Dissecting Inflation

Why does inflation matter?
High levels of inflation are negative for economies for a number of reasons. Strong inflation levels are detrimental as they lead to distortions in the economy and give confusing price signals to producers. For individuals on fixed incomes, the rise in prices increases the cost of living, eroding purchasing power. Furthermore, for investors it erodes the value of saving, while effectively reducing the real rate of borrowing for debtors. Meanwhile, if inflation is higher than the level in comparative countries, export competitiveness of goods and services is lost, assuming no compensatory currency adjustment.

With regards to the GCC countries, high inflation levels hamper the diversification of their economies due to difficulties in attracting foreign direct investment. For instance, the higher inflation level is increasing the cost of living in Dubai. In its Cost of Living Survey, Mercer Human Resources Consulting place Dubai as the 25th most expensive city in the world in 2006, out of 144 cities ranked; Dubai's ranking jumped from 73rd position in 2005. Areas of diversification, such as tourism and financial services are becoming less competitive. Indeed, there are indications that the cost of living has resulted in a number of smaller companies looking to move away from Dubai to cheaper locations in the Middle East. Furthermore, a number of expatriates leaving the emirate have highlighted increasing costs as one of the factors behind their decision. The IMF noted in 2006 that inflation remained one of the largest challenges for the UAE economy. However, it has to be noted that FDI into the UAE remains strong, reaching USD 19bn in 2005, suggesting the UAE remains competitive, at least for now.

Measuring true inflation levels
There has been some concern that the CPI data does not adequately measure actual inflation levels in the GCC economies. For example, in its latest article IV consultation report on the UAE (released in July 2006), the IMF indicated shortcomings in the methodology used to compile CPI data, including outdated weightings, lack of imputations for missing data and different reference periods. Although the IMF estimated that inflation increased by 8% in 2005 (compared to the government figure of 6.0%), it highlighted the risk of inflation being even higher. Indeed, in June, at the release of an IMF publication in Abu Dhabi, even the UAE central bank governor Sultan Nasser al-Suwaidi indicated the authorities are not entirely sure what the current level of inflation is.

As a result, we conducted a survey to measure price rises in Jordan, Bahrain Oman, Qatar, and UAE for Standard Chartered Bank employees. We had two main aims for the survey: 1) to get data on key components of CPI, such as price changes in rent, education and weekly shopping baskets; and 2) to understand the main drivers of inflation in the different countries. Although we did not conduct an official survey in Saudi Arabia, a phone survey was conducted to gain anecdotal evidence. We had the strongest level of responses for UAE, which we believe are statistically significant. The results of the survey were used as guidelines for our CPI inputs. Using our survey results, we have revised our inflation estimates and forecast for Qatar and UAE and feel that the IMF/government figures underestimate inflation in these two countries. While we have revised our inflation forecasts elsewhere in the region, this is more due to a reevaluation of inflationary pressures rather than a direct consequence of the survey itself.

Rising rents pushing costs
In the case of Dubai and Qatar, the main factor behind the rise in prices in has been infrastructural bottlenecks that have not been able to keep up with the strong growth, investment levels and the subsequent increase in the inflow of people. This is especially the case for non-tradable services, where increased demand cannot simply be met by increasing imports, most notably housing, which has led to marked increases in rental costs. Furthermore, there is a time lag for the housing supply to hit the market.

According to our survey results, average rents increased in Dubai in 2005 by 22.5% in 2005 and was the main factor behind inflation in the UAE accelerating to 10.4% in 2005. With regards to Qatar, the results of our survey indicate that rents increased by 51.3% in 2005. As a result, we estimate a higher inflation level in Qatar for 2005 of 11.1%, higher than the official figure of 8.8%.

The increase in rents has resulted in costs increasing in other areas. For example, schools have increased their fees to cover their higher rental costs. According to our survey, education costs increased by 27.9% in Sharjah and 16.6% in Dubai in 2006. In addition, there is evidence that wage demands have also increased as a result of the higher rents and educations bills. There are indications that these price increases are making it harder for some companies to recruit and retain junior and middle ranking staff.

UAE inflation to further accelerate in 2006 before falling in 2007
We have also increased our UAE inflation forecast for 2006 and are forecasting inflation will further accelerate to 13.8%. This is a result of rents increasing in Abu Dhabi and Sharjah. Abu Dhabi is going through a similar trend as Dubai earlier, with higher investment and spending levels. Our survey indicates that rents will increase by 36.6% this year in Abu Dhabi. This is below the 50% increase in rents indicated by the Abu Dhabi Chamber of Commerce and Industry (ADCCI) for 2006, but rent increases will still contribute 7.3 percentage points, or over 50%, to overall inflation to the UAE. Just to stress the sensitivity to the Abu Dhabi rent increase assumption, were we to input the ADCCI estimate into our model, UAE inflation in 2006 would jump to 16.9%. With regards to Sharjah, rents have been increasing as a people relocate from Dubai in respond to the increasing cost of living. This has resulted in Sharjah rents increasing in 31.6% in 2006.

