AGLOBAL / COUNTRY STUDY AND REPORT ON FINANCIAL MARKET OVERVIEW OF UAE Submitted to Gujarat Technological University UNDER THE GUIDANCE OF PROF. DEEPAK SANGHAVI Submitted by : Enrollment Name of Student No. 117070592010 Patel Viral R. 117070592013 Satoniya Ramji J 117070592024 RasadiyaVasant.H 117070592042 Kadivar Ravi I.(Leader) 117070592056 BagadiyaTarun R. 117070592058 DharajiyaMukesh G.C.U.SHAH COLLEGE OF ENGG.&TECH. (DEPARTMENT OF MBA) WADHVAN CITY
INTRODUCTION OF UAE DubaiDubai, the second largest of the seven emirates, is ruled by the Al Maktoum family. Itoccupies an area of approximately 3,900 kilometres, which includes a small enclavecalled Hatta, situated close to Oman, amongst the Hajar Mountains. Dubai, the capitalcity, is located along the creek, a natural harbour, which traditionally provided the basisof the trading industry. Pearling and fishing were the main sources of income for thepeople of Dubai. Under the wise leadership of its rulers, Dubais focus on trade andindustry transformed it into the leading trading port along the southern Gulf. HisHighness Sheikh Maktoum bin Rashid Al Maktoum is the current ruler of Dubai.SharjahSharjah, which shares its southern border with Dubai, is ruled by the Al Qasimi family.It is approximately 2,600 square kilometres and is the only emirate to have coastlines onboth the Arabian Gulf and the Gulf of Oman. In the nineteenth century the town ofSharjah was the leading port in the lower Gulf. Produce from the interior of Oman, Indiaand Persia arrived there. Sharjahs salt mines meant that salt constituted an importantpart of its export business, along with pearls. In the 1930s when the pearling industrydeclined and trade decreased due to the creek silting up, Imperial Airways flying boatsset up a staging post for flights en route to India, which benefited the residents ofSharjah. Today, under the leadership of Sheikh Sultan bin Mohammed Al Qasimi,Sharjah is the cultural and educational centre of the UAE and takes pride in preservingthe countrys cultural heritage as well as promoting Arab culture and traditions.AjmanAjman is the smallest emirate, comprising only 260 square kilometres. It is ruled by theAl Nuami family. Surrounded mostly by the emirate of Sharjah, Ajman also possessesthe small enclaves of Manama and Musfut in the Hajar Mountains. Along the creekdhow building was the specialised trade. Fishing and date-trees provided the localpopulation with their primary means of sustenance. Ajman benefited greatly from theunion of the emirates, a fact that is reflected today in their stately buildings andinfrastructure. Sheikh Humaid bin Rashid Al Nuami has been the ruler since 1981.
QaiwainUmm Al Qaiwain is ruled by the Al Mualla family. It is the second smallest emirate,with a total area of around 770 square kilometres. Positioned between the emirates ofSharjah and Ajman to the south and Ras Al Khaimah to the north, Umm Al Qaiwain hasthe smallest population. Fishing is the local populations primary means of income. Datefarming also plays a significant role in the economy. After the union of the emirates in1971 Umm Al Qaiwain developed into a modern state, and continues to progress underits present ruler, Sheikh Rashid bin Ahmed Al Mualla.Ras Al KhaimahRas Al Khaimah, the most northerly emirate, is ruled by another branch of the Al Qasimifamily. It covers an area of 1,700 square kilometres. Thanks to the run-off water from theHajar Mountains, Ras Al Khaimah has a unique abundance of flora, so it is no surprisethat agriculture is important to the local economy. The emirate also benefits from itsstone quarries, and fishing, which is plentiful in the rich waters of the Gulf. The city ofRas Al Khaimah, situated on an inlet, has a rich history. It was renowned for itsprosperous port and for its exquisite pearls, which were famous as being the whitest androundest available anywhere. Ras Al Khaimahs current ruler is Sheikh Saqr binMohammed Al Qasimi.FujairahThe only emirate without a coastline on the Arabian Gulf is Fujairah, which is ruled bythe Al Sharqi family. Situated along the coast of the Gulf of Oman, Fujairah coversabout 1,300 square kilometres. Unlike other emirates, where the desert forms a large partof the terrain, mountains and plains are its predominant features. Fujairahs economy isbased on fishing and agriculture. Like Ras Al Khaimah, the land in Fujairah is irrigatedby rainwater from the Hajar Mountains, making it ideal for farming. Sheikh Hamad binMohammed Al Sharqi is the present ruler.
