The subject captivating global investors during the last week was the resolution of the big question: when will the Federal Reserve complete its first rate hike and how will global assets react. Although equity markets have dropped in the U.S. since the policy change occurred, it is still too early to tell what the economic impact on MENASEA region countries which Finance Forward explores below based on recent trends in export data. We looked at exports because not only do many MENASEA region countries depend on trade for a significant proportion of their economies, after capital account flows, a primary channel for the effect of U.S. monetary policy changes to be transmitted to MENASEA economies.
The U.S Fed Finally Hiked Rates: What is its Impact on the MENASEA Economies?
The Federal Reserve raised interest rates for the first time in 9 years on Wednesday and the initial reaction has been somewhat subdued, although US equity markets followed with a sharp sell-off after an initial positive reaction. The effect of the first rate hike is not going to drive much in the way of future developments because it was almost fully priced in months before it occurred. The future trajectory is much more dependent on how ‘gradual’ the rate hiking cycle is and whether the Federal Reserve continues its ‘dovish hikes’.
As we highlighted in our Finance Forward Islamic Finance Outlook 2016 report, the macroeconomic developments in MENASEA countries was dependent on oil, China and interest rates. On the impact of the Fed’s shift on emerging markets across the MENASEA region can be viewed in terms of how different regions adjust through trade channels since most countries are small, relatively open economies and the impact of external factors like US monetary will occur via their terms of trade and the demand for their exports.
As a result, we look at the likely effect of the Federal Reserve shift on MENASEA economies through the impact to the size and trends in the exports. To do, we focus on:
- Exports from the Middle East and North Africa (MENA) region and Turkey to the broader European Union (EU-28) countries
- Exports from the ASEAN region and intra-ASEAN trade
The Middle East and North Africa is not a homogenous bloc and to differentiate these disparate trends, we separated it into Turkey and the Levant; GCC; and North Africa. Starting from the end and working backwards, the dollar value of exports from the GCC dropped in 2014 and likely continued dropping through 2015 as a result of low oil prices.
The Federal Reserve policy shift is not likely to change the direction of commodity prices except for possibly a ‘sell the news’ fall in the dollar. Otherwise, the fundamental imbalance of supply and demand in oil is likely to contribute to lower trade values for GCC exports and also slower economic growth as the region raised rates to maintain the dollar peg (even Kuwait whose currency is tied to a basket of currencies). Despite limited prospects for rising commodity prices, the currency peg forces monetary policy to be contractionary in GCC countries which should slow their overall growth in non-oil sectors.
Within North Africa, there are geopolitical issues, as well as hydrocarbon exports that are driving economic impacts that are not likely to be as affected by Federal Reserve policy. However some countries—notably Tunisia and Morocco—are likely to see their economic growth tied more to the European Union which is seeing stronger growth than in previous years.
The Federal Reserve policy should amplify the stimulative effect of ECB actions through a lower Euro. The resulting growth will increase demand from imports, including North Africa. The headwind of falling commodity prices for both oil exporters Algeria and Libya will fade even if the price does not rebound simply by not further reducing exports (and could be significantly additive for Libya if production rebounds following the peace deal).
Turkey will be affected more like the non-oil exporters across North Africa, particularly since almost 50% of its exports go to the EU-28 countries (two-thirds of Maghreb exports are bound for Europe as of 2014). Despite regional geopolitical instability, particularly that related to Syria, disputes with Kurds and the rise of ISIS in Iraq near Turkey’s southeast border, its important exports to the EU-28 have grown 8% annually from 2012-2014.
The elections in November put Turkey in a more secure position in terms of the domestic environment and the stronger European economy is likely to support demand for imports (particularly if ECB actions lead to a weaker Euro). However, relative to regional peers, the relative strength of the Lira may offset some of the gains that the Fed’s decision (and future ECB easing) would provide for Turkey’s exports.
The other region that will see a major impact of the Federal Reserve’s action is the ASEAN region. Unlike many of the MENA region currencies (many of which are pegged in some fashion to the dollar or Euro), ASEAN currencies are generally floating and have seen significant depreciation as a result of slowing China growth and a historic outflow from emerging markets in 2015. The International Institute of Finance estimated in October that full year net outflows were expected to be $541 billion in 2015, the first time the net flows have been negative since 1988.
These outflows were responsible for much of the currency depreciation although lower exports as a result of Chinese economic weakness also played a role as well. In light of the Fed raising rates while economies like Malaysia and Indonesia hold their rates steady, the currencies would be expected to decline further. However, non-resident capital flows are likely to reverse since the underlying economies are not in crisis (assuming remaining weaknesses stay contained) which will offset continued weakness in trade flows as Chinese import demand remains depressed.
