Pleasure of high oil prices brings pain of inflation to Gulf countries

Lebanon, 14 Oct 2005

The old adage - where there is pleasure there will be pain - lends itself well to the current economic cycle of the Gulf Cooperation Council (GCC) countries. On a bright note, high oil prices are providing all the GCC economies with massive trade and current account surpluses, which enable governments to invest heavily, and in turn fuels private sector demand. On the flip side, however, this economic boom is now becoming increasingly apparent with exorbitant asset prices and inflation.

Inflation occurs when consumption and demand increase relative to the supply of goods and services - for instance, consider the current rental prices and the current price/earnings ratios of many of the GCC listed stocks compared to those that prevailed a year ago.

It is likely that the official inflation statistics underestimate the real rate of inflation prevalent in the GCC countries and it is highly probable that inflation will be considerably higher in 2005 than it was last year. Central bank figures for inflation in 2004 ranged from as little as 0.2 percent in Saudi Arabia to 6.1 percent in Qatar.

There are problems with any attempt to measure in one simple number the overall movement of millions of prices in an economy. Any of the GCC countries methods of deriving the inflation level is necessarily subjective, measuring the change in the price of a "representative basket of goods and services," which can only be based on a fraction of the many goods and services in its economy.

In the U.A.E., for example, the price of petrol at the fuel stations increased by 32 percent on September 1. According to a recent survey by Gulf Talent, a Dubai-based recruitment agency, rents in the emirate rose 34 percent in the past year. The consumer price index computed by the U.A.E. Central Bank does factor in rents, which are weighted as a third of the index, yet the official inflation figure of 4.7 percent does not seem to reflect the findings of the survey. Business Monitor International found that rents in the U.A.E. increased by 20 to 40 percent from last year, as did prices of household goods and services, though relatively less.

A number of informal indicators suggest that the rate of inflation is much greater than that indicated by official statistics. A recent survey by HSBC, the Middle East Business Confidence Index, found that a large proportion of businessmen and women were feeling the pinch of higher prices. Almost 70 percent of those questioned, felt that the cost of living had risen by more than 20 percent over the year, and 26 percent thought that it had risen by a staggering 40 percent or more.

Independent studies have also found the price of goods and services are growing faster than what is officially reported. Standard Chartered Bank estimated that prices for goods and services in the U.A.E. rose 10 percent on average last year. 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 U.A.E., 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, but at the same time generate extra demand; and in an economy already suffering from supply shortages, it pushes prices even higher.

The prices of assets such as real estate and stocks have become alarmingly high. Nomura Bank of Japan has argued that prices of some Saudi stocks are unrealistically high. In June this year, a detailed report by Nomura pointed out that the market capitalization of Saudi Telecom was greater than the combined value of Britain's BT ($35 billion), America's AT&T ($15 billion), South Korea's SK Telecom ($15 billion) and South Africa's Telekom SA ($9 billion). These figures illustrate the huge liquidity flows being pumped into the region's stock markets. Another case in point is the IPO for Aabar Petroleum Investments in the U.A.E., which was oversubscribed by 800 times and raised pledges worth over $100 billion, an amount greater than the U.A.E.'s entire GDP.

Both are examples of too much money chasing too few products, a classic economic problem of inflation.

With this excess liquidity in the GCC countries and private and public sector demand outstripping supply, it thus seems that the only way for prices is up. The usual recourse in times of inflation is toward central bank monetary policy. The main aim of central banks today across the world is to stabilize growth and prices, to minimize their volatility, which can lead to painful economic adjustments such as unemployment or inflation. Few economies, however, have to deal with the kinds of economic swings endemic to the Gulf countries.

Yet the problem for the GCC countries is that their central banks cannot directly influence inflation or growth through the use of interest rates because all six currencies are pegged to the dollar. The GCC interest rates have to follow those set by the U.S. Federal Reserve, which have been at historically low levels for the past few years. These rates are set and decided upon in relation to the U.S. domestic economic outlook - an industrialized net-oil importing country - not for the buoyant oil-exporting GCC countries. Consequently, the policy-makers in the GCC countries have few tools at their disposal to deal with or cap inflation. The fact that the dollar has fallen against the euro, the currency of the GCC's main trading partner, compounds the problem. Last month the U.A.E. Central Bank announced it would issue Certificates of Deposit with maturities of up to five years in an attempt to drain liquidity from its economy, but this is unlikely to have much of an impact.

In a longer term attempt to take control of the U.A.E. economy and make economic policy effective, the U.A.E. Central Bank Governor, Sultan bin Nasser al-Suweidi, has called for an independent monetary policy and more flexible exchange rate regime to be seriously considered following the launch of the GCC currency union scheduled for 2010. Such a move would allow future GCC policy-makers to better control their economies with monetary tools and policies and, thus, be in a better position to rein in inflation.