Straight talk from Chief Economist at al khaliji
Businesses will gain from a de-pegging of the Qatari Riyal, according to the first ever business optimism survey of Qatar by Dun & Bradstreet, sponsored jointly by al khaliji and the Qatar Financial Center.
According to the survey of 340 businesses spread across a range of sectors in Qatar, 46% overall will benefit from a de-pegging of the Qatari Riyal. The underlying reason is simple. Businesses that import raw material, machinery and labor from non-dollar countries like Europe, Japan, India and China, have to pay more in Riyals as it depreciates in line with the dollar because of the fixed exchange rates.
The Riyal peg is a key driver of inflation in the region Broadly speaking, inflation in the region has four sources:
A global liquidity driven boom has pushed commodity, agriculture and construction materials prices sky high. The IMF's commodity price index has risen by a cumulative 10 percent in 2008 after having increased by about 30 percent between December 2006 and December 2007.
The weak dollar has been one of the key reasons for rising global commodity and energy prices. Suppliers raised prices of their products (for things like steel, food, energy) as a weakening dollar eroded their profits. In addition, commodities that also serve as assets (e.g., gold and other precious metals, oil) saw their prices rise because a weaker dollar made them more attractive for financial investors and speculators.
A falling US dollar combined with the dollar-based pegs have transmitted the global price increases to the GCC, in a phenomenon called "imported inflation". The falling dollar has caused the QAR to depreciate by as much as 20-30% in the past few years. The combined contribution of this, with the commodity price inflation above, may have added as much as 60-70 percentage points to the rise in the price of products imported from Europe, Japan and other non-dollar countries.
The fixed dollar peg is fueling inflation further through an indirect effect that maybe even greater. It is forcing the GCC central banks to cut interest rates in line with the US Fed, thus causing money supply to increase. But, what is needed instead is to tighten money supply and raise interest rates. Qatar, for example, has lowered its key policy interest rates to 2.00% in line with the US Fed, from 5% only a few months ago. As a result, we are seeing money supply growth at double-digit rates in recent years (on top of the already 37% growth in 2006).
Too much liquidity caused by the dollar peg policy is driving domestic private and public spending to excessive levels thus generating unsustainably high growth in demand for locally produced goods, services and housing. Combined with supply bottlenecks it takes time to build new manufacturing facilities, or build new housing this has fueled inflation in certain sectors. The biggest culprit in this area are rental, housing and property prices.
The Riyal peg is directly responsible for two of the above four causes of inflation (nos. 2 and 3), and indirectly responsible in the two remaining cases.
Why is inflation bad?
Inflation, in general, hurts the economy by reducing the purchasing power of consumers and wage earners, and by increasing the cost of business for companies.
Inflation begets further inflation. It is a disease that spreads easily. As prices of raw materials and consumer goods rise, businesses will raise their own prices and workers will demand higher wages to compensate. Thus, what may have started in particular sectors (e.g., oil, property), spreads to other segments of the market.
What Economists dread most in this context is if inflation gets built into people's expectations and thus become a self-fulfilling prophesy. When businesses expect inflation to continue, they incorporate it into their business and pricing decisions. Similarly, when workers expect inflation to stay, they incorporate that into their wage demands. The combined end result is not just inflation, but spiraling inflation.
This is what happened in the US in the 1970s ever increasing double-digit inflation combined with high unemployment - giving rise to the term 'stagflation'. The world is again in the throes of yet another phase of stagflation, and, as in the 1970s, the solution is to raise interest rates to high levels. In the US, the then-Fed Chairman, Volcker, raised interest rates to double-digit levels, and only then succeeded in killing inflation and inflationary expectations. Unfortunately, raising interest rates is an option not available to the GCC given their fixed pegs.
Unchecked inflation will have further consequences for the GCC
Inflation in the GCC has additional longer-term consequences that are unique to the region. An overwhelming majority of the GCC labor force are expatriates and continued inflation makes it less desirable for them to come or continue staying in this region. Inflation and the dollar peg hurts expatriate labor in two ways: it erodes the local purchasing power of their wages and salaries, and they are hit with a double whammy when the value of their remittances in their home countries fall because of the Riyal depreciation. Continued inflation thus will threaten the growth potential of the GCC if, as some countries are finding out, it starts drying up the supply of labor from abroad and creates unrest locally.
The GCC-variety of inflation, driven as it is by excessive liquidity, is also responsible for an asset price bubble, that has other troubling consequences. Asset price bubbles are not good not only because they end up bursting eventually but also because they distort economic signals and divert too much of the economy's wealth and resources into the bubble sectors. Unfortunately, too often policymakers tend to ignore asset price bubbles before it is too late because many people get enriched (albeit, at the expense of others) and it creates an aura of success.
Can a revaluation stop inflation?
There are really only two ways that GCC countries can eliminate inflation. Either, they cut government spending, or they pursue an independent monetary policy and raise interest rates. Unfortunately, the second option is not available to the GCC as long as their currencies are tied to the dollar (or any currency). This means, cutting spending is the only option left, and most GCC governments are unwilling to do that either because it means slower growth or it is difficult given the large oil revenues.
However, doing nothing is not a good option either because it means continued high inflation. Even worse is what some GCC countries are doing, namely, subsidy and salary increases because they will actually end up fueling inflation and result in further demands for salary and subsidy increases in the future.