HISTORY OF FINANCIAL MARKET IN UAEThe UAE’s relatively open borders and economy have won praise from advocatesof expandedfreedoms in the Middle East while producing financial excesses, socialills such as human trafficking, as well as opportunity for both illicit and legitimateIranian businesses to operate there. Moreover, the social and economic freedomshave not translated into significant political opening; the UAE government remainsunder the control of a small circle of leaders, even as it allows informal citizenparticipation and traditional consensus-building. Members of the elite (the ruling families of the seven emirates and clans alliedwith them) also routinely obtain favored treatment in court cases and lucrativebusiness opportunities. However, economic wealthcoupled with some governmentmoves against political activists—have enabled the UAE to avoid widescalepopular unrest that have erupted elsewhere in the Middle East since early 2011.Political reform has been limited, both before and since the Arab uprisings beganin the region. Lacking popular pressure for elections, the UAE long refrained fromfollowing other Gulf states’ institution of electoral processes. It altered thatposition in December 2006 when it instituted a selection process for half themembership of its consultative body, the Federal National Council (FNC). Possiblyto try to ward off the unrest sweeping the region, the government significantlyexpanded the electorate for the September 24, 2011, FNC election process.However, turnout was only about 25%, suggesting that the clamor for democracyin UAE remains limited or that the citizenry perceived the election as unlikely toproduce change.Government has not announced a major expansion of the FNC’s powers, whichmany intellectuals and activists seek. On foreign policy issues, the UAE—alongwith fellow Gulf state Qatar—has become increasingly and uncharacteristicallyassertive in recent years. This assertiveness is probably a product of the UAE’sample financial resources and its drive to promote regional stability. The UAE hasjoined the United States and U.S. allies in backing and then implementing mostinternational sanctions against Iran, causing friction with its powerful northernneighbor.
In 2011, it sent police to help the beleaguered government of fellow GulfCooperation Council (GCC) state Bahrain, supported operations against MuammarQadhafi of Libya, joined a successful GCC diplomatic effort to broker a politicalsolution to the unrest in Yemen, backed the Arab League suspension of Syria, andappointed an Ambassador to NATO. It gives large amounts of internationalhumanitarian and development aid, for example for relief efforts in Somalia. TheUAE’s growing assertiveness on foreign policy marks its emergence from the2008-2010 global financial crisis and recession. That downturn hit Dubai emirateparticularly hard and called into question its strategy of rapid, investment-fueleddevelopment, especially of luxury projects.For the Obama Administration and many in Congress, there were early concernsabout the UAE oversight and management of a complex and technically advancedinitiative such as a nuclear power program. This was underscored bydissatisfaction among some Members of Congress with a U.S.-UAE civiliannuclear cooperation agreement. The agreement was signed on May 21, 2009,submitted to Congress that day, and entered into force on December 17, 2009.However, concerns about potential leakage of U.S. and other advancedtechnologies through the UAE to Iran, in particular, have been largely alleviated bythe UAE’s development of strict controls, capable management, and cooperationwith international oversight of its nuclear program. GOVERNMENT PROCUREMENT The UAE is not a signatory to the WTO Agreement on GovernmentProcurement. The UAE grants a 10 percent price preference for local firms ingovernment procurement. The UAE requires companies to register with thegovernment before they can participate in government procurements, but to beeligible for registration, a company must have at least 51 percent UAEownership.This requirement does not apply to major projects or defense contracts where thereis no local company able to provide the goods or services required. The UAE’soffset program requires defense contractors which are awarded contracts valued atmore than $10 million to establish a commercially viable joint venture with localbusiness partners that is projected to yield profits equivalent to 60 percent of thecontract value within a specified period (usually 7 years).
