In a recent move, the Saudi Arabian Monetary Agency (SAMA) lifted the interest rates on the Saudi riyal significantly above the hike in the US dollar Federal Reserve rates, and widened the spread between the riyal and the dollar interest rates by 50 basis points. SAMA’s aim was to keep a lid on the price pressures building in the economy and contain hyper inflation.
However, under the fixed peg of the riyal to the US dollar, monetary policy tools, especially interest rates, remain of limited use and hardly help the Saudi monetary system to keep high prices contained.
In that regard, SAMA, the central bank, increased the riyal interest rate it pays banks for overnight funds to 3%. It embarked on this strategy in an effort to curb the surge of money supply in the Saudi economy after several years of low interest rates that triggered the current boom in lending. The major concern for economists is that high oil prices are here to stay, which could prompt a more permanent spiral of upward price pressures.
Costs and prices rise
Inflation risks appear to be on an upward trend, with the non-oil GDP deflator increasing by 4% on average in the past two decades (see graph 1). This deflator reflects the rise of producers’ cost, which will be passed to consumers. Plus, low interest rates imply a negative real cost of funds to investors, or a negative when wiping out inflation. The weaker dollar also contributed to the surge in price levels by 6% in the past two years through more expensive European and other non-US imports in the kingdom.
Since last year, the appreciation of the euro and yen against the dollar in relation to the riyal has caused the riyal to depreciate by 20% for Saudi imports from Europe and by 10% from Japan. This had an average annual inflationary impact of 6% over the past two years. Although this may not have an immediate negative impact on the consumer basket, its effects will definitely be felt within the next one-and-a-half to two years.
Higher oil prices may, therefore, harm the Saudi economy in the medium term more than the developed economies’ short-term growth rates. In fact, some oil-importing countries’ governments, Italy for example, make three times the income (through high energy taxes imposed on their consumers) than the United Arab Emirates (UAE) generates from higher oil prices as an oil-producing country. Maintaining a stable purchasing power requires an annual adjustment to earnings of 3% at least.
Nevertheless, speculation has increased the flow of capital towards the Saudi stock market and real estate sector, leading to a speculative bubble in both. In the Saudi stock market, despite the privatisation of some government companies, private sector initial public offerings, bullish economic growth and an average 2% short-term stock market correction, a 20%-25% correction is possible and is long overdue, according to economists and technical analysts. Multiples are so high and speculation is obvious, through much higher volatility and instability parameters, which all indicate a sharp rise in asset prices.
As an indicator of an overheating stock market, the estimated fair value of the price/earnings ratio in the market should be only 14, which is way below its current level of 34. The longer it takes for a correction to materialise, the more severe it will be.
Correction triggers
So what triggers that correction? Two things: first, fears that the Saudi economy may slow down unless it starts creating high value-added jobs, which it has not. Second, the unfriendly business environment and regulatory framework, which affect investors’ tendency to invest in long-term projects of productive sectors.
Higher inflation may be healthy in developed economies but for Saudi Arabia, with lesser investment in real productive sectors, inflation can lead to stagnation – if not lower expansion – in the medium to long term. Slower growth reflects lower corporate earnings. If corporations do not deliver the expected earnings growth for the coming few years, the index will show less bullish readings. Moreover, if geopolitical uncertainties send the oil price soaring, the combination of inflation and recession known as stagflation will appear. This means Saudi economists, together with decision makers, need to find the economic model that will test the breaking point between the current inflationary situation and a recession in the future.
Inflation targeting has worked so far for the central bank. However, SAMA, the Ministry of Finance and the Capital Market Authority will have to do more to pre-empt bubbles. SAMA’s role is to continue monitoring and containing inflation through interest rates. Meanwhile, the authority and ministry have to accelerate the issuance and trading of Islamic sukuk (bonds) to enable long-term finance schemes for a sustainable expansion of mega projects and the building of industrial clusters.
In addition, enhancing venture capital funds to stimulate small and medium-sized enterprises has an essential role to play in transforming the economy and improving the purchasing power of individuals. This is essential to enhance stability, diversify the capital market and help manage the wealth of the kingdom.
