Gulf should watch its speed and move the dial

Though rising rents are considered a pivotal force, pegging to the dollar is undoubtedly driving inflation trends in the region, says Monica Malik, economist at EFG-Hermes, talking with Financial Review

The UAE and Gulf countries seem committed to the dollar peg and no revaluation. What are the implications for inflation, and what can otherwise be done to contain it?
Inflation rates in the region will continue to remain strong going forward even if the GCC countries move away from the US dollar pegs or revalue their currencies against the dollar, as inflation is mostly being driven by domestic factors.

The main component has been the rising cost of rents. With the higher investment levels, the influx of expatriates has accelerated, and housing supply has not kept up with demand.

Higher rental costs are in turn causing costs to rise in other areas, such as education. This spill over was first witnessed in Qatar and the UAE, but is now increasingly driving inflation in other GCC countries as well.

Nevertheless, the dollar pegs are contributing to the inflationary environment. The weakening of the dollar against other global and emerging market economies is resulting in higher imported inflation, as the majority of imports into the GCC originate from either Europe or Asia.

In addition, given their pegs, central banks must align their interest rate movements to US rate movements to avoid arbitrage conditions.

Interest rates in the GCC are negative in real terms, and even more so after the aggressive US interest rate cuts last month.

This will boost credit and money supply growth in the GCC. A shift to linking the GCC currencies to a basket of currencies would provide the advantage of greater monetary flexibility, which a straight revaluation against the US dollar would not provide.

How important is the announcement in the UAE of the creation of a government bond market, and what economic and financial possibilities does it create?
The formation of a government bond market is an important step in developing the capital market and a dirham yield curve. Once developed, the yield curve will be a useful benchmark for local corporate borrowing.

An increase in domestic borrowing and reduced dependence on foreign borrowing is important if the UAE should decide to peg the dirham to a basket of currencies instead of solely to the US dollar.

The development of a bond market is also an important step in increasing monetary tools and absorbing liquidity from the banking system.

Can you describe how fiscal policy basically works in the UAE, and how it relates to monetary policy, considering that they are supposed to be complementary in economic management?
Fiscal and monetary policies are the main tools for managing an economy. As a result, if the GCC pegs to the US dollar the main component of monetary policy (i. e. interest rates) are out of the hands of GCC central banks.

Consequently, the main economic tool for GCC governments is fiscal policy. The role of fiscal policy is heightened by the fact that hydrocarbon revenues are accrued to the government, and it is through government spending that this revenue enters into the economy.

Government spending is an important driver of both private consumption and investment.

Fiscal policy in the GCC and the UAE has been expansionary, particularly from 2005, with the high oil price and increase in fiscal surpluses.

Expenditures have grown at a relatively constrained pace given the rise in the oil price, as can be judged from the low breakeven oil price for the budget. Nevertheless, government spending has continued to add a strong fiscal stimulus to the economy.

The UAE is focusing on its investment programme, which is aimed at diversifying its economic base, increasing hydrocarbon production and upgrading infrastructure, which are all important for the future development of the county.

Wages and salaries will also increase in 2008,which will add to inflationary pressure. However, given this level of spending and economic activity, interest rates need to be higher, but cannot be, owing to the dollar pegs.

How do you view the trend outlook for economic growth of the UAE relative to the cyclical forces which presumably are superimposed? What are the basic, determining factors in this relationship?

The main economic driver for the UAE and the wider GCC is oil revenue. As mentioned earlier, government spending of oil revenues is the main way oil prices feed into the economy.

However, the build-up of foreign assets is important. With continued strong current and budget surpluses, financial reserves will continue to increase in 2008 and 2009.

The build-up of foreign assets will provide a substantial cushion to the economy in times of lower oil prices, and increase governments' the ability to stimulate the economy fiscally.

On these most substantive issues, how does the UAE compare essentially to its neighbouring GCC states? Can you broadly characterise their relative strengths and weaknesses?
One of the key factors that differentiates the UAE from the other GCCountries is that it is more diversified, mostly owing to Dubai.

The more diversified nature of the economy means that it is important as a service provider, and in trade for the GCC and the wider region.

However, the UAE continues to face a number of challenges along with the wider region. In the immediate term, this includes higher inflation and supply bottlenecks.

As the UAE and Qatar started their investment drives ahead of the other GCC countries, the higher inflation was first seen in these countries. However, with the other GCC countries embarking on their investment drives, inflation is increasing in the wide region.

The GCC region is facing a number of supply constraints, such as in the supply of materials and skilled and unskilled labour, that could increase the cost of projects and slow their completion.

In addition, contractors and sub-contractors are also in short supply. Also, the GCC countries are all facing negative real interest rates and the issue of limited monetary tools linked with the currency pegs.

What expectations do you have, realistically, of the GCC Common Market recently introduced, and the proposed Monetary Union?
The GCC countries plan to establish a monetary union with a common currency in 2010. However, doubts have been raised over the timetable, and we believe that it is very unlikely that this deadline will be met.

In economic terms the integration process is facilitated by the fact that the GCC countries are structurally similar and already exhibit a degree of monetary and fiscal convergence. Oil and gas are central to their fiscal and wider economic outlook.

Thus, government spending cycles, economic activity and external development tend to move in unison. Trade and investment flows are also similar.

That said, with less than two years to go until the deadline, the countries have yet to take certain key steps needed for a well-functioning monetary union and common currency.

These include better-defined monetary policy objectives, the use of more uniform monetary instruments, and the establishment of an institutional framework.

Indeed, the countries have not finalized their own convergence criteria. Though the criteria are not a prerequisite for membership to the GCC monetary union, it is important that the GCC countries develop measures that are more suited for GCC economies.

The introduction of the common market is a step towards monetary union and single currency. GCC citizens now have the same rights and entitlements in each country, including employment, healthcare, education, social security and residence.

On the economic side, GCC citizens will now have the same rights in trading in stock markets, setting up companies, and buying and selling properties.

Although the common market has come into effect and there has already been some integration in laws and regulations, this is the beginning of the process, and more regulatory harmonization and implementation will need to be implemented.

How far are the UAE and GCC truly decoupled from the US slowdown and the rest of the world economy? To what extent have your own forecasts generally been affected by weaker international conditions?
GCC macroeconomic fundamentals remain strong at a time of increased fears of recession in the US and weaker growth in the EU leading to a global economic slowdown.

The GCC is relatively protected from that slowdown. The main mechanism by which global economic developments are spread to the GCC is through oil demand and price.

Positively, the oil outlook remains strong for 2008. Domestic factors will also support the GCC macroeconomic outlook, with loose fiscal and monetary policy.

We continue to forecast that economic activity in the GCC will remain robust in 2008, and that the region will realize some of the strongest growth globally.

Importantly, oil prices do not have to be at current levels for regional budgets to stay in surplus or for fiscal stances to remain expansionary.

Overall, the oil price needs to remain above US$50-55 per barrel for public finances to remain healthy and for governments to continue with medium-term investment plans.