Business | General
'VAT is good for Gulf, but timing must be appropriate'
Mohsin S. Khan, the Director of the Middle East and Central Asia Department of the International Monetary Fund, has more than three and a half decades of experience as an economist with the IMF.
- By Babu Das Augustine, Banking Editor
- Published: 00:04 May 30, 2008
- Image Credit: Gulf News archive
- Khan believes a lot work needs to be done faster in order to meet the deadline for the 2010 monetary union.
Dubai: Mohsin S. Khan, the Director of the Middle East and Central Asia Department of the International Monetary Fund, has more than three and a half decades of experience as an economist with the IMF.
As an IMF economist, Khan has worked with several governments and central banks in an advisory capacity. Khan has published widely on macroeconomic and monetary policies in developing countries, economic growth, international trade and finance, Islamic banking, and IMF programmes.
He has edited several books and published numerous articles in major economic journals. With his wealth of extensive experience on the Middle East economies, Khan discusses a range of macro economic topics such as inflation, structural changes and sustainable economic growth in the Gulf region.
Gulf News: The IMF forecast for 2008 says the GCC's and the UAE's inflation is set to fall. Is that realistic?
Mohsin S. KhaN: The inflation figures attributed to the International Monetary Fund for 2007 has been an estimate. Our initial estimate for 2007 was eight per cent. We have recently revised it to 11 per cent. It is a weighted average of inflation for Abu Dhabi, Dubai and Sharjah.
In Abu Dhabi, the planning office says that the inflation was about 10 per cent. You would figure that in Dubai it (inflation) could be somewhat larger, but Abu Dhabi has a larger weight. So we are estimating the overall inflation at 11 per cent.
I would say that the inflation in the UAE would be about nine to ten per cent in 2008. The reason we were wrong on inflation estimates last year was because we were expecting more housing units come into the rental market.
The housing units were built as per our expectations but only a portion of it went into the rental market. And therefore the problems continue to remain very high.
In the 11 per cent estimate that we have made, more than half of it is housing related. So essentially, we underestimated the impact of housing and rents on the actual outcome of inflation.
This year, I think rents will continue to be an issue, but I think food is going to be another important factor, certainly in the first half of this year. With that it mind, we should treat this years' inflation estimate of nine per cent as a floor-level estimate rather than an upper limit.
The GCC's export surpluses are bulging, so is the fiscal spending and money supply, giving rise to further inflationary pressure. Shouldn't regional governments slow down spending?
There are significant demand pressures and also in this case oil prices have been rising, more revenues are coming in and therefore there is more expansion by the government because it has more revenues.
But also, high oil prices give businesses more confidence and they expand more. So what is happening right now is that raw material prices and all sorts of input prices are rising very rapidly. Cost factors are really pushing up inflation.
Right now in the Gulf region, living with inflation averaging around 10 per cent seems to be the reality. In Dubai, this figure could be even higher.
Under the current circumstances, fiscal discipline (slowdown in government spending) is the only instrument the governments have on their hand to control inflation. But I think the Gulf governments have a dilemma here.
On the one hand, they need to continue with fiscal expansion to develop the economies - put the infrastructure in place, modernise the systems, encourage the private sector through public-private partnerships to create jobs etc.
And on the other hand, they are also hitting absorptive capacity constraints. So, it is a delicate balancing act between achieving the long-term diversification of the economies and the short-term costs of dealing with inflation.
What the governments in the region have been doing is that they are going ahead with fiscal expansion while trying to control inflation through other measures such as rent caps, controls on prices of food items and raw material.
Some of these measures amount to direct or indirect subsidies, which are targeted at helping the population to tide over rising prices. These measures help only temporarily. We know historically from experience around the world that these measures can help only temporarily.
The real risk is that if inflation persists over a longer period, it would find its way into wage increases. If the trend forces regular wage increases, resulting in a wage price spiral will lead to entrenching inflation.
There are indications that some sovereign wealth funds from the region are turning to domestic investment opportunities, will this not cause severe asset price distortions in the region?
