Public Information Notice No. 05/89

Public Information Notice: IMF Executive Board Concludes 2005 Article IV Consultation with the United Arab Emirates

July 15, 2005

On July 1, 2005, the Executive Board of the International Monetary Fund (IMF) concluded the Article IV consultation with the United Arab Emirates.¹

Background

An outward-oriented development strategy, a good record in macroeconomic management, and a business friendly environment have resulted in impressive economic growth in the U.A.E. over the years. Economic diversification has advanced rapidly, supported by an increasing role of the private sector, which has laid the foundation for further economic and social progress in the period ahead.

Reflecting sharply higher oil prices and increased oil production, strong investor confidence, and a significant increase in foreign direct investment (FDI), economic growth in the U.A.E. is estimated to have been very strong in 2004. Preliminary data for 2004 indicate that the real non-hydrocarbon GDP grew at 10 percent, while hydrocarbon production rose 3 percent. Growth was broad based with most sub-sectors growing at historically high rates, with manufacturing leading the way, followed by services and construction. The depreciation of the U.A.E. dirham (AED) in real effective terms and strong economic growth in the U.A.E.'s export markets helped drive faster growth in manufactured exports. Both the external current account and consolidated fiscal balances are estimated to have recorded large surpluses in 2004 of 12 percent and 18.3 percent of GDP, respectively. The non-hydrocarbon deficit (excluding investment income) narrowed by about 5 percentage points of non-hydrocarbon GDP, to about 27.5 percent. Asset prices in the real estate and the stock markets have soared, aided by stronger economic fundamentals and investor optimism. The composite equity market index rose by 88 percent in 2004. Net FDI is estimated to have reached US$9 billion. The broad money stock rose by 23 percent, mainly on account of an increase in private sector credit.

The banking sector in the U.A.E remains strong, bolstered by effective supervision. Overall, the capital-assets ratio (CAR) declined slightly to just under 17 percent, as banks increased their lending activities, but remains well above prudential norms for all banks. At end-2004, while the official ratio of non-performing loans (NPL) to total loans remained somewhat high at 12.5 percent, provisions were considerable, bringing the net NPL ratio below 4 percent. Banks' exposure to the booming real estate sector has so far been limited. Information on the non-bank financial sector exposure to the real estate sector is not available. The U.A.E. authorities, including the Emirate and Securities and Commodities Authority (ESCA) have undertaken steps to continue to strengthen supervision of securities and non-bank financial institutions. Major steps have been taken to put in place a strong legal framework to prevent money laundering and financing of terrorist activities. Two laws were passed in 2004, one on dealing with financing of terrorism and the other addressing AML/CFT issues in the financial free zones. The Dubai International Financial Center (DIFC) began operations in September 2004. Considerable progress has been made with respect to the regulatory framework governing the DIFC, and an extensive set of laws has been established based on best international practices.

The pace of liberalization gained momentum, in particular in Dubai, and to a lesser extent in the other Emirates. Dubai's policy of extending foreign ownership of land and properties for real estate developments have resulted in a construction boom and a significant increase in FDI in this sector. Sharjah has also established a number of industrial free zones while the privatization of Abu Dhabi's utilities sector is proceeding as planned with one power plant being sold to private investors. Consideration is being given in Abu Dhabi to follow Dubai's example of relaxing government control over the real estate market. The Federal government continues to play an important role in the federation, taking the lead in public administration reforms by implementing a range of reforms including performance-based budgeting and setting up a modern treasury system.

The U.A.E.'s general policy has been to avoid imposing wide-ranging employment quotas for nationals as it recognizes the significance of expatriate labor's contribution to growth and to maintaining the competitiveness of the economy. However, given the rising unemployment among nationals, a string of new measures have been implemented in recent years which include raising the cost associated with hiring expatriate workers. The authorities are also taking measures to create employment opportunities for the U.A.E. nationals in the private sector. These measures include programs for training and job placement to match the needs of the private sector, entrepreneurship programs that provide funds at low rates to nationals for them to start their own businesses, and enactment of a pension plan for nationals working in the private sector in a plan equivalent to that which applies to the public sector.

Executive Board Assessment

Executive Directors agreed with the thrust of the staff appraisal. They commended the authorities of the U.A.E. for pursuing an outward-oriented development strategy and prudent macroeconomic policies, which have led to impressive economic growth, rapid development of the non-oil economy, and a sizable accumulation of foreign assets. They welcomed the continued progress in diversifying the economy and the implementation of structural reforms, which have enhanced the economy's resilience to external shocks.

