It's a free run for inflation in GCC

Inflation in the GCC region is set to rise further in the absence of effective policy tools to prevent it. However, potential sovereign credit ramifications - mainly fiscal and socio-political - are modest, being outweighed by the impact of continued high oil prices on public finances and sovereign balance sheets.

Inflation is currently at its highest rate for 30 years in the region, running at double digits everywhere in the GCC but Bahrain, where the rise in price level is a more modest five per cent.

As in the seventies, some of the region's increased oil wealth is feeding through into higher prices, and with policy tools limited, inflation will rise further before it starts to fall.

Exchange rates

The region's increased oil wealth warrants an increase in real exchange rates, which can come either though a revaluation of the nominal exchange rate or higher prices, or a combination of the two. Given the decision to stick with dollar pegs, Kuwait excepted, higher inflation is inevitable.

Higher inflation has many causes. Spending oil revenues, even at a measured pace, boosts demand and liquidity growth. Although imports have satisfied much demand, shortages are mounting and costs rising. Property markets are especially tight as expatriate labour bring massive population growth. Rents are the main cause of high inflation in the two highest inflation countries - Qatar and the UAE.

Dollar pegs and falling US rates have dictated increasingly negative GCC real interest rates, which encourage bank borrowing and purchase of real assets, especially property. Credit growth accelerated throughout the region last year, exceeding 30 per cent everywhere but Saudi Arabia and reaching 50 per cent in Qatar. Fitch believes this channel to higher inflation is as important as the direct impact on import costs of weaker dollar-linked currencies. Nevertheless, Fitch notes that Bahrain, with the lowest inflation rate, sources a larger share of its imports from within the region, compared to its GCC neighbours.

With at least some soft commodity prices now moderating, inflationary pressures from this source may abate later this year. However, lower inflation must also await improved property supply, especially in Qatar and the UAE where soaring rents are a main driver of rising prices.

Credit concerns

Higher inflation brings some credit concerns, though these are largely offset by the impact on public finances and sovereign balance sheets of higher oil prices. Governments have moved to defuse potential socio-political pressures by raising wages and subsidies to preserve purchasing power of their citizens. Countries with the highest inflation are also best able to shoulder such costs, with budget surpluses of at least 20 per cent of GDP expected in all except Bahrain and Oman this year.

Budgeted oil prices are creeping up, but actual oil prices remain well above levels that would raise serious credit concern.

Higher costs could mar the attractiveness of the region as a place to work and do business and will reduce the viability of some projects, all of which will hamper the region's diversification strategies.

Rising and increasingly divergent inflation also poses another challenge to the GCC's goal of monetary union. A recent meeting of GCC central bankers decided to set up a regional Monetary Council by 2010, but with a host of technical and political issues still to be addressed monetary union will not become a reality until after that date.

The writer is associate director (Middle East & Africa Team) at Fitch Ratings.