Root cause of inflation is here to stay

Dubai: The interest rate cuts by Gulf central banks in tandem with an aggressive 75 basis points (bps) Fed rate cut is expected to further aggravate the already high inflation in the region.

However, economists and bankers said yesterday that regional central banks are unlikely to change the currency peg which is responsible for inflation in the short to medium term.

The Fed cited a weakening economic outlook and increased downside risks to growth as the main reasons for the rate cut from 3 per cent to 2.25 per cent on Tuesday. Its action is designed to lower borrowing costs and boost spending by consumers and businesses and thus increase economic activity.

Given the GCC currency pegs to the dollar, Gulf countries have to closely track US interest rate moves although modest differences are possible. The UAE central bank matched the Fed precisely by cutting the repurchase (repo) rate by the full 75 bps to 2.25 per cent yesterday.

Saudi Arabia and Bahrain lowered their policy deposit rates by 75 basis points yesterday, also matching the cut in the United States in moves which are likely to fuel economic growth and inflation. However, Saudi Arabia kept its repurchase rate unchanged at 5.5 per cent. Kuwait, the only Gulf state without a dollar peg, left its discount rate unchanged at 5.75 per cent.

"Interest rates are slashed across the GCC to prevent interest rate arbitrage and speculation on regional currencies. Under the pegged regimes, central banks have no choice but to follow the interest rate of currency to which the domestic currencies are pegged," said John Sfakianakis, chief econ-omist at HSBC Holding's Saudi affiliate, SABB.

With real rates sinking deeper into negative territory and the Middle East still recording strong domestic-led growth, increasingly lower rates run the risk of pushing inflation higher. Some economists have argued that it is high time GCC states followed independent monetary policies. "While the extremely loose monetary policy will support domestic demand, it is not positive for overall macroeconomic management. Credit growth to the private sector is rampant in the region and money supply growth has been accelerating. This will add to inflationary pressure, and provide conditions for the development of asset bubbles," said Monica Malik, director of economics with EFG Hermes, an investment bank.

"The rising inflation will definitely apply pressure on GCC central banks to reform their monetary policies. The solution lies in anchoring the exchange rates against a basket of currencies," added Simon Williams, chief economist at HSBC Middle East.

Inflation has been on the rise in the Gulf, as econ-omies here have benefited on the back of a global rise in oil prices, fuelling expansion of the local economies, while a drop in the value of the dollar globally pushed up prices of imports.

Recent reports put inflation at around 14 per cent in Qatar, 7 per cent in Saudi Arabia and more than 10 per cent in the UAE.

Given those rates, some economists say Gulf central banks will have little choice but to alter their currency-trading systems. Central banks in the UAE and Qatar have recently said they are studying making such a move.

Authorities in the UAE need to go ahead with this revaluation, said Marios Maratheftis, regional head of research at Standard Chartered Bank in Dubai. "If the best solution [depegging from the dollar] is not possible, the revaluation is the second best, if not the only solution," he said.

Although economists like Malik, Maratheftis and Williams see revaluation is closer to reality, there are several other economists, academics and bankers who see it not happening anytime in the near future.

"Traditionally oil exporters have been financing significant portion of the US deficits through their holdings in Treasury instruments. A revaluation at this stage would further erode confidence in the dollar, which would further adversely affect the value of foreign assets held by these countries," said Dr Ekart Woertz, programme manager, Gulf Research Centre.

Stephen Jen, an econ-omist with Morgan Stanley, agrees.

"Gulf central banks kept accumulating dollar-denominated assets despite the fact that the currency has been on a secular decline. Any attempt to revalue or de-peg local currencies would mean significant losses on these portfolios."

Economists like Sfakianakis and Woertz believe that although lower interest rates would stoke inflation, it will help fuel economic growth and job creation.

"The move will no doubt fuel inflation, but it is certainly going to accelerate economic growth led by the private sector. Considering the overall positive impact of the economic growth, inflation is a small price to pay for the benefits in terms of job creation and infrastructure," said Sfakianakis.

Impact: Depositors take the hit

The declining interest rates in the UAE have resulted in the real interest rates becoming negative, while interest rates on deposits earn next to nothing. The falling deposit rates have also resulted in widening spreads for banks, boosting their bottomlines.

"Depositors in dirham are earning just about one per cent, while those who have dollar deposits have lost in terms of currency depreciation and inflation. In reality, the returns on these deposits have been negative for a long time," said Mohieddine Kronfol, managing director, asset management of Algebra Capital.

Kronfol said people should think in terms of shifting their deposits into other options such as mutual funds, fixed incomes schemes and stronger currencies. Banking industry analysts said the reduction in deposit rates has not caused major asset-liability mismatches for the Gulf banks, as many of them are resorting to medium-term debts. Although some GCC central banks have been keeping lending rates on hold in an attempt to reduce the monetary stimulus of the interest rate cut, this policy will have only a limited impact on stemming credit growth. Given the strong level of liquidity in the sector, borrowing from central bank is limited. Moreover, interbank rates are lower than central bank lending rates, thereby reducing the incentive of commercial banks to borrow from the central banks.