AMMAN, 28 March 2005 — Share prices in various countries of the region continued their strong uptrend so far this year, with the Shuaa Capital index for the Arab counties up by more than 35 percent since the beginning of the year, on top of 64.8 percent and 56.8 percent increases recorded in 2004 and 2003 respectively. Real estate prices in the main Arab cities have also been rising at an average annual rate of 20 percent-30 percent. Should central banks try to curb such excesses in asset prices through a big enough increase in domestic interest rates before the bubble bursts and becomes very difficult to manage? Or is it better to stay the course and let market forces prevail?
Real interest rates on local currency deposits across countries of the region have collapsed after reaching their highs in 1999 and have until recently been in negative territories, marking the most accommodative monetary policy we have seen in the region since the 1970s. The short term interest rates in most Arab countries are below 3 percent and the corresponding real short term interest rate i.e. after deducting inflation are either negative or very low and way below their normal historic averages. The protracted period of low interest rates of the past few years helped boost domestic liquidity, and led to double-digit growth rates in bank deposits and credit extended by commercial banks operating in various countries of the region. It is perhaps more appropriate today to define inflation as too much money chasing limited number of shares and real assets rather than too much money chasing too few goods.
Some central bankers in the UK, the EU, Australia and New Zealand have stated publicly that monetary policy needs to take into consideration the rise in asset prices. They argue that in case of asset price inflation, interest rates may have to rise by more than what is needed to keep consumer price inflation within target. Through the “wealth effect”, a period of higher asset prices would give consumers “extra” purchasing power to spend, and this will contribute to higher consumer price inflation down the line. On the other hand, the Federal Reserve of the US, among other central bankers in the world have, argued that monetary policy should not be used to prick bubbles in asset prices. Not only because it is very difficult to identify when asset prices have reached inflated levels, but also because a big enough increase in interest rates to halt a strong surge in share prices could trigger a recession. Those supporting this point of view prefer to wait for a stock market bubble to burst and then cushion the economy by cutting interest rates. This what the Federal Reserve actually did when it lowered interest rates by 5.5 percent during 2001-2003 following the burst of the US stock market bubble.
Because most regional currencies are pegged to the dollar, central banks feel compelled to follow the directional movements of dollar interest rates, even when the economic cycle in their respective countries are not moving in tandem with that of the US. For example, during periods of slow domestic economic growth where monetary policy needs to be accommodative, central banks of the region will not be able to lower interest rates on local currencies if the US dollar rates are firm or rising. However, when interest rates in the US are on an upcycle, as it is the case now, and economic conditions in various countries of the region require tighter monetary policy, then central banks should be able to allow domestic interest rates to rise at a much higher pace than those on the dollar. This will change the risk/return profile of investors, encourage higher savings and less speculation in the stock markets, with more money moving into local currency deposits instead of dollar accounts.
If interest rates rise faster than the majority expects, it will discourage margin borrowing to buy shares, thus deflating the bubble in the stock markets without necessarily bursting it. The higher interest rates policy could also be complemented by lowering loan to deposit ratio, as Kuwait did recently to relieve pressure on its bubbly domestic stock market.
There is always the risk that the economies of the region may slow down if a tighter monetary policy is put in place. This should be affordable at this point in time, as most Gulf countries are growing at double digit growth rates, underpinned by strong oil prices and higher crude production levels. Slower economic growth, if it materializes, would help reduce inflationary pressures that are starting to surface, both in the financial and the real economies of the region.
A move by a widely respected authority like the country’s central bank 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. If central banks of the region decide to move more aggressively in raising short-term interest rates to deflate asset prices, they should communicate their policy to the public, as Alan Greenspan (Fed chairman) did when he talked about the “irrational exuberance” of the US market in the middle of the technology stock market bubble of 1999-2000. 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. For this reason, central banks’ pronouncements and policies could help deflate the bubble in the region’s stock markets and steer them in the right direction.
(Henry T. Azzam is chief executive officer at Jordinvest.)
