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Fed hints at more rate hikes, GCC faces higher cost of funds

The US Federal Reserve (Fed) has kept interest rates unchanged but hinted that more rate hikes are likely coming later this year as the economy continues to strengthen. However, the overall tone of the Fed statement, analysts think is less hawkish, hinting at a gradual approach to further rate hikes
The Fed’s published statement after the meeting on Wednesday stressed that inflation is approaching the target of 2 per cent, suggesting that the Fed sticks to its intention to hike rates further this year.
“The labour market has continued to strengthen and … economic activity has been rising at a moderate rate,” the central bank wrote in a statement. For 2018, the Fed predicts the US economy will keep expanding at a “moderate” pace, hiring will remain strong, and inflation will “run near” the central bank’s 2 per cent target.
Analysts expect three more rate hikes this year as the Fed left the rate target unchanged on Wednesday with the probability of a 25 basis point hike in June stronger supporting the recent US dollar strength.
“We continue to expect the next rate hike at the June meeting followed by rate hikes in September and December this year. The outlook for a rising interest-rate advantage of the US over other economies has supported the US dollar in the past weeks and we expect this support to continue in the next 3 to 6 months,” said David Kohl, Chief Currency Strategist, Julius Baer.

The Dollar had topped the leader board of developed world currencies since late April when 10-year US bond yields broke above the 3 per cent threshold, marking a multi-year high.
Although the greenback weakened broadly during the overnight session as markets weighed the contents of the Fed statement, the prospect of further hike is likely to lend support to dollar in the short to medium term subject to policy stance of other leading central banks.
“What could inspire further dollar strength is if other developed central banks, like the Bank of England (BoE) and European Central Bank (ECB) remain hesitant towards tightening monetary policy. We have seen the British Pound suffer a nosedive following BoE Governor Mark Carney once again backtracking from his previous upbeat tone on higher UK interest rates, and this has provided a reminder that interest rate differentials between the Federal Reserve and other developed central banks can still drive traders towards the US Dollar,” said Jameel Ahmad, Global Head of Currency Strategy & Market Research at FXTM.
Macro headwinds
Rising interest rates combined with strengthening dollar could have some headwinds for the GCC economies that faced deeper than expected economic slowdown in 2017. In the GCC, overall GDP fell by 0.2 per cent last year, with Saudi Arabia witnessing its first economic contraction since 2009. The International Monetary Fund (IMF) in its latest regional economic outlook has revised growth outlook downward for most GCC countries.
Relative to the forecasts in the October outlook, with the pickup in oil prices, prospects for oil exporters have improved somewhat with a positive revision to 2019 IMF growth outlook.
While the expiration of Opec+ deal this year combined with slower approach to fiscal reforms is expected to boost growth from year end 2018, rising interest rates could pose challenges to cost funds for many GCC countries that have been heavily dependent on market funding to bridge fiscal deficits.
Interest burden
Although public debt remains manageable for most GCC oil exporters, the rapid build-up of debt in some of them is a cause for concern, according to the IMF. Debt has increased by an average of 10 percentage points of GDP each year since 2013, with countries financing large fiscal deficits through a combination of drawdowns of buffers and increased domestic and foreign borrowing.
Looking ahead, several factors are likely to continue to drive debt upward for GCC countries. These include the slower pace of fiscal consolidation, weak growth prospects, and the possibility of higher financing costs given the expected monetary policy tightening in advanced economies.
Given anticipated financing needs — cumulative overall fiscal deficits of the oil exporting countries from the region are projected to be $294 billion (Dh1.08 trillion) in 2018—22, while cumulative government debt amortizations amount to $71 billion for the same horizon — countries are increasingly vulnerable to a sudden tightening of global financial conditions.
An additional amount of $312 billion of nongovernment-issued international debt (of which almost 40 per cent corresponds to state-owned enterprises) is coming due over the next five years.
“The fiscal impact these debts could be larger if along with the rising interest rates, these countries also experience a sudden stop in international market access that leads to a materialisation of fiscal contingent liabilities, said.
Policy constraints
GCC countries with their currencies pegged to the dollar have limited policy options to resist US rates. Historically in most countries’ domestic interest rates move in tandem with US dollar rates. Rising rates along with rising dollar is likely to increase cost of funds for local corporates, small businesses and retail borrowers. Although rising dollar is likely to bring some respite to imported inflation, analysts say, it could have adverse impact on sectors such as tourism, retail and hospitality that could become dearer and less competitive of the local currency’s peg to the dollar.

Source: Gulf News

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