To date, more than 40 such joint venture projects have been launched, including,inter alia, a hospital, an imaging and geological information facility, a leasingcompany, a cooling system manufacturing company, an aquiculture enterprise, aforeign language training center in Abu Dhabi, and a firefighting equipmentproduction facility. Two of the largest offset ventures are an international gaspipeline project (Dolphin) and the Oasis International Leasing Company, a BritishAerospace offsets venture. There are also reports, as well as anecdotal evidence, indicating that defensecontractors can sometimes satisfy their offset obligations through an up-front,lump-sum payment directly to the UAE Offsets Group SERVICES BARRIERS InsuranceForeign insurance companies may operate only as branches in the UAE. In 1989,the UAE government banned additional foreign insurance companies from openingdue to the perception that the market was saturated. In 2004, the Ministry ofEconomy and Planning announced that it would open the UAE insurance sector tonew foreign insurance companies. In 2006, the President of the UAE issuedFederal Law No. 16 of 2006, amending some provisions of Federal Law No. 9 of1984 on insurance companies and agents. An insurance company established in the UAE must be a public joint stockcompany. At least 75 percent of the capital in such companies must be owned byUAE nationals, while the remaining 25 percent may be owned by a foreigner. Inthe Emirate of Abu Dhabi, the offering of insurance coverage for constructionprojects and companies under the Abu Dhabi National Oil Company (ADNOC) isrestricted to Abu Dhabi-based insurance companies.
BankingThe UAE Central Bank does not grant new licenses to foreign banks. However, theCentral Bank has granted licenses to some GCC banks. In 2008, the Central Bankallowed several foreign banks already operating in the UAE to set up newbranches. According to Central Bank statistics, there were no new foreign bankbranches in 2009, but local banks opened 43 new branches, six new electronicbanking services units, and nine new pay offices.In 2006, the UAE made important changes to the Commercial Agencies Law(Agencies Law), which previously had required that all commercial agents beeither UAE nationals or companies wholly owned by UAE nationals, and hadrestricted the number of agents a foreign principal could appoint as well as theterms of the agency relationship.The 2006 amendments:(1) limited an agency contract to a fixed time period;(2) required mutual consent to renew an agency agreement;(3) allowed either party to file fordamages;(4) eliminated the Ministry of Economy’s Trade Agencies Committee,(5) which handled agency disputes; and(6) allowed the import of ―liberalized goods‖ without the agents approval. Nonetheless, foreign companies still find it difficult to dismiss a non-performinglocal agent without protracted litigation in the local courts, and experience hasshown that the authorities’ application of the new law has not always eased theway for the termination of agents as expected. It also remains difficult, if notimpossible, to sell in UAE markets without a local agent.
FINANCIAL ECONOMYIn the 40 years since oil was first discovered and exported, the UAE hasbeentransformed from a region of small sheikhdoms subsisting on pearling,fishing, herding, and agriculture to a modern state with a high per capita incomeand substantial trade surplus. The largest and wealthiest emirate is Abu Dhabi,which is the principal petroleum producer and financier of the federation. Dubai,the second largest emirate, thrives on wealth derived from a services-basedeconomy (tourism, construction, telecommunications, media, real estate, andfinancial services). Together, the two emirates provide more than 80 percent of theUAE’s income, while the northern emirates remain relatively undeveloped. Keyeconomic policy decisions are made at the emirate level with little coordinationamong the seven emirates.The UAE economy remains heavily dependent on oil and natural gas; the revenuefrom oil exports in particular enables the government to finance infrastructure forthe non-oil economy. Economists forecast that in 2007–8 the economy is expectedto grow at an average annual rate of approximately 7 percent. Investment inmanufacturing and energy-intensive sectors such as petrochemicals and metals willdrive the non-oil sector, aided by exports made more competitive by the weaknessof the U.S. dollar.The services sector, primarily tourism, is expected to continue to gain strength whosucceeded his father as president of the UAE in November 2004, is expected tocontinue the relatively liberal economic policies of his predecessor: privatization ofsome government assets; provision of incentives for foreign and domestic privateinvestment; avoidance of a national income or sales tax; and curtailment of bothmoney laundering and the use of the banking system to foster terrorist activities.In April 2007, vice president and prime minister Sheikh Mohammed ibn Rashid AlMaktumdelivered a major policy speech in which he outlined a comprehensivethree-year UAE Government Strategy, the core of which is sustainable economicdevelopment. He placed heavy emphasis on upgrading the UAE’s educationsystem and making emiratisation a national priority. Gross Domestic Product (GDP)
