monetary authorities may have been wary of the potential increase in domestic liquidity resulting from a further reduction in policy rates. However, this is somewhat surprising, given that current data do not point to any excess liquidity in the banking system. If anything, they seem to indicate the opposite. Not only has the interest on interbank lending increased by about 210bp over the past two months, but it has also failed to drop in tandem with the sharp decrease in LIBOR rates over the past two weeks. Moreover, the spread between the repo rate (the rate at which banks can borrow from the central bank) and the interbank rate (the rate at which they can borrow from each other) currently stands at about 325bp; this is again is a sign of significant liquidity constraints. 2. Reversal of pressures on the dirham in the forward market: In an interesting turn of events, forward currency markets are currently pricing in a potential 1% ‘depreciation’ in the dirham over the next 12 months, and that’s only a few months after the massive speculative pressures for a revaluation for the currency. We do not believe that this reflects the intrinsic value of the dirham, which remains fundamentally sound, supported by large fiscal and external surpluses and massive official foreign assets. However, it is an indication that currency markets do not seem to be trading based on fundamentals these days. The central bank’s decision has indeed had an effect on the forward markets, which seemed to have experienced a greater demand for the dirham yesterday. However, given the overall bearish sentiment towards emerging market currencies these days, we do not expect substantial speculative inflows as a result of the authorities’ decision to maintain rates at their current level. 3. Continuing concerns about inflation: Consumer prices in the UAE have been rising over the past five years due to rapid economic growth, housing constraints, rising food and commodity prices and excess domestic liquidity. However, the latter factor has been less of any issue lately as the reversal of speculative funds and the reduced availability of foreign credit have significantly restricted domestic liquidity (as discussed above). Therefore, it is not clear why additional monetary tightening would be needed to combat inflation at this point, considering that: (i) rental pressures are expected to stabilize over the next two years; (ii) international food prices have started to decline; (iii) the US dollar has appreciated significantly over the past three months; and (iv) credit growth is expected to slow down substantially over the coming year as the banks’ access to foreign funding is reduced. We believe that the costs of maintaining interest rates at their current level outweigh the potential benefits of doing so: Given the change in market sentiment towards emerging markets, the UAE authorities may indeed be able to maintain the positive rate spread over the US dollar. This may even have a marginally beneficial impact on inflation in the long run. However, we believe that the main macroeconomic concern at this juncture is the provision of sufficient liquidity to the banking system. To this end, the UAE authorities have certainly gone a long way towards ensuring that financial institutions have access to necessary funds. However, given the continuing tightness in domestic liquidity, we believe that the decision not to reduce interest rates may have been untimely.
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More Cuts, and What Else?
October 31, 2008
By Joachim Fels | London
Only four weeks ago – admittedly, it feels much longer – we bemoaned the leading central banks’ lack of action on official interest rates in response to the credit turmoil and argued that this would likely change soon (see “Time to Recalibrate Monetary Policy”, The Global Monetary Analyst, October 1, 2008). Since then, we have in fact seen major rate cuts of at least 50bp from ALL of the G10 central banks except Japan, and also in a few large EM economies such as China, India and Korea. The recalibration of monetary policy is still in full swing, so further rate cuts by virtually all major central banks look likely in the next few days, weeks and months. This, together with the unlimited provision of liquidity and the many measures taken by governments to stabilise the financial sector, should imply that monetary policy eventually gets traction, even though the timing is highly uncertain. And if the policies used so far don’t work, we believe that central banks and government won’t shy away from even more unorthodox measures. A global recession looks unavoidable, but the multi-year deflationary outcome that markets now price in looks unlikely to us in the light of massive monetary and fiscal policy intervention. The great monetary easing continues. Since the publication of last Wednesday’s The Global Monetary Analyst, no less than six central banks – the Reserve Bank of New Zealand (100bp), the Swedish Riksbank (50bp), the Bank of Korea (75bp), the Bank of Israel (25bp), the People’s Bank of China (27bp) and the Norges Bank (50bp) – have lowered official rates. In the near future, we expect the following central banks to do the same: • Later today, the Fed is likely to announce a 50bp cut in the fed funds target to 1.0%. While this is not a done deal yet, our US economists believe that even if the Fed surprises by keeping rates on hold today, an inter-meeting cut before the next FOMC meeting on December 16 would be likely in response to the ugly news from the real economy that appears to lie ahead. • This coming Friday, the Bank of Japan now looks likely to either cut the official target policy rate by 25bp to 0.25% or at least sanction an easing of the effective overnight call rate towards that level – a move which Takehiro Sato calls a “stealth easing”. • On November 4, the Reserve Bank of Australia, which front-ran the coordinated global rate cuts earlier this month with a 100bp reduction in the cash rate, may cut rates by another 50bp to 5.5%, even though Gerard Minack believes that the RBA is more likely to wait until December as the AUD tumbled since the last meeting and the government announced a 4Q fiscal boost. • On November 6, the European Central Bank is expected to cut its refi rate by another 50bp to 3.25%, according to Elga Bartsch (who was appointed to the ECB Shadow Council this month – congratulations!). Anything but a cut would be a disappointment following recent dovish comments by ECB President Trichet. • On the same day, the Bank of England’s MPC will most likely vote for a 50bp reduction of the base rate to 4.0%, according to our UK economists. A very substantial easing. Together with the rate cuts already announced during October, these steps imply a very substantial easing in global monetary policy. They complement the many other measures that have already been implemented in recent weeks and months, most notably the unlimited provision of liquidity to banks by several major central banks including the Fed and the ECB (quantitative easing), public capital injections into banks, guaranties for bank liabilities, and liquidity backstops for money market funds and commercial paper issuers. Thinking unconventional measures. Naturally, investors worry deeply whether these measures will be sufficient to stabilise the financial sector and prevent an economic depression. We think so, but would be the first to admit that the degree of uncertainty is very high. However, we feel sure that the authorities will keep using all available means to address the problems if things don’t stabilise in the coming weeks and months. What could this entail? Here’s a highly subjective and patchy list of possible actions that might still be taken if the measures enacted so far don’t help: • If needed, there is no reason why official interest rates could not be cut all the way down to zero. • Central banks such as the Fed and the ECB already provide unlimited liquidity against collateral. If this is not sufficient, they could engage in unsecured lending to banks. • Central banks could start to buy private sector assets such as equities or corporate bonds directly, in order to stabilise prices. • Also, central banks could start to make loans to the private sector directly in order to alleviate the credit crunch. • Governments could ‘persuade’ banks, especially those that receive a capital injection and/or a liability guarantee from them, to keep lending to the private sector. • Or, governments could simply nationalise a large part of the banking sector and instruct banks to lend. To be clear, we are neither saying that such steps are desirable, nor that they are particularly likely. Also, there are several legal and technical hurdles that would have to be overcome. However, we do believe that, if needed, central banks and governments would be willing and able to take even highly unconventional measures such as these or others in order to prevent the great unraveling. In the Great Depression, policymakers stood by watching most of the time. In Japan in the 1990s, policymakers waited for several years into the stagnation and deflation phase before contemplating and then enacting some of the measures that have already been put in place in the current turmoil. This time, the message from policymakers appears to be that it will not be allowed to happen again. Bottom line. Massive policy action has already been taken, and more is to come, both from central banks and governments. In our view, even highly unorthodox measures such as zero interest rates, direct central bank lending to the private sector, heavy government interference with private banks’ lending policies or large-scale bank nationalisations cannot be excluded. In short, we believe that the authorities will do whatever it takes to prevent a depression. While a global recession appears unavoidable, we believe that markets have gone too far in pricing in a multi-year deflationary outcome.
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