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Dubai: There is growing pressure on some Gulf countries with sovereign wealth funds (SWFs) to invest part of these resources in domestic projects to ease infrastructure constraints. However, this could result in high domestic inflation, according to Stephen Jen, an economist with Morgan Stanley.
"SWF money is meant to be spent. Some countries may want to spend it today, while others have the luxury to save it for future generations. Spending SWF or reserve money on domestic projects has implications for inflation, the exchange rate and potential growth," said Jen.
Depending on the source of the external surplus, some of the reserves/SWFs should not be spent at all, or invested in particularly risky assets. According to Jen, not all balance of payments (BoP) surpluses are created equal. There are broadly three types of BoP surpluses, such as those that rely on commodity trade surplus, non-commodity trade surplus, and capital flows.
Surpluses from commodities export tend to be more durable; they are usually "fiscal surpluses" that can be spent by the government without incurring more domestic debt. On the other hand, reserves and SWFs generated from non-commodity exports and capital flows should not be spent on domestic projects.
Thus, whether official reserves or SWFs should be spent of domestic projects is a function of the durability and the "reversibility" of these surpluses. For countries with capital flow surpluses, official reserves will need to be kept high and in liquid assets to guard against 'sudden stops' in capital inflows or even a reversal.
Supply constraints
In the Gulf, with supply constraints being attributed as the main reason behind rising inflation, SWF spending on infrastructure is widely justified. However, the Morgan Stanley economist acknowledges that public spending on infrastructure is inflationary in the short-run (as it adds to demand growth through investment), but disinflationary in the long-run (as it could enhance the economy's potential growth rate).
"The issue, of course, is that not all governments are able to execute these major infrastructure projects efficiently, and that the 'temporary' inflationary pressures could turn out to be less temporary than planned, and the efficiency gains less than originally envisaged," he said.
But if governance and efficiency issues are set aside, short-term inflationary pressures should be positive for the currencies as interest rate and exchange rate policies should be expected to change to counteract the inflationary pressures. Over time, as potential growth and productivity are enhanced, the currency should strengthen too.
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