Dollar Peg Restricts UAE Money Market

The ready availability of dollar liquidity to the UAE banks, given the dirham’s peg to the greenback, has restricted the country’s resolve to develop a more active money market in local currency, a working paper by the IMFsaid.

The Washington-based IMF said it saw drawbacks in the UAE Central Bank’s efforts to manage domestic liquidity, including its reserve requirements for banks.

“The features of the UAE money market and of the UAE Central Bank liquidity management operations have been shaped by the tight constraints set by the fixed exchange rate regime,” said authors of the working paper Alexandre Chailloux and Dalia Hakura.

“The large US dollar balances held by local banks, their easy access to the dollar market, and the credibility of the dirham’s peg to the greenback, have always allowed the UAE banks to manage their liquidity globally and to regard dollar and dirham financing “as fungible and readily available,” said the IMF paper.

“With US dollar liquidity readily available, banks did not have to worry about raising cash in domestic currency. This, in turn, limited the authorities’ resolve to develop a more active money market in local currency,” it said.

The paper argued that the protracted situation of ample liquidity in the system has contributed to limit money market operations to essentially short-term tenors, and also limited the need of local banks to diversify the potential funding sources and instruments used in the interbank market.

The study said lack of diversification in interbank funding instruments and in tenors, has contributed to the vulnerability of the UAE banking system to a bout of liquidity stress, particularly for banks not supported by an overseas parent.

“While foreign banks can use a more diversified set of instruments to fund their asset expansion, thanks to their franchise and the support from their parent bank, local banks had to rely on the growth of their deposit base, and had to borrow abroad but with little insurance on the rollover prospects in case of tensions, unlike subsidiaries of foreign banks,” it added.

The IMF paper, entitled “Systemic Liquidity Management in the UAE: Issues and Options,” argued that as a result of these limitations, the UAE banks have become gradually stretched relative to their retail deposit base with loans to deposit ratios of several banks operating in the country moving well above 100 per cent in 2008.

“Indeed, the chronology of the liquidity squeeze that began in the summer of 2008 suggests that tensions on the international US dollar market triggered the dirham liquidity tensions, and there is little doubt that the lack of depth of the dirham money market contributed to exacerbate these tensions, as local Treasurers could not easily find local funding alternatives nor could they rely on sufficient holdings of genuinely liquid assets,” the IMF said.

The study urged the UAE Central Bank to create what it called “a given level of reserve money shortage” which would enhance its control of money market interest rates and overall money market conditions.

It said this liquidity deficit would not only make the market dependant on liquidity injections but also have the merit of enhancing the functioning of money markets and improving commercial banks’ liquidity management standards.

issacjohn@khaleejtimes.com