Interbank lending rates in the UAE have fallen significantly over the since mid-May, indicating that liquidity in the banking system is improving and credit growth to the private sector may start to pick up.

The three-month Emirates interbank offered rate (Eibor) has fallen by over 20 per cent since the beginning of the year, falling to 1.68 per cent from over 2.1 per cent in early January. Eibor is also on a downward trend after spending the last few years stubbornly high.

The Eibor rate is now at its lowest level for 17 months, although it remains much higher than the Central Bank of the UAE’s key policy rate, which is set at 1 per cent.

Interbank lending rates had been high because banks were worried about the financial strength of their peers they were lending to. “Rates were high due to worries about bank balance sheets and risk aversion,” says Farouk Soussa, economist at the US’ Citigroup in Dubai. “Banks were worried about what exposures people had to things like real estate and Dubai debt, and whether they had properly provisioned for it.”

Worries about counterparty risk have been declining over the past 12 months as the economy gets back on track and debt restructuring deals are agreed. Most recently, the political unrest in the region has caused a spike in oil prices, adding to the liquidity in the economies of oil producers like the UAE.

Eibor should continue to fall over the coming months, says Giyas Gokkent, chief economist at National Bank of Abu Dhabi. “If you look at Saudi Arabia, where the currency is also pegged to the US dollar, the Saudi interbank offered rate is around 68 basis points. I would expect to see Eibor head in that direction, although it won’t get there overnight.”

As Eibor rates fall and the liquidity situation in UAE banks improves, lending to the private sector is expected to slowly start to increase as well. “More abundant liquidity in the economy has to go somewhere, so loan growth should pick up a bit,” says Gokkent.

The pace of loan growth will still be much lower than the 30-40 per cent growth during the 2006-07 period though. “Demand for loans is still limited because there is overcapacity in the economy, so not a lot of demand to finance expansions or investment,” says Soussa. He expects loan growth for the year to be in the low single-digits.

That should help further reinforce the economic outlook for the UAE, as low loan growth was considered a factor is stifling the country’s growth rate.