The International Monetary Fund (IMF) mission visited the United Arab Emirates from February 27 to March 7, to hold discussions for the United Arab Emirates’ 2011 Article IV consultation.¹ Discussions focused on near-term economic policies; measures to maintain financial stability; and a medium-term strategy to mitigate risks posed by the highly-leveraged Government-Related Enterprises (GRE) and maintain macroeconomic stability over the business cycle.

1. The global financial crisis brought an end to a decade of high growth. The U.A.E. has had remarkable achievements over the last decades with its open and outward orientation, which allowed diversifying the economy and generating sustained high economic growth. The decline in oil prices, the post-Lehman shut down of international capital markets, and the price correction in the property market in Dubai have put significant strains on the economy. The authorities supported the banking sector through liquidity injection, recapitalization, and deposit guarantees, and the Emirate of Abu Dhabi provided financial support to the Emirate of Dubai. Nevertheless, the combination of substantial short-term borrowing, the price correction in the real estate market, and maturity mismatches forced Dubai World (DW), a major Dubai GRE, to seek a debt standstill, generating another round of ripple effects, including in the GCC region. Real GDP is estimated to have contracted by 3.2 percent in 2009.

2. The economy is recovering gradually but risks remain. Benefiting from high oil prices and strong demand from traditional trading partners, and despite fiscal contraction, the economy grew by an estimated 3.2 percent in 2010. The momentum is carrying into 2011 with non-oil GDP growth projected to accelerate from 2.1 percent in 2010 to 3.3 percent, reflecting strong tourism, logistics, and trade in Dubai; and large public investment spending in Abu Dhabi, including through GREs. Higher oil prices are contributing to a marked improvement in the fiscal position and balance of payments. The successful restructuring of DW’s debt has improved market confidence, allowing top-grade Dubai issuers to regain market access. However, credit spreads remain high, reflecting uncertainty about debt restructuring needs of other GREs, and more recently a higher regional risk premium. The large overhang in the real estate market will also remain a drag on the economy, and the unrest in the MENA region poses downside risks.

3. The U.A.E. needs to strengthen the economy’s resilience to shocks in the future. The recent episode of debt restructuring in Dubai and the ramp-up of GRE borrowings in other emirates underline the need to identify, assess, and mitigate the risks posed by these entities. The recent boom-bust experience. highlights the challenge of macroeconomic management over the cycle. Given the pegged exchange rate regime, this requires mutually-supportive countercyclical fiscal and macroprudential policies. Underpinning these reforms is the need to improve statistical capacity to inform policy decisions and disclosure.

II. Economic outlook and risks

4. A fragile recovery is gaining strength, benefiting from a favorable global environment. High oil prices, improved growth prospects in Asia, and low interest rates are contributing to the recovery. Real GDP is projected to continue to grow at 3.3 percent in 2011. Driven by higher food prices, consumer price inflation is expected to rise, but will remain moderate at 4.5 percent in 2011, as rents continue to decline. Analysis of the real exchange rate suggests that the dirham is in line with fundamentals.

5. Growth trends differ across Emirates. Higher oil production and increased infrastructure spending, including through GREs, are the main drivers of growth in Abu Dhabi, though its non-oil growth will continue to slow down partly due to last year’s fiscal contraction. Dubai is benefiting from its leading position as a regional hub, with growing links to Asia, and improved competitiveness thanks to the ongoing price correction in the real estate market.

6. Several factors make the economic recovery fragile.

• The large property overhang and uncertainty regarding its size. The excess supply of property in Dubai –which will further increase in light of the expected completion of unfinished projects– and uncertainty regarding its size will continue to weigh on property prices, investment, and growth. There is also a risk that Abu Dhabi’s strategy to ramp up its housing supply, unless carefully managed, will put further pressure on the property market.

• Lack of clarity on GRE financing strategies. With an estimated US$31 billion of debt due in 2011–12, of which at least $5 billion in the real estate sector, Dubai continues to face significant rollover risks in the short term. Despite better communication, the absence of a well-defined, coherent, and transparent strategy to address GRE financing will translate into higher borrowing costs for Dubai (both sovereign and GREs) in an already difficult market. In addition, the government of Dubai’s strategy to use the earnings of the well-performing GREs to finance the underperforming entities may dampen investment and growth.

• International sanctions on Iran. The sanctions on Iran, one of the U.A.E.’s largest trading partners and a traditional source of demand for Dubai real estate, could undermine the recovery.

7. Furthermore, the unfolding turmoil in the region poses downside risks to the outlook. The re-pricing of risk in the region would result in more difficult market conditions. On the positive side, there are indications that the U.A.E. may benefit from increased tourism and investments looking for diversification within the region. Higher oil prices are also benefiting the U.A.E. as a hydrocarbon exporter, though if sustained, they may dampen the recovery in view of lower demand from Asia.

III. Short-term policies

8. Macroeconomic policies should aim at supporting the recovery in 2011 and responding to the economic spillovers from the unfolding events in the region, if needed.

