UAE reaping the benefits of its early efforts to diversify the economy IMF Staff Report for UAE - 2012

The UAE economy is gradually recovering from the 2009 crisis. The banking sector was strengthened through significant capital injections, and some progress has been made in restructuring the debt of government-related entities (GRE). The ailing real estate sector is beginning to find bottom but, given the ongoing oversupply, an early and broad-based recovery of the sector remains unlikely.

Outlook and risks. The recovery of the nonhydrocarbon economy, however, looks set to continue this year, backed by strong trade, tourism, logistics, and manufacturing, and helped by high oil prices. With limited near-term potential for further increases in real oil production, overall GDP growth is expected to moderate to 2.3 percent. Downside risks relate to a possible increase in regional geopolitical tensions, a potential decline in oil prices, a renewed worsening of global financial conditions, or a marked slowdown in Asia.

Macroeconomic policy mix. The UAE plans a gradual fiscal consolidation this year which will help unwind the fiscal stimulus of recent years and lower the currently high fiscal breakeven oil price without undermining the economic recovery. The planned fiscal consolidation will also increase the room for maneuver in case the downside risks materialize. Monetary policy will stay appropriately accommodative under the U.S.dollar peg.

Government-related entities. The GREs continue to face financial challenges in light of their high debt and rollover needs. Further deleveraging and strengthening of impaired GRE balance sheets is needed. Improving GRE corporate governance and increasing transparency about their financing strategies, financial conditions, and debt profile would be important to strengthen market confidence. Channeling bank funding to non-viable GREs should be avoided.

Financial stability. The banking system maintains significant buffers to withstand a further deterioration in asset quality and external liquidity conditions. The central bank should nonetheless continue to closely monitor banks’ liquidity and capital buffers as individual banks could be affected if downside risks materialize.

Statistics. Effective policymaking is contingent on timely and accurate data, rendering further improvements in the statistical framework important

BACKGROUND

1. Following the 2009 crisis, the economy has been slowly recovering and repairing its balance sheets. The Dubai World debt restructuring was completed, but several other troubled government-related entities (GRE) are still in the process of restructuring. The authorities strengthened the banking sector through liquidity support, recapitalization, and deposit guarantees, and the emirate of Abu Dhabi provided financial support to the emirate of Dubai. The Dubai Financial Support Fund (DFSF) was called to support troubled entities in the emirate and has now almost exhausted its funding of $20 billion.

2. The UAE has been reaping the benefits of its early efforts to diversify the economy. As the UAE developed into a major services hub in the Middle East, its dependency on oil exports declined markedly.

Based on its well-developed hospitality and services sectors, tourism, transportation and logistics have been major drivers of the post- 2009 recovery. The UAE has also been benefiting from high oil prices and strong growth in Asia. As a result of its perceived safe haven status and developed services sector, the country benefited from an increase in demand for property by expatriates and a

surge in tourism in the wake of the turmoil in the MENA region that began last year.

Recent Developments

3. The economic recovery continued and the external position strengthened significantly in 2011. Real GDP growth reached an estimated 4.9 percent, supported by high oil prices and production in response to disruptions in Libya. Nonhydrocarbon growth also strengthened, to around 2.7 percent, backed by strong trade, logistics and a surging tourism sector, despite the continued weakness of the construction and real estate sectors in the aftermath of the 2009 crisis. Backed by high oil prices and buoyant Nonhydrocarbon exports, the external current account surplus increased markedly, to around 9 percent of GDP. Inflation remained subdued at an average of 0.9 percent in 2011, mainly due to a continuing decline in housing rents and limited pass-through of international food prices.

4. The large property overhang continues to be a drag on the economy. Since mid-2008, real estate prices have fallen by more than 60 percent in Dubai, and to a lesser extent in Abu Dhabi. The large supply overhang and the completion of additional projects in the coming years render an early and broad-based recovery of the sector unlikely (Box 1).increased its current and development expenditures, and extended substantial financial support to Aldar, its flagship real estate developer.2 Following a contraction in 2010, Dubai’s deficit increased slightly in 2011, mostly on account of further spending from the DFSF. Nonetheless, high oil prices led to an improvement in the consolidated overall balance from a deficit of 2.1 percent of GDP in 2010 to an estimated surplus of 2.9 percent of GDP in 2011.

 5. The recovery was supported by an expansionary fiscal policy. The consolidated government nonhydrocarbon primary deficit (including loans and equity) rose to nearly 42 percent of nonhydrocarbon GDP in 2011 (from 36 percent in 2010), as Abu Dhabi increased its current and development expenditures, and extended substantial financial support to Aldar, its flagship real estate developer.2 Following a contraction in 2010, Dubai’s deficit increased slightly in 2011, mostly on account of further spending from the DFSF. Nonetheless, high oil prices led to an improvement in the consolidated overall balance from a deficit of 2.1 percent of GDP in 2010 to an estimated surplus of 2.9 percent of GDP in 2011.

6. Supported by accommodative monetary policy, banks remained amply liquid but private sector credit growth did not pick up. In light of low U.S. interest rates, monetary policy stayed accommodative under the fixed exchange rate regime. Lending to the private sector has nonetheless remained sluggish and lagged behind the recovery in credit growth in neighboring GCC countries, as

excess capacity in the real estate sector and the debt overhang still limit lending opportunities. Despite a continued rise in nonperforming loans (second highest level among GCC countries), the banking sector has remained well-capitalized and profitable, as the net interest margin has remained

comfortable. In October 2011, the authorities quickly resolved Dubai Bank through a takeover by Emirates NBD bank

1 The Dubai Financial Support Fund, financed in equal parts by the central bank and Abu Dhabi, was established in 2009 to provide financial support and liquidity to government and government-related entities undertaking projects of strategic importance in Dubai.

2 The consolidated government comprises the federal, Abu Dhabi, Dubai, and Sharjah governments accounting for over 99 percent of total UAE fiscal expenditures.

3 In connection with this transaction, Emirates NBD received a Dh2.8 billion deposit from the ministry of finance. The government of Dubai has provided a guarantee—with a fair value of Dh768 million—for any losses relating to existing assets for seven years.