February 4, 2009

Inflation: Cooling Down Overheated Economies

The financial and economic crisis that is plaguing the world may have far greater impact on countries who have not managed inflation well. While inflation has been increasingly pervasive in the G7 as well as in emerging economies, the very highest jumps in the rate of inflation have been registered in the hydrocarbon rich economies of the GCC.

Inflation makes the GCC extremely vulnerable to economic shocks. While the GCC region has been flourishing with economic expansion, surging oil revenues and an influx of foreign capital, in the event of  a sharp and substantial drop in oil prices or a global credit crunch coupled with sustained contagion effects—the GCC’s economies could contract very swiftly and likely stay constricted for some time. Additionally, inflationary threats are likely to be exacerbated as policymakers rally to prevent prolonged downturns by adopting expansionary macroeconomic policies.

“Countries that choose a sustainable development growth model, and who thereby manage inflation and overall macroeconomic stability, typically have an easier time sustaining real GDP growth and can recover far more quickly from contractions,” remarked Rabih Abouchakra, a partner at Booz & Company.

The goal, then, for any country is to structure an economy so it can perform well and recover swiftly no matter what happens. This article examines the root causes of inflation and proposes a holistic approach to policy making that can ultimately help stabilize economies under any circumstances.

The worldwide question is what to do about inflation: developed and emerging economic powerhouses—including the U.K., EU, China, India, and Russia—have all failed to meet their target inflation rates earlier this year. Now is the time for policymakers in countries that don't have strong inflation-fighting and macroeconomic stability systems to develop them.

“The GCC must move from a model characterized by overheated economic growth to one that emphasizes growth through sustainable development beginning with fighting inflation comprehensively,” explained Richard Shediac, a partner at Booz & Company. It must examine the ways governments can influence inflation, including through monetary, fiscal, and exchange rate policy, and trade/market intervention policy. In so doing they can create a holistic policy framework to fight inflation—a macroeconomic stability framework.

Global and Regional Approaches to Measuring Inflation

Measuring inflation is an inexact science. Countries that meticulously measure inflation know that different evaluations work best at different points in the economic cycle. The producer price index, a measure of average changes in prices received by domestic producers for their output, can be an important leading indicator of other types of inflation, as can certain commodities futures price indexes. Commodities futures price indices tend to be imperfect because their components may not fully capture the inputs and real dynamics relevant to any given region. 

Other indicators lag inflation. The GDP deflator is calculated by dividing nominal GDP by real GDP. While the GDP deflator provides a holistic view of price rises, it is not easy for consumers to interpret. The CPI, another lagging indicator, is more intuitive—measuring a fixed and weighted basket of goods in areas like housing, transportation, food and clothing. This is only an accurate measure if it is kept up to date.

This CPI data has been an issue in many emerging economies. The GCC's CPI is based on a basket of goods first used in 1995 and 1996 and hasn't been updated to reflect population changes or new consumption patterns; demonstrated by the numbers in the UAE. The International Monetary Fund and other authorities have given inflation figures for the UAE—the GCC's second-biggest economy—ranging from 15 to 25 percent. Conflicting reports about the real level of inflation encourage behaviours that worsen it: people are inclined to spend out of concern their money may soon be worth less. Economically developed countries understand the limits of inflation gauges, and use multiple tools to reduce the likelihood that any one may give a false read.

The biggest inflation jumps have been in the GCC countries of Saudi Arabia, Oman, and the UAE. Fast growing populations, high wage growth, limited supplies in key areas like housing and relatively immature financial systems are common to each and their inflation rates are highly correlated. “There are regional inflationary pressures that individual countries can not eliminate, which suggests that GCC countries should address some of their inflation problems at a regional level, as opposed to a national one,” stated Chadi N. Moujaes, a principal at Booz & Company.

