UAE: Investments to drive growth and diversification

The strong oil price and higher investment levels are continuing to drive growth. According to IMF data, nominal GDP growth increased by 28.4% in 2005, to USD 133.8bn; this is similar to the Abu Dhabi Chamber of Commerce's estimate of 2005 GDP USD 135bn. Real GDP growth stood at 12.0%. The figures highlight that the economic performance was exceptionally strong last year. The IMF also indicated that the UAE's federal budget posted a surplus equivalent of 24.9% of GDP; the surplus is forecast to surge to 28.4% of GDP in 2006.

Recently, the IMF increased its real GDP growth forecast for 2006 to 10.5% in 2006, up from 7%. This will be partly driven by 11% growth in the oil sector, due to the completion of several significant oil production facilities and higher oil prices. Furthermore, government's diversification plans will continue to promote strong growth going forward. Dubai will continue to focus on expanding the tourism, media, commercial and service sectors. Abu Dhabi is also increasingly looking to diversify into the service sectors. In May, Abu Dhabi announced plans to invest more than USD 100bn over the next 4 to 5 years. Areas will include tourism, a new airport to handle up to 20m passengers and a new world scale port. In addition, Abu Dhabi plans to build on its comparative advantage and is also planning to make major investments in its energy and industrial sectors. This will include expanding crude oil production to 3.5m bpd from the current 2.5m bpd, and building of refineries, gas processing plants and petrochemical complexes. Gross fixed capital formation will be the main positive contributor to real GDP growth.

Although there have been large corrections in the local stock markets, these losses will not lead to wider contagion in the economy. At the time of writing, the Abu Dhabi Stock Market has fallen by 31.5% year to date, while the Dubai Financial Market has dropped by 54.5%. These are two of the worst performing stock markets globally. Nevertheless, investment and private consumption remain buoyant. Strong oil prices and negative real interest rates will sustain the strong growth momentum. In addition, business sentiment remains high.

Furthermore, the impact of the stock market correction on private consumption and investment will be partly mitigated by the higher government spending, which will keep domestic demand high. The Federal budget for 2006 has been approved and although it only counts for around 25-30% of total expenditure (with the majority of spending taking place on the individual emirate level) it is a proxy indication of the scale of spending increases. The 2006 federal budget sees government expenditure increasing markedly by 20%. This will be partly due to the absorption of the sharp increase in wages and salaries in mid-2005. The wage increases helped to offset the increase in the CPI for locals as well as spreading the oil wealth; many nationals work in the public sector.

With regards to the banking sector, banks remain highly capitalised and the fundamentals remain strong. Although the fall in the stock markets is likely to affect profitability for some banks in Q2 (especially those with strong brokerage businesses), overall the sector will remain healthy. Importantly the Central Bank is looking to introduce measures to improve the UAE's securities rules. Meanwhile, the Emirates Securities and Commodities Authority is keen to enforce the regulations, having penalised 74 companies or their representatives for alleged 'irregularities'. Central bank measures include tackling the massive oversubscriptions for IPOs; the authorities are looking to move towards a more conventional method of pricing, with investment banks acting as book runners. Generally IPO valuations have been low, partly to encourage national investors to participate in the stock market.

However, the IMF has indicated that inflation is a major area of concern given the limited monetary tool available to the central bank. Companies as well as expatriates have expressed their concern over the rising cost of doing business in the country. A number of smaller companies have indicated that they are looking to move to cheaper regional countries due to the rising costs. Increasing rents continue to be the main factor behind this. Inflationary pressures are also increasing with the weakening of the US dollar. The IMF forecasts an inflation rate of 8.0% in 2005, although it noted that the CPI does not reflect true price increases as the basket of goods and services does not weight the housing costs and rents realistically.

We believe that greater foreign exchange flexibility, such as monitoring the dirham against a trade weighted basket would have a number of advantages, including greater monetary policy flexibility. Given high inflation levels, real interest rates have been negative. In order to dampen inflation, Dubai has capped annual rent increases to 15%. While, there is anecdotal evidence that a number of landlords are not adhering to this limit, this cap will result a lower inflation level in 2006. Residential rents in Dubai increased by an average of 17.1% in Q1 compared with 30.1% over the same period in the previous year. Furthermore, the rise in cost is transitory as rents are forecast to come down by the end of the year, with greater housing supply coming onto the market.

Despite the recent sharp increase in the cost of doing business, it is important to note that the UAE still remains the top destination for FDI in the region, with many companies basing their regional headquarters in the UAE given the investment-friendly environment. FDI inflow into the UAE was over USD 19.0bn in 2005, equivalent to 14.2% of GDP. Investment inflows are forecast
to remain at similar levels in 2006.

Moreover, the government will continue to promote reforming the business environment, which will further help to further attract FDI in to the UAE. The government has pledged to take prompt action to address a number of issues raised by the WTO during a round of trade policy review discussions held at the end of April. The Ministerial Legislative Committee has approved a federal draft law amending some provisions of the Commercial Companies Law. The draft law will be submitted for approval at the Cabinet's next meeting. Currently, the Commercial Companies Law restricts foreign ownership to 49%. Moreover, the agencies law had recently been amended to outlaw exclusive agency. With the continuation of strong FDI and the diversification of the economy, the UAE outlook will remain positive going forward.