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Cevik: the Gulf needs to revalue, and fast

February 20, 2007

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Serhan Cevik has published a series of interesting notes on the Gulf.  Last week, he gave away the Gulf’s dirty little secret: an awful lot of the Gulf’s foreign assets are still in dollars.  This week, he highlights how the GCC’s dollar peg – combined with an understandable desire to put the GCC’s oil money to work at home – is leading to rapid inflation.  Cevik:

…Exchange rate regimes pegged to the US dollar have also turned into a channel for importing inflation  …. Consumer price indices show a clear upward trend in inflation in all oil-producing countries, but we believe that measurement errors in outdated official figures understate the degree of acceleration in inflation. For example, in the United Arab Emirates, independent surveys point to an inflation rate of 15-25%, as opposed to 10% according to the official index. Given the extent of liquidity abundance and the mix of extremely accommodative macroeconomic policies, the behaviour of non-tradable prices is the obvious culprit. But we should not overlook the role of imported inflation. Pegged to the dollar, the currencies of oil producers in the Middle East have tracked the dollar’s sustained depreciation since 2002, even as their export earnings have soared to record levels. And since the majority of imports come from Europe and Asia, the dollar’s weakness has become a major source of inflation by pushing up the price of imported goods and services.

Indeed.  Oil states dollar pegs combined with surging oil state revenues have led to monetary instability.  The necessarily real adjustment has come from inflation – and with the dollar falling, generating a real appreciation has required a lot of inflation, and led to negative real rates that risk leading to over-investment.

Saudi Arabia is the exception.  Inflation ticked up in 2006 (recorded inflation) but it still remains remarkably low, all things considered.    However, the odds are that Saudi inflation is higher than the reported number, as is the case in the UAE.  More importantly, low inflation rates may not last once the Saudis get around to really spending their current oil wealth.  The Saudis currently seem to have a bit of Dubai envy: $650b in planned “infrastructure investment” certainly has caught the eyes of London’s vigilant I-bankers.  The Saudis have -- up til now -- saved far more of the oil windfall than most.  That looks set to change.

Cevik also highlights something that I think should get more attention.  Real interest rates in most GCC countries – for that matter, most oil countries that peg their currencies – are negative.   Very negative.  Dubai has inflation of say 20% and US dollar interest rates.   No wonder there is an investment boom.   

Russia is less extreme, but real interest rates are negative there too.  No surprise, it too has its mega-projects (Gazprom tower, Gazprom city … ).  And, like Dubai, its own property boom.  Moscow property prices are way up

Much is made of how the oil exporters learned the lesson from the last oil boom, and aren’t ramping up wasteful spending.     Samih Massoud highlights the conventional wisdom:

certain Gulf oil States, especially the GCC member States have learned valuable lessons from the first oil boom and are now exerting great efforts to control and improve the management of public spending ...

He argues that the current oil windfall is being used more productively, both at home and abroad.  At home, wasteful spending has given way to useful investment.  Abroad, the Gulf is buying more real assets -- and financing the construction of more petrochemical plants -- while buying fewer "unproductive" Treasury bonds.

Perhaps true.  But the argument shouldn't be pushed too far.  The gulf states still buy far more financial assets than real assets. Look, for example, at the growth in the financial assets held on the balance sheet of the Saudi Arabian Monetary Agency.  Conventional spending certainly has trended up.  And perhaps most importantly, I suspect that the wave of unproductive spending in the last oil boom will give way to an a wave of  unproductive investment this time around.

Make no mistake: a lot of that investment will be financed by the government.  Some such financing comes about indirectly: when the government repays its domestic debt, it provides the banks with funds to lend to the government’s favored mega-projects.  Cevik:

Since the beginning of 2002, oil exporters have spent less than half of the windfall on imports of goods and services, compared to more than three-quarters during the previous oil booms. While a number of countries in the region have dedicated extra funds to debt repayment — lowering debt-to-GDP ratios by as much as 50% — the abundance of liquidity has also led to rapid credit growth

Initially a lot of that liquidity flowed into local stock markets.  Right now, I expect a lot is flowing into property – and into various government-sponsored mega-projects. 

And in some cases, the government’s funds -- and its borrowing capacity -- will be deployed more directly to support favored projects.    This shouldn’t be a surprise: the government gets the oil revenue, so it is the one with the cash to spend, or invest. 

Throw in an exchange rate policy – pegging to the dollar and allowing real appreciation through high levels of inflation – that generates negative real interest rates and the oil countries are almost begging to create the conditions for a classic investment boom/ bust cycle.  With negative real rates, you don't even need exotic mortgages to generate a real estate boom ...

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