The economists on 2008

To gain insight into the state of the Gulf economy in 2008 who better to turn to than the region's leading economists. David Westley asked HSBC's Simon Williams, Standard Chartered's Mary Nicola, EFG Hermes' Monica Malik and Moody's' Tristan Cooper to give us their views on what 2008 holds in store for businesses across the region.

What are the threats to the GCC from outside the region? What are the dangers of the US and Europe going into recession in 2008?

Simon Williams, HSBC:The outlook for the US is troubled. Growth will slow down in the first half of the year, although quite how much is difficult to gauge at the moment. Recession is possible, but we don't believe probable.

In Europe, the UK like the US, faces difficult times. Mainland Europe is at a different phase in the economic cycle, but will feel the impact of slower growth in the US and UK over the first half of next year.

Tristan Cooper, Moodys:We consider an outright recession in either the US or Europe to be unlikely. We rather predict a slowdown in growth given the difficulties in the housing market and the persistent turbulence in financial markets. Such a slowdown will inevitably affect global growth, which is likely to decelerate in 2008 from its very strong performance over the past four years.

How shielded are the GCC economies from what happens elsewhere?

Simon Williams:The underlying story in the Gulf is robust and as well protected as anywhere in the world from a US recession.

The key issue for the Gulf is the impact of a developed world slowdown on emerging Asia.

High oil prices are premised on China's demand for energy continuing to rise, and if China's growth stalls, oil prices will fall. Historically, the link between emerging market growth and developed world trends was very close, but in recent years we see growth trends have decoupled. What we will find out next year is how thorough and how deep that decoupling actually is.

Remember, though, that the GCC does not need oil to be at a US$100 per barrel to prosper. This region needs oil to stay above US$45-50 per barrel for public finances to be in surplus and for investment projects to be funded over the medium term. I don't see prices falling below that level any time soon.

Monica Malik, EFG:Hermes Unless there is marked slowdown, and both Europe and the US head into a real recession, the GCC is fairly protected. The principal connection is, of course, the price of oil.

Traditionally the US has been the largest importer, and were demand to fall off dramatically because its economy weakened significantly, that could signal lower demand and see prices fall. For oil prices to fall substantially, the recession will also have to spread to Asia.

However, we don't predict that. We expect oil prices to remain strong. While the US remains the biggest importer, we do not see a recession, and emerging economies, particularly China, will continue to fuel demand. In addition commodities - including oil - are being used as a hedge against the dollar weakness - increasing demand, on paper, for oil contracts.

A full-blown US recession could have an impact, but also bear in mind that the GCC economies are structurally stronger, with strong foreign reserve position and continued strong surpluses. Oil prices would have to fall a long way to US$20-30 per barrel.

Most GCC budgets are based on low oil price assumptions and have budget break even points lower than the current oil price or the oil price forecast for 2008. Oman and Bahrain, the two most sensitive economies, with budget break even points just below US$60 a barrel (Brent crude). Meanwhile, the UAE and Qatar have budget break even points below US$40 a barrel.

Mary Nicola Standard Chartered:We saw a measure of how protected the GCC is with the liquidity crisis that affected the US and Europe back in August.

As the US was suffering from a liquidity crunch, the GCC was dealing with ample liquidity. It barely rippled here.

However, while the issues of sub prime [lending to a higher risk market] may not have had much of an effect on the local markets, local markets have been indirectly affected via US monetary policy. The Fed has been cutting rates to contain the problem thereby causing the GCC to cut rates as well.

We predict that by the end of Q1 2008 it will have cut another 50 basis points. If that is the case and if the GCC keeps the dollar peg, then they too will have to cut interest rates. That is at odds with what GCC economies need. GCC economies are booming and there is already ample liquidity in their markets. Monetary loosening is not what the markets need here. They should be increasing interest rates to contain inflation.

There has been considerable money supply growth across the UAE over the few years and that will have an impact in the short and long term. The GCC lacks the monetary tools it needs to absorb the liquidity. There is no bond market to soak up liquidity. Essentially there is too much money chasing too few goods.

Tristan Cooper:The key variable for the GCC is clearly oil prices given that all GCC economies continue to be dominated either directly or indirectly by hydrocarbon export receipts. The futures market still takes a rather rosy view of oil prices, as do we, despite the more gloomy global growth outlook. This is mainly because of booming energy demand in emerging markets, particularly in Asia, and the still relatively low level of spare oil production capacity among OPEC producers.

Hence, we are predicting that global oil prices will rise in 2008 compared to their average level in 2007. This is good news for the GCC.

Will inflation continue into next year? At what levels? Will that affect business in the GCC?

Simon Williams:Inflation has been the key story over the second half of this year and is going to remain the main concern over 2008.

Inflation used to just be a problem in the UAE and Qatar but we have seen price growth pick up across the board, even in economies like Saudi Arabia which previously experienced very low inflation levels.

This will cause some difficulties, but we must remember it is a reflection of the success of the broader economy. When economies double in size in just four years - as the GCC has done - it is inevitable there will be some pressure on prices. Provided we don't see an accelerating inflationary spiral, I am confident that the region can continue to prosper.

However, policy makers will need to be careful, they need to ensure that growth strategies are set for the medium term and that the expansion in domestic demand does not run ahead of what still small economies can actually sustain.

Fiscal policy - public spending - is already expansionary and against a backdrop of high oil prices and rising consumer prices, it will be tempting to agree large public sector pay increases which will feed through into higher private sector salaries, too. This would provide short-term relief but create increasingly serious inflationary pressures down the road. Monetary policy also needs to be reviewed if it is to stem, rather than fuel, inflation. Because of the dollar peg, the region's currencies are weak at a time they should be strong and interest rates are far below their optimal levels.

It may not be enough for policy makers to simply wait for a time when the US and the Gulf are back in synch. The Gulf is strong enough to take matters into their own hands and regain control of their monetary policy and currency regimes.

Monica Malik:The GCC will remain high inflation area, although the UAE will see a slight decline because of lower rental increases. Abu Dhabi will see higher inflation - rent driven - and this will be the main factor stopping the inflation rate falling in substantially 2008.

The region as a whole will see inflation continuing to accelerate in 2008. Inflation will mainly be driven by rents and food price increases. The majority of the GCC countries have embarked on an investment drive, which is leading to a greater influx of expatriates and more pressure on housing - presently the key driver of inflation in the region.

Meanwhile, the dollar weakness will import inflation for food items - exacerbated by the fact that world prices going up anyway... There is also huge liquidity in the region, and strong credit and money supply growth - real interest rates are negative in the UAE and Qatar. However, interest rates have to follow US rates.
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.