MANAMA, 28 January 2008 — Inflation has become a major policy challenge for the GCC as a bloc. Inflation in the Gulf increased from 0.3 percent in 2001 to an estimated 6.3 percent in 2007, ranging widely from 3.0 percent in Bahrain to 14.0 percent in Qatar. The common trait for all six countries is the fact that inflation is on the rise. While there is a wide consensus that higher inflation is a side effect of the GCC’s rapid and oil-driven economic boom, views differ widely as to pinpointing the source of the region’s rising inflation, Merrill Lynch in a report released yesterday said.
The report attributed the pegs to be the main source of inflation. With the exception of Kuwait, GCC countries have a long history with US dollar pegs, which have served them relatively well until recently. However, as the global economy is becoming less dependent on the US, this is now changing. Decoupling has kept commodity prices high, despite a slowing US economy meaning that the business cycles of the GCC and the US are no longer in sync.
However, this is one of the prerequisites of pegs, as monetary policy is outsourced in fixed currency regimes. The set menu deal of open macroeconomics for policy-making is quite straightforward. Choose any two from a set of three: (1) perfect capital mobility, (2) fixed exchange rates, and (3) domestic monetary autonomy.
The “Impossible Trinity” says that all three cannot be achieved at the same time, and under capital mobility, monetary policy (i.e. interest rates) is used to achieve an external balance, floating the FX rate, and the fiscal policy to achieve internal balance. GCC countries have enjoyed an oil bonanza over the last five years. The region has staged a strong economic revival, driven by the oil windfall. The accumulation of massive Current Account (C/A) surpluses is helping the GCC build up international reserves, reduce indebtedness, finance structural change and invest in social and economic projects.
Having learned from their past mistakes, GCC countries have saved some 80 percent of the oil windfall, nearly triple the amount they saved in past oil booms. However, going forward, we expect fiscal spending to gain pace to finance mega investment projects. Domestic absorption is also on the rise, feeding into higher import growth. Based on flat oil prices in 2008–09, we estimate that $75 billion of the region’s C/A surplus is likely to be eaten up. Despite some short-term bottlenecks, this is likely to keep GDP growth at 5.7 percent on average in 2008–09.
GCC countries have grown at a 7.3 percent real average rate since 2002, and this high growth is becoming less dependent on the oil sector. While the contribution of the non-hydrocarbon sector to GDP growth was 49.0% back in 2003, it increased to 85.0 percent in 2006. As governments introduce market liberalization measures, privatization and tax reforms to improve the investment environment, this trend is likely to become more pronounced as FDI inflows multiply.
Contrary to previous oil booms, GCC governments have been quite prudent on spending. The breakeven oil price for budget expenditures is approximately c. $40/bbl. While we do not expect a significant reversal in oil prices in the short term, fiscal spending is likely to gain pace as mega investment projects are launched across the region. Together with increased private sector confidence and involvement, investment projects to be implemented in the next five years are estimated to total $1.5 trillion, according to MEED Projects.
GCC countries have built up a cumulative C/A surplus of some $730 billion over the past five years. Capital inflows have gained pace, and the region is awash with cash. Big investment projects are kick starting one after another. Some supply-side bottlenecks seem inevitable in the short term (e.g. in the housing sector in the UAE and Qatar). With heated domestic demand, pegs to the sliding dollar not only import inflation and fuel domestic liquidity but, more importantly, they also import easing monetary policy as the Fed cuts rates and GCC countries follow suit. This pushes inflation further. Inflation is likely to stay on an increasing trend in the short term.
In a region with constrained policy choices, we expect currency strengthening to be used as a policy tool in the fight against inflation. Therefore, de-pegging and/or revaluation of the currencies will remain under spotlight.