The Root Causes of Inflation

There are three main causes of inflation in emerging economies. Demand-side, or pull inflation results from a prolonged period of economic expansion, surging oil revenues, an influx of foreign capital, and growing demand for inputs. This is accompanied by supply-side, or push inflation, caused by rising input prices, shortages in supplies of facilities, an increase in government wages and higher rent prices. The region also has built-in inflation: low confidence in officially released inflation figures or in their policymakers' ability to keep prices stable leads for instance workers to push for higher wages—translating into higher production costs and higher prices. In this respect, inflation becomes a self-fulfilling prophecy.

Goods and services inflation, stemming from population growth, is often the biggest contributor to rising prices in emerging economies. This is true of the GCC, where supply-demand imbalances account for more than half of regional inflation. House and food prices have risen sharply in the GCC and in the UAE and rents have risen stridently over the recent period. “The UAE's high rents have persisted despite attempts to cap rent increases. That is an example—not uncommon in the GCC—of narrow economic policymaking that backfires as it is in isolation from an overall macroeconomic policy framework that can equally be used to stabilize or stimulate real activity,” said Mazen Ramsay Najjar, a senior associate with Booz & Company.

Monetary inflation accounts for around a quarter of inflation in the GCC. This is worst where policymakers have not made it a priority—and don't have the tools to sterilize excess liquidity. In the GCC, excess liquidity comes from oil revenues, foreign investments, and capital gains. Real GDP growth (nominal GDP growth adjusted for inflation) should at least match the growth in an economy's money supply after taking into account change in money velocity. Where this doesn't happen, alongside a dearth of savings instruments—prices for consumer goods tend to rise. This has been a problem in the GCCmoney supply growth has outpaced real GDP growth for the last 15 years, growing at triple the pace of real GDP in 2006 and 2007.

Imported inflation can be problematic for emerging economies whose currencies lose value versus the currencies of their trading partners, especially in the GCC, as most currencies are pegged to the U.S. dollar. As the dollar declined between 2002 and early 2008, most GCC currencies lost between 35 and 50 percent of their value against their trading partners. Regional policymakers may find respite now that the dollar is showing signs of recovering. “The right move isn't to express relief that the currency pressure is abating—and postpone a policy reassessment. It is much smarter to take steps now to protect the future,” explained Najjar.

What's Wrong with a High-growth, High-inflation Economy?

Economic growth can't be achieved without some inflation. One result of a growing economy is higher wages, when people earn more; they spend more, adding to inflationary pressures. But uncertainty created by high inflation dampens business’ interest in making capital investments. It encourages borrowing, discourages saving and an unexpected redistribution of income and a disinclination to save, cuts the money available for loans, putting more upward pressure on interest rates. High inflation can also produce hoarding: “consumers buy durables to get rid of cash they perceive as less valuable, producing shortages and instigate new waves of inflationary pressure,” explained Shediac.

Disadvantages of a high-growth, high-inflation economy can be understood by comparing it to an alternative economy that does a good job of managing inflation. The former is an overheated economic growth model and the latter a sustainable development growth model.

GDP growth in the GCC is positive, growing more than seven percent in each of the last two years—there is high nominal GDP growth and a satisfactory level of real GDP growth. In this way—the overheated growth model can function well. In the event of an external shock like a sharp drop in oil prices, this economy is vulnerable to nominal GDP growth falling below the inflation level, leading to stagflation. “Attacking inflation by increasing interest rates causes nominal GDP growth to contract further, yet attacking low growth by injecting more money into the economy causes inflation to surge,” Najjar commented.

Countries that follow a sustainable development growth model thereby managing inflation and overall macroeconomic stability have an easier time sustaining real GDP growth and will recover more quickly from contractions. Policymakers can pursue expansionary policies without worrying as much about the negative effects of inflation—by keeping nominal GDP growth above it. Those using an overheated economic growth model usually have less control over inflation and face extended bouts of stagflation and long recovery periods.

