Mission Concluding Statement 

United Arab Emirates: 2013 Article IV Consultation Concluding Statement of the IMF Mission

June 11, 2013

I. Introduction

An International Monetary Fund (IMF) mission visited the United Arab Emirates from April 30 to May 15, 2013, to hold discussions for the 2013 Article IV consultation.¹Against the backdrop of a strengthening economy, discussions focused on: pursuing appropriate near-term macroeconomic policies; managing old and new risks stemming from Government-Related Entities (GRE); and pursuing policies to support financial sector stability. The mission would like to thank the authorities for the open and fruitful discussions and for their hospitality.

II. Recent Developments

1. The economic recovery has continued to strengthen amid favorable oil prices and capital inflows. Supported by a perceived safe haven status amid regional political and social unrest, capital flows have strengthened, demand from expatriates from the broader region has increased, and the real estate sector, which had been impaired since the 2009 crisis, has stabilized in Abu Dhabi and started to recover in Dubai. Oil prices remained high and economic confidence strengthened. The repair of balance sheets of government-related entities (GRE) that were at the center of the 2009 crisis continued but is not yet complete.

2. Economic growth is estimated to have reached 4.3 percent in 2012. Hydrocarbon production expanded by around 5.2 percent, and non-oil growth continued to accelerate to 3.8 percent, driven by growth in services sectors. Backed by high oil prices and production, as well as buoyant non-hydrocarbon exports, the external current account surplus rose to almost 17 percent of GDP in 2012. Dubai’s non-hydrocarbon exports, in particular, recorded high growth rates, despite a significant decline in bilateral trade with Iran (down 31 percent year-on-year in 2012). Inflation remained subdued at 0.7 percent on average, in light of a still declining rent component and limited pass-through of international food prices.

III. Economic Outlook and Risks

3. Non-oil growth is expected to strengthen further in 2013. A broadening recovery in construction and real estate, and ongoing growth in tourism-oriented sectors are likely to underpin non-oil growth, which could reach 4.3 percent this year. Growth in oil production will likely slow to around 2 percent in 2013 after two years of substantial expansion, as growth in global oil demand remains weak amid expanding global supply. Inflation could pick up somewhat this year to around 2 percent as the housing market continues its recovery.

4. Medium-term growth and diversification prospects are promising. Dubai aims to build on its successes in becoming a services hub for the wider region and recently announced plans for several megaprojects in real estate and tourism, notably including Mohamed bin Rashid City. If Dubai succeeds in its bid for the World Expo 2020, the implementation of many of these plans would likely accelerate. Abu Dhabi continues to expand its hydrocarbon production capacity. Meanwhile, its economic diversification strategy relies primarily on manufacturing, petrochemicals, aviation, renewable energy, and cultural tourism.

5. Downside risks to this outlook have declined over the last year but remain substantial. On the external side, they reflect the UAE’s reliance on hydrocarbon exports and its close links with international financial markets and emerging Asian economies, while domestically, a key medium-term risk is related to a possible renewed building up of a boom-and-bust cycle.

• A global re-emergence of financial stress. Reduced availability of international finance could make it difficult to roll over some of the GREs’ and other companies’ maturing debt and would raise the overall cost of their borrowing from international markets, straining their balance sheets. While the banking system is very liquid, a few banks, particularly those that have relied on foreign wholesale funding, might face liquidity pressures.
• A deeper than expected economic slowdown in emerging markets, particularly in Asia. Emerging Asia, especially India, accounts for a large and growing share of exports, and robust external demand from Asia has helped limit the impact on the UAE of the weaknesses of European economies and of the sanctions on Iran. A slowdown in emerging Asia would weaken an important driver of goods export growth and reduce tourism and foreign real-estate demand.
• A large and prolonged decline in hydrocarbon prices triggered by a renewed global recession. Hydrocarbons are a key contributor to exports and remain the dominant source of government revenue, both of which would be impaired in the event of a large fall in oil prices. The UAE’s substantial foreign assets and improving fiscal position provide insulation against moderate or short-lived shocks. However, a large and prolonged fall in oil prices would ultimately result in reduced fiscal spending and non-hydrocarbon GDP growth and could expose weaknesses in GREs’ and other companies’ balance sheets.
• Insufficient domestic policy reform to mitigate the risk of a renewed boom-bust cycle. Renewed optimism fueled by rising real estate prices and loose global liquidity conditions could prompt a renewed cycle of imprudent risk-taking and re-leveraging by GREs and private companies, which could also affect banks’ balance sheets in light of their strong interconnectedness with GREs. In the absence of prudent policies, this could fuel short-term growth at the expense of medium-term stability.

6. There are also a number of upside risks to the outlook. A faster recovery in the advanced economies would have a positive effect on global growth and oil prices. More generally, higher oil prices would further support fiscal revenues and the external current account, as long as oil exports are not disrupted and confidence is maintained. Adequate macroeconomic policies and borrowing restraint by GREs in the currently favorable economic conditions can support high and sustainable economic growth without incurring undue macroeconomic risks.

