GCC's steps to curb inflation unorthodox, say economists

Branding the measures taken by the GCC governments to ease inflationary pressures as unorthodox, economists warned that unbridled price escalation is presenting the region a key micro challenge as the oil windfall continues to boost infrastructure spending.

Maintaining that the unorthodox measures including wage increases, price caps, subsidies, cutting import tariffs are only effective for the short term in checking price flare-ups, economists warned that in the medium term, inflationary pressures would be cumulative. "The GCC countries have got the money to delay — and also exacerbate — the inflation problem through such measures. The longer the delay to address, the stickier the inflation gets and the more inflated the asset bubbles become," warned Radoslaw Bodys and Turker Hamzaoglu, Merrill Lynch economists for the region.

They said inflated asset bubbles posed the biggest risk to the GCC’s business model, which rests on the expansion of human and physical capital in the region. "Note that with 75 per cent of planned projects not yet at construction stage, cost escalation becomes a real problem and shortages and labour unrest (often over wages) are already evident."

Gulf-based analysts point out that most of the currencies of the GCC are undervalued against the dollar, based on their current-account balances, inflation and costs of goods and services. The UAE dirham was undervalued by 10-15 per cent and the Saudi riyal by 25-30 per cent, according to a report by Deutsche Bank AG.

According to currency experts, the dollar peg prevents nominal appreciation of Gulf curencies. Since the dollar itself has been falling, the result is rising domestic inflation. Markets piled pressure on Gulf currencies last year as speculation mounted that more GCC countries would follow Kuwait and abandon links to the weak dollar partly to curb imported inflation.

Recently monetary experts said the UAE and Qatar are expected to ditch the dollar peg within six months, but Saudi Arabia will wait until late 2009 to break away from the tumbling greenback.

Merrill Lynch said the rapid pace of expansion in the GCC comes at a cost, as it expects inflation to hit 9.7 per cent in 2008. "The popular view is still that inflation in the GCC is mainly driven by supply bottlenecks. We find this unconvincing. Rapid economic growth and population expansion exacerbate the supply bottlenecks. The surge in food prices also adds to problem. But one cannot ignore the huge negative real interest rates in the region. All in all, we still believe that the core of the problem is “too much and too cheap money chasing too few goods and services.”

Economists said with oil prices scaling new highs, the GCC, home to 40 per cent of the world’s proven oil reserves and 23 per cent of natural gas reserves, continues to enjoy the massive hydrocarbon windfall. "Large external (30.6 per cent of GDP in 2008) and fiscal (22.4 per cent of GDP) surpluses allow governments to press ahead with more diversification, while building up reserves for rainy days. With the infrastructure boom and deeply negative interest rates, GDP should continue to expand at six per cent in 2008-09, and inflation to remain the key macro risk."

Merrill economists said while the hydrocarbon sector accounts for 33 per cent of the economy, growth in the sector, expected to be 2.7 per cent in 08 lags non-oil sectors which are expected to post 7.4 per cent growth. "The four main drivers for strong non-oil growth are loose monetary and fiscal policies, infrastructure investments and favourable demographics. Since November 07, GCC countries have eased their monetary policies substantially. Fiscal policy has become more expansionary as governments try to compensate for higher living costs. Real estate/construction remains a key driver with the planned projects estimated at $1.9 trillion in April 2008.