Public Information Notice No. 03/30

Public Information Notice: IMF Concludes 2002 Article IV Consultation with the United Arab Emirates

March 11, 2003

On February 12, 2003, the Executive Board of the International Monetary Fund (IMF) concluded the Article IV consultation with the United Arab Emirates.¹

Background

U.A.E. economic development over the past decades has been based on a highly liberal, business friendly and market-oriented growth strategy aimed at diversifying the economy and strengthening the export base. With a pegged exchange rate used as a nominal anchor for the economy and an open border foreign labor policy, this development strategy has made the economy more resilient to oil price fluctuations, as well as contributed to a large accumulation of government financial wealth, which has provided ample latitude to respond to external shocks. Amid volatile oil prices, the United Arab Emirates has also systematically recorded a trade- and income-driven external current account surplus, and remained a net creditor nation. However, fiscal vulnerability to weakening oil prices has increased lately owing to rapidly rising current expenditures, notably defense and subsidies to agriculture since 1998, as well as the absence of a developed tax system.

Despite lower oil revenue, the U.A.E. economy performed relatively well in 2001. The external current account surplus remained large, even though average oil prices declined by 12.6 percent to $23.78 per barrel, leading to a loss in oil export receipts equivalent to 5 percent of GDP. Real GDP grew by about 4 percent, as a number of projects were launched in construction, electricity and water, and downstream oil sectors. Nevertheless, a continued rapid increase in current spending in the face of declining oil revenue led to a sharp deterioration in the fiscal accounts. In 2001, the consolidated fiscal balance moved back into a deficit (of about 5 percent of GDP) largely financed by drawing down official foreign assets. On monetary developments, broad money growth remained stable at about 11 percent in 2001-the increase in domestic assets accounted for much of this expansion. Private sector creditor grew by 9 percent from a year earlier, with personal lending and construction loans experiencing the fastest growth. The central bank's reserves reached US$14.3 billion at the end of 2001-equivalent to five months of imports of goods and services.

The banking system in the United Arab Emirates remains strong, broadly profitable, well supervised, and capitalized. Benefiting from relatively low operating costs and widening margins between deposit and lending interest rates, net profits of national banks rose by 8 percent in 2001. The ratio of gross nonperforming loans (which are adequately provisioned for) to total loans continued to decline, while capital adequacy ratios remained significantly above international standards.

In 2002, the U.A.E.'s macroeconomic performance, however, appears to have been mixed. Although average crude oil prices are estimated to have risen by 4 percent to US$24.70 per barrel, oil output is likely to have declined by about 9 percent in line with OPEC-mandated cuts. These cuts are estimated to have contributed to a fall in real GDP growth, even though non-hydrocarbon growth remained robust on account of ongoing construction projects and rising petrochemical output. Moreover, lower crude oil receipts, together with rising imports and lower investment income, have also contributed to reducing the external current account surplus. Amid declining revenue, government spending is expected to have remained broadly unchanged, leading to a sharp deterioration in the fiscal accounts. The estimated consolidated fiscal balance registered a deficit of about 9 percent of GDP, and the non-hydrocarbon deficit widened to 26 percent of GDP. Meanwhile, monetary developments through end-November 2002 showed a stable broad money growth, with central bank foreign assets reaching more than US$15 billion. The stock markets remained bullish during much of 2002, mostly as a result of continued strong bank profits.

Domestic institutions have been strengthened over the past few years. The authorities took important steps in 2000 to address deficiencies in the securities markets. These included the enactment of the Federal Securities Law and the creation of the Emirates Securities and Commodities Markets Authority. Also, the first two formal stock exchanges, the Dubai Financial Market and the Abu Dhabi Securities Market, opened in that year. The authorities have also put in place a comprehensive regime to combat money laundering and terrorist financing. The federal government is currently implementing a public expenditure management reform, aiming at gradually introducing a performance-oriented budget to ensure greater efficiency in public spending. It is also restructuring support services to ministries, while carrying out an electronic government project to improve fee collection and significantly reduce red tape. On other reforms, privatization of the power sector has been stepped up, particularly in the emirate of Abu Dhabi where several independent power projects are currently under way, while Dubai has expanded foreign direct investment opportunities by launching new free zones and allowing foreign ownership of properties.

