With a rocky but ultimately necessary 2010 behind it, the United Arab Emirates looks like it may finally have become more mature about its economy and policy. Gone are the days of unending credit that financed a real estate bubble which, when it popped, nearly dragged the rest of the economy over the cliff. But as the new year beckons, many of the prickly issues that could be ignored during the boom years have bubbled to the surface and how the Emirates deals with them will likely define its prospects for 2011.
For starters, there is the issue of tax. The most recent International Monetary Fund (IMF) report on the UAE reveals that the organization was told value added tax (VAT) would be implemented by 2012, while the Economist Intelligence Unit (EIU) predicts “the government is likely to increase charges for transport and public services in an effort to increase revenue.” Despite the speculation, the government has kept quiet.
“They are also talking about increasing utilities, which would be good because they are too cheap,” says Eckart Woretz, visiting fellow at Princeton University and former program manager of economics at Dubai-based Gulf Research Center. “It’s always a question of the social contract between government and locals,” he adds.
Any future VAT would have to be a federal decision, but increasing the costs of utilities will be easier for individual emirates because such decisions can be taken without consulting other members of the union. Dubai, for instance, recently announced a 15 percent hike in fees for both water and electricity for households and industrial consumers in addition to a surcharge that will fluctuate with global prices. The only other real government-imposed rise on the cost of living — a 5 percent annual housing tax on leases that starts in January 2011 — falls mostly on expats.
“There are some issues which need to be addressed like residency permits for foreigners who buy real estate, because it’s unlikely people would take the financial burden if they don’t see themselves staying in the country for the foreseeable future,” says Fabio Scacciavillani, director of macroeconomics and statistics at the Dubai International Financial Center.
Keeping the taxman at bay
Even though prospect of VAT has been in the cards for some time, many don’t expect one to be imposed by the government for an array of reasons. The UAE maintains a comparably attractive tax environment, which it has used to bolster investment in the country. Any change to that will likely have to carry with it widespread fiscal advantages and come at a time when the books are balanced.
“One of the reasons they are holding off is because the situation in the UAE is still quite uncertain,” says Ayesha Sabavala, deputy editor and economist for the Middle East and North Africa at the EIU. “You have Dubai World coming to terms with its creditors, but you also have a whole new set of possible restructurings and definite extensions on loan agreements by Dubai’s holding companies. For them to introduce VAT now, even if it is low, would probably affect residents quite a lot.”
What may be more important is that VAT, along with a host of other thorny issues such as de-pegging from the dollar, are seen by many to be more regional than local. The logic of this thinking stems from a proposed 5 percent VAT acting as a substitute for the customs tax that Gulf Cooperation Council countries have been unable to agree to scrap, even though they announced a common market as far back as 2003.
“Definitely the VAT is something that might happen. It has been talked about but I don’t see any developments any time soon,” says Philippe Dauba-Pantanacce, senior economist for the Middle East and North Africa at Standard Chartered in Dubai. “If something happens in that field, it would probably be in coordination with the rest of the GCC and the same goes for the [currency] peg.”
In early December the UAE’s Minister of Economics, Sultan Saeed al-Mansouri, told the Alsharq Al Awsat daily that Gulf countries should consider pegging to a basket of currencies to be able to better protect their currencies and investments. A few days later the central bank governor left no doubt about the UAE’s intentions. Speaking on the fringes of the annual GCC summit he reportedly said that the country did not intend to de-peg from the dollar or join the planned monetary union it left in May 2010. “What are the choices? There is yen and euro. The choice is limited. The US dollar is still the best choice,” he was quoted by the state-run news agency WAM as saying.
“[The peg] has taken them through thick and thin so there is going to have to be an extremely high level of inflation or a collapse of the dollar in the short term to justify wanting to de-peg,” says Sabavala. “Even if they come up with a basket of currencies, it’s very likely that the majority of that basket will comprise of the US dollar simply because oil is priced in dollars.”
As such, the UAE’s ability to affect monetary policy will remain limited. In any case, inflation looks to remain low in 2011, although the EIU still expects government policy to be focused on this issue. Prices of items such as foodstuffs already saw significant hikes in 2010 and economic recovery may well place upward pressure on the cost of living. Even so, the inflationary barbarians are unlikely to be storming the gates in 2011.
“Besides Saudi [Arabia], which has specific problems, in the GCC inflationary problems are almost non-existent,” says Standard Chartered’s Dauba-Pantanacce. “The reason for that is simple: the biggest component of [the consumer price index] all over the region is housing. As long as you have a housing market that is completely muted, it’s difficult to see how you would have headline inflation coming back.”
Change in the offing
One area where change seems to be likely, however, is the sponsorship system. A recent move in late 2010 by the labor ministry to decrease the amount of time expats have to stay with their employers looks to be the first step to liberalizing the kafeel (guarantor) system to make the labor market more flexible.
Another area that looks to be changing is Dubai’s historical trade relationship with its Persian neighbor. Last year Executive reported that Emirati financial institutions had stopped offering letters of credit to facilitate trade with Iran, requiring traders to use cash instead. The pressure has come from Abu Dhabi, which has always taken a more hawkish stance towards Iran and now has leverage over its little brother Dubai because of the some $20 billion the latter owes it.
“The United States is still the UAE’s key partner in terms of having military bases and there has to be a very delicate balance between appeasing the West and keeping Iran as its trade partner,” says Sabavala. “Growth in Dubai is uncertain to begin with, so for it to lose its massive business with Iran at this point in time, when the economy is already suffering, would be quite detrimental,” she said, adding that the true impact of United Nations Security Council sanctions and Abu Dhabi’s pressure to stem trade with Iran will only be evident in Dubai’s third quarter results, which have not yet been released.
On the other hand, growth in Abu Dhabi is almost certain, with prospects for the emirate bolstered by steady oil prices that are its main source of revenue and investment. The emirate’s recent $7 billion investment in a semiconductor plant in Abu Dhabi signals that it’s looking to a diversification strategy that has a manufacturing base as its foundation.
“The key policy [for Abu Dhabi] will be to divert its oil revenue more toward an industrial base rather than just having clusters of manufacturing,” says the EIU’s Sabavala. “The concentration is definitely to turning Abu Dhabi into a manufacturing hub. Whether that happens within the time frame and the cost that they hope remains to be seen because past projects have not. Simply investing $7 billion in the semiconductor industry is not enough.”
Whether it likes it or not, the UAE will still have to grapple with restructuring its debt and raising revenue. Most estimates are that gross domestic product will rise by around 3 to 4 percent next year. While there will be growth, “there will not be a boom,” says Dauba-Pantanacce.
“A lot more has to be done in order to attract investor confidence and keep it,” says Sabavala. “They are going to have to make investors believe that this is not just a policy for the sake of policy — they have to implement it.”
First published in Executive Magazine’s 2010 year-end double issue