When raging global inflation hit industrial nations in the 1970s, sparking political and financial turmoil, it destroyed the fixed exchange rate system that had underpinned the rebuilding of allied economies in the wake of the Second World War.
Lasting more than two decades, this period of overheating economies, known as the Great Inflation, eventually drove developed economies to enter the Great Moderation - a time of low, steady inflation, with independent central banks setting interest rates to govern demand.
These events hold lessons for Middle East economies. The Great Inflation is stalking Gulf states and threatening the region’s long-held fixed exchange rate system, which is pegged to the US dollar.
Kuwait is the first, and so far only, country to move to a more flexible foreign exchange regime. In the summer, it dropped the dollar peg to gain more flexibility in tackling domestic inflation. The move effectively sounded the death knell for a GCC single currency and earned Kuwait the brief status of a pariah among Gulf countries.
|GDP (nominal KD '000 million)||24.5||29.6||30.6||31.8||33.9||36.5|
|GDP per capita (KD)||7820||9,082||9,012||9,037||9,262||9,573|
|Real GDP (% change)||10.0||7.8||6.0||6.1||6.2||6.2|
|Real GDP per capita (% change)||1.1||3.6||1.7||2.3||1.9||2.1|
|General govn debt KD million)||2,969||2,296.6||3,060||2,989.2||2,915.4||2,847|
|General govn debt (% of GDP)||13.6||10.7||10||9.4||8.6||7.8|
|Imports (KD million)||4,613.9||4,629.2||na||na||na||na|
|Exports (KD million)||13,101.6||16,166.7||na||na||na||na|
|Trade balance (% of GDP)||38.8||43.4||39.8||36.2||34.1||32.5|
|Current account (% of GDP)||41.1||50.5||54.6||53.2||53.2||53.2|
na=not available; e=estimate; f=forecast. Source: Standard & Poor's
Despite the critics, the rehabilitation of Kuwait is under way. Most economists agree it 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 dinar has had a modest appreciation of just 3.17 per cent since 19 May, when it was de-pegged from the dollar.
Its success has led analysts to speculate over which other GCC countries will follow its example. “I know some GCC countries are now looking at what Kuwait has done with its currency as an example that they could follow,” says Mushtaq Khan, Gulf economist at investment bank Citigroup. “They appreciate the way Kuwait handled the speculation on its currency, but also managed to gain some monetary policy tools to tackle inflation.”
Along 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). This has enabled the bank to temper borrowing, without affecting interbank liquidity.
“This difference is often not identified by some observers, who have questioned why Kuwait is cutting interest rates while at the same time saying it is trying to tackle inflation,” says Randa Azar Khoury, chief economist at National Bank of Kuwait (NBK).
The discount rate is 6.25 per cent, much higher than the repo rate, which is level with the US rate of 4.75 per cent following the 75 basis point cuts of September. By keeping its own interest rate level with, or lower than, US rates, Kuwait aims to discourage currency speculators from borrowing dollars to buy dinars and profit from any revaluation of the currency.
“This is a good intermediate position in the face of speculative inflows, but it is not a long-term solution as it can create distortions in the money markets,” says Khan.
It can also serve to institutionalise bank profits, as the greater the difference between these two rates, the more banks can charge on loans.
The big question is what effect this will have on inflation. Most economists agree that the region’s currency pegs to the dollar, which itself fell in value by more than 17 per cent against the euro between January 2006 and October 2007, has had some inflationary effect on the cost of imports. However, the most recent breakdown of Kuwait’s inflation basket shows the main drivers of inflation are domestic.
Food inflation, considered to be a gauge of import inflation, is 2.1 per cent, while domestic inflation is more excessive . Transport and house price inflation are 9.7 per cent and 7.19 per cent respectively.
“The main drivers of inflation are clearly domestic,” says Simon Williams, Gulf economist at HSBC.
However, Kuwait seems to be taking the most proactive stance in the region by tackling the issue on two fronts, he adds. “Kuwait has been more active than some of its neighbours in the GCC in realising that monetary tools can play some part in alleviating inflationary pressures. But it also seems to have realised that monetary tools cannot solve the problem on their own.”
Khoury agrees. “The revaluation is not a panacea for the inflation problem,” she says. “If you look at the other sources of inflation, they are still rising.”
The key to the problem, which is fundamentally the same throughout the GCC, is that the massive government investment programmes, driven by the new paradigm in oil prices, will unavoidably drive up prices. Money supply growth, a measure of the growth of money in the economy, is in excess of 30 per cent in Kuwait. This indicates that liquidity will continue to rise, increasing prices further.
However, Khan says Kuwait will adopt a more cautionary approach to its investment programme. “My view about three to four months ago was that Kuwait was starting to play catch-up with its neighbours’ spending plans,” he says.
“I do not think it is clear that it will continue to spend so aggressively, and could instead become more interested in investing in the GCC and beyond, rather than domestically.”
At present, there are few signs this will be the case. Khoury says Kuwait maintains a “very expansionary fiscal policy”. One of the benefits of having timed its revaluation of the dinar when it did is that any impact it may have had on oil revenues will be blurred by the subsequent rise in oil prices.
The most common reason for keeping the region’s currency pegs as they are is the fact that increasing the value of Middle East currencies would devalue future oil exports.
“If you look at the scale of the fiscal surplus in Kuwait, it has a great deal of room for manoeuvre, so a cut in the value of the dinar will not put public finances under pressure,” says Williams.
Expectations for the future, especially with the oil price hitting new highs, remain positive. Kuwait Export Crude broke the $70-a-barrel level for the first time in September. Khoury says the impact of this on the country’s finances will be enormous, especially when coupled with the 500,000-barrel-a-day rise in crude output announced in September.
The government’s budget for 2007/08 is based on conservative oil price estimates of only $36 a barrel, although about $70 a barrel appears to be a more realistic figure. This is likely to leave Kuwait with its largest ever budget surplus. National Bank of Kuwait is predicting a KD 6,000 million-7,600 million surplus for 2007.
Ratings agency Standard & Poor’s predicts the knock-on effect of this will be for the government’s general debt, as a percentage of GDP, to almost halve between 2005 and 2010. However, it will remain more exposed to the vagaries of the oil price than its peers because its efforts to diversify the economy have been less pronounced.
This is partly because of the popular support for the existing scenario, where public jobs offer generous packages with little or no taxation, and the elected National Assembly (parliament) has held up reforms of corporate tax and privatisation programmes.
The challenge for Kuwait over the next few years will depend on the outlook for the US economy, which is moving increasingly close to a recession, and how to respond to future federal interest rate cuts. These are widely expected, putting more pressure on GCC states to cut their own rates.
Kuwait will then face the dilemma of how far it will allow lending and deposit rates to diverge.
Speculation is concerned with when, rather then if, the oil price will rise above $100 a barrel, indicating that liquidity will not be Kuwait’s problem any time soon. GDP will continue to rise, and the government will have to find a use for cash, particularly with a population keen for oil wealth to be redistributed through investment.
Inflation will continue to be the inevitable consequence, regardless of how Kuwait’s innovative monetary policy stance may temper price rises.
While Kuwait has shown the first signs of attempting to break out of the region’s Great Inflation, the Great Moderation still seems some way off.