RIYADH, 11 April 2005 — In our last column, we spoke of liquid wealth as money sloshing around in a number of economic buckets: Consumption, imports, savings, direct investment, equity and mutual funds and real estate. Let us explore this issue further.
Wealth is nothing but society’s lifetime accumulated savings (plus inheritance). Wealth is purchasing power, i.e., it can be used to acquire goods and services or financial and real assets. Wealth increases from income-generating productive activity (measured by GDP).
A part of the GDP is spent on goods and services by people and the part that is left adds to their wealth. Wealth has to be held in the form of liquid or real assets such as cash, bank accounts, equity shares, financial securities, mutual funds, real estate, etc. People allocate their wealth among the different assets classes depending on their relative attractiveness and this has a corresponding impact on the supply-demand and price of different asset classes. Wealth also has a feedback effect on economic activity.
People can liquidate and spend a portion of their wealth (called dissaving), especially if, unexpected increases in the market value of their assets increase wealth beyond what they expected. In a modern economy, the increased desire to purchase goods and services results in a corresponding increase in demand and “price” is the ultimate equalizer between demand and supply. In an economy with no trade restrictions, supply can be met from domestic or foreign sources.
If supply is constrained then demand creates inflation. Although, we do not have current data, we believe that the large increase in liquid wealth in the Saudi economy from oil export revenues, etc. has increased the demand for imports. It has also created inflation in the prices of locally produced goods and services because of limited domestic productive capacity.
However, we believe that the bulk of the new liquidity has gone into domestic equity and real estate and raised their prices immensely. This is clearly manifested by the large increase in domestic shares (which have quadrupled in value in the last two years) and real estate for which we do not have hard data. Thus, the increase in liquid wealth due to asset price increases is most likely, also causing further rounds of demand increase for goods and services as well as continued reallocation of liquid wealth among various assets. This upward spiral of wealth (liquidity), demand and economic activity is certainly positive as long as it lasts.
However, the reverse can also be equally negative. Any reduction in national wealth caused by a correction in equity and real estate prices thus will not only affect the assets markets but also economic activity. Just like the upward spiral is feeding upon itself to magnify its impact, a downward spiral can have a magnified impact on economic activity. In the next column, we will look at how oil-export based liquidity enters the economy.
(Khan H. Zahid is chief economist and vice president at Riyad Bank. He is based in Riyadh.)