9. The government should avoid contracting further its fiscal stance to ease economic recovery. With the reduction in communication fees, the federal government budget foresees a budget deficit in 2011. In contrast, to preserve fiscal sustainability and with the completion of some investment projects, Dubai is planning a fiscal consolidation. While Abu Dhabi’s budget for 2011 is still not available, the mission concurs with the preliminary intentions of the government of Abu Dhabi to increase infrastructure spending, including through the GREs. The government should also stand ready to expand spending on productive investment, in case the regional unrest starts affecting the economy.

10. The central bank should monitor bank liquidity conditions and stand ready to relieve potential pressures. The re-pricing of risk in the region could trigger a sudden reversal of the recent deposit inflows to the banking sector. The central bank should monitor individual bank liquidity conditions to ensure that banks have the needed liquid assets to respond to such reversal.

11. Completing GRE debt restructurings and greater transparency regarding policy intentions would improve market confidence. The ongoing restructuring of GREs will likely improve financing conditions. Throughout the process, due regard should be accorded to ensuring the viability of these entities through writing-off impaired assets. In addition, the government should clarify and communicate the stock, composition, and maturity profile of the GREs’ liabilities and their financing strategy, including through government support. Disclosing information on the state and outlook of the real estate sector together with a communication of the government’s strategy to address the overhang would also help.

IV. Securing Financial Stability

12. Continued strong core earnings and higher capital compared to pre-crisis levels have prepared the banking system to withstand shocks. Although nonperforming loans (NPLs) have doubled since the crisis, the second highest increase in the GCC, stress tests on aggregate banking data indicate resilience to shocks. This reflects higher capital buffers, thanks to government support, and strong earnings. System liquidity has also improved in light of slower credit growth and high deposit rates attracting foreign flows.

13. Nevertheless Dubai banks face greater pressures from their exposures to GREs and real estate in Dubai. They bear a greater burden of provisions on Dubai loan restructuring; their NPLs are twice as high as Abu Dhabi banks; and they continue to deleverage. As a result, they are losing market share. Islamic banks are also under pressure because of their larger exposure to real estate.

14. The central bank should continue its efforts to monitor and manage risks. The Central Bank of UAE (CBU) has engaged a wide-ranging reform to strengthen financial stability analysis, revamp the regulatory framework, and develop macroprudential policies. In this context, the CBU could consider capital charges above 100 percent for unrated GREs that it deems risky. For that, the CBU would have to develop an internal risk management/rating function, which will also help it manage the increased range of its repo-eligible collateral. In this context, the emirate-level debt management offices (DMO) should share GRE financial information with the CBU to help monitor GRE risks. Broadening the regulation on real estate exposure would also help manage risks.

15. The debt restructuring in Dubai may imply postponing the realization of losses and a new bout of roll-over risk in a few years that requires monitoring. Restructuring assumes that the borrowers’ problem is one of liquidity rather than solvency. However, if asset prices do not recover, there is a risk that some borrowers may not be able to pay when the loans start to mature. The CBU should monitor the performance of restructured loans, and consider regulating their classification and provisioning, should they need further restructuring.

16. The central bank should continue to contain banks’ dividend distribution over the next few years to ensure that the banks can handle this risk without new government support. The CBU could link its approval of dividend distribution to the results of stress tests. It could also consider more forward-looking provisioning (moving from incurred to expected loss) as envisaged by forthcoming changes to the IFRS.

17. Developing a domestic debt market would help banks over time meet the Basel liquidity requirement. The CBU plans to introduce a short-term liquidity ratio along the lines of Basel III. A government securities market would help banks improve their liquidity buffers and IMF staff stands ready to provide technical assistance on market development. Given the limited role of federal debt in the foreseeable future, the authorities could also explore funding from non-traditional sources, such as term deposits from government sources. While foreign term-funding is an essential element of bank asset-liability management, maturities should avoid coinciding with those of GRE debt in case of a market disruption.

18. Government control of banks and high exposure to GREs point to potential governance issues. As in other countries, the crisis has increased government stakes in banks. At the same time, these banks have been heavily involved in lending to GREs and GRE debt restructurings. Good governance should be seen as part of the implementation of risk-based oversight. The mission recommends conducting a bank governance diagnostic prior to the forthcoming Financial Sector Assessment Program.²

V. Strengthening the Economy’s Resilience over the Medium Term

19. As the recovery firms up, policies should progressively shift focus from crisis-management towards strengthening the economy’s resilience to adverse shocks. Dubai’s debt restructuring and its fiscal and financial implications, as well as increasing GRE borrowings in other emirates call for close monitoring of the risks posed by these entities. The high dependency on volatile hydrocarbon revenues underscores the need for strong macroeconomic management over the economic cycle. In the context of a pegged exchange rate regime, this requires mutually-supportive countercyclical fiscal and macroprudential policies. In a federal system like the U.A.E., policies also call for closer coordination between various governments. Underpinning these reforms is the need to improve statistical capacity and timely disclosure of reliable information to inform policy decisions.

