IMF vindicates Saudi dollar peg

A robust economic performance, oil revenue windfalls and strengthened government finances as well as the government's commitment to diversification have been accompanied by the announcement of infrastructure projects valued in excess of $350bn.

However, the huge expansion of wealth has made the economy vulnerable to rapid inflation now at double-digit levels.

The situation is a challenging and new phenomenon that is putting increasing strain on key project areas, such as new refineries, where budget where set up to two or three years earlier when the global outlook was very different.

Construction costs throughout the GCC have risen 20% or more in 2008 as demand for materials and labour increasingly outpaces supply. At the same time inflation is seeping into the kingdom through higher food prices across world markets.

Saudi inflationary pressures

Food prices increased 7% in 2007 and are expected to record at least a 12% rise in 2008. The domestic market is also pressured by fast rising rents which are as much as 25% above the level of a year ago. Food and rents together make up 40% of the consumer price index.

The situation has been aggravated by the weakened state of the US dollar to which the riyal is pegged.

All of the GCC states, except Kuwait, have their currencies linked to the value of the US dollar which means that the Gulf countries are severely limited in their monetary policies which effectively follow US Federal Reserve interest rate policy.

In present circumstances if applying classical monetary policy, Saudi Arabia and other GCC states would be raising interest rates to dampen their overheated economies rather than maintaining low interest rates in parallel with the faltering US economy.

Dollar peg provides macroeconomic stability

In spite of this the kingdom's currency peg to the dollar provides macroeconomic stability benefits that currently outweigh its contribution to short-term inflationary pressures the International Monetary Fund has said, following its recent annual consultation with Saudi Arabia.

Most of the IMF's executive board consider the benefits of maintaining the peg to outweigh the cost of higher short-term inflation, provided that current inflationary pressures prove temporary.

The IMF projects that Saudi economic growth, boosted by increased oil production and growth in non-oil sectors, after allowing for inflation, will reach 5% in 2008. Inflation is predicted to peak at 10.6% this year easing in subsequent years.

But some believe that if inflation persists and GCC monetary union is delayed, then consideration should be given to alternative exchange rate regimes involving a revaluation of the riyal.

The increasingly daunting problem for Saudi-based companies is that they have to prepare budgets with mounting uncertainty over inflation trends in material and personnel, transportation and other costs that could easily unbalance the value and profitability of projects.

See also:
Saudi investments abroad valued at SR1.4 trillion
Saudi non-oil exports top SR10bn in May