Sovereign wealth funds in the region have basically two motivations. First, they target saving for the future from the current surpluses against any future fall in oil prices.
The other motivation is to save for future generations. They are definitely looking for best returns available around the world. Under normal circumstances, they tend to hold more foreign assets mostly in the West. In this boom, the investment patterns have changed. The region has become very attractive in terms on returns, so, a few of them have turned their attention to the region.
But there are limits to what they can invest here because there aren't enough assets available. Their job is to increase the rate of return. Abu Dhabi Investment Company (Adic), for example, is looking for investments internally while Abu Dhabi Investment Authority (Adia) is increasingly focused on external assets. That is quite understandable.
In Saudi Arabia, the Saudi Arabian Monetary Authority (Sama) holds significant foreign financial assets and the public investment funds hold domestics assets. They have been doing this for a long time.
The big change I noticed in investments is that the switch from investing only in the western markets to investing a portion of their resources in the region. There are some who are investing domestically, of course, but they are doing it in partnership with the private sector. So it is another way of helping the private sector.
Housing shortages have been one of the main reasons often sighted for rising regional inflation. If the economies are expanding fast with a rising migrant population, isn't inflation going to be a long-term feature of the region?
We can't really put a figure on the housing requirement of a country like the UAE as there is a huge inflow of expatriates. It is very difficult for us to judge what will be the size of demand for housing next year or the year after.
Apart from the huge demand, other major factor pushing up house prices and therefore rents are the limited investment options available here. House prices in Saudi Arabia are rising, and that has little to do with expatriates.
The fact is that in the past the Saudis who had the money to invest had the option to invest in the stock market or deposit in the banks. The stock market is less of an option now because of the market meltdown in the year before.
Many who burned their fingers in the market have now turned to real estate. Land prices are rising rapidly in Saudi Arabia. It is surprising in the context that land is relatively abundant in supply in relation to demand.
Our financial policy advise to the regional governments is to create opportunities for investment diversification. There is certainly big rush into the real estate that is happening right now and the returns are good in both absolute and relative terms.
Like what happened in the stock markets, two years ago the valuations could be heading high. But in the case of real estate, there is no benchmark with which we could judge how much is too much.
In the case of stock markets, indicators such as the price earnings multiples (P/E ratio) serve as both absolute and comparative indicator. Real estate lacks such basic fundamentals as location is the most important factor. So, it is very difficult to say if we are already facing asset price inflation or are heading towards one going by current real estate valuations.
De-pegging and revaluation is rule out until the monetary union target is achieved. What else is left as monetary policy options for the GCC?
By reaffirming their commitment to the peg, the authorities have implicitly said that their monetary policies are going to be tied to that of the US. However, there is an attempt to reduce liquidity through measures such as reducing the loans to deposit ratio or increasing cash reserve requirements.
What is IMF's assessment of the monetary union target set for 2010?
The timing of the monetary union is going to be decided by the rulers. What happened last year, the rulers did not say anything in December. That was taken as 2010 is still the deadline. There is a lot of technical work under way and there is a lot more required to achieve that target. Whether they will achieve this within the set target is an open question.
But as an observation, year-by-year, it is becoming a difficult target to meet. On the decision if there will be monetary union, our opinion is that there will be one. Will there be a monetary union by 2010? There could be, there needs to be a lot work done and faster to meet the deadline.
Are GCC states ready for VAT?
I don't think any decision has been taken by any individual governments. Yes, in the context of the huge surpluses the regional governments are accumulating, it would be tough to sell the idea that the governments need a tax to diversify their income, even though for the long run it is a very good idea to have a diversified revenue base.
Some would argue that this is a very good time to introduce VAT because the timing gives the option to introduce a very low rate. However, this is difficult political-economic issue.
Rising government revenues and inflation could keep VAT away for some more time from happening at least in some Gulf states. But the idea is sound and it will eventually happen. VAT is good for the Gulf states in diversifying their revenue streams, but this may not the right time for it.
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