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Inflation in the Gulf states: Are subsidies the antidote? (By Dr Samir Ranjan Pradhan)

T oo much money spent chasing too few goods’ or ‘basics becoming luxuries.’ This economic phenomenon known as inflation has taken some of the sheen off the economic boom scenario in the GCC. Consumers, financial policy makers and the ruling elites as well are struggling to deal with this menace. Symptoms are diagnosed, remedial measures are planned and policy machinery is put into action. But are all these efforts sufficient to counter the threat? There are no clear-cut answers. All policy measures are off-the-cuff and more in reaction to the problem. So what is the next best course?

Trends and Symptoms

Inflation is at 16-year highs in Saudi Arabia and Oman, a 19-year peak in the United Arab Emirates and just below record levels in Qatar. Disparate trends and obfuscating analyses abound. This is obvious in the absence of scientifically modeled dataset on the macro trends of the GCC economies; leave alone the unbalanced or non-existent consumer price indexes (CPI), particularly in case of the UAE. So we at GRC relied on conventional wisdom by calculating the rate of inflation from the annual average changes in CPI data provided by all national monetary authorities in the GCC countries. It is found that average consumer price inflation in the GCC reached a 15-year high of 5.3 per cent in 2006, and rose to 6.8 per cent in 2007 (third quarter). As per our estimates, inflation rates in Bahrain, Kuwait, Oman and Saudi Arabia were 8.4 percent, 6.6 percent, 5.3 percent and 6.5 percent respectively, in comparison to a staggering 12.8 percent and 11.3 percent in Qatar and the UAE. Nevertheless, inflation trends in the GCC as evinced from almost all current analyses ranging from academic outputs to mass media seem to converge towards the uptick level.

For Saudi Arabia, Saudi British bank estimates a 35 percent share of imported inflation in overall inflation. For Kuwait, estimates of 25 percent have been given using food imports as a proxy for imported inflation. Still, even in these countries the domestic part of inflation (non-tradables like rents, services and fees) is dominant. This is all the more true for the UAE and Qatar. Official UAE sources recently stated that 50 percent of the inflation can be attributed to rent and close to 30 percent to imported inflation. The weights assigned to CPI components in the UAE are distorted as they only attribute 36 percent to rents, which is lower than many expatriates actually have to pay. Thus the amount of domestically generated inflation could be even higher. In Saudi Arabia, the average inflation rate as measured by annual changes in the cost of living index during the 12 months ended September 2007 rose by 3.3 percent while the average index during the preceding five years (October 2001-September 2006) was 0.6 percent. Importantly, the group of food and beverages and the goods and other services (mostly imported items including metals and other raw materials) group rose by 6.7 percent and by 5.7 percent, respectively. Another important component of the tradables contributing to inflation is the housing furnishings group whose average index for the period, October 2006-September 2007 rose by 1.1 percent. This phenomenon is prevalent in all GCC economies more or less. In Qatar, the index of tradables increased by almost 15 percent from the year 2005 to 2006. This is why Qatar experienced the highest rate of inflation in the GCC. In Kuwait, the general level of wholesale prices of imported goods (whose relative weight in the General Wholesale Price Index is 76.9 percent) also increased in the year 2007. The inflation rate of food prices in the UAE was between 27 and 30 per cent in 2007, according to a survey conducted by the Emirates Consumer Protection Society (ECPS).

Diagnosing the Causes

What are the factors propelling the inflation? While government authorities point to ‘economic boom beyond capacity’ as the root cause, analysts attribute it to other major factors such as the structural economic rigidities like lower absorptive capacity amid huge liquidity, domestic currencies pegged to sliding greenback and prodigal welfarism resulting in unwanted fiscal expenditure. But a closer look reveals that the root causes are deeply entrenched and also influenced by beyond-border factors. Across GCC, inflation is caused by a combination of demand pull and supply shock or cost push factors. On the demand side, GCC economies are flush with burgeoning liquidity as a result of higher oil prices, thereby pushing aggregate demand. Increasing government expenditure for economic diversification further fuels the flame. Adding to the additional demand factor is the ever increasing population, due both to demographic transition and huge influx of expatriates. It has been impossible for the supply side, in terms of goods, services, housing and infrastructure, to keep pace. The result is price spikes all along the value chain due to cost escalation, which then percolates to other sectors of the economy. On the supply side, the most controversial cause of the inflation is domestic currencies pegged to the sliding dollar, thereby sapping the purchasing value of local currencies. Also the movements between the US dollar and the euro/yen have been devaluing local currencies that are pegged to the dollar and, therefore, also contributing to the acceleration of inflation by increasing the cost of goods imported from Europe and Japan. Supply shock or cost push is also due to the shortage of skilled labor required for maintaining the growth momentum in the GCC economies. More importantly, there have been global supply shocks prevalent in most of the fast moving economies due to higher food and commodity prices that have direct repercussions for open economies of the GCC. Thus GCC economies seem to be located at the higher spectrum of the inflation cycle.

