The US dollar's fall means inflation's return

The fall and fall of the US dollar is the finance story of the second half of 2003, and threatens to have major implications for 2004.

To start with the most immediate impact on business in the Gulf, prices of goods and services from Europe have risen sharply. That means 10-15% price rises for cars made in Europe, and a sharp hike in building material prices.

This is inflation at its prime cause. For example, last week the Jumeirah Beach Residence, the largest residential project under construction in the region with 6,800 apartments, put its unit prices up by 20-25%. Insiders say the spiraling cost of steel made the price hike essential if the project is to breakeven.

Now as the GCC imports 45 billion euros of goods from the European Union each year, it is not hard to see that inflation is unavoidable. It is impossible to suddenly switch to sourcing all these imports from countries with US dollar linked currencies.

Higher EU import costs will thus have to be passed on to local consumers who will in turn demand higher wages to pay for imports and then local employers will have to raise prices to pay for higher salaries.

This is the classic wage/price spiral of inflation, and in a rapidly expanding economy like the Gulf region then companies should be able to hike prices.

In theory competitive pressure should make this impossible. In reality in the construction sector, for example, it is presently hard to get enough contractors to tender for many projects. The refurbishment of the Hyatt Regency Hotel in Dubai, for instance, was put on hold because not enough contractors expressed interest.

However, inflation works with a long time-lag, and the full effects of the devaluation of the US dollar will not be with us until later next year. Dubai jewelers, for example, are selling off old stock and the new higher prices will not be evident until next year.

Thus all business plans for 2004 should include a consideration of inflation, how to account for it and how to respond. For this will be a very real problem for cash flow and business planning next year.

From an investment perspective inflation favours investment in tangible assets such as real estate and shares, and is bad for fixed income and deposit accounts.

Money left idle in accounts will not only depreciate against other currencies but its spending power will be eroded by inflation, in short negative real interest rates.

By comparison real estate and shares will rise in value as rents and dividends go up. Also those who buy such assets with debt will see inflation reduce the real size of debt at the same time as pushing up nominal earnings.

To conclude, business and investors should watch out for inflation in 2004, but this does not have to be all bad news.