The massive development programme now under way in Abu Dhabi is likely to place major strains on the financial and legal system, according to Terence Allen, Managing Director of Allied Investment Partners PJSC.

This figure, he noted, is only the amount that is required from the Government, and does not take into account the financial needs of the private sector or the continuing needs of other Emirates, particularly Dubai. These, he suggested, could be as much as another US $ 270 billion over the same five years period. The UAE, he suggested, is in 'uncharted waters' in financial terms, with regards to the total amounts of investment required and the pressures that this unprecedented pace of development will have on the financial system.

Since the end of 2004, Allen pointed out, "there has been a deliberate policy by the Government of Abu Dhabi to open up Abu Dhabi to private, local and foreign, investment. Indeed, the demands of foreign direct investors, whether as private equity or investment monies in the form of borrowings such as bonds or bank loans, seems to be the driving factor as to why Government does not open its cheque book to pay completely for all the governmentsponsored investment planned. Banks and financial institutions, and private equity, are finding many opportunities to put their money to work in Abu Dhabi."

But, he warned, "the impact of these investment needs are creating major pressures on the financial system, as well as on the legal system and on the general environment in which we all live and work."

One of the impacts, he noted, had been the recent rise in interest rates, with the cost of borrowing having doubled in the past two years. While this has been due primarily, he noted, to the rise in global inflation and in US interest rates, and this then feeding into the local market as a result of the dirham being pegged to the dollar, he said also that margins charged by local banks above the interbank cost of borrowing had risen substantially due to the pressures on the local financial system.

"Some of the local banks are overlent and are currently operating outside of the ratios set by the Central Bank, which require that a bank's lending must be matched 1:1 against customer deposits," he said. As a result, "they are obliged to pay customers more than their published rates, in an effect to maintain, and correct, their legal ratio obligations."

This, in turn, provides an opportunity for foreign banks to enter the market more actively. "As the cost of funding for these foreign banks is substantially lower than for the local banks, we are rapidly approaching a situation where much of the borrowing needs of both the Government of Abu Dhabi and the private sector will be met by foreign banks, rather than by the traditional borrowing from local banks."

While this may be a positive development, in the sense that Government seeks to promote inward foreign investment, Allen also warned that it could lead to major changes in the structure of our own local banking system.

"I believe we will see a situation where local banks are reduced to retail and 'savings' institutions, and the major part of the development programme for Abu Dhabi, indeed for the UAE, will be financed with foreign money."

"As the market share of local banks is inevitably reduced, in time their profitability will also reduce, thus having an impact on their share value in the stock market. The local banks therefore need to seek alternative business practices to keep up their profitability in future years. Merger of some of the local banks will be inevitable in an effort to maximise market share, but this alone will not stave off indefinitely a reduction in business and profits."

Looking further ahead, Allen drew comparisons with other countries where local banks have been priced out of their own markets during a phase of major economic expansion at home, this then being followed by international banks moving in to purchase the local institutions "at bargain prices."

"Thus it is possible," he suggested, "that, due to the development plans currently under way in Abu Dhabi and the UAE, we will see our local banking institutions more and more owned by foreigners."

"My message to local banks," he said, "is: 'stop making commitments to fund local development programmes if you cannot afford to fund those commitments. The consequences for this unrestrained lending will eventually lead to disappointment for your shareholders.' "

Allen also commented on the impact of inflation on the local financial system. While much inflation is global in nature, "much of the inflation in the UAE is imported unnecessarily because of the persistence of maintaining the current currency peg of the dirham to the US dollar. The current peg has been in existence for 26 years. Times have changed. The perception of a strong dollar has changed.

US Government policy has changed." Quoting figures cited by the Governor of the UAE Central Bank at a previous BBG lunch, Allen said that approximately 88 per cent of the UAE's imports were from non-dollar based countries. "Therefore, as the dollar and the dirham continue to weaken against other major currencies, the cost of everything is rising here, particularly labour."

The current development programme, he said, is bringing in engineers, teachers, doctors, nurses and many other categories, and "to attract the right people, the cost of wages has increased substantially. It is no longer taken for granted that people will come to work here because the salaries and tax-friendly environment is beneficial." In his own industry, he said, it is difficult to attract good quality staff "because the buying power of a dirham or dollar package has decreased by approximately 30 per cent in the last three years."

One step that could be taken immediately to tackle inflation, he suggested, would be to de-link the dirham from the dollar.

"For a country like the UAE, which has one of the strongest economies in the world in GDP terms, a simple realignment of the value of the dirham against the dollar would alleviate the inflation problems - almost overnight. The only Emirate that I can see who could object to this would be Dubai. They would naturally have concerns that a revalued dirham would hurt their blossoming tourist and industrial development markets. But to allow the import of unnecessary inflation on a continued scale of what we have seen in the last few years will have the same effect. How long is it going to take for the ever-increasing cost of rents, food and services to wipe out the advantages to businesses and individuals of being in the Emirates? Indeed, it is impossible to reverse the damage already done by having failed to curb this unnecessary import of inflation."

The International Monetary Fund, he noted, had suggested that the Gulf states should maintain their link to the dollar until the planned integration of Gulf Co-operation Council, GCC, currencies in 2010. But why, he asked, "should Gulf currencies be held ransom to a fluctuating dollar, when their domestic economies, collectively and individually, call for an upward revaluation of the domestic currencies?"

In summary, he concluded, he believed that the main impacts on the local financial system of the unprecedented programme of development launched by the Government of Abu Dhabi would be major changes in the current banking system, increasing inflationary pressures, higher borrowing costs and a moderation of corporate profits, as a result of rising costs, that would then feed into a longterm stock market adjustment.

"I believe," he said, "that it is incumbent upon the authorities here to develop more robust policies and practices to reduce these pressures, so as to allow a more orderly move into the next generation."