Non-oil recovery strengthens, despite weak construction and real estate sectors

Government-related entities still pose risks

Fiscal consolidation should increase government’s room for maneuver

Growth in the United Arab Emirates is expected to moderate to 2.3 percent in 2012 as oil production levels peak, the IMF says in its latest annual assessment of the economy. However, nonhydrocarbon growth is strengthening as the country’s dependency on oil declines.

The UAE has been slowly recovering from the 2009 property market crisis, which hit the economy hard. The country is benefiting from high oil prices and oil production volumes. Going forward, there is limited near-term scope to expand oil production further. “Strong trade, tourism, logistics, and manufacturing are now driving growth, despite lingering weakness in the construction and real estate sectors,” said Harald Finger, IMF mission chief for the UAE.

The UAE has been reaping the benefits of its early efforts to diversify the economy, the IMF says, projecting that the country’s nonhydrocarbon growth will reach 3.5 percent in 2012.

Real estate drag

The large oversupply of real estate continues to be a drag on the economy, the IMF notes. Since mid-2008, real estate prices have fallen by more than 60 percent in Dubai, and to a lesser extent in Abu Dhabi. The current glut, together with the completion of additional projects in the coming years, make an early and broad-based recovery of the sector unlikely, the report says.

The UAE’s government-related entities—which posed a risk to the economy in 2009—are still facing financial challenges in light of their high debt and rollover needs. While the debt of some of these companies, including Dubai World, has been restructured, this process is taking longer in other cases. “Improving corporate governance of these entities and increasing transparency about their financing strategies, financial conditions, and debt profile will be needed to strengthen market confidence,” Finger said.

Shielding the country’s banking system from risk stemming from these government-related entities is essential, and the recently introduced aggregate limits on banks’ lending to government-related entities are a step in the right direction, the report says. Although the banking system maintains sufficient buffers to withstand a further deterioration in asset quality and external liquidity conditions, individual banks could be affected if downside risks materialized.

Fiscal tightening

In response to the 2009 property market crisis, the authorities put in place expansionary fiscal policies. In 2012, they plan to begin the process of fiscal consolidation. This is prudent, the IMF report notes, given that UAE’s “break-even” oil price—that is, the price at which fiscal accounts would be in balance—has risen markedly in recent years (from $23 in 2008 to $92 in 2011), leaving the country vulnerable to a fall in oil prices. Since fiscal consolidation is envisaged at a gradual pace, it is not expected to jeopardize the economic recovery.

Potential risks

The report states that the UAE’s continued economic recovery is encouraging, with growth supported by high oil prices and strong demand from trading partners. And the sizeable buffers of the sovereign wealth funds and the central bank help shield the country from external shocks.

There are a number of downside risks to the outlook. For example, a pronounced decline in oil prices in light of weak growth prospects in the advanced economies would reduce export earnings and fiscal revenues. A renewed worsening of global financial conditions would make it more difficult to roll over government-related entities’ debt and raise their borrowing costs, thus further straining their balance sheets. A marked slowdown in emerging Asia, while appearing unlikely in the near term, would affect trade, tourism, and external financing conditions.

If a slowdown of the economy were to occur, however, it would likely also cause spillovers to other countries. Given the UAE’s large foreign labor force, remittances to countries in South Asia and the Mashreq (Egypt, Jordan, Lebanon, Syria, and Sudan) could be significantly affected.