Public Information Notice No. 06/76

Public Information Notice: IMF Executive Board Concludes 2006 Article IV Consultation with the United Arab Emirates

July 12, 2006

On June 12, 2006, 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 and prudent financial policies have resulted in impressive economic growth over the years and have led to a large accumulation of external financial assets. This success has been underpinned by Abu Dhabi's prudent management of its oil wealth and Dubai's strong push for economic diversification. All indications are that the liberal economic policies followed thus far will be broadened and accelerated in the period ahead. Strong economic fundamentals and a pro-business approach to economic management are resulting in high levels of domestic and foreign investment in the manufacturing, services, and real estate sectors. These dynamics bode well for the economy's medium-term growth prospects.

Economic growth has been impressive, reflecting sharply higher oil prices, increased oil production, strong investor confidence, and a significant increase in foreign direct investment. Preliminary data for 2005 indicate that real nonhydrocarbon GDP grew at 11 percent, while the hydrocarbon sector registered a growth rate of 2.1 percent. Growth was broad-based with most sub-sectors growing at historically high rates, especially in manufacturing, real estate and construction, and trade. However, inflation has been on the rise, driven by the strength of domestic demand, a hike in gasoline prices and a significant increase in the prices of non-tradables such as rents and services. Both the external current account and overall consolidated fiscal balances are estimated to have recorded large surpluses in 2005 (14.7 percent and 26.9 percent of GDP, respectively). The nonhydrocarbon deficit (excluding investment income) narrowed by 1.7 percentage points of GDP, to 17.3 percent. The broad money stock rose by 34 percent, mainly on account of a rapid increase in private sector credit.

In 2005, Abu Dhabi's budget improved markedly owing to high oil prices and moderate expenditure increases. Its work force was reduced by about 8,000 workers (14.5 percent) because some services previously provided by the municipality were outsourced to the private sector. The two other key emirates, Dubai and Sharjah, maintained their policy of executing budgets that are largely in balance. However, Dubai's budget does not provide a comprehensive picture of its fiscal accounts. Considerable fiscal operations continue to be carried outside the budget, and information about these operations is currently not available. The public sector across the U.A.E. is undergoing a major shift to restructure and outsource many activities to the private sector.

The equity markets, after having risen significantly since 2004, have had a sharp correction since their peaks in November 2005. The sharp corrections in the U.A.E. bourses were due to market overvaluation and the liquidation of existing positions to fund subscriptions for Initial Public Offerings (IPOs). The high demand for IPOs was in turn the result of a policy of underpricing them.

The banking sector in the U.A.E. remains strong, bolstered by effective supervision, but the fast growing capital markets and nonbank financial institutions pose new regulatory challenges. Overall, the capital-asset ratio increased slightly to 17.4 percent, while the ratio of nonperforming loans (NPL) to total loans declined and provisions were considerable, bringing the net NPL ratio below 2 percent. The share of banks' direct lending to the equity market increased to about 6 percent of total loans in 2005 from just slightly over 1 percent in 2004. The U.A.E. authorities, are taking steps to continue to strengthen supervision of capital markets and nonbank financial institutions. Also, considerable progress has been made with respect to the regulatory framework governing the Dubai International Financial Center and an extensive set of laws have been enacted, benchmarked to best international practices.

The major emirates (Abu Dhabi, Dubai, and Sharjah) are capitalizing on the favorable economic environment to carry out reforms that will foster more private sector participation and further diversify the economy. Dubai passed a property law which allows 100 percent foreign ownership of properties in pre-designated areas, while working with the private sector to provide infrastructure and other services that are traditionally provided and financed by the public sector. Sharjah established a number of industrial free zones and also benefited from attracting new small and medium-sized enterprises that are rapidly expanding. Abu Dhabi has embraced utility privatization and rationalized its fiscal policy through outsourcing of public expenditure.

The authorities are planning to increase development expenditures significantly in 2006 and over the medium-term. Key government entities (such as the Abu Dhabi National Oil Company, Dubai Ports Authority, and Dubai Aluminum Company) have massive investment plans to further increase the capacity of upstream activities in the petrochemicals sector, infrastructure in airports and ports, and new manufacturing plants in the metals sector. Over the medium-term, the total investment in Dubai is conservatively estimated at $200 billion. Similarly, about $160 billion worth of projects are planned for Abu Dhabi. Over the next five to seven years, oil production capacity in Abu Dhabi is expected to expand from 2.9 million barrels to 3.5 million barrels per day.

Limited improvements have been made in the U.A.E.'s economic and social statistics which continue to suffer from numerous structural weaknesses with respect to data quality, coverage, periodicity, timeliness, and inter-sectoral consistency.