Inflation is not the only danger from an unchecked boom in asset prices. Such a boom also carries the risk of a bust that will devastate the value of securities held by financial institutions and therefore induce “a collateral-induced credit crunch”. As the boom gathers momentum, more severe monetary restriction is required to puncture it. SAMA may then find itself in the paradoxical position of having to induce a recession now to forestall the risk of a more severe recession arising when the bubble bursts.
Banking panics
The depth and length of the depression will depend upon panics in the banking sector, which may lead to a serious decline in the money supply. It is not asset prices themselves that pose a threat to the stability of the financial system but the combination of rapid credit growth, rapid increases in asset prices and, sometimes, high levels of physical investment. In any case, international experiences show that for many countries there is a strong link between asset price growth and the growth of private credit.
SAMA is sticking to the logic of untapped resources and low capacity utilisation to argue that inflation cannot possibly happen with so much slack in the economy. The agency also argues that significant business opportunities will arise from the serious economic diversification strategy through structural reforms, privatisation and allocated capital expenditures for mega projects.
However, in the medium to long term, imported inflation will be felt in the Saudi economy, whereas the higher costs of goods and services, resulting from higher energy prices, will be passed from producers to consumers.
It was originally feared that inflation targets would be achieved at the expense of growth and employment. That is one reason why some decision makers and economists would have preferred realistic objectives and measures of economic expansion, including real GDP and non-oil GDP growth rather than nominal parameters.
Signals of inflation
As an indicator of inflation, real per capita GDP (1975 prices) declined for the past two decades from $6400 in 1975 to only $3900 in 2004, according to SAMA reports (see graph 2). This has a major impact on reducing the Saudi economy’s consumption and absorption capacity.
In other Gulf Co-operation Council (GCC) economies, the UAE looked at inflation seriously and acted upon it recently through a 25% increase in state salaries for nationals. This might create further pressure on the government’s current expenditures but, with the oil boom, it is essential for structural reforms.
Moreover, inflation led to what is called an “output gap” in the Saudi economy. When inflation becomes higher than expected, the actual output becomes higher than potential output (GDP), reflecting a positive output gap. This, with time, will limit GDP growth rates after inflation rates adjust in the future. The economy can only expand above its trend rate when the level of output is below its potential. This means that the Saudi economy’s ability to grow after oil prices stabilise will be constrained, or may even have a negative growth if crude oil prices sag.
The challenge facing the Saudi economy is to achieve much faster real economic growth through the expansion of its productive sectors to compensate for the higher imported inflation that will be seen in more expensive imported goods and services.
Policymakers will have to move on from targets aimed at inflation alone. The implicit model behind these targets is that all economic ills are reflected in inflation rates that are either too high or too low. Therefore, if these can be kept within sensible bounds, all other problems will cure themselves. Denying that there is inflation and keeping short-term interest rates suppressed will only make inflation worse and the economic bust in stocks, bonds, real estate and housing will stand out dramatically in the record books.
Lesson in diversification
Investors will feel cheated when they discover that they are being asked to accept interest rates that guarantee the value of their riyal assets will be taxed away by inflation. As a result of this, investors are likely to ask for higher profit margins to compensate for the higher risk premium.
In the late 1990s, many dollar-based economies in east Asia realised enough was enough and they began to diversify their foreign exchange holdings to cope with the weakening dollar. The diversification of foreign exchange holdings is now also China’s stated policy, and this is likely to have a negative impact on the dollar, particularly as China’s sentiment spills over to the rest of Asia. Moreover, the Middle East economies are setting the shadow price of oil in euros and want to hold non-dollar assets for safety.
Saudi Arabia and the GCC economies should revise their currencies’ rigid peg to the dollar and consider having a basket of currencies to cushion their reserves, in accordance with their main trade partners. The aim of this is to reduce the impact of inflation and to build stability and confidence in the local currency.
More important, inflation should be nothing more than a tax on all financial assets, namely cash, notes, stocks and bonds. If an investor holds a financial asset, he or she will have to pay the inflation tax. Sophisticated Saudi investors will be selling their financial assets and investing in real assets, such as commodities, or in projects in the productive economic sectors based on competitive advantages.
Dr Nahed Taher is senior strategic economist at Saudi Arabia’s National Commercial Bank in Jeddah
