GCC Report : Inflation Stalks The Gulf


Currency pegs could come unglued as the region’s economies heat up.


Just when it seemed that it couldn’t get any better for the oil-rich countries of the Gulf Cooperation Council, oil prices spurted still higher. Record hydrocarbon earnings are supporting government investment and boosting the confidence of the private sector in the six countries of the GCC, a burgeoning common market with more than half the oil reserves of the Organization of Petroleum Exporting Countries.

The GCC economy is experiencing a spectacular boom and is set to surge past the $1 trillion level in nominal terms in 2008, making it larger than that of South Korea and putting it on a par with India, according to Howard Handy, general manager and chief economist at Riyadh-based Samba Financial Group.

GCC governments have stepped up fiscal spending markedly since 2004, with total expenditures growing by 15% annually in the three years through 2007 on a gain in revenue of 27% a year in the same period, Handy says. “The solidity of the GCC’s fiscal position has reassured the private sector that public investment will be maintained even in the unlikely event of a major correction in oil prices,” he says.

Continuing economic reforms are also buoying confidence. “Increasingly, GCC governments view the private sector as their natural partner in the provision of infrastructure and services,” Handy says. GCC economies will grow 8.2% on average in real terms this year, while growth in the non-oil sector will be 8.5%, he forecasts. The GCC, established in 1981, groups Bahrain, Kuwait, Oman, Qatar, Saudi Arabia and the United Arab Emirates.

While the medium-term outlook for the GCC is positive, there are some risks and challenges, Handy says. “Foremost among them are rising inflation, which will surpass 10% this year, related supply bottlenecks and constraints, and the uncertainties stemming from the recent turmoil in international financial markets, as well as the weakening of the global economy,” he says.

Inflation Spreads its Tentacles

While the booming metropolises of Dubai and Doha have experienced double-digit inflation for years, the surge has now reached the biggest GCC economy, that of Saudi Arabia. Inflation in the kingdom will likely average between 10.5% and 11% for the full year of 2008, up from an average of 4% in 2007, Handy says.


Coverdale: Labor shortages are more of a threat than inflation.

The Saudi government has taken a number of steps to ease the burden of rising prices on the kingdom’s population of 28 million, including 5.5 million foreign residents. It did away with import tariffs on wheat and lowered them on a number of food products and building materials. It also raised public sector salaries by 5% and increased social security benefits by 10%, while reducing the cost of certain fees and permits, such as passports and driving licenses. “These are palliatives like aspirin; they actually exacerbate inflation by injecting government cash into the system,” Handy says. “What is really needed is a more effective policy of monetary restraint.”

Meanwhile, the recent decline in the dollar has exacerbated the underlying increase in the prices of commodity imports, pushing up domestic prices in the GCC states, most of which peg their currencies to the greenback. While monetary easing by the US Federal Reserve has been motivated by a desire to avert recession, the GCC has followed suit at a time when their economies are overheating, Handy says.

“The dollar peg has outlived its usefulness,” Handy says. “At a time when oil prices are high and volatile, it would be better for the Gulf to move to a more flexible currency arrangement with an independent monetary policy that responds to ups and downs in oil.” This could be combined with a moderation in the growth rate of fiscal spending, he suggests. The supply of expatriate labor is critical to the business model of the GCC economies, Handy says, but as the dollar has declined, these workers have felt the pinch of devalued wages and rising inflation.

The room to maneuver on fiscal policy is also limited in view of the need for higher investment to eliminate supply bottlenecks, as well as political pressure to increase spending on wages and social programs, the International Monetary Fund said in its latest economic outlook for the region, released in May. “Therefore, tolerating somewhat higher inflation for a while may be necessary,” it said. Because of the dollar peg, real interest rates have become increasingly negative, spurring credit growth and adding demand pressures to already overheated economies, according to the IMF.

Adel A. El-Labban, group CEO and managing director of Bahrain-based Ahli United Bank (AUB), says the GCC governments have limited policy options. “They have delegated monetary policy to the Fed and politically cannot reduce spending at a time of rising revenues and cannot raise rates,” he says. “They are left with one tool, which is direct intervention on the banking side to tighten liquidity ratios and discourage lending to various sectors by creating multiple disincentives.”

El-Labban says the GCC countries should move toward a more flexible peg and gradually allow their currencies to float. “If you maintain the peg, you have lost your monetary policy independence,” he says.

“The rising hydrocarbon wealth is in the hands of the governments, which redeposit a good amount of it offshore,” El-Labban adds. The increased government spending on projects also involves capital spending offshore for machinery and equipment,” he explains. This means that domestic bank deposits reflect only a small fraction of the increased oil revenue.