In 2004 the UAE’s GDP was US$105.2 billion. Economists calculate the 2005 realGDP growth rate at 8.2 percent, with GDP exceeding US$132 billion. Per capitaGDP for 2005 was high compared with other Arab countries—almost US$29,000.For theperiod 2006–7, real GDP growth is expected to remain strong, driven notonly by high oil earnings but also by sustained expansion in the non-oil sectors.Real GDP is forecast to grow 8.9percent in 2006, with GDP exceeding US$162billion, and to grow 7 percent in 2007. Government BudgetThe UAE federal budget accounts for approximately 25 percent of total federationfiscal transactions; the remainder consists of the fiscal operations of theindividualemirates, and the combined expenditures constitute the consolidatedaccounts. Oil revenue accounts for more than 60 percent of all income, andconsequently the volatility of the oil market has created significant fluctuations ingovernment income. Economists calculate that based on rising global oil pricesoffset by significant public-sector pay increases and higher capital expenditures,the 2004 budget ran a relatively small deficit of US$233 million (0.2 percent ofgross domestic product (GDP), as compared with deficits in 2002 and 2003 thatwere 11 percent and 4.5 percent of GDP, respectively).According to the UAE government, in 2005 a 20-yearperiod of fiscal deficits cameto a close when the government budget had a surplus of approximately US$10.4billion (almost 8 percent of GDP), as revenues increased by 70 percent,andexpenditures, fueled by large increases in public-sector wages, rose by 27 percent.In 2006, as a result of rising oil prices and increased production, the budget isexpected to generate an estimated US$20 billion surplus (approximately 12.4percent of GDP). The surplus is expected to decline to 8.4 percent and 7.4 percentof GDP in 2007 and 2008, respectively, as a result of expenditure growthoutpacing revenue growth.
However, economists caution that UAEfiscal data inaccurately reflect the actualstrength of the government’s finances, for two reasons. First, a significant portionof Abu Dhabi’s oil earnings are not reported as current revenue, but rather are paiddirectly into reserve accounts. Second, the data do not reflect the substantialincome generated by the emirates from overseas investments (estimated in 2006 tobe more than US$600 billion), most of which are held by Abu Dhabi. Both of theserevenue streams fund part of the federal deficit; were they to be factored into thebudget equation, the government budget would actually show no deficit in 2004and a higher surplus in ensuing years. Banking and FinanceThe UAE Central Bank was established in 1980 to direct monetary,credit, andbanking policy. It maintains the UAE government’s reserves of gold and foreigncurrencies, acts as the bank for banks operating in the UAE, and serves as thestate’s financial agent at international financial institutions. In response to pressurefrom the World Trade Organization to open the banking sector to more foreigncompetition, in late 2004 the UAE Central Bank stated that it would considerallowing new foreign banks to establish themselves in the UAE for the first time in20 years. As of late 2006, however, no new licenses had been issued. Relative to its population and gross domestic product, the UAE has an unusuallyhighnumber of banks—21 local, 25 foreign, 2 specialized, and approximately 50representative offices of other foreign banks. The top six commercial banks control70 percent of total bankingassets and reported very strong profit growth from 2002through 2005.Although the sharp drop in prices on the UAE stock markets negatively affectedbank profits, in 2006 the sector remained profitable overall, primarily as a result ofthe growth of conventional retail and commercial banking (personal loans, creditcards, and residential mortgages).The Dubai International Financial Center (DIFC) opened officially in September2004. The DIFC is a self-regulating financial free zone, operated independently of
