Fiscal expansion fuels inflation

10 December 2007
Gulf states need monetary policy tools to combat rising prices driven by excess liquidity

Inflation is the biggest economic issue in the GCC right now, threatening to tear apart plans to unite the region under a single currency. Governments frequently point to the huge scale of projects under way and claim they will alleviate some of the demand constraints that are driving up prices. This is their main strategy for fighting inflation.

A key contributor to the problem is the huge amount of money the governments in the region are spending. Even a cursory glance at the figures shows the correlation between the most fiscally expansionary regimes, UAE and Qatar, and those countries where inflation is highest.

At its peak in Qatar in 2005, money supply growth was more than 40 per cent for the year. The inability of the markets to cope with such huge volumes of capital slowly pushes up prices.

A general measure used by economists is that if money supply is greater than real gross domestic product (GDP) growth, inflationary pressures will increase in the short term. Although this is an oversimplification, it illustrates that GCC members will have major problems from excess liquidity, not just demand pressures or the weak dollar, which are typically blamed by politicians and economists.

“Money supply is a long-term concern that needs to be addressed,” says Mary Nicola, economist for Standard Chartered Bank in Dubai. “In general, across this region, money supply is extremely high, and that is aiding and abetting inflation.”

One of the things that makes the money supply issue worse for the Gulf countries is having to follow US monetary policy because of the dollar peg, which prevents the region's central banks from lifting interest rates to absorb some of the excess cash in the economy.

Long-term concern

“The key to soaking up the excess liquidity in the area is monetary policy tools,” says Nicola. “But the central banks just do not have those tools and as the oil price rises further it will add more liquidity to the economy.”

This means even if the much-discussed revaluations of the dollar peg occur, there will remain a significant amount of excess cash in the Gulf. “These figures show there is a significant monetary overhang in the Gulf economies,” says Mushtaq Khan, Gulf economist at Citigroup. “How soon this will start producing domestic inflation depends on the circumstances of the country, but it could take between 12 and 18 months.”

This would indicate that the inflationary effects of fiscal expansion will continue to flow through the economy for at least the next 12 months, meaning inflation could still be a problem until 2009 at least. Figures for private sector credit expansion also show a clear trend upwards, growing as much as 75 per cent over five years and there is little sign of this abating.

Governments have some control over money supply growth but less over bank lending. The main recourse for central banks to dampen private sector credit expansion is to use what the Bank of England refers to as “moral persuasion”. This involves applying informal pressure on banks to slow lending growth rather than explicit regulation. So far, there are few signs this is occurring.

When examining money supply and private sector credit expansion figures across the GCC, it is clear that the inflationary effects of money supply growth have already started to flow through the economies that started expanding earliest. Qatar and the UAE, where the money supply first started to increase dramatically in 2004, are now suffering from the highest inflation levels. Elsewhere, the situation is more complex.

In Saudi Arabia, for example, money supply appears to fluctuate, possibly as a result of government debt, as a percentage of GDP, decreasing from 81 per cent in 2003 to 26 per cent in 2006. But the general trend is clear. The increase in money supply from a relatively low average at the turn of the millennium to nearly 20 per cent more recently has coincided with inflation rising off its historically low base.

The decision by the UAE in late November to start auctioning off certificates of deposits indicates it is becoming concerned about how to absorb the excess liquidity in the country as a result of high broad money growth. This should help develop the maturity of the capital markets and build a yield curve for government treasury bonds. It will also serve as a sterilisation mechanism for excess liquidity.

The figures also indicate that Oman could soon reach the end of its relatively benign price environment. Money supply increased by 21 per cent between 2004 and 2005, and a further 25 per cent in 2006. Private sector credit expansion has also continued its upward trend, and inflation has already hit a six-year high this year.

Further rises

Kuwait's figures could indicate that inflationary pressure will continue, although it is difficult to tell how the effect of shifting to a currency basket has changed the situation. “Kuwait's inflation has steadied since adopting a currency basket and it shows that regaining monetary policy tools can quickly affect the inflationary picture,” says Nicola.

The growth in credit offered to the private sector in Kuwait has risen steeply to 30 per cent by May 2007 from about 20 per cent in January 2006. Although Kuwait is attempting to temper the growth by adopting limited monetary tools, the success of this strategy is uncertain.

The Kuwait example shows that additional tools are vital if the region is to combat inflation. Being able to set more appropriate interest rates to absorb some of the excess capital will help to reduce price increases. However, to focus solely on this and ignore the other shortcomings of the dollar peg misses the fact that fiscal expansion will always lead to either inflation or high interest rates.

While monetary expansion is becoming more of a concern in the Middle East, and the link to inflation made more often, there is still little demand to really reduce spending. The historic highs in the oil price will also make it politically difficult to slow down investment programmes, while government revenue remains high.

Inflation will remain a problem because of the high oil price, which in turn fuels massive government spending plans. Moving to a more flexible foreign exchange regime will give governments additional tools to address the problems, but governments should not expect this to be a panacea.

What is money supply?

Money supply is a measure of all the cash in the economy at a given time, available for the purchase of goods and services. In its widest form, the indicator M3 - often referred to as broad money - includes all the physical currency in circulation, plus bank deposits by the public and private sector.

The growth in money supply is a measure of the growth in liquidity in the economy as central banks produce more cash to drive investment programmes. Growth in money supply is an indication of future inflationary pressure because excess liquidity will be absorbed by rising prices. Another way to consider it is that if money supply is rising faster than real GDP growth, inflation will occur.

As money supply rises, either the interest rate or the inflation rate has to increase to absorb the extra capital. The problem faced by the GCC countries is that their peg to the US dollar means they must keep interest rates in line with US policy. The collapse of the sub-prime housing market has prompted the US to cut rates and as the GCC countries follow, inflation will rise.

Money supply figures can misrepresent fiscal policy. Because governments in the region are repaying old debts, government borrowing is effectively negative. This has resulted in some economists interpreting private sector credit expansion as a good indication of real growth in money supply.

This is a much broader measure of the banking facilities offered to corporates and individuals through banks and other institutions in the private sector. It also has a particularly adverse effect on inflation because it more immediately affects consumer spending levels by extending additional debt to the public.

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