Recent Economic Developments

2. The U.A.E. economy continued to perform strongly in 2004, underpinned by favorable oil market developments and a commitment to an outward-oriented and business-friendly strategy. Although hydrocarbon revenues continue to play a dominant role in the economy, the authorities have firmly pursued an aggressive strategy to optimally utilize oil resources to intensify economic diversification and strengthen private sector activity in the non-oil sector. The dividends of this strategy are reflected in a robust economic growth, with non-oil growth remaining strong at 10 percent supported by the boom in the manufacturing, services and construction sectors, as well as increased non-oil exports and a healthy surplus on the current account of 12 percent of GDP. With a streamlined regulatory environment, buttressed by liberal employment policies and an advanced infrastructure, the U.A.E. emerged as one of the most competitive economies at the regional and, to a large extent, global levels. Bolstered by strong economic fundamentals, investor confidence was reflected in a boost in FDI inflows and a surge in equity markets. Economic activity further accelerated, as the economy generated an average of 177,000 jobs per year (almost ten times the annual increment to its national labor force), at a time when other economies were shedding them. Inflation edged up to 4.6 percent in tandem with the surge in economic activity.

3. The medium-term outlook for the economy is promising. Given the momentum in private sector activity and the favorable outlook for oil prices, the overall fiscal position remains resilient to shocks in oil prices as low as $23 per barrel. Looking ahead, to reinforce the role of the U.A.E. in stabilizing global prices and supply of oil, the authorities are now embarking on huge investment projects with the aim of increasing production capacity to 3.5 mbd by 2006 and to 4.0 mbd in the longer term. Concurrently, the authorities have taken initiatives to tap into their vast resources of natural gas to reduce the reliance of the non-oil sector on changes in oil. The expectation is for natural gas production to fulfill the domestic demand for energy, especially in manufacturing, and to release more oil for exports.

Fiscal Policy

4. Guided by conservative assumptions about oil prices, fiscal policy in the U.A.E. is crafted to maintain fiscal sustainability over the medium term while implicitly ensuring inter-generational equity. Saving for future generations is essentially achieved through the large accumulation of foreign assets from surpluses on oil revenues by the government of Abu Dhabi. With higher oil revenues and a prudent expenditure policy, the consolidated fiscal position strengthened considerably, registering a surplus of over 18 percent of GDP, and the non-hydrocarbon deficit continued to narrow.

5. To consolidate the fiscal gains from oil revenues and further stimulate expansion of the non-hydrocarbon sector, the authorities are pursuing measures to enhance fiscal performance on two fronts: improving the budget structure and strengthening fiscal coordination among the Emirates. Regarding the budget structure, public expenditure management has been improved at the Federal level with the introduction of performance-based budgeting. In Abu Dhabi, reforms have been initiated to enhance the composition and quality of current spending. Agricultural and utility subsidies continue to decline, and one power plant has been privatized as part of the broader divestiture plan of the water and power sectors by 2006. Measures to rationalize the wage bill were also taken, notably through scaling back civil service employment and outsourcing certain services to the private sector. The authorities are cognizant of the concerns expressed by staff regarding the recent wage increase and its implications on domestic demand and employment. However, given the structural shift in oil prices and the limited fiscal impact of this measure, the authorities deemed it opportune to transfer part of the windfall to the population. In the period ahead, the authorities will remain vigilant to tighten financial policies should inflationary pressures emerge and continue with their active labor market policies to improve employability of their nationals. On the revenue side, measures to expand the revenue base are pursued. Specifically, deliberations are now underway to introduce a value-added tax (VAT), with the potential of eventual harmonization at the GCC level. The authorities have requested the Fund’s technical assistance in this regard.

6. Given the current legal set up which grants considerable autonomy to the individual Emirates, the authorities are keenly aware of the importance of stronger coordination and harmonization of fiscal accounting among the Emirates, especially in the run-up to the GCC union. To this end, a new economic planning committee has been formed at the Federal level, with the objective of establishing a framework to guide and coordinate economic policy and statistics. This framework is expected to improve fiscal policy assessment and ensure consistency of policies at the Emirate level with the overall macroeconomic objectives.

Monetary Policy and the External Sector

7. Supported by a strengthened foreign asset position and sound financial policies, the pegged exchange rate system continues to serve the U.A.E. economy well. The cumulative appreciation since 1990, while partly mitigated by the recent real depreciation, does not appear to have affected overall competitiveness of the economy.

8. With the capital account being fully convertible, monetary policy relies on a prudent credit stance to smooth out domestic liquidity and support the peg. In view of the rapid growth in private sector credit and the emerging inflationary pressures, the Central Bank of U.A.E. (CBU) stands ready to tighten credit conditions if needed through an increase in the reserve requirements on demand deposits. The CBU further intends to extend the maturity of the certificates of deposits (CDs) issued, with the objective of expanding its range of instruments in managing liquidity and developing a CD-based repo market.

