|Inflation keeps upward pressure on interest rates|
|Countries of the region are experiencing strong economic growth conditions on the back of high crude prices, larger government expenditures, expansion of credit, and a more confident private sector increasing its consumption and investment to unprecedented levels. As expected, the economic boom coupled with the rise in import prices and shortage of rental property in major cities has led to higher inflation.
Worried that the rising inflationary pressures would have negative social and macroeconomic repercussions, several central banks in the region put in place tighter monetary policies, with interest rates on monthly time deposits rising from an average of 2.5 percent in 2004 to the current level of 5 percent, in line with the rise in US dollar rates.
Interest rates on the US currency, to which most regional currencies are pegged, are believed to have reached a peak for the current cycle, making it easier for the region's central banks to maintain tight policies in the months ahead. This is needed in order to dampen rising inflationary pressures and counter-balance the expansionary fiscal policy associated with higher expenditures and surplus budgets. Growth in money supply has reached an average annual rate of 20 percent in the past three years. With excess liquidity and accommodative fiscal policies it is not surprising to see accelerated credit expansion and booming real estate prices.
Official inflation figures vary across the region, ranging from an estimated annual rate of 2.2 percent in the first nine months of the year in Saudi Arabia, to 2.8 percent in Bahrain, 3.2 percent in Kuwait, 7 percent in the UAE, 6.3 percent in Jordan and 9.6 percent in Egypt. While domestic fuel prices did not increase in Saudi Arabia, Kuwait and Qatar, they rose by 30 percent in UAE and 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.
Price indices with unrealistic and/or distorted weights do not reflect "true" inflation. A number of informal indicators suggest that the actual rate of inflation may be much higher. In a recent survey, almost 70 percent of businessmen interviewed felt that the cost of living had risen by 15-20 percent in Dubai over the past 12 months. London-based Mercer Human Resource Consulting reported in its cost-of-living survey that Dubai had jumped from 73rd place among the most expensive cities in the world in 2005 to 25th out of 144 cities ranked. The key source of underestimation is the non-tradable, i.e. housing and various services. Consumer price inflation based on unrealistic weights of non-tradable component fail to capture in full the underlying inflation pressures.
There is also the effect of second-tier 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 some $5.5 billion from the government during the past two years. 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 and Japan have been on the rise, reflecting the weaker Gulf currencies and the US dollar exchange rates vis-a-vis the euro, sterling and 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 less inflation) on short-term CDs and deposits are negative in the UAE, Qatar, Jordan and Egypt, suggesting that monetary policy is still loose at a time when these economies are recording historically high growth rates and some of them have double digit nominal 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 apartment and housing prices, which will be reflected sooner or later in higher rents.
Price inflation inevitably leads to wage inflation, as employers hike salaries in order to hold on to staff. Average pay in the construction and financial sectors are estimated to have increased by around 15 percent so far this year. Bigger and more established firms can afford to pay the higher salaries but the small- to medium-sized ones are finding the climate tough and margins are shrinking.
Expansionary fiscal policies are likely to continue next year, with another increase in government expenditures being forecasted for 2007 budgets. While domestic interest rates have been on the rise in the past 18 months, in line with the rise in dollar rates, monetary policy is not yet tight enough, given the negative real interest rates. Perhaps the regions needs to maintain tight monetary policy in the months ahead in order to put the breaks on the rise in domestic demand, slow down credit expansion and reduce inflationary pressures. The region's central banks should engineer a soft landing for their economies, gradually deflating the current real estate bubbles before they become unmanageable.
Loose fiscal policy and negative real interest rates could eventually lead to economic and financial instability. This is why it is important to maintain tight monetary policy, in order to change the risk/return profile of investors and encourage higher savings and less consumption and direct investors more toward productive ventures and less speculation in the real estate and stock markets. There is always the risk that the economies of the region may slow down if tight monetary policies remain in place. However, this should be affordable at this point in time, as most countries are recording historically high economic growth levels.
Beirut,11 10 2006
Henri T. Azzam
The Daily Star