Executive Board Assessment

Executive Directors noted that the U.A.E.'s open, market-oriented economic system, and the authorities' sound economic management have helped sustain robust economic growth, low inflation, and a comfortable external position, notwithstanding the wide fluctuations of global crude oil prices over the years. They welcomed the continuing progress in diversifying the economy, as evidenced by the rapid expansion of a broad range of economic activities and services. Going forward, Directors considered that the main challenges facing the authorities will be to maintain strong economic growth and enhance job creation in a stable macroeconomic environment. This will require a sustained strengthening of the fiscal position, which has deteriorated markedly since 2001, and pushing ahead with structural reforms-in particular, by further strengthening the financial sector, developing human resources, and expanding opportunities for foreign direct investment.

Directors underscored that a key challenge in 2003 will be to restore fiscal discipline, in accordance with the authorities' intergenerational economic equity objectives. In the immediate future, a significant portion of the fiscal strengthening will need to come from cuts in current spending, with priority given to phasing out subsidies on water, electricity, and agriculture, and cutting back nonproductive outlays. Directors encouraged the federal authorities to persevere in their efforts to ensure greater efficiency in public spending, including by fully implementing a performance-oriented budget policy.

Directors urged the authorities to develop and implement budgetary policy in a comprehensive, viable, and sustainable medium-term framework and, given the complexities of the U.A.E.'s political structure, stressed the importance of initiating soon the process of mobilizing the necessary political consensus to do so. Such a framework will strengthen the budget structure and reduce the still considerable dependence of the economy on volatile hydrocarbon resources, and help the authorities to build-in precautionary savings to preserve official foreign assets. Within this framework, the authorities should aim at strengthening the budget formulation process and improving fiscal transparency by adopting international standards of economic classification for expenditure and revenue statistics.

Key to the medium-term strategy will be steps to strengthen and diversify the revenue base. Directors urged the authorities to adopt a broad-based modern tax system with a view to reducing fiscal vulnerability. As initial steps, they suggested that the authorities should expand taxes in line with policies that are already in place in other members of the Cooperation Council of the Arab States of the Gulf (GCC), and consider implementing a broad low-rate consumption tax on services, while local governments should introduce a property tax. Several Directors encouraged the authorities to avail themselves of Fund technical assistance for tax reform and institution building.

Directors commended the authorities for the priority they have accorded to maintaining a sound and well-supervised banking system, which should play an important role as a regional financial center for the Middle East. They welcomed the progress made in further strengthening the financial sector, including through the adoption of a broad system of risk management in the banking sector and of the recommendations of the Financial Sector Assessment Program. Directors also praised the authorities for putting in place a comprehensive regime to combat money laundering and terrorist financing that also covered informal fund transfers. They encouraged the authorities to focus in the period ahead on reforming the insurance sector, improving securities sector supervision and monitoring, and enforcing existing regulations for companies to adopt international accounting standards.

Directors welcomed the authorities' ongoing efforts to foster the further development of the non-hydrocarbon sector and to promote the role of the private sector and foreign direct investment. They also encouraged the authorities to gradually eliminate remaining foreign investment restrictions outside of the free zones. Moreover, Directors considered that adoption of a common strategy for foreign ownership across the emirates would be helpful in promoting investment opportunities throughout the U.A.E. They welcomed the reform of the power and water sectors in recent years, and called for further efforts in this direction, including steps to restructure companies in the transmission and distribution sector.

Directors endorsed the authorities' commitment to the exchange rate peg, which has promoted economic stability by serving as a nominal anchor in the U.A.E.'s open economic system. They considered that the country's success as a resource exporter in maintaining a fixed exchange rate and competitiveness in the face of significant export price volatility owes much to its flexible labor policy. Directors stressed that fiscal discipline and a sound banking system will remain crucial supports for the exchange rate regime.

Directors noted that the U.A.E.'s open border foreign labor policy has enabled employment growth to contribute significantly to non-hydrocarbon sector growth and diversification. They endorsed the authorities' long-term labor market strategy to increase employment opportunities for nationals of the U.A.E, which will help absorb the rapidly rising local labor force and strengthen the prospects for robust economic growth. Directors suggested that this strategy should continue to focus on improving the skills of nationals through better education and training programs geared toward private sector labor demand, while, in general, avoiding mandatory administrative measures, such as quotas.

Directors urged the authorities to make stronger efforts to improve the quality, coverage, and timeliness of official data to support policymaking in an increasingly complex economy. Directors considered that improving coordination and cooperation across public agencies should remain a priority, while strengthening the good institutional base that currently exists within several government agencies. Directors also encouraged the authorities to develop comprehensive statistics on capital flows, particularly foreign direct investment and private sector external debt, as well as to provide available data on government foreign assets investment income on a timely basis to enhance macroeconomic assessment. Directors recommended that the U.A.E. participate in the Fund's General Data Dissemination System.

It is expected that the next Article IV consultation with the U.A.E. will be held on the standard 12-month cycle.