Impact and Reprisal

Stung with the pernicious effects of inflation, strong opinions started to channel into public discourse. In Saudi Arabia, 19 prominent clerics posted an unusual statement on the Internet in December 2007 warning of a crisis that would cause theft, cheating, armed robbery and resentment between rich and poor. Over this week, GCC policy makers and business chambers held a high level official conference with IMF and EU executives to mull over measures to combat inflation. Analysts talked about the Great Depression that altered the global monetary system and similar is about to happen in the GCC. The government authorities as usual played to the gallery, protecting the nationals through benevolence. In the absence of sophisticated monetary tools, most GCC countries have come up with a package of measures designed to either counter the negative impact of rising inflation on incomes or to contain price increases. The United Arab Emirates increased the salaries of federal public sector employees by 70 percent; Oman raised them 43 percent. In January 2008, Saudi Arabia announced a set of measures designed to contain inflation including subsidising a wide range of fees, awarding a 5 percent cost-of-living allowance to all state employees and pensioners, and boosting social security payments. Bahrain set up a $100 million fund to be distributed to people most affected by rising prices. Besides the pricing control measures, authorities lowered duties on imports especially on construction materials to ease the pressure. All these taken together are reactionary in the sense that they would add to inflation in the medium term.

However, the hardest hit section continues to be neglected. In economies depending overwhelmingly on expatriate work force and in certain cases like UAE where they outnumber nationals, this critical segment is the prime mover of domestic consumption. With no access to a social safety net, for expatriates, the surging inflation is equivalent to taxation without legislation. While the lower and middle income expatriates are finding it difficult to make both ends meet, the higher end executives in some cases are leaving for greener pastures. With a skewed salary structure in the region which is in contrast to global corporate norms, expatriate executives are under duress. This is a point to be considered by the policy makers. How long they will neglect the expatriates who are indispensable for the much avowed diversification process ongoing in the region?

Policy Appraisal and Best Course

As evident, all the GCC countries except Kuwait have relied upon price control measures and distortionary subsidies that, though they help in reining in inflation initially, would certainly worsen the situation in the medium term. Importantly, certain government interventions like implementing rent caps in the case of UAE is also becoming a futile exercise as landlords hardly bother to abide by the decisions. These non-market measures such as higher subsidies, allowances, irrational wage increases, caps on rents will mostly soon be inflationary. Apart from that, keeping pace with US Fed cuts, they have also revised interest rates. The result is mushrooming credit in the banking and mortgage market further adding to inflation. One silver lining seems to be the course adopted by Kuwait. Kuwait moved to a more flexible foreign exchange regime in May 2007 when it dropped the dollar peg to gain more flexibility in tackling domestic inflation. Barring a cataclysm, Kuwait is plotting a wise course between monetary flexibility, rebuffing currency speculators, and minimising the devaluation of future oil exports by a significant revaluation of the dinar. The authorities have allowed dinar to appreciate substantially by almost 7.5 percent since it is de-pegged from dollar on May 19 2007. Importantly, with the decision to move to a currency basket, Kuwait split interest rates between a discount rate (the rate charged on borrowing) and the repo rate (the rate charged on deposits) which has enabled the central bank to temper borrowing, without affecting interbank liquidity, simultaneously not discouraging investment-oriented credit flow. While it is premature to replicate Kuwait’s experience, there is definitely place for serious thought on holistic policies to counter the menace. The GCC authorities should therefore adopt a judicious policy mix of monetary control and fiscal prudence.

The Peninsula

Dr Pradhan is Senior Researcher, GCC Economics Programme,

Gulf Research Centre, Dubai
-Gulf Research Centre, Dubai

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