the UAE Central Bank and including more than a dozen international financialinstitutions. In September 2005, it established the Dubai International FinancialExchange, which provides markets for equities, bonds, funds, sharia-compliantproducts, and derivatives and is fully open to foreign investment.The Dubai Financial Market (DFM) and the Abu Dhabi Securities Market openedin March 2000and have been linked electronically since 2004. Both stock marketssurged in value and liquidity from 2002 until November 2005, when a steepdecline began that did not reverse until early 2007.The sharp downturn in stockprices in 2006 was Gulf-wide and is attributed to the overvaluation of stocks andheavy bank borrowing to finance initial public offerings.Islamic banking has assumed a more prominent role in the UAE in recent years,and most conventional banks are opening or expanding Islamic bankingdepartments; sharia-compliantconsumer and investment products also are beingintroduced. Government agencies and majority state-owned companies are usingIslamic bonds—sukuk—to finance development and acquisitions.Terrorism is financed using the banking system in two primary ways—throughmoneylaundering and through financial transactions in the hawalasystem, which isa traditional alternative remittance system that operates outside the control of theconventional banking sector. After 9/11 a link was drawn between branches ofCitibank in the UAE and the UnitedStates and financing of the terrorist attacks. In response, the UAE Central Bank has frozen theassets of organizationssuspected of having ties to al Qaeda or to the former Taliban regime inAfghanistan and educates financial institutions on countering money launderingand terrorist financing Legislation was enacted in 2002 Tightening reporting requirements for financial transactions and increasingpenalties for money laundering. Hawalaoperators, thought to be the conduit formuch of the funding earmarked for terrorist activities, are now licensed in the UAEand required to report suspicious transactions to the UAE government. As of early2007, the UAE Central Bank had registered 201 hawaladealers.MACROECONOMIC AND FINANCIAL SECTOR DEVELOPMENTS
At the time of the 2001 FSAP, the U.A.E. financial sector and itsregulationand supervision were developing unevenly. The financial sector wasdominated by strongand well-supervised banks, which posed minimal near-termsystemic risk. The insurance andsecurities industries were found vulnerable, lessdeveloped, and in need of strengthenedsupervision. The legal and judicialinfrastructure for the financial system was also in need ofreform.The results of the detailed assessments of banking supervision (BCP),transparencyof monetary and financial policies, and payments systems were alsomixed. There was a high degree of observance of the BCP, although severalimportant changes in the banking law were recommended by the FSAP team.Transparency practices in conducting monetary policy and banking supervisionwere well observed, while some practices were found in need of improvement. Thepayment systems, although simple and far from state-of-the-art, were found to bewell managed and systemic risks well contained.Since the 2001 FSAP, the authorities have made progress inimplementingfinancial sector reforms. In the banking sector, the Central Bank ofthe United ArabEmirates (CBU) is in the third year of its risk-based supervisoryprogram, which involvessupervisors examining a bank’s credit, operational, andmarket risks, and how the bankimplements policies to address them.The CBU has engaged, since late 2004, in intensepreparations for theimplementation of Basel II. In the area of AML/CFT, several key lawshave beenapproved including Federal Law No. 4 of 2002 on anti-money laundering,FederalLaw No. 1 of 2004, which addresses combating the financing of terrorism,and Federal LawNo. 8 of 2004, which addresses AML/CFT in the DIFC. Also the authorities have establishedand staffed the Emirates Securities andCommodities Authority (ESCA), which has become fully operational in overseeingthe securities markets. They have also established the legal and regulatoryframework governing the DIFC and the institutions and markets it supervises.Finally, the payment system has been fully automated and computerized and anRTGS system for large value payments has been functioning smoothly since 2002.Macroeconomic Developments
An outward-oriented development strategy and prudent financial policieshaveresulted in impressive economic growth over the past few years and led toa large accumulation of external financial assets. This success had beenunderpinned by AbuDhabi’s skillful management of the country’s oil wealth andDubai’s strong push foreconomic diversification. Oil export revenues have pushedthe current account surplus toabout US$36 billion in 2006, equivalent to 22 percentof GDP, the fiscal surplus to almost29 percent of GDP and gross official reservesto US$28 billion (Table 1).2 The dirham wasFinancial Sector DevelopmentsThe monetary aggregates and credit to the private sector continued to growata double-digit pace in 2006. Given the pegged exchangerate, domestic interestratesclosely tracked the increase inU.S. dollar rates, but werenegative in real termsgiven theacceleration in inflation. Partlyas result, growth of credit to theprivatesector was 37 percentfor the year as a whole, downfrom 44.5 percent in2005.Money growth showed asimilar pattern, decelerating to23.2 percent in 2006from 33.8 percent in 2005After an extended run-up, stock markets in the U.A.E., as in the rest of theGCC generally, suffered a sharp correction starting in late 2005. Whilemarkets andcorporate earnings initially rose in line with oil prices, from 2005onwards, price gainsseemed to