(MENAFN - Arab News) The likelihood of the US dollar weakening further in light of the new wave of quantitative easing (QE2) by the US Fed once again risks exposing the vulnerabilities of Gulf Arab countries whose currencies are pegged to the US dollar. The extent of the US dollars depreciation in the months ahead, as well as the extent of complementarities between US and Gulf economic cycles, is likely to renew focus on concerns surrounding imported inflation, the cost of trade and the sustainability of regional currency policies.
However, in our view, a shift in currency regime would be highly unlikely.
Gulf economies are on a recovery footing and inflation rates are not a concern in most of the region like they were in 2007-08. At that time, vigorous currency reform speculation stemmed from the underlying disparity between the USs struggling economy (forcing Fed rates to fall) and the then-booming economies in the Gulf. Economic cycles are no longer completely out of sync, with loose monetary policy serving the interests of both, and hence upholding the viability of Gulf dollar pegs.
Inflation rates in most Gulf states are rising after a period of rapid deceleration, and deflation in the case of Qatar and the UAE, during 2009. It was inflation reaching double-digit levels in 2007 and 2008 that steered currency speculation as the weak US dollar drove up imported inflation for import-dependent Gulf economies. In 2008, inflation averaged 15.2 percent in Qatar, 12.5 percent in Oman, 12.3 percent in the United Arab Emirates and 10.6 percent in Kuwait. Saudi Arabias inflation rate accelerated at an alarming average pace that year to a decades-high 9.9 percent while Bahraini inflation was more subdued at 4.7 percent. Any US dollar appreciation in 2011 would dissuade anyone from expecting a quick change in policy. The region is known for not changing its mind based on temporary, short-term fluctuations and views.
Even with the current phase of US dollar weakness, a return to such levels of inflation is unlikely through to the end of 2011. Inflation in Saudi Arabia is now the region's steepest - climbing about 6 percent in August - but it is resulting more from domestic supply pressures rather than any acute import inflation pressures and a commensurate depreciation in the real effective exchange rate. In the UAE, for the first nine months of 2010 inflation was 0.6 percent while Qatar experienced deflation of 3.2 percent in the first three quarters.
Saudi inflation is neither comforting nor alarming at the moment, reaching a historically high 5.2 percent in the first nine months of 2010 due to a mix of high food prices, continued steep rents and a general rise in the cost of goods and services. Even in Saudi Arabia, though, inflation is nearly half its 2008 peak - and price rises are not fixable with monetary policy at the moment.
Economic circumstances in the Gulf region are starkly different to what they were during the cycle of US dollar weakness that spurred streams of hot money into Gulf currencies and assets in 2007 and 2008. Gulf economies are recovering following a challenging 2009, during which aggregate private demand has declined across the region. Money supply growth is subdued throughout the region and private sector investment is taking a very gradual path toward recovery. Banks are holding on to their liquidity due to their reluctance to jump-start lending, while the private sectors appetite for expansion remains anemic compared with pre-2009 realities. Capital inflows into emerging markets are expected to remain strong; however, Gulf economies are likely to receive a small fraction. Regional equity markets could receive a bit more foreign capital, on a selective basis, but real estate would not as investors still foresee further price corrections due to oversupply. Moreover, as the revaluation debate is not making a comeback, an inflow of capital in the form of bank deposits is not expected to recur.
Across the Gulf, aggregate demand remains a far cry from pre-crisis levels, the real estate frenzy has subsided, wage inflation is subdued and an abundant labor supply is available. We expect inflation in Saudi Arabia and the UAE - the largest Gulf economies - to be contained. Saudi inflation is likely to average 5.3 percent this year and 4.7 percent in 2011, while UAE inflation should not exceed 1 percent in 2010 and 3.1 percent next year.
Still, further US dollar weakening does not bode well for Gulf economies. Gulf states are heavily dependent on imports of food, machinery, cars, luxury goods and other items from Asia and Europe. Sharp fluctuations in the US dollar could lead to additional variations in the cost of importing various commodities. We do not expect imported inflation to pass through immediately, however, since Gulf economies denominate more than 60 percent of their letters of credit in the US currency. Inflationary pressures among key trading partners - more than 50 percent of Gulf imports are sourced from China, Japan, the euro zone and the US - have also not reached alarming levels.
While Gulf import bills may swell in the coming months should US dollar weakness be sustained, the cost will be largely offset by greater state revenues stemming from stronger exports to Asia and higher oil prices. Still, higher oil revenues cannot cushion local populations from short-term price shocks, and the previous policy of subsidizing food and increasing wages and salaries has price pressure perils, negative market consequences, harbors inefficiencies and furthers entitlement expectations.
By John Skakianakis