Gulf war on inflation can’t wait for revaluation

13 March 2008

UAE's plans to freeze food prices in 2008 confirms that the war against inflation is the year’s top economic issue.

Throughout the region, cost increases are complicating economic management, discouraging long-term investment and making life more difficult for many. Economists criticise price controls as inadequate. Their policy recommendation is an early and substantial revaluation of GCC currencies against the declining dollar. According to some, the UAE dirham is now about 40 per cent below the value it would command if it was allowed to float. Even the purists believe this would be too much in a single move, though it would contain prices at a single stroke.

But the case for revaluation is itself incomplete. Pegging GCC currencies to the dollar means that monetary policy is determined by America’s Federal Reserve System not by the region. The US is combating recession by cutting interest rates and they may fall to 1 per cent later this year. This will mean that the five GCC states with a dollar peg will have to follow with similar rate cuts. It is the opposite of what should be done when annual money supply growth is running at about 40 per cent.

The case for revaluation, however, becomes less compelling when it comes to the details. By how much should GCC currencies be altered and when should the revaluations take place? Should the peg be dropped or simply restored at a different level? All these issues encompass more than just economics. They are profoundly political, particularly the consequences of abandoning the dollar when the American economy struggles and the presidency is being contested.

The revaluers are also peddling the myth that revaluation alone will deal with inflation. This is far from the truth. However and whenever it is done, all revaluation will do is replace American hands on the steering wheel directing the regional economy with GCC ones. It will not determine its speed.

GCC governments, particularly Saudi Arabia’s, will continue high levels of public spending on the infrastructure, homes, schools and hospitals their people need. Since none have comprehensive systems of taxation, their capacity to remove spending power from the economy is limited.

Under any exchange rate regime, therefore, fiscal policy is bound to be simulative. But will GCC governments be prepared to hike interest rates to levels in real terms that will depress private investment and spending sufficiently to offset the inflationary impulse public spending will create? The answer is no.

Economists will argue that the only option, if fiscal measures and interest rates are out, is to allow the real exchange rate to rise to engender capital outflows big enough to drain off surplus liquidity. This raises questions about what is the right long-term value of GCC exchange rates. It is an issue economists duck.

Depegging will also invite further scrutiny of one of the biggest challenges facing the GCC: are the economies of the region sufficiently similar to make the overarching economic convergence programme possible? They may be, but the differences in the short-term are getting bigger by the day.

With oil at more than $100 a barrel, the GCC is dividing into two. There are the high per capita oil-exporting countries of Kuwait, Qatar and the UAE, which have labour shortages, and the rest, which have labour surpluses. Left to its own devices, the market would radically change the social face of the GCC. But the consequences would be utterly unacceptable to the ones with the most to lose.

Economists lobbying for revaluation also have little to say about this matter and are paying the price for being irrelevant to top policy-makers. They are being ignored.

This is the context shaping the UAE’s decision to expand price controls. The fact is that, even if there is a revaluation soon, the inflationary impulse embedded in economies exporting more than 16 million barrels a day (b/d) of oil will demand GCC government intervention. There is no panacea.

The GCC needs a range of weapons that can be used in the long war against inflation. It is probably unwinnable until their economies are big enough to absorb the liquidity the energy boom is creating. But it need not be lost. Anything that helps, price controls included, is surely welcome.

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