be spurred by unrealistic expectations of continuedearnings growth and easycredit conditions. Volatility was exacerbated byinvestors’ liquidation of existing positions tofund speculative subscriptions toinitial public offerings (IPOs).In 2002, the Emirate of Dubai announced the creation of the DubaiInternational Financial Centre (DIFC) as a regional financial hub. In June2004, theestablished the DIFC as a Federal Financial Free Zone, a 110-acrecomplex withinDubai, as well as the Dubai Financial Services Authority (DFSA),responsible for regulationand supervision of entities licensed to carry out banking,securities market and reinsuranceactivity in the DIFC.Although their exact size is not published, the external assets of the AbuDhabiInvestment Authority (ADIA), are believed to be substantially largerthan CBU holdings. ADIA is owned by the Government of Abu Dhabi, and is
charged with managingthe emirate’s financial assets. While ADIA’s investmentsare mainly outside the country, it isthe largest shareholder in National Bank of AbuDhabi (73 percent) and Abu DhabiCommercial Bank (65 percent), the two largestbanks, and also has shares in two smallerbanks.FINANCIAL SYSTEM Banking SystemThe U.A.E. banking sector is well developed and gaining in sophistication.Thesector is the second largest among GCC countries after Saudi Arabia’s, withassets equivalent to 130 percent of GDP in 2005. The banking sector is not highlyconcentrated, with the five largest banks accounting for about 44 percent of systemassets. Although there are 25 foreign banks compared with 21 local banks, theshare of foreign banks in total banking assets declined from 25 percent in 2001 to22 percent in 2006.The number of banks has been quite stable for a number of years, because of a banon new foreign entrants and the government’s desire to avoid mergers. This policyappears to be changing with the announcement in April 2007 of the plannedmerger of two Dubai banks, which when completed would result in the largestbank in the U.A.E. (and among the largest in the GCC).Welcome steps are being taken to lift the moratorium (since 1981) on thelicensing of new foreign banks, but further steps in this direction would beappropriate.The CBU authorized three new GCC banks (from Qatar, Kuwait, andSaudi Arabia) in 2006,with the understanding that U.A.E. banks will be givenreciprocal treatment. Foreign banksare present as branches and each can have amaximum of eight branches in the country.Moreover, they are subject to a 20percent tax on profits, which is not applied to domesticThe bank ownership structure reflects the prevalent role of the state andofgovernment related entities, complemented by an active private sector. Stateownedinstitutions are run on a purely commercial basis and listed on local stockmarkets, and theyaccount for 63 percent of total bank assets. Among the five
largest domestic banks, only onehas no government or ruling family ownership.Large family-owned conglomerates are alsoshareholders of banks.The Islamic banking sector is developing rapidly alongside theconventionalsystem. Islamic banks have increased their share of total bank assets,from 8.8 percent atend-2002 to 12.6 percent at end-2006 (14.2 percent of deposits).Dubai hosts the oldestIslamic bank, while two conventional banks became Islamicbanks in 2004. There are alsoseveral Islamic finance companies, and a number ofcommercial banks have opened Islamicwindows.As their activities are rapidly growing, Islamic banks are exposed to risks similartothose of conventional banks. However, Islamic banks do not benefit from theavailabilityof hedging instruments, money market instruments, and fundingfacilities at longermaturities. Islamic banks also tend to be smaller and lessdiversified than conventional banks.The impact of the sharp correction in the equity market on the banking sectorhas been limited. The strength of retail banking and credit growth, as well asdiversification(including outside the U.A.E. for some of the largest banks), havemitigated the impact onbank profits of the sharp decline in equity markets and thedrying up of IPO operations, onwhich the banks had made substantial fees andmargin interest income in 2005.The sheer size of real estate development, notably in Dubai, raises concernsabout the exposure of the financial sector but the exposure including toconstructionand mortgage loans is estimated conservatively at 15 percent ofloans, and is concentrated in some institutions and geographical areas. The loan portfolio of financecompanies is also growing rapidly. In terms ofresidential property, several analysts haveindicated that a large number ofresidential units is to come to the market during 2007–2008,and have expressedsome concerns regarding speculative activity in the market. Anecdotalevidence suggests that excess demand for commercial property andretail space will continueover the medium term. It is notable that a significantnumber of projects are undertaken bylarge property developers owned by the stateor ruling families.
