GCC citizens should brace themselves for an increase in inflation this year but it bodes well for currencies and import costs, according to experts.
Influenced by internal and external factors, the inflation rate in Arab countries may reach 9.8 per cent and 9.6 per cent in 2017 and 2018 respectively, the Arab Monetary Fund predicted in its latest Arab Economic Outlook (AEO) report.
The report said 2016 saw a rise in inflation rates in the Arab countries as a group to roughly 8.4 per cent, compared with the approximately 6.6 percent recorded during 2015.
The report said: ”This increase reflected the effect of reforms adopted to rationalise subsidy systems, especially for fuel and energy products in most of the Arab countries, as well as the impact of measures that have been taken by some countries to rationalise imports of luxury goods due to of pressures on the exchange rates. The inflation rate in 2016 was also affected by the internal conditions in some countries and their impact on the supply of goods and services.”
Explaining internal and external factors that affect inflation in Arab countries, the AMF said: “Internally, the general price level will be impacted in some Arab countries by the continuation of reforms aiming at rationalising subsidy systems, the adoption of value-added taxes, as well as the tendency towards imposing taxes on harmful goods. On the other hand, the expected improvement in the agricultural production will mitigate part of the inflationary pressures in some Arab countries.”
About external factors, it stated the inflation rates will be influenced by the expected increase in international oil prices, in line with the agreement between the main oil-exporting countries to adjust production, as well as the expected increase in the dollar value against the other major currencies, which will reduce the value of imports in Arab countries adopting fixed exchange rate regimes against the dollar.
Stronger GCC currencies
Economists at Citi Research forecast a ten per cent appreciation of the dollar against the euro, partly due to the expected fiscal stimulus and rising rates under a Trump administration.
Citi said in its Middle East Economic Outlook: “With the (partial) exception of the Kuwaiti dinar, GCC currencies are pegged to the dollar, meaning that these too will strengthen in 2017.”
The report argued that a strengthening currency reduces the cost of imports, thereby strengthening the terms of trade. “This reinforces the impact of rising oil prices, which has helped the terms of trade improve by 61 per cent since the start of the year.”
By the end of 2017, the strengthening dollar should see GCC terms of trade improve by almost 90 per cent relative to their nadir in January of this year (still more than 50 per cent down from its peak in June 2014), said the report.
“Strengthening terms of trade are generally a good thing for an economy as they imply a higher standard of living and stronger economic growth, particularly where economic inputs are largely imported. They also imply lower inflationary pressures as the imported basket of consumption will see price deflation,” economists explained.
In the GCC, where a large percentage of domestic consumption is import-dependent, this effect is momentous.
The report said: “On the other hand, a strengthening in the terms of trade may not be such a good thing in the context of efforts to diversify GCC economies. A stronger currency erodes competitiveness, for example, which will have a negative impact on non-oil exports such as tourism, a major pillar of the economy in Dubai and Oman.”
Stronger currencies hinder inward foreign direct investment (FDI) flows as operating costs for foreign companies rise. “Finally, it dampens incentives for import substitution, reducing the viability of nascent domestic industries which have to compete with cheap foreign imports,” economists at Citi argued in the report.
All of these are potentially negative for GCC economies as they seek to grow the private non-oil sector. “Either way, we do not foresee any changes in GCC foreign exchange policy in 2017. That is not to say pressure will not build on the pegs during this time.”
The research argued that there are downside risks to oil prices that could renew speculation, for example, or capital outflows could accelerate in an environment of tighter US monetary policy.
“Also, a new theme that may emerge in 2017 is the need for greater monetary policy independence in the GCC given the rising divergence between the US business cycle (where growth is accelerating along with inflationary pressures) and the GCC cycle (where it is decelerating). This was a key driver behind peg speculation in 2007-08,” economists said.
How will it affect you?
Here are some of the ways an increase in inflation may affect everyday lives of GCC residents:
- The report forecasts an increase in oil prices.
2. Economists do not anticipate changes in the GCC foreign exchange policy in 2017.
3. GCC currencies are pegged to the dollar, meaning that these too will strengthen in 2017.
4. Stronger currencies deter foreign direct investment (FDI) flows as operating costs for foreign companies rise.
5. Terms of trade have improved by 61 per cent since the start of the year, according to the report. It is a precursor to a higher standard of living and stronger economic growth, particularly in the GCC where most domestic consumption is dependent on imports.
6. GCC terms of trade are expected to improve by almost 90 per cent by the end of 2017, the report says.
7. Fixed income groups will be affected because their salaries will not be revised to include the cost of living even as prices of items soar.
8. A higher rate of inflation can make repaying loans easier because they can end up paying back less money if the interest rate is lower than the rate of inflation.