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'Investment demand will absorb high liquidity'

DUBAI — The huge investment demand in the region will absorb the overwhelming liquidity in the Middle East economies resulting from high oil prices, said David Bloom, Director Strategy, Global Markets at HSBC.

“Unlike the excess liquidity situation faced by Japan and the European economies in the past, the high liquidity situation in the Middle East is sustainable as there is a huge demand for liquidity here,” Bloom said.

Rising oil prices, inflow of repatriated regional investments, and cross-border fund inflows had resulted in high liquidity in most of the AGCC states. According to the Central Bank annual report for 2004, the UAE's domestic liquidity had expanded substantially by Dh15.39 billion (11.3 per cent), in addition to the expansionary impact of net domestic credit of Dh41.26 billion (27.1 per cent).

The high liquidity has brought in its share of economic woes, primarily in the form of inflation. To put it simply, the large quantities of money inflow into the country from oil revenue and foreign investments have driven up the cost of goods and services.

Commenting on the direction of dollar, Bloom said the factors such as the growing US trade deficit, recycling of petro-dollars to pay-off dollar denominated international debts, reduction of dollar reserves by central banks and particularly the diversifying reserves by Middle East and Asian countries are likely to force dollar further down.

“The purple patch of dollar in the second quarter had a lot to do with higher interest rates expectations, the rejection of European Union Constitution by France and the Netherlands and fears of the dollar-positive flow regarding the Home Land Investment Act,” Bloom said.

Now, the trend is clear as the US rate expectations are not being matched now with the dollar's performance and Eurozone politics has not emerged a bid dampener for Euro, while most of the funds companies repatriate are in dollars. In addition there is growing evidence that the excess dollars from oil are repatriated for investments elsewhere and debt repayments. Recently Russia had repayed its Paris Club debts.

The weakness of dollar and the relative gains of Euro are likely to have an adverse impact on dollar pegged currencies including the UAE dirham. The UAE imports more than 80 per cent of its requirements from Asia and Europe. Higher prices increase costs for importers and reduce the spending power of UAE consumers.

The loss in the relative purchasing power of dirham against most of its Asian and European trading partners will affect the import costs which will be reflected in the overall prices in the country.

Apart from increasing the cost of imported goods, a weaker dollar (stronger Asian currencies and euro) also reduces the relative value of dollar denominated assets and investments.

In the case of a predominantly oil exporting country like the UAE, the impact of weaker dollar will be more pronounced. The US dollar's decline is one of the reasons why dollar denominated oil prices look so high, in other words, a significant portion of the oil windfall is being wiped out as the currency in which it has been priced is declining. As oil is priced in dollars, with every depreciation in dollar value oil prices tend to rise.