Some financial institutions appear to be vulnerable to risks emerging in thesmall but rapidly developing mortgage market. The U.A.E. property market issignificantly less bank dependent than other regions, and bank mortgages are only6.6 percent of bank loans (Table 3), since both locals and expatriates purchaseproperty largely with other assets.7 Mortgage loans were initially developed byIslamic finance companies, and are provided at floating rates. Most lenders operate with loan-to-value ratios(LTVs) of 70 to 80 percent, but withincreased competition and the need to sell some units, a relaxation of lendingstandards has also been observed, with LTVs approaching 90 or 100 percent insome segments.8 Demand for credit is also being fueled by high population growthand low interest rates both in real terms and compared to rental yieldscontributingin turn to speculative behavior and increasing asset prices. Beyond traditional mortgages, household real estate exposure is deemed to behigher than the single stock ofmortgage loans, as the final use of personal loans forbusiness purposes is not well apprehended in the data.Staff recommends enhancing the prudential regulation and monitoring ofbanks’ exposure to the real estate sector. Although the CBU has undertaken torevise its classification of the exposure of banks to the real estate sector, significantuncertainties remain on the extent of real estate exposure.10 More appropriateprudential oversight ofbanks’ exposure to real estate is also under consideration bythe CBU. The current CBU regulation limits a bank’s real estate exposure to 20percent of its customer deposits.However, this is not adequately linked to the expansion of the market and theevolvingfunding structure of commercial banks. Staff recommends continuedimprovements in the sectoral classification of loans, enhanced oversight ofnonbank financial institutions involved in real estate financing, and theintroduction of more adequate prudential regulations, such as maximum LTV anddebt-to-income ratios.Over the past three years, U.A.E. banks have been steadily increasing theirborrowing from abroad (Figure 1). In addition to bank loans, several U.A.E.banks havebegun to issue Euro Medium-Term Notes (EMTNs).
Since the domestic banks’ favorable ratings have allowed them to borrow atrelatively low rates, EMTNs have generally been issued with five-year tenor and atan interest rate in the range of 30 to 50 basis points over LIBOR.Although potentially increasing their exposure to exchange rate risk, theseinstruments have allowed banks to better match the duration of their liabilities andassets, thereby reducing their sensitivity to interest rate risk. The banking sectorremains profitable. After exceptional gains in brokerage, fee, and trading incomein 2005, and with some institutions experiencing a slowdown in profit growth,returns on asset and equity declined somewhat in 2006,while still remaining at comfortable levels. Continued growth in retail bankingactivities have contributed to alleviate the effects of the slowdown in noninterestincome while margins have narrowed in some market segments. However,personnel expenses are on the rise because of the increased cost of living and theneed to attract highly qualified professionals.Payment SystemsUnder the Banking Law, the CBU operates and oversees the paymentsystem.promote banking and supervise over the effectiveness of the bankingsystem according to theprovisions of this Law.‖states that the Board ofDirectors ofthe CBU shall ―establish clearing houses….‖ These two provisions, permit theCBU to run a fully centralized accounting system, through which all interbankpayments are settled.Licensed commercial bank are required to maintain three separate accountswith the CBU. A dirham current account is used for settling the bank’s financialtransactions, while two additional accounts, one in dirham and another in U.S.dollars, are used to hold the bank’s reserves at the CBU. Recently, banks andmoneychangers have alsobeen allowed to open euro and U.S. dollar currentaccounts, benefiting from the new Fund Transfer System’s ability to handlesettlements in multiple currencies and to utilize cash deposits and withdrawals forlocal trade settlements.FTS is a Real-Time Gross Settlement (RTGS)system based on a secure intranetnetwork. It allows member banks to view their statementsin real time. All U.A.Ebanks have been part of the new system since 2002. The laborintensive CheckClearing System (CCS) is scheduled for a comprehensive upgradeduring 2007.
