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May 20 2008

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Saudi Arabia economy: Quick View - Inflation shoots up

Saudi inflation hit a new high of 9.6% year-on-year in March, compared with 4.1% at the end of December 2007 and an annual average of less than 1% in the previous five-year period. Speaking just before the data was released, the governor of the Saudi Arabian Monetary Agency (SAMA, the central bank) , Hamad Sayyari, acknowledged that inflation could exceed 10% this year. According to data released by SAMA in April, the money supply has continued to rise sharply, with M1, the measure of broad money and demand deposits, rising by 26% year-on-year in February.

THE EIU VIEW

The Economist Intelligence Unit expects that inflation will average 10% in 2008, given that domestic demand remains strong, the money supply continues to grow rapidly on the back of rising government spending, international commodity prices are expected to rise further, and the pressure on housing is unlikely to abate. In 2009, we forecast a slightly lower inflation rate, of 9.6%, on the basis that international commodity prices are projected to ease. We also expect the US dollar (to which the Saudi riyal is pegged) to strengthen slightly against the euro in 2009. Both these factors should help to ease imported inflation. However much of the current inflationary pressure is due to very strong monetary growth, as high government spending injects large parts of the country's record oil-export revenues into the local economy. Coupled with supply bottlenecks—notably in housing, construction and skilled labour—this monetary growth is feeding inflation.

Meanwhile, monetary policy instruments to address inflation are limited, as the currency peg requires that Saudi riyal interest rates roughly track US rates. The recent round of interest rate cuts by the US Federal reserve, starting in September 2007, have led SAMA , like other Gulf Co-operation Council (GCC) central banks, to cut policy rates in order to offset speculative pressure on the riyal. In early May SAMA cut its reverse repo rate–the overnight interest rate for banks depositing money at the central bank—by 25 basis points, to 2%, in response to a commensurate cut in the US Federal Reserve (central bank)'s benchmark funds rate. SAMA has tended to cut the reverse repo, which guides deposit rates, without cutting the repo rate, which guides lending rates, in an effort to prevent commercial lending rates from falling well below the rate of inflation. Liquidity is so high that banks can afford to lend at negative real interest rates because their own cost of funds is even lower. However the very low deposit rates, coupled with rapid inflation, means consumers have little incentive to save. The government could potentially issue more long-term bonds as a means of encouraging saving and mopping up excess liquidity, but so far has been reluctant to issue new debt. (A stream of initial public offerings is, however, absorbing some of the liquidity.) In early May SAMA also increased banks' reserve requirements from 12% to 13% for demand deposits, and from 2% to 4% for time deposits.

Government officials are aware that high government spending is itself a cause of inflation. However the authorities have already promised large-scale investments in infrastructure, education and health, which would make it politically difficult to rein in spending significantly. They will also spend money on "anti-inflation" measures, which may themselves be inflationary. Notably, the government has agreed to give public-sector workers and state pension recipients a new "cost of living allowance" equivalent to 5% of their annual salary this year. This is to rise by a further 5% in 2008 and 5% in 2009. These rises are lower than the salary increases recently agreed in Kuwait and the UAE, where the national population is much smaller, and the government could yet be pressured into more significant wage hikes. Meanwhile, large inflows of immigrant labour will keep average private-sector wage growth in check, but salaries in skilled sectors are likely to continue rising strongly amid intense competition for staff. New subsidies on rice and baby milk were introduced in January and further subsidies may be introduced over the outlook period. Nonetheless the rising cost of living will remain a hot political issue and will generate resentment among the less well-off.

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SOURCE: ViewsWire