Increased spending set to trigger inflation spiral - Emirates24|7

Increased spending set to trigger inflation spiral

(DENNIS B MALLARI)  

 

 
Soaring Gulf government expenditure could trigger spiralling inflation, credit analysts Moody’s has warned.

The prediction comes amid an unprecedented jump in state spending across the region, with public budgets increasing by an average of 22 per cent in 2006, the last year when full figures were available.


“There are many drivers, including the social obligation felt by Gulf governments to redistribute oil income and the economically justified desire to raise capital expenditure to accelerate diversification and boost productivity,” said Moody’s Vice-President Tristan Cooper.

“However, governments are also hiking current expenditure in the form of salaries and subsidies to offset the effects of rising inflation.

“This risks triggering an inflationary spiral that would be difficult to control in the absence of other policy options and would further raise fiscal pressures.”

While the six GCC members have followed a conservative fiscal policy during the ongoing oil price boom, the sudden surge in expenditure could leave them more dependent on ever higher oil prices to balance their budgets, Cooper said.

This would leave the respective states vulnerable to sudden downturn in oil prices, a scenario that seemed remote when oil set a new record high of $100.09 on January 3.

But the world now seems a vastly different place than it was just three weeks ago, with the US and Japan already in recession according to some analysts, and global stock markets enduring record falls.

A sudden downturn in the US economy, which remains the largest consumer of oil, will see a demand slump and prices would surely fall, although it is unlikely Brent crude would slip below $80.

Nonetheless the current turmoil should act as a warning to the Gulf producers that oil prices are at the whim of global economy.

“Fresh memories of the oil price crash of 1998 to 1999 motivated GCC governments to resist popular calls for expenditure increases in the early stages of the current oil boom,” a Moody’s report said.
 
“However, such resistance has become increasingly difficult as time has passed, oil prices have risen further, and fiscal surpluses have widened.”

According to Moody’s figures, GCC nominal growth in government spending rose from four per cent in 2002 to 22 per cent in 2006.

For the UAE, these figures are minus nine per cent and 23 per cent respectively, while Qatar’s government expenditure has increased by more than 30 per cent per year since 2004.

Although 2007 figures are not yet available, Moody’s believes that public expenditure growth was once more very strong in 2007.

Moody’s claims that the hydrocarbon-dependent economies of the Gulf, which are controlled by the respective governments, “give rise to an expectation among citizens that national authorities should redistribute wealth through higher public spending, especially on salaries, subsidies, and procurement”.

This creates a strongly cyclical fiscal policy. Public money has been used to successfully boost private sector investment across the Gulf and increase economic diversification away from oil and gas.

This has helped to better insulate the region’s economies from any potential energy shocks, but the subsequent boom has led to dizzying increases in national inflation rates.

Qatar has seen inflation top 11 per cent for the past two years, while the situation in the UAE is less clear.

The official inflation rate was 9.3 per cent in 2006, but critics claim this significantly underestimates actual inflation, with the UAE’s consumer price index woefully inadequate and outdated. UAE inflation is estimated to have fallen in 2007, but again the figures are in dispute.

Expatriates and nationals are feeling the pinch from inflation, a fact reflected in UAE’s decision to raise federal employees wages by 70 per cent from this month.

Meanwhile, Dubai’s 2008 budget revealed a 31 per cent increase in government spending, while Oman last year announced a 15 per cent rise in state salaries.

Gulf governments also employ another tool to tackle the effects of inflation – price subsidies. Both Saudi Arabia and Kuwait raised their respective subsidies on basic goods in December last year.

“Governments’ attempts to offset the effects of inflation by raising salaries and subsidies may provide short-term relief to citizens,” the Moody’s report said. “However, they risk exacerbating price growth by stimulating demand, which will in turn generate further calls for spending hikes. Such an inflationary spiral would be difficult to control in the absence of other policy options.”

The region’s persistence with a fixed exchange rate prevents a tightening of monetary policy, with interest rates continuing to be set in Washington, where the economic climate is markedly different to that of the Gulf.

This has seen the US slash rates to stimulate its ailing economy, forcing the GCC states to follow suit, despite such a move running contrary to economic wisdom, which calls for high interest rates to tackle rising inflation.

“The imposition of direct price controls, which has already begun in the form of rent caps in some countries, is only likely to provide temporary relief and, if extended, could damage real estate sector activity by undermining incentives and distorting the operation of markets,” Moody’s said. “Given this, the burden of controlling inflation inevitably falls on fiscal policy. However, as we have seen, tightening fiscal policy is a very difficult decision for GCC governments.”

Moody’s concludes that with oil prices remaining at historically high levels, fiscal surpluses are being maintained despite the hike in government spending.

“The robust creditworthiness of GCC governments is unlikely to be undermined by strong spending growth over the short to medium-term. Budgets are still being set on the basis of relatively conservative oil prices that are considerably below current market levels,” the report said.

GCC government budgets are conservatively based on an oil price of between $40 and $50 per barrel, considerably below yesterday’s Brent crude price of just under $90.

The report added: “However, the danger is that governments across the GCC may find it increasingly difficult to limit expenditure growth in the face of rising inflation, thereby locking themselves into higher and higher oil prices in order to balance their budgets.

 

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