The authorities are aiming to introduce a new Image CCS that will allow for thesettlement of checking transactions within 2 to 4 hours, improving significantly onthe current paper-based system that clears in T+1. A SWITCH system continues tobe used to settle ATM transactions. A project is currently under way to create aGCC-wide SWITCH network that would facilitate transactions between membercountries.THE DUBAI INTERNATIONAL FINANCIAL CENTER (DIFC)The level of banking activity in the DIFC is small compared with thedomesticmarket. As of January 2007, seven banks were authorized to acceptdeposits or providecredit in the DIFC, and three of them were operational. Inaddition, 20 firms regulated asbanks in other jurisdictions are authorized to provideinvestment banking services.As ofDecember 2006, DIFC banks held total assets of around $518 million, a tinyfraction of theUS$200 billion in total U.A.E. banking assets. U.A.E. banksestablishing a presence theDIFC are required to obtain approval from the CentralBankDIFX has succeeded in attracting a sizeable number of listings and competeseffectively with other exchanges in the U.A.E. As of January 2007, the totalmarket capitalization of DIFX was about US$21 billion, 45 percent of whichoriginated from bondinstruments (including sukuk). Seven equity securities arelisted on the exchange (3 of which are ordinary shares) with a market capitalizationof about US$6.7 billion.The Dubai International Financial CenterThe Dubai International Financial Centre (DIFC) was established in 2004 as thefirstFederal Financial Free Zone in the U.A.E. Activities permitted within thecenter include banking services, capital markets, asset management, reinsurance,Islamic finance, ancillary services, and business processing operations. Under theFree Zone legislation, financial institutions licensed to operate in a free zone mayconduct. Business with residents and nonresidents but when conducting ―financialbankingactivities,‖ they are prohibited from transacting in the U.A.E. Dirham andfrom taking deposits (regardless of currency of denomination). DIFC is constitutedof three independent authorities under the Office of the President of the DIFC:
Dubai International Financial Centre Authority (DIFCA) is primarilyresponsiblefor setting the center’s overall development strategy. It also acts as the registrar ofsecurities and companies. Its subsidiary, DIFC Investments is home to the DubaiInternational Financial Exchange (DIFX) and Hawkamah, an institute dedicated tothe promotion of corporate governance in the region.Dubai Financial Services Authority (DFSA) is the financial services regulatorybody of the DIFC. As an independent regulator, its activities include: (i) rule-making and policy development; (ii) (ii) licensing and registration; (iii) supervision of DIFC participants; and (iv) enforcement of legislation.Dubai Judicial Authority (DJA) is an independent judicial system that dealswith civil and commercial matters arising from or within the DIFC. The legalsystem, including property and contract law in the DIFC is based on common law.The mission statement of the DIFC is to be ―a catalyst for regional economicgrowth, development and diversification.‖ In pursuit of this goal, the founders haveattracted aninternational team of highly qualified professionals and establishedrules and regulations based on industry best-practices. Moreover, the facilities havebeen equipped with world-class infrastructure and state-of-the-art technology.The establishment of DIFC has been well received at regional and internationallevels. As of end-January 2007 it had attracted more than 330 companies that havebenefited from 0 percent taxation and no restrictions on the level of foreignownership. Close to half of the institutions registered by DIFC are financial andancillary service companies.Twenty-three securities have been listed on DIFX, which has been growingsteadily and specializing in Islamic finance. Stress tests of the aggregate bankingsystem and of individual banks wereconducted based on data provided by theauthorities.The focus was on credit risk, with particular attention to developments in the realestate market. Interest and liquidity risk was also quantified. Foreign exchange riskwas also reviewed, although this risk has been limited by the commitment of theauthorities to the exchange-rate peg. Stress tests were conducted based on data for
end-September 2006 on the 46 U.A.E. commercial banks, and were based on thecurrent loan classification system for nonperforming loans. 19 Staff noted that the set of data available would need to be enhanced toconduct a comprehensive assessment of risks in the banking system by including: (i) household and corporate balance sheet data; (ii) data on large exposures in the banking system; and (iii) a moreprecise breakdown of personal loans and estimate of real estate exposure.Stress tests suggest that the banking system would be generally resilient to anacross the board and significant deterioration of asset quality. A situation of adoublingof the current level of substandard, doubtful and loss loans would bewithstood relativelywell by banking sector capital, with overall capital adequacydeclining from 16.3 percent to11.5 percent Large banks and foreign banks wouldbe the most affected. Areplication of one of the tests performed in the initial FSAPwas also conducted to test howmany banks under extreme conditions wouldexhaust their Tier 1 capital. Because of thehigher leverage of the banking systemand of some banks in particular, 11 of the21 locally incorporated banks instead of 6in the initial FSAP stress tests would exhausttheir Tier 1 capital.Overall, the banking system would be resilient to a deterioration ofcreditquality caused by external shocks. Fluctuations in world oil prices have abearing on thebanking sector predominantly through banks’ liquidity, while theireffects on asset qualityare difficult to estimate because banks have little directcredit exposure to the oil and gassector.Nonetheless, a deterioration of loan quality which might result from externalfactors(e.g., significant uncertainties created by turmoil in a neighboring country orindirect effectsof strong international sanctions), affecting significantly thefinancing of trade and relatedservices (transportation) in the U.A.E. was simulated.The banking system would weather theshock relatively well (capital adequacywould decline to 13.2 percent). Four locallyincorporated banks would see theircapital drop below the minimum required 10 percent.