Countries of the region are experiencing strong economic growth conditions on the back of high crude oil prices, larger government expenditures and a more confident private sector expanding its consumption and investment to unprecedented levels. As expected, the economic boom has been accompanied by higher consumer price inflation and exuberant asset prices. Worried that the rising inflationary pressures would have negative social and macroeconomic repercussions, central banks in the region started putting in place tighter monetary policy.
Interest rates on domestic currencies have risen recently and the gap with dollar interest rates has started to widen. Fortunately, interest rates on the US currency, to which most regional currencies are pegged, have also been rising making it easier for monetary authorities in the region to implement their policy. Tighter monetary policy is likely to continue in the months ahead in order to dampen inflationary pressures and counter balance the expansionary fiscal policy associated with higher expenditures and surplus budgets expected for 2006.
Official inflation figures vary across countries of the region, ranging from an estimated annual rate of 2 percent in the first nine months of the year in Saudi Arabia, to 3.3 percent in Bahrain, 4.2 percent in Kuwait, 5.2 percent in the UAE, 5.7 percent in Jordan and 6.1 percent in Qatar. While domestic fuel prices did not increase in Saudi Arabia, Kuwait and Qatar, they rose by 32 percent in UAE and by around 20 percent in Jordan. Rents which account for around one third of the region’s consumer price indices rose by 25 percent in the UAE but recorded marginal increases elsewhere in the region, where the rental market is not yet fully liberalized.
A number of informal indicators suggest that the actual rate of inflation may be much higher than indicated by official figures. A recent survey by HSBC, the Middle East Business Confidence Index, found that almost 70 percent of businessmen interviewed felt that the cost of living had risen by more than 20 percent in Dubai over the past 12 months. London-based Mercer Human Resource Consulting reported that Dubai had jumped 10 places to become a more expensive city to live in than the likes of Washington.
There is also evidence of second-tier effects of inflation occurring in the labor market. Many GCC countries have increased wages in the public sector. In Saudi Arabia, for instance, wages rose by 15 percent. In the UAE, public sector pay was increased by 25 percent for nationals and 15 percent for expatriates, while Kuwaiti nationals received one-off cash bonuses of $680 each from the government last year. Such wage increases and cash bonuses improve the real income of nationals and public sector workers, boost their purchasing power and generate extra demand pushing prices even higher.
The higher inflation rate in the region is also due to the fact that prices of imports from Europe, UK and Japan have been on the rise reflecting the weaker Gulf currencies and the US dollar exchange rates vis-à-vis the euro, the sterling and the yen. The expansion in credit, especially consumer finance, and the presence of excess liquidity conditions further added to domestic inflation. As a matter of fact, real interest rates (normal interest rates less inflation rates) on short-term CDs and deposits are still negative in most countries of the region, reflecting a loose monetary policy at a time when these economies are recording historically high growth rates and some of them have double digit growth rates.
Prices of non-traded services have also been on the rise due to the surge in domestic demand. Many of them are passing on some of their labor and fuel costs to their customers, thus contributing to higher rates of consumer price inflation. In recent weeks, some airline companies, transportation and delivery firms have added fuel surcharges to their prices. Chemical companies have announced price increases to their plastics and chemical products. Surging construction costs are adding to apartments and housing prices which will be reflected sooner or later in higher rents.
One should not also underestimate the impact of the “wealth effect” on domestic prices. In the past three years when prices of real assets (stocks and real estate) surged, it gave consumers an extra purchasing power to spend. Even though their income may not have been higher, the increase in their wealth, whether realized or not, made them feel richer and therefore more willing to spend. The higher demand contributed to inflationary pressures in the region. This partly explains the unprecedented rise in imports to satisfy the surge in consumption.
Expansionary fiscal policies are likely to continue next year with a considerable increase in government expenditures being forecasted for 2006 budgets. While domestic interest rates have been on the rise in the past eighteen months, in line with the rise in dollar rates, monetary policy remains generally accommodative, with domestic interest rates below the corresponding inflation rates. Perhaps what is needed is a much tighter policy to put the breaks on the rise in domestic demand, slow down credit expansion and reduce inflationary pressures generated by the excess liquidity. The region’s central banks should engineer a soft landing to their economies, gradually deflating the current real estate and stock market bubbles before they become unmanageable.
A move by a widely respected authority like the country’s central bank to tighten monetary conditions would make speculators and investors pay attention to the message it is sending to the market. Once the central bank takes a clear policy stance vis-à-vis a certain issue, it will help shape public opinion, making it very difficult for rational market participants to bet against it. However, central banks should communicate their policy to the public explaining the rationale behind the uptrend in short and long-term interest rates. What counts is that everyone will pay attention to what the central bank is trying to say and everyone knows that everyone else is paying attention.
If interest rates on local currencies rise faster than the majority expects, this will change the risk/return profile of investors and encourage higher savings and less consumption. There is always the risk that the economies of the region may slow down if a tighter monetary policy remains in place. This should be affordable at this point in time, as most countries are recording historically high levels of growth rates.
(Henry T. Azzam is founder & CEO of Amwal Invest.)