Business | Economy
Tackle inflation credibly: Merrill
High inflation is a major medium-term challenge to the sustainability of the GCC's business model and must be addressed in a more credible manner, global investment bank Merrill Lynch said on Sunday.
- By Babu Das Augustine, Banking Editor
- Published: 22:46 January 27, 2008
Dubai: High inflation is a major medium-term challenge to the sustainability of the GCC's business model and must be addressed in a more credible manner, global investment bank Merrill Lynch said on Sunday.
Merrill Lynch analysts disagreed with the regional governments' view that inflation is a purely welfare cost and their attempts to overcome it via non-market measures such as higher subsidies, allowances, compensatory wage increases, caps on rents, etc.
"These measures are mostly "soon to be inflationary" and, with rising costs hidden by subsidies and transfers, domestic demand will continue to grow unabated.
"We do not agree with the GCC governments' "inflation is a temporary phenomenon" view, said Turker Hamzaoglu, EMEA Macro and FI Strategist of Merrill Lynch.
While admitting that the region's strategy of diversifying away from an oil-dependent economy is well-grounded, given the painful swings in the past with oil and gas prices, Merrill Lynch analysts said resources are still scarce in terms of human capital, and physical absorptive capacity is limited.
The Gulf Cooperation Council plans to alleviate the supply bottlenecks through two main channels - an increasing expatriate population and mega infrastructure projects.
Inflation threatens the sustainability of both channels as the cost of living and the cost of production and construction are increasing at an accelerated pace, the report said.
Reconsider peg
According to Merrill Lynch, US interest rates are expected to fall to one per cent by the first quarter of 2009, and this would mean a significant liquidity addition to the GCC economies if they continue to follow US monetary policy.
"In such a case, we believe that monetary policy in the Gulf would be too expansionary, as real interest rates would plunge further, thereby fuelling the fire of inflation," said Hamzaoglu.
GCC countries have built up a cumulative current account surplus of some $730 billion over the past five years.
Capital inflows have gained pace, and the region is awash with cash. With heated domestic demand, pegs to the sliding dollar not only import inflation and fuel domestic liquidity but, more importantly, they also import easing monetary policy as the Fed cuts rates and GCC countries follow suit. This promotes inflation further.
According to Merrill Lynch, exchange pegs have become the main source of inflation in the region.
With the exception of Kuwait, the GCC countries have a long history with dollar pegs, which have served them relatively well until recently.
However, as the global economy is becoming less dependent on the US, this is now changing, the bank said.
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