These figures reaffirm our view that inflation in the UAE will remain high, although the dynamics within the UAE will change. Price increases will decelerate in Dubai as increase supply comes into the housing market. Indeed our inflation figure for Dubai in 2006 falls to 9.3% from 12.7% in the previous year. Our survey indicated that rent costs increased by 23.7% in 2006; however, we believe this is a result of overlaps from 2005. We are forecasting the increase in rent to fall to 16% in 2006. This is marginally above the government cap on annual rent increases of 15% as there are indications that some landlords have increased prices by more than 15%, despite this cap. Going forward, the inflation in the UAE is forecast to decline to 9.6% in 2007 as the buy inflation forced 2% with increased housing supply entering the market.

Expatriates versus nationals
In the case of the GCC countries, it is important to note there is a difference in the inflation levels felt by nationals and foreigners. In the majority GCC countries, a number of benefits are provided to nationals. For example, UAE nationals are provided with land to build a house and can apply for a soft loan to finance the building of a house. Other differences include the fact that UAE nationals pay less for electricity than expatriates and are not charged for water. In the case of Saudi Arabia, the government gives land to Saudis to build a house. In addition, a SAR 300,000 loan is provided for 25 years. Over the term of the loan, only SAR 260,000 has to be repaid in total. Furthermore, in the GCC countries, education tends to be free for public schools. Indeed, the majority of the nationals that responded to our survey indicated they did not rent. This factor is most likely a reason for the lower official estimates of rent inflation in the UAE and Qatar as the majority of the rent increases would have been felt by expatriates. Taking these factors into account, we reduced the weighting of housing in the basket to 32% in the UAE from the government weighting of 36.1%, while increasing the weighting for Qatar to 27% from around 21%. Meanwhile, we reduced the increases in education costs when inputting our data for all the GCC countries.

Strong growth in liquidity
Elsewhere in the GCC, although inflation levels have remained manageable, they have been accelerating. For example, in Saudi Arabia in the first five months of 2006, CPI increased by 2.2% y/y compared with 0.4% y/y over the same period in the previous year. Anecdotal evidence suggests there has not been the sharp increase in rental costs in Saudi Arabia and Kuwait, and the increase in Oman has been muted. One of the factors behind the acceleration in inflation is the high liquidity in the GCC. The US dollar peg has meant that monetary policy and interest rates have had to be in line with the US' policy and not based on needs of the regional economies.

Despite the Fed's tightening cycle, interest rates in the GCC are still low, especially in the backdrop of extremely strong growth in government spending. Indeed, in the case of Qatar and the UAE, interest rates are negative in real terms. This is reflected by strong money supply growth in the GCC, which is adding to inflationary pressure. Broad money growth is boosted by the strong credit growth to the private sector, which ranged from 12% y/y growth in Oman to 65% y/y in Qatar in 2005.

Increased imported inflation
Furthermore, the weakening of the US dollar against other major currencies is contributing to higher imported inflation. As all the GCC currencies are pegged to the US dollar, and much of the region's imports originate from Europe and Asia, this weakening is resulting in rising imported prices.

One of the main categories pulling up inflation levels is foodstuff and beverages, which tend to be imported. Furthermore, other imported goods are likely to be placed in the Other Expenses & Services category, which has seen strong growth in 2006, corresponding with the weakening of the USD. Meanwhile, fuel costs fell in Q2 2006 in Saudi Arabia after the government reduced gasoline and diesel prices by around 30% in order to boost domestic demand and soften the blow
of the stock market crash, which has hurt many ordinary Saudis.

Allowing currencies to strengthen
One option would be to allow regional currencies to appreciate against the US dollar. Indeed, Kuwait's revaluation of the KWD was meant to offset the impact of the weakening US dollar. Inflation rose to 4.1% in 2005, due to a time lag for imported inflation to be felt in the domestic economy. According to the wholesale price index, the average rise in prices of imported items between 2004 and 2005 was 4.8% - compared with 3.3% for domestically produced items.

The role of subsidies
In the case of Jordan, inflation accelerated to 9.2% y/y in June 2006 and averaged 6.2% in H1 2006. As a result, we have increased our 2006 inflation forecast for Jordan to 6.5%. The main driver of inflation in Jordan is the reduction in government fuel subsidies. In April 2006, the government endorsed a 12% to 65% price hike on fuel derivatives. This was the third increase in less than a year and the steepest. In H1 2006, the Housing Fuel component of CPI increased by 29.4% y/y and Transport & Communications increased by 11.2% y/y. However, from a fiscal standpoint, the government's decision to increase fuel prices is to be welcomed to avoid the budget deficit deteriorating further.

Policy implications
There are limited policy options available when inflation is being driven shortages in housing and an increase in rental costs. The rise in rent cost would not be affected by an increase in interest rates. Nevertheless, price pressures linked with rents are likely to be transitory and are forecast to come down with greater housing supply coming onto the market. But fiscal policy is working against this trend, albeit understandably. It is vital for the oil exporting countries to increase investment, both for improving infrastructure and to diversify their economies to generate long-term sustainable growth. But it is exactly this type of investment which has, by increasing the level of imported labour, led to the dramatic rise in rents.

However, the other two factors driving inflation in the region are linked with the local currency pegs to the US dollar. Although inflation levels remain manageable in the GCC countries that are not facing steep rent increases, rising prices highlight the desirability for increased monetary flexibility. We believe that greater foreign exchange flexibility, such as monitoring the GCC currencies against a trade weighted basket, would have a number of advantages, including providing the central bank with greater monetary tools.