1. The Rate Hike Decision
In mid-June 2017, the US Federal Reserve raised its key benchmark interest rate, the federal funds rate, by 25 basis point from 1.00% to 1.25%, preceded by three rate hakes in March 2017, December 2016, and December 2015, after years of record lows and quantitative easing following the 2008 financial crisis. Projections expect a third rate increase in 2017 to 1.40% by year's end. The Fed also announced its plans to unwind its $4.2 trillion portfolio of Treasury bonds and mortgage-backed securities. This combination of a rate hike and balance sheet reduction reflects a tightening monetary policy and confidence in the US economy as well as the solid growth in hiring that has driven the unemployment rate down to 4.3%, its lowest level in 16 years.
GCC countries with dollar pegged currencies were quick to raise interest rates in tandem with the Fed’s hike, despite a slowdown in economic growth due to low oil prices. Central banks in each of Saudi Arabia, the United Arab Emirates, Bahrain, and Qatar, as well as Jordan, followed suit by raising rates by 25 basis points, while the Central Bank of Kuwait refrained from mimicking the Fed’s rate hike for the first time since 2015. The interest rate increases were as follows:
• The Central Bank of Qatar raised its deposit rate by 25 basis points from 1.25% to 1.50%, while the lending and repo rates were left unchanged.
• The Central Bank of the UAE raised interest rates applied to the issuance of Certificates of Deposit (CODs) by 25 basis points. The repo rate for borrowing short term liquidity from the central bank against Certificates of Deposit was also raised by 25 basis points to 1.50%. Notably, Certificates of Deposit issued by the central bank to banks are the monetary policy through which interest rate changes are transmitted to the banking system.
• The Saudi Arabian Monetary Agency (SAMA) raised its benchmark reverse repo rate by 25 basis points to 1.25%, while the repo rate was left unchanged at 2.00%. Increasing the reverse repo rate usually encourages banks to increase deposits with SAMA and so decreases the incentive for commercial lending.
• The Central Bank of Bahrain raised its key policy interest rate on Bahrain's one-week deposit facility from 1.25% to 1.50%. It also increased its overnight deposit rate from 1.00% to 1.25%, the one-month deposit rate from 1.75% to 2.15%, and the lending rate from 3.00% to 3.25%.
• On the other hand, the Central Bank of Kuwait kept its discount rate at the current level of 2.75% as of March 2017, despite following the 3 previous rate hikes since 2015, due to factors such as low oil prices and modest economic growth. The central bank assured it would continue its efforts to maintain the attractiveness of the Kuwaiti Dinar.
The pegged currency regimes of GCC countries, with the exception of Kuwait, mandated following the Federal Reserve’s monetary policy and rate hikes, with all GCC currencies pegged to the US dollar with the exception of the Kuwaiti dinar, which is pegged to a basket of currencies dominated by the dollar, giving it relative flexibility in setting its monetary stance. Moreover, had interest rates not been raised in line with the Fed’s rate hike, investors would have sold their assets in the Gulf in favor of higher-yielding dollar-based investments, which could have put downward pressure on local currencies, making the pegs difficult to maintain.
2. Repercussions of the Interest Rate Hike on GCC Economies and Banking Sectors
As oil revenues constitute over 85% of their government revenues and 70% of their GDP, GCC countries have been facing economic and financial pressures since mid-2014 following the steep decline in oil prices. These pressures are translated in the slowdown of economic growth of GCC countries from 5% during the period 2000-2013 to 2% in 2016, and a mere 0.9% expected by end-2017. Similarly, non-oil GDP growth declined from 7% during the period 2000-2013 to 1.9% in 2016 due to fiscal austerity measures undertaken by GCC governments. Figure 1 shows the slowdown in economic growth in each of the six GCC countries over the period 2013-2017.
Figure 1: Weaker Economic Growth in GCC Countries
Consequently, the recent decision to raise interest rates in tandem with the Fed’s decision has a ripple effect across the entire economy, stock market, and banking sector, and may have both positive and negative ramifications on GCC countries.
