Dr. Paul Wetterwald Image Credit: Supplied

DUBAI: Saudi Arabia has reported a sharp rise in inflation on value-added tax (VAT) and subsidy reforms with inflation accelerating to 3 per cent in January.

Consumer price inflation in Saudi Arabia strengthened to 3 per cent year on year in January, after seeing deflation of -1.1 per cent in December and -0.8 per cent over 2017.

Saudi introduced a new inflation index including different weightings of components. “We estimate that under the old CPI index, headline inflation would likely have strengthened to over 6 per cent year on year in January. CPI rose to 4 per cent month on month in January (new data) from just 0.3 per cent in December. The sharp pick-up in inflation reflected key fiscal reforms, namely the introduction of VAT and reductions in fuel and electricity subsidies implemented on 1 January 2018,” said Monica Malik, Chief Economist of Abu Dhabi Commercial Bank.

Economists expect inflation to reach 4 per cent this year, up from -0.3 per cent in 2017. “For businesses, levies on expat labour and rising input costs pose additional challenges. While on the monetary policy side, the expected three rate hikes in the US this year will translate into higher interest rates in Saudi given the US dollar peg — this would raise the cost of borrowing for businesses and consumers alike,” said Oxford Economics in a recent report.

The increases in fuel prices in 2018 were much greater than those seen in the previous round in January 2016. The price of diesel for transport purposes only saw a 5 per cent rise in January, reflecting the cost of VAT. Electricity users with average consumption also saw a much greater price rise in 2018 than in 2016, and a more marked increase than heavy users. On the back of the increases in administered prices, inflation for the electricity, gas and other fuels sub-component jumped by 24 per cent year on year in January, while transportation rose by 10.5 per cent.

Saudi Arabia’s broad VAT base could also be seen in the January inflation data with 10 out of the 12 major categories of the CPI basket seeing a monthly and yearly rise. This includes a 5.6 per cent month on month and 6.8 per cent year on year increase in food prices, which accounts for 18.8 per cent of the new CPI index.

Analysts expect the potential surge in inflation following VAT introduction will normalise in the months ahead.

“We do not want to downplay the various impacts of the VAT, but we emphasise that on the inflation front the base effect linked to the VAT’s introduction will dissipate in 12 months from now. The same happened in Japan in April 2014 when VAT rate’s hike from 5 per cent to 8 per cent allowed the National CPI change to reach +3.7 per cent year on year in May 2014, before receding to +0.5 per cent twelve months later,” said Dr Paul Wetterwald, Chief Economist for Indosuez Wealth Management.

Overall consumption is expected to remain soft despite support from allowances. Analysts see private sector activity remaining soft in 2018 due to fiscal reforms and higher inflation. However, the government’s allowance packages for nationals, which have been followed by some private sector companies, will reduce the impact of the higher prices on consumer spending.