The ASEAN economies are not likely to overcome the impacts of Fed rate rises on the back of exceptional economic performance. Instead, it will occur as a result more of relief that the uncertainty about the process of rate rises has lifted. The Fed has begun to tighten and the sky has not fallen. China’s economy has slowed but is still growing. There are other concerns remaining but many that have caused volatility since 2013’s ‘Taper Tantrum’ are behind us.
For ASEAN trade flows, this should be beneficial. Not only have chances of a stronger China slowdown (destination for 22% of ASEAN exports including Taiwan and Hong Kong) diminished. But US growth remain strong (destination for 10% of exports), Europe and Japan (9% of exports for each) is getting stronger and despite the difficult economic backdrop, ASEAN economies (destination for 22% of exports) are still growing. This should support healthier economies than would necessarily be expected based on the direct impact of US monetary policy alone.
The bottom line for many of the MENASEA region economies is that the negative potential impacts of the Federal Reserve shift into rising rate mode have already, through currency markets and capital flows, had their impact on the region. The slow anticipated rate of policy increases and continued easing from the ECB (notwithstanding disappointment about the December announcement) and from the Bank of Japan will support trade flows which are important sources of hard currency. No country in the region can completely ignore the impact of rate hikes and commodity exporters will have to rebalance fiscal policy if it continues. However, until these second round effects materialize (and they could be significant and negative) or the pace of US monetary policy tightening accelerates, the primary effect of US monetary policy is largely over.
Is the UAE insurance sector prepared to comply with EU based Solvency II regulations?
Tighter requirements being set down by Solvency II in EU, are leading to efforts in other markets, supported by the International Association of Insurance Supervisors which is trying to make Solvency II a baseline for regulation in other markets. Earlier this year, the UAE insurance authority set down new regulations for traditional insurers and takaful operators, to be phased in during the next one-to-three years.
The minimum requirements for paid-in capital remains at AED 100 million ($27 m) for insurers and AED 250 million ($68 m) for reinsurers. The primary changes occur in the calculation of a minimum guarantee fund, solvency requirements and the investment policies covering an insurers’ assets. The highlights of the regulations are that:
- Insurers maintain a minimum guarantee fund (at least a third of the Solvency Capital Requirement);
- Insurers are required to build their technical provisions based on an actuarial report from an accredited actuary;
- The insurer takes into account underwriting risk, market/liquidity risk, credit risk and operational risk in calculating solvency risk; and,
- Investments of the insurance company have to be more fully diversified and, in particular, must have more local market (equity or fixed income) exposure and less real estate exposure.
These requirements are broadly in line with the proposals under Europe’s Solvency II, which, for example, also sets a similar threshold for the minimum guarantee fund. However, the Insurance Authority has yet to release the template for the calculation of solvency margins and so the extent of the parallels with Solvency II are not fully clear.
In addition to the solvency related guidelines, the insurance authorities have also set out investment thresholds that may also, in effect, lead to changes in the insurance market because it will require insurers to focus their attention away from new lines of business and towards ensuring they meet the new requirements. The investment rules impose a 30% limit on real estate investment, 30% in equity instruments in UAE companies (with no more than 10% exposure to a single counterparty) and a minimum requirement for 5% of assets be held as bank deposits.
The rules permit insurers to invest 100% of their funds in government bonds or other types of securities although limited supply of assets and the counterparty limits at 25% may effectively limit the investments in government bonds. They may hold some of their assets outside of the UAE but not more than 50%; all technical provisions must be held in assets within the UAE.
The above regulations would help ensure insurance companies in the UAE stay solvent and provide a better regulatory framework for the UAE insurance sector. However, under a more complex regulatory regime, insurers should expect to incur greater costs, and will require additional staff, in order to ensure compliance with the new requirements. This may be a challenge for the UAE insurance market which today is overcrowded with each insurer facing intense competition across most lines of business resulting in tighter profit margins.
The tighter new regulations may hurt some insurers and drive smaller players out of the market but may help the market overall where the low profitability is becoming a problem for international players in the market. For example, multi-line insurer Zurich has announced it plans to close down its general insurance business by end of 2016.
A tectonic shift is likely to take place in the UAE insurance industry if the UAE insurance authorities are able to implement this risk-based blueprint effectively, it will speed the painful changes needed for the industry to thrive over the long-term. That may require many of the small to medium size insurance companies, which may struggle to comply with new requirements as they have more difficulty with asset diversification, may be forced to look into consolidation. In an overcrowded market, regulations which stimulate this activity may deliver an unintended positive impacts.