AMMAN, 1 March 2004 - Interest rates on the Jordanian dinar and the Gulf currencies have dropped to their lowest levels recently, with monthly deposit rates on local currencies dropping below 1.5 percent, compared to corresponding dollar deposit rates of less than 1 percent. At yearend 2003, the spreads between yields on bonds and bills issued by the governments of Jordan and the Gulf countries compared to those issued by the US Treasury declined to just under 1 percent. A combination of internal and external factors makes us believe that the decline in interest rates on local currency deposits that started almost two years ago has reached its limit for the current cycle and we expect domestic interest rates to start edging higher later in the year.
Interest rates on the Saudi riyal, UAE dirham, Omani riyal, Jordanian dinar and other Gulf currencies are influenced by both domestic and external factors. Because the Jordanian dinar and the Gulf currencies are pegged to the US dollar, the most important factor influencing domestic interest rate is the corresponding dollar rate. Historically, there has been a spread between domestic interest rates and those on the US currency in favor of the domestic rates. The spreads varied over time and from one country to another depending on the country's economic fundamentals, the size of its foreign reserves, its inflation differential with the US, and markets' assessment of the risks of devaluation of the local currency. The availability of such spreads helped preserve the attractiveness of the local currencies and provided support to their fixed dollar peg.
Interest rates differentials between Saudi riyal and dollar deposits rose from a low of 0.35 percent in January 1998 to a high of 1.95 percent in March 1999. The widening spreads were a reflection of heightened speculative pressure against the riyal at a time when oil prices were on the decline, dropping to their lowest average of $11.37 for Brent crude in the first quarter of 1999. With the rise in oil prices in 2000-2003, speculative pressure on the Saudi riyal and the other Gulf currencies subsided and the differentials between interest rates on local currencies and those on the dollar dropped to less than 0.1 percent in December 2003. During periods of high oil prices and strong economic growth, there will be little or no speculation against the Gulf currencies and interest rates on local currency deposits would tend to move closer to corresponding dollar-rates.
An improvement in a Jordan's economic fundamentals made it possible for the country's monetary authorities to steer domestic interest rates lower, closer to those on the dollar. This occurred following the upgrading last year of Jordan's credit rating by Moody's and Standard & Poor's. Jordan's economic growth in the past four years has been strong ranging between 3 percent and 5 percent annually, and the country's foreign reserves reached an all-time high of $5 billion by the end of 2003. However, there is a limit to how much interest-rate differentials could be reduced. A positive spread over US interest rates is needed to compensate holders of the Jordanian dinar for the higher risk incurred (both actual and perceived) when holding the local currency. Rates on three-month CDs assumed a declining trend in 2000-2003, dropping from a monthly average of 6 percent in December 2000 to 3.9 percent in December 2001, 3 percent in December 2002 and 2.2 percent in December 2003. The differential between interest rates on 3 months Jordanian CDs and 3 months US Treasury bills narrowed from 5.9 percent in late 1998 to 1.3 percent in December 2003.
It has become evident that there is no room left for the spreads between interest rates on local currency deposits and those on dollar deposits to tighten further as they are now way below their historic average. This is happening at a time when consumer price indices in Jordan and the Gulf countries are expected to rise this year, while US inflation rates are likely to remain subdued at 1.5 percent, slightly higher than the 2003 level of 1 percent.
Prices of imports to the region from Europe, UK and Japan have been on the rise reflecting the weaker US dollar and local currencies exchange rates vis-à-vis the euro, the sterling and the yen. The ongoing surge in construction activities in the Gulf and Jordan together with credit expansion and excess liquidity conditions will further boost domestic demand. All these variables will have an inflationary impact on the economies of the region. Accordingly a slightly higher consumer price inflation should be expected in 2004 compared to those of the US.
However, no one expects interest rates on local currency deposits to rise any time soon nor at a fast rate and any possible tightening of monetary policy is likely to be delayed till later in the year when US dollar rates are forecast to rise. The Federal Reserve caught the financial markets by surprise on Jan. 28, when it backed away from its promise to keep interest rates low "for a considerable period". The monetary authorities in the US inched closer to an eventual tightening of credit, but the statement does not mean dollar interest rates need to rise right away, nor does it mean they will have to rise quickly once the Federal Reserve starts to tighten monetary policy. What will ultimately determine interest rate direction is the outlook for the US economy, inflation and demand for credit. On that basis, there are reasons to believe that short and long-term interest rates are likely to stay low for some time before they start to rise in the second half of the year.
The faster growth of the US economy, the stronger demand for credit by corporates, the surge in government borrowing, the higher cost of oil and the weaker dollar saw the consumer price index rise to 0.5 percent in January this year from 0.2 percent in December 2003. If these trends continue and growth in employment picks up momentum, inflationary pressures in the US economy will start to build up, justifying a rise in interest rates later in the year.
While it is true that the Federal Reserve may not need to raise interest rates until the consumer price inflation is clearly on the upside, nevertheless, there is a big risk that the current policy of easy money is fueling inflation in the price of shares and houses. The 33 percent rise in the broad Standard & Poor's index of the US stock market in the past twelve months, is encouraging already over-indebted households to borrow more and invest more, inflating in the process housing and real estate prices. These in turn will eventually be reflected in higher inflation.
Companies in the region should therefore give serious consideration to the prospects of borrowing medium to long-term now that interest rates on the domestic currencies are close to their lowest level and are expected to rise later in the year. The domestic bond markets have developed to a level where this has become possible. Issuing bonds denominated in local currencies will not only help corporates to lock in historically low interest rates for say a five-year period, but will also help them to diversify sources of funding, reduce the corporates' overdependence on borrowing from banks and give them the advantage to repay the principal amount borrowed in one bullet repayment upon the maturity date of the bond. Equally important, companies will be able to capitalize on the process of issuing bonds to enhance financial transparency and improve their corporate image.
(Henry T. Azzam is chief executive officer at Jordinvest.)