The economists on 2008

A move to linking the regional currencies to the basket of currencies will give greater interest rate flexibility.

Mary Nicola: Our forecast for inflation for UAE in 2008 will be 9% - a slight decline from this year, largely because we are factoring in more housing on the market; Qatar inflation will also decline from 14% this year down to 9% next year. Saudi will continue to see low inflation levels relative to the region at around 3.5% . However, it is still high for Saudi Arabia with a GDP per capita of around US$15,000.

Inflation is a concern throughout the region. Last week we saw Saudi clerics expressing their concerns. Prior to that, the government summoned two separate commissions to look into the causes of inflation and possible solutions. There is a lot of social and political pressure to address inflation.

Tristan Cooper: Inflation is the most important short-term economic challenge for GCC countries as it threatens to undermine economic competitiveness and the diversification effort.

In our view, the main drivers behind inflation in the GCC are severe capacity constraints in booming economic sectors such as real estate, the rapid growth in expenditure by governments and other public sector entities, exchange rate pegs to a falling US dollar, surging private sector credit growth, and the high level of immigration in some GCC countries that is ramping up demand in capacity constrained sectors. Given the breadth and depth of these drivers, it is likely that inflation will persist into 2008. The primary effect on businesses will be the rising price of inputs and escalating wage demands that will increase costs and hamper budgetary planning.

Is there any danger of the region losing its attractiveness because of this?

Monica Malik: The one area of concern is labour. Inflation means that it will become harder to attract labour. Costs are going up and thus less is being saved. Furthermore, with the weakening of the dollar (and subsequently the dirham owing to the peg) the amount being remitted in foreign currency terms (sterling, the Indian Rupee etc.) is less.

Mary Nicola: There could potentially be a concern - simply because it will be more difficult to attract businesses and workers to a region with higher costs, and a weakening currency.

Tristan Cooper The main danger is that inflation continues to outpace productivity growth over an extended period of time, thereby leading to a deterioration in unit labour costs relative to competing markets.

There is risk that this will happen if inflation accelerates further and the main causes of inflation listed above are not tackled over the short to medium term. However, it is worth bearing in mind that the average inflation rate for emerging markets globally is around 6%.

Only two GCC countries, the UAE and Qatar, have inflation rates that are substantially in excess of this level. Furthermore, our high ratings for GCC countries continue to be supported by strengthening government balance sheets.

Should the GCC repeg or move to a basket of currencies?

Monica Malik: Being tied to the dollar means two things - firstly your currency depreciates in value with any dollar weakness, and secondly you have to follow US monetary policy in regards to interest rates. Repegging the currency only solves one problem - it appreciates your currency in a one-off move, but if the dollar continues to weaken then you have the problem and most likely increased speculation of another revaluation. If one believes that the dollar is structurally weak, then the main benefit of the peg (ie currency stability) is removed.

Furthermore, it does not address interest rates - which for the GCC are too low - there is already ample liquidity here, and low interest rates increases the money supply (lower borrowing, easier credit). Unless the GCC moves to a basket of currencies it will not gain greater interest rate flexibility. Also GCC countries have to develop other monetary tools.

Mary Nicola: The booming economies of the GCC should drop the peg and move to a basket of currencies. The key here is valuation and flexibility. These economies are tied to a weakening dollar.

As regional economies continue to diversify they will need to set their own monetary policy and have the tools to do so. You don't want your real economy to absorb the shock (ie inflation); the exchange rate should absorb the shock via appreciation or depreciation.

Tristan Cooper: There are pros and cons to every exchange rate policy option, whether it is no change, appreciation within the dollar peg, repegging to a basket, or the most radical proposal of a free float.

In each case there is a variable trade off between long-term exchange rate stability amid volatile external flows versus the benefits of gaining greater control over monetary policy in order to smooth economic cycles.

However, the overriding current motivation for a shift in exchange rate policy is the need to reduce inflation. In our view, while a potential exchange rate appreciation (in whatever form that took) would inevitably have a short-term beneficial effect on imported inflation by reducing the price of imported goods, it would not be a panacea because it would not address the other primary structural sources of inflation outlined above.

Will GCC currencies be repegged - by how much?

Monica Malik: We believe so - likely to be between 3-5%. At the moment, the focus of GCC countries is moving together. Currency stability is also a key issue. We believe that there is a greater than 60% probability of a change in currency policy in the first half of 2008 by one or more states (UAE and/or Qatar - to a currency basket)) or the GCC as a whole (a revaluation against the dollar).

Mary Nicola: Ideally the GCC should revalue by 20%. However will likely be between 5-10. Under 5% signal would not be enough of a signal to curb market speculation nor would it be a strong policy response.

What will happen to GCC currencies next year? Will they continue their decline, and how will that affect Gulf businesses?

Simon Williams: For now at least, the fate of the region's currencies will remain directly tied to the US dollar. 2007 was a bad year, with dollar weakness driving the Gulf currencies downward at a time when their fundamentals would otherwise have been pushing them sharply upward. Near term, it is hard to be optimistic.

The US economy is in trouble and if US rates continue to fall, the dollar will decline and take the Gulf currencies with it. As 2008 progresses, though, we expect to see the dollar stabilise, and possibly even begin to recover. In essence, everything that can go wrong for the dollar has already taken place - it's already in the price. As UK rates continue to fall and the Euro zone growth slows, the dollar - and by extension, the Gulf currencies, should start to see some support, at least against the majors.

I don't expect this to result in the Gulf currencies regaining the ground they have lost over the last year or so, though. A modest dollar recovery also shouldn't put an end to the debate over the future of the Gulf states' currency regimes.

Monica Malik: We expect that the dollar will rebound in Q1 2008.

Will next year be a good year for GCC businesses?

Simon Williams: This region is in excellent shape. I don't know of a more exciting economic story in the world, or a more promising period in this region' economic history.

What we are passing through is a long-term adjustment to the new oil price environment - an era that sees this region's oil production generate in less than three months what it used to take an entire year to accumulate.

Monica Malik: With strong domestic demand (both private consumption and investment), the outlook for the non-hydrocarbon sector remains strong. The non-hydrocarbon sector growth will continue to outpace hydrocarbon growth. Along with strong demand, the reform and liberalisation is also supporting the outlook for a number of sectors, such as financial sector and telecoms sector. The outlook for business will remain very strong.

The Panel:

Simon Williams is HSBC chief economist for the Gulf markets. He joined HSBC in 2006 and has more than a decade's experience as a Middle East analyst.

Monica Malik is a senior economist at Standard Chartered Bank in Dubai.

Mary Nicola is a senior economist at EFG Hermes

Tristan Cooper is Moody's vice president/senior analyst in its Sovereign Risk Unit. He is the primary sovereign analyst for the Middle East region.

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