20. The authorities’ plan to upgrade the infrastructure in the northern emirates is a step towards more inclusive economic development and should be expanded. The plan will help ease the electricity shortages in the northern emirates. In addition, replacing the current mostly implicit subsidies on water and electricity with explicit cash transfers to lower-income households would better target those in need, while reducing bottlenecks through more effective conservation. Although overall unemployment in the U.A.E. is low, unemployment among nationals remains high and concentrated in the northern emirates. The federal and local governments are setting up employment programs to encourage the recruitment of nationals in the private sector. Local governments have also established SME funds and training programs. The mission encourages the government to consider launching its planned active labor-market policies in the northern Emirates and locating some of its agencies/entities in the North to create jobs in these areas.

Managing the risks posed by GREs

21. The GREs have contributed significantly to the U.A.E. growth, but the recent bailouts and expansion of GRE borrowings in several emirates underscore the need to have a proper risk management framework. Such a framework entails effective identification, assessment, monitoring, and reporting of contingent liabilities arising from GREs, and disclosure of these liabilities in government accounts. To this end, the authorities should consider including a statement of fiscal risks as part of the annual budget documents including discussion of past experiences with the materialization of risks, a presentation of policies to mitigate and manage risks, and forward-looking risk estimates. In the case of the U.A.E., such a statement should start by focusing on risks posed by GREs, and expand later to public-private partnerships (PPP) and other risks, as they arise, the IMF staff stands ready to provide technical assistance in this area

22. Containing GRE borrowing is key for fiscal sustainability at the emirate level and requires a strong institutional framework. This could be achieved through limits on GRE borrowing, which could be defined by individual governments and communicated through the fiscal coordination committee. The DMOs that have been already established at the federal and emirati levels could monitor compliance with these limits. The federal DMO could coordinate information-sharing across DMOs and disseminate data on public sector debt by emirate. To enable this mechanism, the current draft law on public debt should clarify the relations between the federal and emirate-level DMOs and expand coverage to emirati GREs. The draft law also needs to define better the federal DMO’s scope and objectives; and encourage coordination between the DMO, and fiscal and monetary authorities within clearly defined roles and responsibilities.

23. Improved corporate governance and transparency are also key for mitigating the risks posed by GREs. An assessment of corporate governance against the OECD standard would be useful. In particular, it would be important to delineate clearly between the commercial and noncommercial operations carried by GREs, clarify the government support strategy to the GREs, and standardize the accounting, auditing, and financial reporting practices of GREs. Better information disclosure about GRE financial accounts would also help attract investors and ultimately translate into lower funding costs.

Managing the economy over the cycle

24. Countercyclical fiscal policy could help avoid boom-bust cycles in the U.AE. economy. As a main tool for macroeconomic management under a pegged exchange rate regime, fiscal policy should aim at delinking government and GRE spending from the volatility of oil prices. Given that Abu Dhabi owns the bulk of hydrocarbon wealth in the U.A.E., a medium-term fiscal framework should guide Abu Dhabi’s fiscal policy with a view to ensuring long-term sustainability and intergenerational equity. Other emirates need to ensure medium-term fiscal sustainability. In this context, Dubai should undertake fiscal consolidation to achieve a comfortable debt-to-GDP ratio over the medium-term. The planned introduction of a GCC-wide VAT would enhance revenue mobilization capabilities and facilitate such consolidation.

25. Given the federal structure, effective intergovernmental coordination is key to promote both short-term demand management and medium-term sustainability. Timely and reliable information-sharing systems, including on medium-term fiscal frameworks, annual budgets and their execution, as well as consolidated fiscal accounts to inform policy making are prerequisites for such coordination. In this context, the Fiscal Coordination Council has made progress in sharing information.

26. In addition to countercyclical fiscal policy, macroprudential tools could help avert a resurgence of imbalances. In this respect, the CBU should: tailor its early warning system to system-wide risks it has identified as being systemic (e.g., GRE borrowing, real estate, speculative flows); ensure that a matching range of prudential tools are in place to act on warning signs; and decide on trigger values that will ensure activation of the tools and communicate them effectively to stakeholders.

Improving the statistical capacity

27. The establishment of the National Bureau of Statistics (NBS) is an important step in developing statistical capacity at the federal level. The NBS has made some progress in establishing databases for key statistics. Thanks to sustained coordination efforts between the federal and emirate governments, the Ministry of Finance has developed consolidated fiscal accounts. Nevertheless, further efforts are needed for the timely compilation and dissemination of key statistics, including on national accounts, balance of payments, and fiscal accounts, and this requires harmonization of methodologies across emirates. The IMF staff stands ready to provide technical assistance in this area. It also encourages to move towards timely dissemination of existing data.

¹ The mission, comprising Ms. Koranchelian and Messrs. Sensenbrenner, Cevik, and Guzzo, met with H.E. Minister of State for Financial Affairs Obaid Humaid Al Tayer, H.E. Minister of Economy Sultan Bin Saeed Al Mansoori, H.E. Governor of the Central Bank of United Arab Emirates Sultan Bin Nasser Al Suwaidi, the heads of economy and finance departments of the emirates, as well as other senior officials and representatives from the business and financial community. Mr. Kammer joined the team during March 6–7.

² The FSAP is a joint program of the Fund and the World Bank. The World Bank can assess bank governance upon the authorities’ request.