A one-off revaluation will not eliminate future inflation, but it will eliminate the impact of past inflation, without fueling more inflation. A 20-30 percent revaluation will restore the purchasing power of expatriate wages and the consumers. Given the policy dilemma, it buys time for the authorities to come up with more durable solutions. And, it demonstrates to the public that the authorities take market signals and concerns seriously.
Hold your breath, the dollar is strengthening Naysayers, i.e., those who say that the dollar is already coming back up, will say that a revaluation is no longer necessary. However, they may not want to hold their breath for long. The life history of the euro, which has been in existence since January 1, 1999, shows little cause for optimism in a sustained dollar recovery, given the underlying fundamentals. Of course, one can never say never, but the chart shows that the dollar has been declining against the euro for most of the latter's life, starting as far back as 2001. In fact, the latest bout of dollar strength doesn't even register as a big blip in the chart, and it shows a number of previous failed attempts.
That the dollar's decline has been long and sustained suggests fundamental forces at work against the dollar, which are no mystery at all huge US government budget deficits as a succession of US presidents cut taxes to the bone, bloated further by the massive spending on the "war on terror', an almost "enforced" globalization of the world by none other than the US itself that, ironically, has moved jobs and manufacturing away from America to the emerging world, and has come back to haunt it in the form of a massive US trade deficit (reaching as high a $800 billion in recent years), that together with interest rates so low that no one wants to hold dollars anymore.
But a more fundamental issue is at stake here. Any currency will always have ups and downs. Why should the GCC, which has become an economic might in its own right in recent years, tie its currency and its economic fortunes to any other currency, let alone a falling one? The dollar may have been mighty at one time, but now there is also the Euro.
The Puzzle
In our view, there is really little economic justification for not revaluing the GCC currencies, the recent strength of the dollar notwithstanding. Economist would never say that a price set decades ago is still right except by pure accident. Businesses would never last if they kept their prices fixed for decades. This should also be true of the price of currencies.
The pegging of GCC currencies to the dollar in the mid-1980s made sense for a number of reasons, but those reasons are now mostly gone. Back in the 1980s, the GCC was a minor economic player in the world. Their currencies and their central banks were untested, inexperienced and globally insignificant.
The main issue for them at the time was to preserve the global purchasing power of the single-most important asset they owned at the time oil, and to build up currency credibility and stability. Thus, it made sense to tie oil prices and their currencies to the dollar, the currency of global trade. Now, the situation has changed: the dollar is no longer the king, the GCC has diversified its wealth significantly away from oil, together the GCC countries are a major force in global trade, investments and financial flows, and a single GCC currency can become a regional, if not a global currency of choice. But, this cannot be achieved, if the GCC currency still plays second fiddle to another currency and they tie their monetary policy to the fortunes of another country in the world.
Official resolve to keep the GCC currency prices fixed against a falling dollar has hardened in recent months. Authorities have instead put their resolve back into the GCC monetary union by the original 2010 deadline. Until recently, this was thought to be almost impossible by most observers, given that Oman had already voted to opt out and Bahrain and Kuwait were having reservations. In fact, it may have become even harder to achieve given that Qatar, the UAE, and even Saudi Arabia, much to the latter's consternation, will fail to meet the existing convergence criterion on inflation (i.e. no more than 2% away from the GCC average, which is currently around 6.9%).
Some red herrings on the road to monetary union
A number of "red herrings" (i.e., myths) have been floated around about why a revaluation or de-pegging will not work:
Disturbing the pegs now will cause difficulty on the road to monetary union.
But, all the major currencies of the European Monetary Union were floating in the run up to the Euro and it did not hurt the euro monetary union. All that is required for monetary union, as for the euro, is for the GCC currencies to set a fixed ratio among themselves, NOT a fixed ratio to currencies outside.
The Riyal peg is not the main reason for inflation. But, it is directly behind two of the four main reasons and indirectly behind the other two.
A fixed exchange rate regime has served us well. This is fine, but this is not the same as saying that the same rate established decades ago still serves us well. Moreover, it is time for the GCC to stand on its own feet, as a new emerging global economic bloc, and establish its own future course.
Kuwait has revalued its currency but still shows rising inflation. The Kuwaiti revaluation was too little too late, and unlikely to blunt inflation anyway because they still continue to match US Fed rate cuts (so the currency does not revalue too much?).
We see four possible reasons for the GCC resolve against revaluation:
Political, i.e., do not hit the dollar when it is already down.
Revaluation will erode the value of US dollar assets held by the GCC.
GCC oil revenue, and hence, government budgets, will be worth less in local currencies, thus, forcing governments to cut expenditure. But, this is actually good because it will cut back on inflation pressure.
GCC non-oil exports will be hurt if the local currencies are allowed to appreciate.
Inflation is benefitting some segments of society, e.g. asset-owners and businesses.
There is no place to hide
The uncertainty regarding the dollar peg and inflation is making life difficult for businesses, workers, consumers and financial institutions alike. Market expectations of a revaluation and speculation will not die down as long as inflation continues and a credible anti-inflationary policy is not implemented and explained.
By Khan zahid
© The Peninsula 2008
