Can 60,000 smiles worsen UAE inflation?

Dubai: The UAE's federal budget for 2007 has achieved something unprecedented in the country's history by offsetting the impact of the rising cost of living of more than 60,000 federal government employees through a one-stroke increase in salaries by 70 per cent.

Hardly did the euphoria died down than economists, analysts and finance professionals began questioning the efficacy of such a salary increase in fighting already-high inflation.

Many feel the salary hike could backfire and lead to a price-wage spiral resulting in potentially higher inflation and higher costs of living including the cost of doing business.

The government has allayed such fears. After unveiling the details of the federal budget, Dr Mohammad Khalfan Bin Kharbash, Minister of State for Financial and Industrial Affairs, said the decision to increase salaries of federal employees is unlikely to create an imbalance in the economy; instead it is aimed at offsetting the disparities in federal and local government payscales.

A day after the budget the Ministry of Economy issued an advertisement in local dailies warning suppliers and traders against raising prices of goods and services in an "unjustified" manner to take advantage of the 70 per cent pay rise next year.

Many economists fear that a sweeping pay hike by the federal government would pave the way for demand for higher wages from local government and private sector employees and an overall increase in salaries would apply further upward pressure on prices.

"The surging money supply has been a key factor behind the rising inflation in the UAE. A general increase in salaries could mean money in circulation and additional purchasing power applying pressure on an economy which faces severe supply constraints," says Marios Maratheftis, regional head of research for the Middle East, North Africa and Pakistan for Standard Chartered Bank.

Apart from 60,000 federal government employees and personnel in the Interior Ministry, several thousand pensioners including retired civilian and military personnel will also benefit from the federal government's move.

Although the government has not specified the allocation for the salary hike, sources say the figure could be close to Dh3.5 billion. For the UAE, a country that sits on a huge surplus of almost Dh600 billion, the fiscal burden is almost negligible.

However, the additional purchasing power unleashed by this new source of liquidity could be worrying.

Analysts say that could be the reason behind the warning issued by the Ministry of Economy.

Symptoms of inflation

"By hiking wages we can only treat the symptoms of inflation by compensating for the diminished purchasing power through higher salaries. However, in real terms, inflation will rise further as higher wages are bound to increase the overall money in circulation, causing prices to rise." Analysts say although higher salaries would increase consumers' ability to buy products for a while, it will increase the overall inflationary pressure on the economy.

The economy has already been constrained on the supply side due to excessive liquidity and unprecedented economic development. Economists say additional demand generated from the new income would create a demand-multiplier effect leading to a rise in prices.

Larger implications

According to economists, higher salaries could mean not just higher prices, but higher costs in real terms, thus complicating efforts to encourage export-oriented industries, and probably the diversification of the economy.

However, the government believes that the private sector has the ability to cope with the 70 per cent salary hike declared by the Federal Government.

"The private sector is very dynamic, the move is unlikely to put any pressure on it," Dr Kharbash said.

In the UAE, which has a relatively consumption driven economy, additional income could mean an immediate impact on consumption. Economists say the salary-earners' propensity to consume is much higher than the affluent.

A sudden surge in the nominal earnings of the working class could mean a surge in disposable incomes resulting in higher demand and higher prices.

The salary increases could work as a stimulus to the current high inflation in the country, however will not become a major factor in the future inflation growth according to Monica Malik, an econ-omist with EFG-Hermes.

"Increased federal government spending on salary hikes is expansionary in nature. But it constitutes only a small portion of the overall money supply in the system.

"Although we do not subscribe to the view that higher salaries are a solution to the high cost of living in the UAE but more a result of it, we also have not revised our inflation forecast for the UAE because of salary hikes," said Malik.

Another important angle of this salary hike is the socio-economic dimension of spending habits.

The likelihood of the increased federal salaries applying pressure on demand is higher in the UAE as a significant number of federal employees are nationals with higher spending power.

Many of them own their own houses and enjoy subsidies on housing, power and water tariffs and unlike the expatriate employees they do not have the compulsion to save or remit a significant portion of their earnings.