Saudi Arabia’s economy is booming. Massive investment on the back of record oil prices has resulted in the kingdom undertaking an audacious programme of construction and development.

Six economic cities are being planned across the kingdom at a total cost of $86.6bn.

On the Red Sea, Jeddah’s corniche is undergoing a major transformation, with investment giant Kingdom Holding set to issue a tender in the coming months for a project to build the world’s tallest tower. There are also plans for an industrial city at Sudair, north of Riyadh, which will be 70 per cent bigger than Emaar’s King Abdullah Economic City.

The Saudi economy has doubled in size since 2002, and its nominal gross domestic product (GDP) is projected to reach $465bn in 2008. But the rapid economic expansion has been accompanied by a sharp jump in inflation.

Imported inflation is entering the kingdom via higher food prices on world markets and the weakening dollar, while domestic pressures are resulting in rent prices rising rapidly. Rental costs increased by 18 per cent in the year to the end of February, while food costs rose by 13 per cent.

Consequently, Saudi Arabia’s inflation hit a 27-year high in February, at 8.7 per cent.

Saudi Arabia has always been a low-inflation environment, with inflation typically below 3 per cent. It is now nearing the levels seen in the UAE and Qatar, which had the highest inflation rates in the GCC over the past year, at about 11 per cent and 14 per cent respectively (MEED 28:3:08).

Importing inflation

“It is a combination of supply and demand factors,” says Howard Handy, chief economist at Samba. “On the demand side, you have a rapidly growing economy and relatively high rate of imported inflation. These factors are weighing heavily. We estimate food prices, which rose about 7 per cent in 2007, will rise 12 per cent in 2008.”

Brad Bourland, chief economist at Saudi investment bank Jadwa Investment, agrees. “Food and rent make up nearly 40 per cent of the consumer price index basket,” he says. “High inflation in those two areas is very important for the overall inflation rate.”

As with other GCC economies, Riyadh is finding it difficult to deal with inflation because of its close monetary links to the US through the riyal’s peg to the dollar. “The traditional way to deal with inflation was to tighten monetary policy and cut back on spending,” says Handy. “But you cannot do that in an economy where you have an absolute tie to the US dollar. You do not have independence from monetary policy.

“There is not a great deal that can be done, because you are locked in with the US monetary policy, and the US is dealing with a recession and a banking crisis. Its inflation is modest at the moment, so it is not an issue. They are not worried about it, as they are dealing with other problems.”

In February, the kingdom announced a raft of measures in an attempt to curb inflation. These include cutting import duties on 180 goods, such as frozen poultry, dairy products, vegetable oils and building materials, to 5 per cent from 20 per cent.

Companies have also raised salaries. Saudi Aramco announced in December 2007 that it will increase salaries by 15-40 per cent for its employees in a bid to meet rising living costs.

However, analysts warn that such measures only offer a short-term solution. In the longer term, wage rises increase the pressure for further price rises.

Reducing pressure

But rather than introduce more heavy-handed measures, economists suggest patience is the only real answer to the kingdom’s situation. Food price inflation may ease over the course of 2008, while pressure on rental prices could drop as planned developments are completed.

“I would not advocate any protectionist measures,” says Bourland, who does not expect any major change to inflation in the short term. “Food price increases are a global phenomenon. Rice, corn and wheat are at an all-time high. Rental prices, however, reflect local bottlenecks.

“Food price inflation will subside naturally over this year. Rental inflation will probably stay high until the market clears. It will take a year or two at least to build adequate housing. We will see inflation stay at high single-digits this year, close to 10 per cent.”

Just as much of the kingdom’s inflationary pressures are coming from abroad, so might the solution to its difficulties. Despite its reliance on international markets to buy oil, Handy says a slowdown in the global economy could help the kingdom.

“The domestic boom is going to continue, but the imported inflation could abate if you get a gradual cooling of the global economy, which is likely to grow much less than in recent years” he says.

“The dollar could turn the corner, and the enormous rise in food and commodity prices may abate as well.

“If all these factors kick in together, it may take the heat off domestic prices. So that is one way to take the pressure off.”