9. Recognizing the important role of trade openness and economic integration in catalyzing the diversification process, the authorities have intensified their efforts towards regional and global integration. At the regional level, deliberations are ongoing among GCC member countries on convergence criteria in the run-up to the monetary union. Specifically, five convergence criteria were discussed by the governors of the respective monetary authorities, including targets on inflation rates, short-term interest rates, foreign exchange reserves, as well as fiscal deficit and public debt ratios. In pursuing liberalization beyond the regional context, the authorities remain mindful of the principles of the GCC customs union. A Trade and Investment Framework Agreement (TIFA) with the U.S. was recently signed, boding well for the country’s efforts to further strengthen its global relations.

Financial Sector Issues

10. The financial sector in the U.A.E. remains sound and its role as a regional hub continues to evolve. The banking sector is strong, well-capitalized and highly profitable, with prudential and oversight regulations being continuously strengthened. Despite a rapid growth in private sector credit, sound lending practices have effectively limited the exposure of the banking sector to the real estate boom. With limits set on the property value amenable to bank financing, total lending to real estate activities remained confined to less than five percent of total lending portfolio. The CBU has also intensified its efforts to reinforce existing regulations regarding the financing of IPOs, to safeguard the banking sector from excessive exposure to asset market risk.

11. Increased investor confidence, on the back of strong fundamentals, contributed to a boost in equity markets and a surge in asset prices, which appears to be a common phenomenon among emerging markets. The composite index of the Abu Dhabi and Dubai securities markets registered the highest growth among the GCC markets and market capitalization almost doubled. Furthermore, the regulatory and supervisory structures of the securities markets continue to be strengthened. To this end, the Emirate Securities and Commodities Authorities (ESCA) has been activated and its operations are being supported through increased employment and training of its staff. Transparency of the system has also been enhanced through several measures, including the establishment of a clear and detailed set of requirements for listing and disclosure. The authorities concur with staff on the importance of establishing a consolidated supervisory framework for the capital markets and the non-bank financial intermediaries. Fund assistance in the form of a Report on Standards and Codes (ROSC) has been requested to help lay the groundwork in this regard.

12. Progress has also been achieved in tightening regulations against money laundering and in strengthening the regulatory capability of the Dubai International Financial Center (DIFC). Two new laws were promulgated in 2004 addressing the financing of terrorism and AML/FATF issues in the free zones. With Dubai vying to become a major regional financial hub, the authorities have promptly established the regulatory framework for the DIFC in line with international best practice, in order to support the growing number of licensed financial institutions. Given the specific structure and arrangements governing its activities, the authorities have agreed to a review of the DIFC’s operations by the Fund within year-end.

Structural Policies

13. The authorities’ development strategy has focused on strengthening the investment competitiveness of the economy while according a prominent role to the private sector in leading growth in non-hydrocarbon activities. An investor-friendly environment was fostered through an efficient and modern infrastructure, a streamlined regulatory climate in production and employment, and a favorable attitude towards foreign ownership. These factors have reinforced the ‘efficiency premium’ of the U.A.E. economy, rendering it an attractive destination for FDI and a regional hub for a large number of international companies that cater to neighboring markets.

14. To intensify competitiveness and strengthen the investment climate, the authorities are advancing on several initiatives. An amended Commercial Company Law that extends foreign ownership beyond the current limit of 49 percent is currently being considered by the cabinet for approval. Additionally, and in line with staff recommendation, the authorities are considering a new FDI legislation that would ensure consistency of regulations across the Federation while allowing flexibility in economic policy at the Emirate level. Moreover, the Dubai International Arbitration Center (DIAC) has been established to improve settlement of business disputes and address weaknesses in investor protection and contract enforcement. Finally, to improve system disclosure, the Dubai Chamber of Commerce and Investment (CCI) is in the process of establishing a credit rating and reporting agency, with international affiliation and federation-wide jurisdiction.

15. The authorities are cognizant of the importance of generating productive employment opportunities for the growing national labor force. Their strategy has focused on measures to enhance the employability of nationals in the private sector without compromising the overall competitiveness of the economy. To this end, and in addition to various initiatives to promote entrepreneurship at the Emirate level, a national training agency has been established to better equip nationals for private sector employment. Furthermore, as part of the authorities’ longer-term plans to improve the incentive structure and reduce the wedge between public and private sector wages and benefits, a pension scheme for nationals in both the public and private sectors has been adopted.

Statistical Issues

16. The authorities are aware of the importance—and urgency—of upgrading the economic and statistical database. Several measures to improve the institutional statistical framework governing the flow of information among the Emirates were initiated to this end. In addition to enhancing the role of the inter-ministerial Statistical Committee, the authorities have expressed interest in participating in General Data Dissemination System (GDDS) and have identified a coordinator at the Ministry of Planning and Economy. They are now preparing for the 2005 population census, which is expected to lay the statistical foundation for the implementation of several sectoral surveys in the future, including household budget surveys and business establishment surveys.

Conclusion

17. The authorities are thankful to the Fund for the provision of valuable technical assistance. In the period ahead, they will remain vigilant to deal with any domestic price pressures that may emerge, and focus their efforts on confronting the challenges that may arise in the process of meeting the GCC convergence criteria.