IV. Correcting Imbalances While Supporting the Economy

7. The UAE began last year to withdraw the large fiscal stimulus that was put in place in the wake of the 2009 crisis. The combined fiscal accounts of the federal and emirate governments posted a consolidation of the fiscal stance by 3 percent of non-oil GDP, driven by consolidation in Abu Dhabi and Dubai.² A salary increase for federal employees and an increase in Abu Dhabi’s subsidies and transfers were more than offset by reductions in other outlays, including Abu Dhabi’s capital expenditure. Together with strong oil revenues, this led to an overall fiscal surplus of close to 9 percent of GDP. As a result, the fiscal break-even oil price, a measure of fiscal vulnerability to oil price shocks, improved from $84 in 2011 to $74 last year.³

8. For 2013, continued fiscal consolidation of around 2 percent of non-oil GDP is planned. Fiscal consolidation is expected to be driven by a rationalization of capital spending (a large new affordable housing program in Abu Dhabi notwithstanding) and subsidies and transfers, while spending on goods and services, defense and security, and the wage bill are expected to increase.

9. The continued fiscal correction is appropriate. In the wake of the 2009 crisis, public spending was substantially increased to cushion the impact of falling private demand on the economy. This raised public spending to levels higher than sustainable for future generations, such that the fiscal consolidation that started last year is welcome in making inroads toward correcting that long-term structural imbalance. The continued plans for consolidation would also further improve the implied break-even oil price to $71 this year, reducing the risk of having to tap into the UAE’s accumulated oil wealth in the event of a renewed large decline in oil prices. At the same time, the recovery in the non-oil economy has gained momentum and is unlikely to be undermined by the planned pace of withdrawal of fiscal stimulus. At the emirate level, a faster pace of consolidation in Dubai would be desirable to address the emirate’s continued debt-related risks. Particularly if risks of overheating in the real estate market rise, this could be supported by targeted increases in real estate-related fees, which would also help generate revenue in support of fiscal consolidation.

10. Medium-term fiscal plans are also encouraging. Both Abu Dhabi and Dubai target continued gradual consolidation in their non-oil balances through 2017, further correcting for the UAE’s long-term intergenerational fiscal imbalances, reducing oil-price related risks, and, in the case of Dubai, addressing debt-related concerns. Fiscal consolidation should be supported by reductions in energy subsidies, which will create fiscal space while improving energy efficiency.

11. The federal government, Dubai, and Abu Dhabi have all made progress in developing medium-term fiscal frameworks (MTFF). The federal government adopted a medium-term budget in line with the federal strategy including improvements in budget automation and revenue forecasting. Abu Dhabi developed a medium-term macrofiscal model to inform policy decision making, while Dubai put in place a three-year budget framework to guide the budgeting process. Building on these achievements, MTFFs should continue to be refined and, in the case of Abu Dhabi, increasingly integrated into the budget formulation process.

12. Accommodative monetary policy under the exchange rate peg to the U.S. dollar remains appropriate in the current environment. Low Central Bank of the United Arab Emirates (CBU) interest rates help cushion the economic impact of fiscal consolidation and will support a recovery in private sector credit growth, which continues to be impaired by the legacy of the 2009 crisis. At the same time, the level of the exchange rate has remained broadly in line with fundamentals.

V. Managing Old and New Risks Stemming from GREs

13. With GREs having been at the core of the 2009 crisis, ongoing focus both on dealing with legacy issues and preventing new exuberant risk-taking is warranted. Dubai’s total debt continues to be substantial at $142 billion (around 102 percent of GDP),⁴ of which $35 billion in government and government-guaranteed debt. Dubai’s GREs increased their debt over the last year to an estimated $93 billion,⁵ up from $84 billion in March 2012, of which about $60 billion falls due between 2013 and 2017. This includes GREs which are operating on a commercial basis and borrow on their own credit strength. While GRE debt restructurings related to the 2009 crisis are nearing completion, several major maturities are now drawing closer: $20 billion Dubai government debt to Abu Dhabi and the CBU related to the Dubai Financial Support Fund is falling due in 2014, and restructured debt related to Dubai World and Nakheel will begin to mature in 2015/16. While the Dubai government and GREs have been actively looking at opportunities for debt refinancing, timely communication about these key maturities will be important to support market confidence.

14. Dubai’s ambitious expansion plans warrant measured execution amid strengthening access to external financing in an environment of high global liquidity. Dubai’s megaprojects will be executed to a large extent through GREs. While further investment in the development of Dubai’s economy is welcome, the authorities should ensure that, in line with current intentions, execution will be gradual and flexible depending on demand. New investments should be structured in a way that strictly limits risk-taking by the still highly indebted GRE sector. This will help contain fiscal risks and reduce the likelihood of another boom-bust cycle. Managing these risks thus calls for prioritizing and sequencing major projects, assessing the quality of planned spending, and for improving the framework to manage scrutiny, selection, delivery, and funding of major projects.

