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After several years of rapid growth the GCC countries are suffering from a steadily worsening bout of inflation.
The problem is worst in Qatar and the UAE, where the inflation rate is thought to have reached double digits, but even in Saudi Arabia the rate is nearing four per cent.
These pressures have been building since 2005, as strong demand for commodities in world markets has pushed up prices for food and construction materials. At the same time, high oil prices and export revenues have nourished an unprecedented econ-omic boom.
Exchange rate policies have also played a part. Five of the GCC's six member states maintain a fixed peg to the dollar, and Kuwait's currency basket weights the dollar heavily. This arrangement has a direct impact on import prices, but its real significance is its effect on monetary policy. By tying their currencies to the dollar, GCC governments have also bound themselves to US interest rates.
Even as their own economies have boomed, they have had to lower interest rates in step with the Federal Reserve Bank, which has made deep cuts to avert a US recession.
As a result, all the GCC countries now have short-term interest rates lower than inflation. That heightens the risk of overheating and still higher inflation - and with the Fed poised to cut rates again, this problem will only grow worse.
Governments in the Gulf region have been slow to react, in part because of inflation's unequal impact. Foreign workers have borne the brunt of it, because they are less shielded from market prices for housing and other goods and services.
While there have been sporadic protests by foreign workers, governments until recently felt little pressure from their own citizens - although this is now changing.
In addition, policymakers in the Gulf argued at first that inflation was caused by factors, particularly international food prices, which they could not control.
Even as other sectors such as housing were being affected, there was a reluctance to take concrete policy measures. Instead, inflation was described as a temporary problem that would be corrected with the easing of supply shortages - better world harvests, for example, and the completion of large-scale housing projects.
Dollar peg
As the problem has worsened, however, it has become clear that there will be no quick, hands-off solution, and GCC governments are considering a variety of measures to deal with it. Central bankers and other government officials still rule out changes to the dollar peg, which limits the policy options. Some central banks, including the Saudi Arabian Monetary Authority (Sama), have raised bank reserve requirements, a move that will tighten lending conditions somewhat.
Another approach might be to tighten fiscal policy, which would slow economic growth and remove some of the upward pressure on prices.
Instead, budgeted expenditures are increasing slightly in the aggregate, as a seventh consecutive year of wide surpluses gives little incentive to public belt-tightening. The massive infrastructure projects under way throughout the region imply that investment spending will remain high for several years at least, while most current expenditure goes to politically-sensitive areas such as public sector employment and subsidies.
Rather than seeking a remedy for the underlying causes of inflation, governments are treating the symptoms. For example, Abu Dhabi and Dubai have lowered the cap on annual rent increases to five per cent, Saudi Arabia has announced a five per cent cost-of-living allowance for public employees, and elsewhere a variety of subsidies and benefits have been sweetened.
This approach will increase demand, making the region's inflation problem worse, not better. Rent and other price controls may be temporarily successful in restraining headline inflation, but they can succeed only at the cost of limiting supply.
Pay and pension increases represent a particularly dangerous approach, because they will tend to create a self-fulfilling expectation of higher inflation, met by still higher pay awards. This is the short path to a wage-price spiral, which would be difficult and painful to eliminate.
Most GCC governments can afford higher spending, in the sense that this will not, under present circumstances, push their budgets into deficit. Even so, these measures-which in addition to worsening underlying inflation will reverse the region's policy trend away from public subsidisation of goods, services and employment-are presumably being undertaken only as a temporary response to a brief episode of dollar weakness.
After all, a vigorous US recovery would boost US interest rates and the dollar, going a long way toward eliminating the current inflationary spike.
If that is the GCC's calculation, it may be a risky bet. Unwinding the housing and credit bubbles in the United States could depress growth for several years, and the Fed will have little reason to raise interest rates while the economy remains weak. The GCC countries could find themselves maintaining pro-cyclical monetary and fiscal policies for an extended period, potentially creating a deep-rooted inflation problem and inflicting serious damage on their economies.
Alternatively, mounting evidence of the harm an unchanged dollar peg is doing might persuade policymakers that de-linking or at least revaluing their currencies would be preferable.
One of the strongest arguments against revaluation has always been that it would have a negative impact on public finances. Now, with the fiscal cost of countering the effects of inflation growing, this argument has lost some of its force. Public debate on the policy options has grown since Kuwait dropped its peg last year, and there are hints that changes may be coming.
Damage to stability
For now, however, assuming that policies continue in their present course, the implications for energy markets are mixed. In the short term, they are likely to keep the Gulf growing at a white-hot pace, supporting energy demand in an increasingly important region. Moreover, in this policy environment fuel and power subsidies are certain to be maintained, and might even be increased, giving a further push to energy demand growth. Over time, however, the damage done to financial stability risks weakening longer-term growth prospects.
- The writer is chief economist for PFC Energy, Bahrain.
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