How Rising US Interest Rates This Week Will Affect Your Finances

Dubai: The Federal Reserve is expected to begin a gradual interest rate hike this week which will impact the cost of funds for individuals, banks and businesses in the UAE.

The Fed is expected to raise interest rates by 25 basis points next Wednesday. A monetary policy reset from the historically low interest rates introduced to combat the economic contraction due to the pandemic has been considered. While most economies are on the road to recovery with rising prices, central banks are forced to tighten interest rates to contain inflation.

War complicates politics

Markets had widely expected US interest rates to rise in the first quarter of 2022, largely due to soaring inflation. Price increases in the United States continued to soar in February, pushing the annual inflation rate up to 7.9%. This is the biggest year-on-year jump since 1982 and up from the 7.5% rate recorded in January.

Under normal circumstances, raising rates to calm inflation is considered a normal political action. However, the war in Ukraine has complicated the decision, as far-reaching sanctions on Russia will disrupt trade flows, leading to soaring input costs, which will ultimately undermine post-Covid economic recovery in the United States. States and in economies around the world.

On Wednesday, as the Fed is set to start raising the benchmark lending rate that was cut to zero at the start of the Covid-19 pandemic in March 2020, it could mark the start of a tightening cycle. policy that will have consequences for economies around the world. world.

Rising inflation is expected to lead to an increase in the federal funds rate, which would lead to an increase in the CBUAE base rate for the Overnight Deposit Facility (ODF), which provides a rate floor for effective interest for overnight money market rates in the UAE.

– Central Bank of the United Arab Emirates

Impact on UAE, GCC

An increase in US interest rates will immediately affect the interest rates of GCC countries whose currencies are pegged to the US dollar, with the exception of Kuwait. In Kuwait too, the dinar is pegged to a basket of currencies dominated by the dollar.

In the United Arab Emirates, lending rates move in parallel with Fed rates, as the Central Bank of the United Arab Emirates (CBUAE) generally mirrors US rates to avoid volatility in the foreign exchange market and speculation against the dirham in the context of the peg of the currency of the United Arab Emirates to the dollar.

In its last quarterly economic review, the CBUAE had hinted at a UAE-style rate hike. “Rising inflation should lead to an increase in the federal funds rate, which would lead to an increase in the base CBUAE rate applicable to the Overnight Deposit Facility (ODF), which provides a rate floor for effective interest in overnight money market rates in the UAE,” the central bank said.

Urge borrowers

A rise in interest rates would impact the cost of funds for banks and borrowers, resulting in higher funding costs across the board.

Individuals and businesses with fixed rate loans will benefit if their rates are locked in for the life of the loan. Those with flexible rate loans will see an immediate increase in their interest charges as the Fed decides to raise rates.

Analysts believe a higher loan load could push up mortgage rates, personal loan rates and financing rates for small and medium-sized businesses. This, combined with the phasing out of central bank support for banks by June this year, is expected to lead to an increase in loan defaults.

“For corporate exposures, we expect banks to take a pragmatic approach by not mirroring the full extent of rate hikes whenever it could plunge their clients into non-performance. For retail clients, the stress tests applied by banks to mortgages at the outset in relation to a rate increase, the granularity of exposure and salary allocations will act as mitigants,” said Puneet Tuli, analyst at S&P.

UAE banks will benefit from rising rates

Rising interest rates will significantly boost the profitability of the UAE banking sector which has suffered from prolonged margin compression due to low interest rates.
With rising interest rates, net interest margins (NIM) of UAE banks are expected to improve. The NIM is a measure comparing the net interest income that a bank/financial firm generates from credit products such as loans and mortgages, with the outgoing interest it pays to depositors and other sources. of financing.
“Broader profitability should be driven by growth in net interest income (NII) as interest rates in the UAE are expected to rise in line with rate hikes by the US Federal Reserve,” said Asad Ahmed, Managing Director and responsible for the Middle East. financial services at Alvarez & Marsal.
The impact of rising interest rates will ripple through banks’ profit and loss accounts fairly quickly, as rate hikes take effect almost immediately on lending and the impact on deposit rates may be smaller. and be accompanied by a lag.
“On average, banks in the UAE will benefit from the expected increase in interest rates. We calculate a 15% increase in net profit and a 1.4 percentage point increase in return on equity for every 100% increase basis points,” said Mohamed Damak, senior director in financial services at S&P Global Ratings.

Cost of funds, liquidity

The cost of funds will inevitably increase as some deposits migrate to interest-bearing products from interest-free or low-interest products. The higher interest rate environment means higher returns on deposits, which could further accelerate the growth of deposits and relatively cheaper funds for banks compared to capital markets.

Although banks’ costs of funds are likely to increase, they are largely mitigated as most banks in the UAE are well capitalized and have adequate funding. Taking advantage of low interest rates over the past two years, many banks have concentrated their fundraising activities.

Additionally, most banks in the UAE have a large share of CASA (current account and savings account) in their funding mix and in some cases it reaches 50%, giving them a clear hedge against an immediate increase in the cost of funds.

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