Fitch: GCC oil boom/currency pegs bring faster inflation

However, potential sovereign credit ramifications - mainly fiscal and socio-political - are modest, being outweighed by the impact of continued high oil prices on public finances and sovereign balance sheets.

In a special report published today, Fitch notes inflation is already in double digits in Oman, Qatar and the UAE and close to 10% in Kuwait and Saudi Arabia, leaving only Bahrain with a more modest inflation rate of around 5%.

'GCC inflation is its highest in over 30 years. As in the seventies, some of the region's increased oil wealth is feeding through into higher prices, and with policy tools limited, inflation will rise further before it starts to fall,' says Richard Fox, Head of Middle East and Africa Sovereign Ratings at Fitch.

The region's increased oil wealth warrants an increase in real exchange rates, which can come either though a revaluation of the nominal exchange rate or higher prices, or a combination of the two.

Given the decision to stick with dollar pegs, Kuwait excepted, higher inflation is inevitable.

'Real interest rates are increasingly negative; fiscal policy is expansionary and administrative measures have had little impact on the main inflation drivers - rent and food,' says Charles Seville, Associate Director and the report's main author. 'The main hope is that improved real estate supply, moderation in food prices and more restrained government spending will start to reduce inflation later this year.'

Higher inflation has many causes. Spending oil revenues, even at a measured pace, boosts demand and liquidity growth. Although imports have satisfied much demand, shortages are mounting and costs rising.

Property markets are especially tight as expatriate labour brings massive population growth.

Rents are the main cause of high inflation in the two highest inflation countries - Qatar and the UAE.

Dollar pegs and falling US rates have dictated increasingly negative GCC real interest rates, which encourage bank borrowing and purchase of real assets, especially property.

Credit growth accelerated throughout the region last year, exceeding 30% everywhere but Saudi Arabia and 50% in Qatar.

Fitch believes this channel to higher inflation is more important than the direct impact on import costs of weaker dollar-linked currencies.

Nevertheless, Fitch notes that Bahrain, with the lowest inflation rate, sources a larger share of its imports from within the region, compared to its GCC neighbours.

Inflation in Saudi Arabia and Oman has been more affected by rising food prices.

With at least some commodity prices now moderating and housing costs less of a factor, inflation may abate later this year.

By contrast, in Qatar and UAE, lower inflation must await improved property supply.

Higher inflation brings some credit concerns, though these are largely offset by the impact on public finances and sovereign balance sheets of higher oil prices.

Governments have moved to defuse potential socio-political pressures by raising wages and subsidies to preserve purchasing power of their citizens.

Countries with the highest inflation are also best able to shoulder such costs, with budget surpluses of at least 20% of GDP expected in all except Bahrain and Oman this year.

Budgeted oil prices are creeping up, but actual oil prices remain well above levels that would raise serious credit concern.

A bigger worry is the contingent liabilities inherent in rapid bank lending growth and booming property markets which have often preceded banking system stress elsewhere.

However, the trigger would most likely be lower oil prices or a geopolitical shock, rather than the more usual sharp policy tightening which is unlikely.

Moreover, as GCC banking systems are generally strong and sovereigns willing and able to support them if required, sovereign credit concerns from this source are also limited.

Higher costs could mar the attractiveness of the region as a place to work and do business and will reduce the viability of some projects, all of which will hamper the region's diversification strategies.

Rising and increasingly divergent inflation also poses another challenge to the GCC's goal of monetary union by 2010.

With a host of technical and political issues still to be addressed, that target looks increasingly likely to be postponed.