With GCC central banks limiting the potential for growth in retail banking, AUB’s medium-term strategy is to shift its product emphasis toward investment banking, regional brokerage, asset management and shariah-compliant products, El-Labban says. “There has been no change in our group expansion strategy, with an aim to be present in all the GCC countries,” he says. AUB already has banking operations in four of the six and is watching for opportunities in the future in Saudi Arabia and the UAE, as well as in Iran.

With eight brokerage platforms, AUB has the biggest regional brokerage operation in the Middle East. It will begin migrating these platforms to a central platform in 2009, El-Labban says. “We also will develop our corporate finance and advisory services dramatically,” he continues.

AUB will maintain its UK presence and plans to establish a Swiss operation to complement its Gulf region expansion and support commercial, private and investment banking activities, El-Labban says.

Consumers Drive Growth
John Coverdale, managing director of Saudi British Bank (SABB), says he expects healthy growth of the consumer market in the kingdom, as the country’s oil wealth trickles down to supply industries. This will increase demand for credit cards and wealth management products, he says. SABB earned $202 million in the first quarter of 2008, an increase of 22.8% from the same period a year earlier. The bank’s loans and advances to customers in the first three months of 2008 rose 56% from the year-earlier quarter to $17.8 billion.


El-Labban: GCC countries should move toward free-floating currencies.

“SABB stood out from its immediate peer group, as it was the only bank with five quarters of continuous increases in profits through the first quarter of this year,” Coverdale says. The bank has 81 offices across the country, and strong deposit inflows were more than sufficient to support the loan growth and an increase in SABB’s investment portfolio, he says.

“The gains in lending came across the piece and were not just in the booming non-oil sector,” Coverdale says. There was also increased lending for high-end infrastructure projects, he says.

“With seven planned new economic cities, a land bridge and new airports coming in time, as well as the petrochemical projects, there will be growing project funding requirements in Saudi Arabia for the foreseeable future,” Coverdale says. General credit quality is sound, he says, especially within the corporate sector, which continues to benefit from the strong underlying Saudi economy. Labor shortages are a bigger threat to economic growth than is inflation, he asserts. “The economy is growing at least as fast as inflation,” he notes.

SABB has managed to contain its costs by continuous investment in automation. “As the volume of our business increases, we need fewer additional bodies, but there is a relative shortage of talented and experienced people,” Coverdale says.

Khaled M. Al-Fayez, CEO of Bahrain-based Gulf Investment Bank (GIB), says that inflation is an international phenomenon and that there is no doubt the weak dollar is a contributing factor. Inflation is also being caused by a regional housing shortage and by heavy government spending that is injecting liquidity into the banking system that is not being neutralized, he says. “There are no sophisticated open-market operations because the instruments don’t exist,” he says. Meanwhile, the money supply in Saudi Arabia is growing at an annual rate of more than 20%.

“Breaking the dollar peg will be no panacea,” according to Al-Fayez. Kuwait abandoned the peg in May 2007, and it still has inflation, he says. “Other things being equal, there should be floating currencies in the GCC, but other things are not equal,” he says. “With an underdeveloped money market and limited instruments, it is imperative to continue to have a fixed rate to act as a control.”


Floating currencies could be subject to speculative attacks, as happened in Asia in 1997, Al-Fayez says. Revaluing GCC currencies would be dangerous, he says. “We should stick with the dollar because GCC reserves in dollars are invested abroad, and if the dollar declines [as a result of GCC revaluations], it will hurt the value of these reserves,” he says. “Anchoring the GCC currencies is very important.”


While the peg and the weak dollar will remain topics of debate in the region, buoyant economic conditions are likely to prevail, Al-Fayez says. The greatest demand for loans is expected to continue to be in the corporate and project finance fields, he predicts. During 2007, GIB’s loan volume increased by 55% from a year earlier to $12.6 billion. The bank’s strategy places greater emphasis on merchant banking activities, including corporate and investment banking, which now account for about half of its revenue. GIB is a leading adviser and arranger for private placements and initial public offerings in the GCC. Last year it advised Saudi Aramco and ExxonMobil on the sale of their joint venture, Petrolube.


GIB manages more than $24 billion of client assets and is the largest Arab-owned commercial fund manager in the Middle East. “Our objective in the coming years is to continue to build the flow of non-interest income through a further increase in funds under management and important investment banking and capital markets mandates,” Al-Fayez says.


Gordon Platt