How to face the inflation monster?

Interest in fighting inflation is a global concern, even becoming a unifying factor among countries, rich or poor, in declaring clearly the intention to adopt policies to contain it.

In the United States, in spite of acting to prevent the economy from sliding into recession, also in the United Kingdom, European Union, Russia, China, India, Australia and many other countries, there is serious concern and true interest to act with available monetary and financial tools.

However, those who are aware of and concerned about the current inflationary phenomenon in the GCC countries will notice that inflation rates have reached levels unseen since the late eighties of the 20th century: more than eight per cent in Saudi Arabia, 11 per cent in the UAE and more than 13 per cent in Qatar.

While there is plenty of gossip, analysis and discussions in the GCC at different official and non-official circles, the institutions charged with the responsibility of maintaining the stability of the GCC currencies, that is the GCC central banks and monetary authorities (central banks in the following), do not announce or tell the public what their plans are for fighting the "monster" that has already grabbed significant portions of the monies they themselves issue.

A glance at the objectives of the GCC central banks, as presented in their laws of establishment, shows that they include, among other things, maintaining the value of their currencies.

Law

For example, Article 5 of the United Arab Emirates Union Law No. (10) of 1980 concerning the Central Bank, the Monetary System and Organisation of Banking states that "the Bank shall direct the monetary, credit and banking policy and supervise over its implementation in accordance with the State's general policy and in such ways as to help support the national economy and stability of the currency"; and for the attainment of its objectives, the Bank shall "endeavour to support the currency, maintain its stability internally and externally, and ensure its free convertibility into foreign currencies".

The question now is: Has internal and external stability been maintained, though free convertibility has been maintained even under very difficult situations? Discussing that question requires definition of functions of money and its value.

Traditional money functions are a 'unit of account', a 'medium of exchange' and a 'store of value'. The situation in the GCC is that its various currencies perform the first two functions but the third is in doubt.

The store of value function of a currency is connected with the value of money, which is connected with prices of goods and services.

For example, the consumer price index (CPI) of the group "foodstuff, beverages and tobacco" in the UAE consumer basket increased by 23.5 per cent between 2000 and 2006. Thus, if a family was paying Dh900 to buy this group of goods in 2000, it paid Dh1,111.50 to buy the same group of goods in 2006.

This calculation means that the dirham's purchasing power in terms of this group of goods declined by 23.5 per cent.

Sinking

If we measure dirham value in terms of the group of "house rent and rental housing items" in the UAE consumer basket, we find that the the value of the dirham declined by 50.1 per cent in terms of this group.

At the overall UAE CPI, if a family paid Dh100,000 in 2000 to buy the basket of goods and services, it had to pay Dh133,000 in 2006 - that is the value of the dirham lost 33 per cent.

There are many and varied studies concerned with inflation, its causes and treatment. However, because inflation is responsible for the decline in the value of a currency, we need to highlight the relation between inflation and money in search for an instrument that could assist in containing inflation and consequently limiting the decline in the value of the currency.

One of the renowned relations in economics in general and in money and banking in particular is the Quantity Equation. This relation, in percentages form, shows that the sum of growth of liquidity and growth of velocity of money is equal to the sum of inflation rate and growth of real income.

For example, if the growth rate of liquidity is 15 per cent, income growth rate is five per cent, and there is no change in the velocity of money, inflation would be 10 per cent.

In general, a high growth rate of liquidity, given an income growth rate and stability in the velocity of money, induces high inflation rates.

Thus, the Quantity Equation indicates that the first step in fighting inflation is to limit the liquidity growth rate not to exceed real income growth rate plus 2-3 per cent for a reasonable inflation rate.

So let's take a glance at real income and liquidity growth rates in the UAE, Qatar and Saudi Arabia. In 2006, the growth rates of real GDP (gross domestic product) in the UAE, Qatar and Saudi Arabia were 5.5 per cent, 7.1 per cent and 4.7 per cent respectively.

The liquidity growth rates were: 21.2 per cent, 37.9 per cent and 20.4 per cent. The velocity of money in the UAE, Qatar and Saudi Arabia was stable between 2005 and 2006.

Thus, the large expansion in liquidity found its way into inflation, i.e. higher rates than the consumer price indexes in these countries indicate.

What is needed is to identify the sources of liquidity in the GCC countries and the factors behind its excessive expansion, and to assess the possibility of containing it within safe limits.

- The writer is former director of Economic Policy Institute, Arab Monetary Fund, Abu Dhabi.