15. Ongoing focus on improving the transparency of Dubai’s GREs will be important to strengthen their resilience. Abu Dhabi has made notable progress in monitoring and disseminating GRE debt and other financial data through its debt management office. Data availability on financial conditions, debt stocks and maturity profiles of Dubai’s GREs continues to be inadequate for an assessment of the sector’s financial health and associated macroeconomic risks. The Dubai government has created a dedicated team for government debt and guarantee issuance. Building on this, Dubai should establish a full debt management office, which would be tasked with implementing a proper risk management framework entailing effective identification, assessment, monitoring, and reporting of contingent liabilities arising from GREs.

16. Further strengthening the Dubai GREs’ corporate governance is also key. The Dubai government has replaced many GRE boards of directors since the 2009 crisis and introduced a requirement for approval by the Supreme Fiscal Committee of any new GRE borrowing. Building on these improvements, key steps for further strengthening the GRE’s corporate governance include (i) delineating clearly their commercial and noncommercial operations; (ii) expanding the coverage of the 2009 corporate governance code to public companies; (iii) strengthening the role and independence of company boards to allow for more effective decision making; and (iv) improving risk management practices.

VI. Financial Sector Soundness and Financial Spillovers

17. The banking system maintains significant capital and liquidity buffers. The CBU estimates that the level of non-performing loans may finally have peaked at 8.7 percent in December 2012, more than four years after the onset of the 2009 crisis. Nonetheless, further restructuring of GRE debt, including possibly on already restructured debt, could still add materially to this level. Joint CBU/IMF staff stress tests show that the domestic banking system could absorb even a significant increase in non-performing loans, with only a few banks falling somewhat below the mandated minimum capital adequacy requirement in the event of an extreme shock. Stress tests on non-resident liquidity withdrawal from the system further show that it would take a very large shock to generate even a moderate systemic liquidity need, still well within banks’ holdings of CDs and reserves at the CBU.

18. Shielding the banking system from concentration risk to the GRE and real estate sectors is key. The UAE’s banks are strongly interconnected with GREs through ownership and financial linkages. The interconnectedness coupled with non-transparent corporate governance structures and practices makes managing the evolution of interconnected leverage challenging, which could give rise to systemic risks. While GRE activities remain an integral part of the UAE economy and their regular financial operations are key to supporting balanced growth, it remains essential that rapid credit expansion and undue loan concentration to this sector be avoided to lessen the risk of a renewed boom-bust cycle and to safeguard financial stability.

19. Implementing the planned mortgage lending regulation and loan concentration limits on GREs and emirate governments will help bolster financial stability. Gradual transition paths should be agreed with any banks that might initially exceed such norms. Regulation related to mortgage lending, including caps on loan-to-value and debt-service-to-income ratios, will help mitigate real estate-related risks, though the imminent effect on the residential real estate market, currently largely a cash market, will be limited. Looking ahead, the CBU should carefully monitor the interaction of mortgage lending and the real estate sector, and tighten the mortgage regulation or introduce new measures as needed.

20. Strengthening the macroprudential framework, including through an enhanced mandate for financial stability for the CBU, could help mitigate systemic risks. Macroprudential policy can play an important role in the UAE, particularly against a backdrop of reliance on volatile hydrocarbon revenues, limited monetary policy independence in light of the peg to the US dollar, a history of procyclical fiscal policy, and an open capital account. The CBU’s publication of its inaugural Financial Stability Review in 2012 was an important step highlighting the importance of macroprudential policy. In addition, it would be desirable to develop a more formal and transparent macroprudential institutional and policy framework. This should entail assigning the mandate for financial stability, and defining a coordination framework, objectives, analytical methods, and the policy toolkit. The adoption of the new Financial Services Law would provide an opportunity to establish the legal base for an improved macroprudential policy framework.

21. The planned financial sector assessment will be a welcome opportunity to review the sector’s strengths and weaknesses. The mission believes that an assessment under the Financial Sector Assessment Program (FSAP) could play an important role in further strengthening the CBU as banking system regulator and supervisor, while facilitating further financial sector development.

VII. Improving Fiscal Coordination and the Statistical Capacity

22. Effective fiscal coordination is important for strengthening both near- and medium-term fiscal planning. The mission welcomes the notable progress made in sharing information among the federal and emirate governments, facilitated by the Fiscal Policy Coordination Council (FPCC). Coordination should be further strengthened by improving the quality and coverage of fiscal information, improving macrofiscal analysis, jointly discussing budgets and MTFFs, and enhancing expenditure policy coordination.

23. Further improving the UAE’s statistical capacity remains key. The authorities have made laudable progress in preparing consolidated government finance statistics, and the planned introduction of an international transactions reporting system at the CBU will be an important step toward strengthening the quality of balance of payments statistics. It will be important to maintain the momentum of strengthening economic statistics by providing adequate resources for improving the quality of the national accounts and for producing demographic and labor markets statistics, while continuing to strengthen balance of payments statistics. Compilation of the International Investment Position will be essential to close an important gap.