To begin with, as benchmark interest rates increase, corporate and household borrowing costs begin to rise, credit growth is likely to slow, restraining consumption and investments, weakening domestic demand, and reducing inflation, hence further deterring economic growth. Along these lines, according to a working paper published by SAMA in May 2015 titled “The Impact of Rising Interest Rates on the Saudi Economy”, the impact of rising interest rates was found to be negative on the overall GDP, non-oil GDP, and on domestic credit to all economic sectors. Therefore, the decision to raise interest rates at this particular time may have a counter-productive impact on the economies of GCC countries struggling to bolster economic growth amid lower oil revenues.
The decline in oil prices pushed GCC countries to issue bonds, primarily sovereign, to fund expected budget deficits, as liquidity constraints strained the banking sector emphasizing the need to diversify sources of financing. International sovereign debt issuance from the region increased from $2.1 billion in 2015 to $38.9 billion in 2016, and Moody’s expects sovereign issuance from the region at around $32.5 billion be end-2017. Consequently, for GCC governments and large corporations, a higher interest rate may increase the cost of raising debt from the bond market at a time of lower oil prices. This means that demand for lower-yield bonds will drop, causing their price to drop.
Regarding the impact of the interest rate hike on Gulf financial markets, it is likely to have negative repercussions on investment in stock markets, due to the competition between the interest rate on deposits and the return on investment. A rise in interest rates could lead to an increase in the sale of equities in GCC markets hence putting downward pressure on their prices, as it may lead to the withdrawal of liquidity from the financial markets to investment in bank deposits, with higher returns and lower risk. On the positive side, raising the interest rate may increase investor confidence and boost trading activity in GCC markets.
The real estate sector, one of the main engines of economic activity in the GCC, may be adversely affected by higher interest rates due to higher financing and borrowing costs which may dampen demand due to rising prices and a decline in the volume of projects. A higher rate will make properties more expensive with the higher cost of bank funding for projects resulting in a corresponding price increase from the side of the developers in addition to rising mortgage rates.
Moreover, interest rate hikes affect individuals and households mainly through increases to credit card and mortgage interest rates, especially if these loans carry a variable interest rate, which in turn decreases disposable income and consumption.
Similarly, companies operating in the Gulf, including SMEs, which rely primarily on bank funding to finance their business operations, are among the most negatively affected by higher interest rates due to higher borrowing costs and higher operating expenses, which reduces profit margins and decreases share value. Less business spending can curb the growth of a company; it might curtail expansion plans and new ventures and even induce cutbacks. There might also be a decrease in profit either through higher debt expenses or less revenues which, for a public company, generally lowers the price of the company's stock due to a drop in the estimated amount of future cash flows.
Furthermore, a strong domestic currency hampers exports and makes imports cheaper. With currencies of GCC countries (excluding Kuwait) pegged to the dollar, a stronger dollar due to a higher interest rate makes Gulf exports less competitive – reducing exports particularly to countries whose currencies are not pegged to the dollar.
Another sector likely to be impacted by the interest rate hike is the tourism sector, as it may become more expensive for tourists from countries of weaker currencies not pegged to the dollar to travel to and spend in the Gulf.
One of the biggest challenges facing GCC countries is the decrease in banking sector liquidity as a result of the decline in oil revenues and the subsequent decline in deposits, particularly from the public sector, which recorded a decline of more than 2% in 2015 and 2016, compared to a growth rate of 5.8% in 2014, as a result of governments withdrawing some of their deposits from banks to strengthen their financial conditions. In a positive development, the first quarter of 2017 witnessed a growth in government deposits of about 3.3% as a result of higher oil prices after OPEC agreed to cut production. Along these lines, slower economic growth along with higher interest rates is expected to increase borrowing costs hence subdue credit demand and lending activity, hence alleviating liquidity pressures or constraints on GCC banking sectors.
In conclusion, the financial sector tends to benefit the most from interest rate increases. Banks, brokerages, and insurance companies' earnings often increase as interest rates increase, because they can charge more for lending. Interest rate hikes boost bank profit margins which may increase competition between banks, hence improving the quality of banking products and services. However, it should be noted that the flipside of bigger margins for lenders is the risk of more loan defaults.
With the rising interest rates, the US and the dollar-pegged GCC countries will be more attractive to foreign investments because of higher interest rates on the dollar and on government bonds. The rise in the value of the dollar as a result of the rise in interest rates also contributes to the increase in the value of GCC countries' foreign investments (denominated in dollars) and sovereign assets abroad.