Executive Board Assessment

Executive Directors commended the authorities of the U.A.E. for pursuing market friendly policies, an outward-oriented development strategy, and prudent financial policies, which have resulted in an impressive economic growth over the years and led to a large accumulation of external financial assets. Directors welcomed the continued progress in diversifying the economy and the implementation of structural reforms. They agreed that the U.A.E. is in a strong position to take advantage of the buoyant regional economic growth, but stressed that the authorities' primary objective should be to ensure that economic expansion proceeds at a sustainable pace while maintaining macroeconomic stability.

Directors viewed that the medium-term economic outlook remains favorable. They stressed, however, that, in the near term, a number of risks, including, price developments in the equity and real estate markets and accelerating inflationary pressures, warrant close monitoring. Given the limitations of monetary policy resulting from the fixed exchange rate and liberalized capital account, Directors stressed that if the rapid increase in private sector credit and inflationary pressure persist in 2006, much of the burden of tightening financial policies would need to fall on public spending.

Directors agreed that the comfortable fiscal position and the significant accumulation of financial assets support increases in infrastructure and social outlays to broaden growth and enhance the absorptive capacity of the economy. Spending should be set in line with the economy's absorptive capacity, in order to maintain macroeconomic stability. They encouraged the authorities to link wage increases to gains in public sector productivity, and to replace subsidies on water and electricity with income-related payments to nationals below a certain income level. Directors urged greater policy coordination between the emirates and the federal governments, and recommended the introduction of legislation to reform the General Pension and Social Security System, while it is running operational surpluses. They urged the authorities to start the preparatory work based on the recommendations of the IMF Fiscal Affairs Department for the introduction of a Value Added Tax system at the federal level.

Directors noted that, notwithstanding the limitations of monetary policy in the U.A.E., if credit growth to the private sector continues at a rapid pace and inflationary pressures persist, the authorities could tighten credit by raising 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. A gradual reduction of the percent at which individuals can borrow against their salaries could also be considered.

Directors commended the authorities for the financially sound and well-supervised banking system. However, they cautioned that increased lending for real estate and equity financing has led to a rise in credit risk, and stressed that banks' direct and indirect exposure to these markets and the increased loan concentration in a few large business groups call for close monitoring by the central bank. The adequacy of prudential regulation should be kept under review, and banks that recorded significant growth in profits from equity markets related activities should be closely supervised.

Directors highlighted the urgent need to define the responsibilities of the various entities involved in regulating the capital markets and its participants, addressing gaps in regulations, and rationalizing the extensive overlaps in responsibilities. They welcomed the planned full assessment of the capital markets regime against International Organization of Securities Commissions' standards. Directors stressed that the pricing of IPOs should be set by the market through professional underwriters based on an appropriate company valuation. Equity markets would benefit from the introduction of market stabilization mechanisms, such as a market maker system and hedging instruments that can provide liquidity and allow investors to manage their risks more effectively. They welcomed the authorities' agreement to undertake a Financial Sector Assessment Program update.

Directors agreed that the fixed exchange rate policy has served the U.A.E. economy well. They welcomed the authorities' intention to remain open regarding the choice of exchange rate regime under the planned Gulf Cooperation Council monetary union.

Directors stressed the importance of enhancing the investment climate beyond the free zones, and fostering private sector participation more generally. They encouraged the authorities to pass the amended company law, which will allow higher foreign investment in U.A.E.-based companies. They stressed that labor policies should be implemented flexibly to avoid undue pressures on private sector salaries, in order to preserve competitiveness. To address employment of nationals, attention should be given to long-term education, training, appropriate wage policies, and labor legislation.

Directors urged the authorities to strengthen the institutional framework and build-up a strong, comprehensive, and consistent statistical system. Data should be compiled on off-budget fiscal operations and on domestic and external debt at the emirate level, and fiscal transparency at the emirates' level should be enhanced by adopting international standards of classification for expenditure and revenue statistics. The authorities are urged to finalize the General Data Dissemination Standard (GDDS) metadata and nominate a GDDS coordinator.

¹ Under Article IV of the IMF's Articles of Agreement, the IMF holds bilateral discussions with members, usually every year. A staff team visits the country, collects economic and financial information, and discusses with officials the country's economic developments and policies. On return to headquarters, the staff prepares a report, which forms the basis for discussion by the Executive Board. At the conclusion of the discussion, the Managing Director, as Chairman of the Board, summarizes the views of Executive Directors, and this summary is transmitted to the country's authorities.