Taking a break during these times of rising inflation

What happens when the economy and monetary policy of the world's largest oil exporter is tied to the fate of the US economy and crude prices keep hitting new highs?

With rising inflation, the growth of the Saudi economy (through high oil process), coupled with a weak dollar and slowing American economy (thus, low US interest rates), has created a policy dilemma for the country's economic managers and policymakers.

According to a report published last month by the Saudi Ministry of Economy and Planning, annual inflation in the country eased slightly to 10.40 per cent in May. This contrasts to a 30-year high inflation level of 10.45 per cent recorded a month earlier. Rising rental and food costs continue to pressure the Saudi economy.

Like the rest of the GCC, the main drivers of Saudi inflation appear to be the rising cost of housing and food. With windfall oil revenues driving an expanding economy's demand for human resources, too much money is chasing goods in high demand (like housing and labour). Considered to be a price for higher growth, Saudi inflation appears to be stabilising at very high levels, especially when compared to its historical inflation rate of one or two per cent.

Oil makes up about 90 per cent of Saudi Arabia's exports. The country generated about $200 billion from oil exports last year; for 2008, the kingdom is expected to earn as much as $300 billion, although some estimates put it at $400 billion.

With global oil prices hovering at over $140 per barrel, and 30 per cent of its GDP coming from hydrocarbons, Saudi Arabia's economic outlook looks robust. Domestic recycling of the country's oil windfall through government spending will remain high throughout this year, with rising government subsidies.

Real GDP growth is projected to accelerate to 6.5 per cent in 2008 and then to slow down marginally to 5.7 per cent in 2009, from 4.0 per cent in 2007.

Inflation has risen across the GCC, and has become a serious policy challenge.

According to analysts, besides a number of global inflationary factors (high food and commodity prices), rising inflation pressure in Saudi Arabia is a result of at least three additional factors:

-Strong economic growth, which has led to the tightening of labour markets and the build-up of several supply bottlenecks, particularly in housing, a problem that has often been aggravated by strong population growth and immigration;

-Fixed exchange rate against the depreciating US dollar, which has led to imported inflation via more expensive imports;

-Large capital inflows in combination with a fixed exchange rate against the (depreciating) dollar. In 2006, foreign direct investment (FDI) reached $18.3 billion, compared with $12.1 billion in 2005.

Fixed exchange rate

Given its fixed exchange rate against the dollar, Saudi Arabia, like most other countries in the region, has closely tied its monetary policy to US rates.

As the US Federal Reserve has cut rates aggressively, the challenges are getting more pronounced as the Saudi Arabian Monetary Agency (SAMA) has had to mirror the Fed's rate cuts at precisely the time when the country's economic situation needs tighter, not looser, monetary conditions.

Rising inflationary pressures have become a concern in Saudi Arabia. It is likely that the boom in domestic demand, coupled with strong monetary growth, supply bottlenecks, high international commodity prices and a weak dollar will result in inflation remaining well above historical levels, despite increased government subsidies.

Real interest rates in many GCC countries, including Saudi Arabia are already negative, and are likely to decline further this year.

Although adjusting the exchange rate peg would not address the underlying causes of inflation (which are primarily domestic in nature), high inflation is the price of relatively stronger economic growth vis-a-vis the US that Saudi Arabia has to pay. The adverse effects of this growth and the Riyal-Dollar peg, however, remain to be seen.

The author is head of investment management at Morgan Stanley, Saudi Arabia. The opinion expressed is that of the author himself and does not necessarily reflect that of the organisation he represents.