Inflation in the GCC is not a “temporary phenomenon” and will remain the key policy challenge this year, according to a research report by global investment bank Merill Lynch. The findings of the report come in contrast to the view expressed by governments in the region with regards to inflation.
According to the report, GCC governments see high inflation purely as a welfare cost and are attempting to overcome it via non-market measures such as higher subsidies, allowances, irrational wage increases, caps on rents, etc.
“These measures are mostly ‘soon to be inflationary’ and, with rising costs hidden by subsidies and transfers, domestic demand will continue to grow unabated,” the report said. Earlier this week, the Abu Dhabi Chamber of Commerce and Industry (ADCCI) said the decision by the Abu Dhabi and Dubai governments to impose a five per cent cap on rent increases was not likely to tackle the challenge.
“What is really needed is a package of measures to check inflation and resolve the problem, which has started to put pressure on the domestic economy,” said the ADCCI. According to the Merill Lynch report, high inflation poses a major medium-term challenge to the sustainability of the GCC’s business model and needs to be addressed in a “more credible way”.
“The region’s strategy of diversifying away from an oil-dependent economy is well grounded, given the painful swings in the past, along with oil and gas prices. However, resources are still scarce in terms of human capital and physical absorptive capacity is limited,” Merill Lynch said.
Earlier this week, Ziad Dabbas, a consultant at National Bank of Abu Dhabi (NBAD) told Emirates Business that the rent cap will help but is “not a complete solution”.
“Inflation is our number one enemy, particularly as it impacts the lower income segment. We really need to manage our control over inflation,” Abdul Aziz Abdullah Al Ghurair, speaker at the UAE Federal National Council at the World Economic Forum in Davos. Al Ghurair is also the chief executive of Dubai’s second largest lender by market value, Mashreq.
Most of the inflation in the UAE is caused by supply bottlenecks, industry experts and analysts have said. “The GCC plans to alleviate these supply bottlenecks through two main channels: an increasing expatriate population and mega infrastructure projects. Inflation threatens the sustainability of both of these channels as cost of living and the cost of production and construction are increasing at an accelerated pace,” Merill Lynch said in its report. “There has been some scaling back of major projects, and this could become a drag on growth and simultaneously fuel inflationary pressures further.”
High wage increases and transfers and subsidies aiming to mitigate the effect of rising prices are likely to erode fiscal surpluses this year, economists have said.
According to the bank, the US Fed is likely to keep cutting interest rates, and expects Fed rates of one per cent by the first quarter of next year, a view expressed by the bank’s chief economist for North America, David Rosenberg last week.
“GCC countries will introduce a significant monetary stimulus to their economies if they continue following US monetary policy. In such a case, we believe that monetary policy in the Gulf would be too expansionary, as real interest rates would plunge further, thereby fuelling the fire of inflation,” said Merill.
The bank said it expects GDP growth in the Gulf to slow down to 5.7 per cent this year, from an average of 7.3 per cent over the past five years.
“We expect fiscal spending to gain pace to finance mega investment projects. Domestic absorption is also on the rise, feeding into higher import growth. Based on flat oil prices in 2008 to 2009, we estimate that $75bn (Dh275.2bn) of the region’s current account surplus is likely to be eaten up,” the report said.
Qatar has logged the region’s highest average GDP over the past five years with a growth rate of 11 per cent year-on-year. Not surprisingly, inflation in Qatar is also the highest in the GCC in the same period.
The UAE’s annual GDP growth has averaged just under 10 per cent over the past five years, according to the bank. Saudi Arabia has averaged five per cent year-on-year growth in the five-year period post-2002.
In the absence of a currency revaluation, there will be too much money chasing too few goods and services in the region resulting in higher prices, according to the bank. “The lemma that inflation in the GCC is mainly driven by supply bottlenecks is true but not complete. We expect the GCC to spend more of its fiscal surplus in the coming years and that oil prices will stay high.”
“Without currency appreciation or tools such as higher reserve requirements, there will be too much money chasing too few goods/services in the short term, consequently pushing inflation higher,” the report said.
“Rapid population growth and a lack of human capital tighten supply bottlenecks and feed into inflation through high wage increases. Big projects that would ease the supply constraints have also seen delays due to labour and capacity constraints and rising costs.”
UAE-based intelligence Proleads estimated the total worth of construction projects under way in the whole Middle East at almost $1 trillion last year.
However, engineering, procurement and construction contract costs have prompted most project sponsors to postpone or even cancel some of their capital projects on the grounds of expected lower returns on their developments.
The number of projects has declined by 10 per cent across the region, except in the UAE, according to Proleads.
UAE fiscal surplus may narrow
The overall fiscal stance of the UAE has been prudent over the past five years, with revenue growth outstripping overall spending. The budget surplus is likely to have peaked at 29 per cent of GDP last year, according to Merill Lynch.
Going forward, the bank expects the federal government to use its surplus partly to finance its mega projects. “External borrowing to finance large investments outside the budget by public and quasi-public entities has gained pace,” the report said.
External debt nearly tripled in two years and reached approximately 50 per cent of GDP at end-2006. However, the external account is still looks strong, according to the bank. The UAE is likely to have posted a surplus of $45bn (Dh165.1bn) last year, most of which the bank expects to be fed into the country’s assets in sovereign wealth funds.
Qatar leads regional inflation rates
While Qatar saw the region’s highest average GDP – at 11 per cent – and population growth – five per cent – annually over the past five years, the gas-rich nation has also led the region in inflation rate.
“The dollar peg not only results in imported inflation but also in real rates slipping further into negative as the Fed cuts rates, while the Qatari economy is already growing well above its absorptive capacity,” Merill said in its report.
“As long as Qatar remains reluctant to de-peg and/or revalue, inflation will continue to be a main threat. The forthcoming housing supply to the market will definitely help lower inflation, but, contrary to many other GCC countries, Qatari inflation is broader-based.” The bank forecast Qatar’s average inflation at 13 per cent for 2008 to 2009.
The UAE and Saudi Arabia have the next highest inflation forecast for this year, according to the bank. The UAE’s domestic economy, especially the non-oil sector, is already heated up, hitting supply-side constraints. “With strong capital inflows, extra-loose monetary policy, weakening fiscal prudence and imported inflation, we expect consumer-price index inflation to further increase to 12 per cent in 2008, unless the UAE were to take a step to revalue the dirham to tighten monetary policy,” the bank said.
Non-oil sector growth on the rise
Diversification seems to be a strong theme in the GCC, with Dubai and Abu Dhabi leading the way in non-oil growth.
While the contribution of the non-hydrocarbon sector to GDP growth in the region was 49 per cent back in 2003, it increased to 85 per cent in 2006.
“As governments introduce market liberalisation measures, privatisation and tax reforms to improve the investment environment, this trend is likely to become more pronounced as FDI inflows multiply,” Merill Lynch said in its report titled ‘Under Construction’.
Within the UAE, the oil and gas sector is likely to continue to grow around three per cent on average in the next five years, thanks to Abu Dhabi’s planned hydrocarbon investments of about $50bn (Dh183.5bn) in 2007–12.
“With planned or in-progress projects estimated to total $700bn at end-2007 (most in non-oil sectors), the UAE is making good use of its oil dividends to diversify,” the Merill report said.
Inflation a major policy challenge for GCC