Directors agreed that the medium-term outlook remains favorable and that the U.A.E. is in a good position to consolidate the recent gains from the high oil prices. They underscored, however, that soaring assets prices and emerging inflationary pressures warrant close monitoring. The sustainability of the U.A.E.'s growth prospects hinges on continued implementation of structural reforms and maintaining financial stability. Directors called on the authorities to promote private investment by lifting remaining impediments to foreign investments outside the free zones, and enhance the long-run employability of the national labor force through training and education.

Directors welcomed the authorities' prudent fiscal stance, as reflected in the narrowing of the non-hydrocarbon fiscal deficit and projected improvement in the overall fiscal balance. At the same time, they pointed to the need for greater fiscal policy coordination between the individual Emirates and the Federal government, standardized accounting systems, and an improved flow of data between the levels of government. They considered that the structure of the budget should be further strengthened by containing government employment and basing the civil service rewards system on productivity. Subsidies on water and electricity should also be phased out, and replaced by targeted payments to nationals below a certain income level. Directors welcomed the continued reduction in agricultural subsidies in the Emirate of Abu Dhabi.

Directors recommended that the revenue base be broadened to reduce reliance on oil and gas revenues, including by introducing a local property tax and a value-added tax, the latter in coordination with other members of the Gulf Cooperation Council. They supported the authorities' request for technical assistance from the Fund for the introduction of a VAT. Directors commented that efforts should also be made to strengthen the institutional capacity of tax administration.

Directors considered that the pegged exchange rate arrangement continues to be supported by strong economic fundamentals and sound financial policies, and provides an anchor for price stability and market confidence. They welcomed the authorities' open-mindedness as to the choice of exchange rate regime under the planned GCC monetary union, but cautioned that more flexible exchange rate regimes require greater institutional development of the foreign exchange markets, and well-defined risk management and intervention policies. They therefore recommended that the authorities formulate strategies in these areas at an early stage.

Directors considered that monetary policy remains appropriately geared to containing inflation. While recent increases in asset prices are attributable in part to strong economic fundamentals, the authorities were nevertheless urged to closely monitor equity and real estate markets and to tighten financial conditions if warranted. The authorities could consider higher provisioning rates for credits carrying greater-than-average risks, increasing the minimum amount of equity needed for approval of real estate and margin trading loans, and tightening collateral requirements.

Directors stressed that a system for collecting information on non-bank financial sector exposure to the real state market is needed.

Directors agreed that the financial sector in the U.A.E. remains sound and its role as a regional hub continues to evolve. They commended the authorities for the progress achieved in improving financial sector supervision. At the same time, they highlighted the need for rationalization and consolidation of regulatory oversight of the capital markets and nonbank financial intermediaries. Effective coordination between the central bank and the Emirate Security and Commodity Authority is needed to ensure that a comprehensive supervisory framework is in place for the entire financial sector. Directors supported efforts to develop a regulatory framework for the Dubai International Financial Center, and welcomed the authorities' agreement to have the Fund assess the Center's structure and operations by year-end. Directors commended the authorities for the work on a legal framework to prevent money laundering and the financing of terrorism.

Directors encouraged the authorities to broaden the scope of the investment regime outside the free zones and enhance its transparency. In this vein, they welcomed the authorities' effort in pursuing new foreign direct investment legislation and an amendment to the Commercial Company law, which would further the development of an unambiguous legal framework for the private sector.

Directors commended the U.A.E.'s open-border foreign labor policy, which has enabled the private sector to recruit expatriate workers at internationally competitive wages and contributed to economic growth. They welcomed the measures to increase employment of nationals in the private sector, which should continue to rely on raising the skills of nationals through better education and training programs, rather than on mandatory measures such as quotas. Labor market reforms should aim at increasing flexibility in hiring and firing, and equalizing benefits for nationals in the private and public sectors.

Directors welcomed the measures to improve the institutional statistics framework, including the efforts of the Interministerial Statistical Committee and the authorities' intention to participate in the General Data Dissemination System. Nevertheless, the statistical database and procedures need to be strengthened to enable effective monitoring of the economy. The compilation of statistics on consolidated government activities needs to be improved, and structural weaknesses with respect to data quality, coverage, periodicity, timeliness, and inter-sectoral consistency need to be addressed. Better coordination between the Federal and Emirates authorities, the commitment of adequate resources, and further staff training will be needed to make progress in this area.

It is expected that the next Article IV consultation with the U.A.E. will be held on the standard 12-month cycle.