To Fight Inflation Narrowly vs. Comprehensively: The Question for Emerging Countries

While economic policymakers in emerging nations occasionally train their sights on inflation, they tend to do so in narrow ways that may not have the intended end results. In early 2008, the UAE put a cap on rice in response to an increase in commodity prices. Rice exporters cut their rice shipments to the UAE, creating shortages that re-lit food-related inflation.

“Inherent flaws in the structure of many emerging countries' economies lead them struggling to find solutions to the problem of inflation,” commented Moujaes.

There is an undeveloped system of institutional investors and highly liquid investment mechanisms (for instance, mutual funds, pension vehicles, etc.) in the GCC. As oil and other revenues are given as wages, workers tend to spend the money instead of looking to invest it, spurring demand-side inflation. “Domestic investment is also channeled into non-productive support sectors such as real estate, with little being plowed into productive sectors like manufacturing that are key to entrenching economic diversification,” Abouchakra said.

Entities normally responsible for sterilizing the region's monetary base, like central banks and finance ministries, are just beginning to grapple with their options. Sovereign wealth funds that have been buying foreign assets have moved some liquidity out of the region, but any inflation benefit from the funds has been coincidental. The countries in the GCC are struggling with inflation and have fallen into volatile economic growth patterns.

Instituting a Macroeconomic Stability Framework in the GCC

For the region to move to a sustainable development growth model it must start with a macroeconomic stability framework that is holistic; with levers that can help governments to influence inflation: through monetary policy, fiscal policy, exchange rate policy, and trade/market intervention policy. A framework can be useful beyond inflation fighting if it is robust enough: It can provide the mechanisms for stimulating economic growth.

GCC central banks should approach monetary policy maturely to become proficient at using open market operations, including sales and purchases of government debt, to control the money supply. An effective fiscal policy entails using discretionary government spending programs to spur growth in important sectors of the economy or strategically adjusting direct or indirect tax rates. A more engaged exchange-rate policy might mean intervening in currency markets or hedging the country's currency exposure. In the long term, it may mean rethinking how currency rates are determined and unifying around a single currency, allowing for further economic integration among GCC economies.

Finally, the framework needs to take account of trade and market intervention policy, using price caps or subsidies, restricting supply and demand, or formulating new trade agreements when needed

“The government side of an inflation-fighting program must work alongside the development of a more supportive private market, by deepening the region's monetary bases to encourage savings, and absorb excess liquidity,” said Abouchakra. Banks must create improved savings vehicles and channel these to foreign assets via macroeconomic policy entities (MEPEs). Central banks are one macroeconomic policy entity; sovereign wealth funds like the Abu Dhabi Investment Authority and the Kuwait Investment Authority are a second. A third prospective MEPE, which policymakers could help form—are dedicated and specialized ‘capital control funds’ that would act as a support mechanism to banks.

Policymakers must also find ways to encourage more investment in export-oriented productive sectors, such as manufacturing and tourism, and in enabling sectors of the domestic economy, such as financial services, healthcare, and education. The output from these productive sectors should be partly reinvested in productive sectors or channeled through the MEPEs.

Six Key Imperatives for GCC Policymakers

The challenge for GCC countries is to create their own macroeconomic stability frameworks and to make sure these are integrated and coordinated regionally and globally. “There need to be formal ways in which the region's central banks interact with each other and those outside the GCC,” Moujaes commented. There are six key imperatives the region's policymakers must keep in mind:

  • Develop Inflation-detecting abilities by putting in place and continuously updating state-of-the-art methodologies and tools for measuring, forecasting, and analyzing price increases.

  • Treat price stability as a continuous challenge that requires a comprehensive approach, rather than something that can be dealt with sporadically and partially. If designed correctly a framework could capture all the important levers of macroeconomic policymaking.

  • Involve all market participants in the mission to fight inflation. Helping financial entities deploy modern currency hedging tools and other mechanisms is part of the solution, and could be instrumental in building a shield against inflation.

  • Create more effective sterilization mechanisms and more productive economic bases to channel and absorb excess liquidity.

  • Adopt a model of sustainable and resilient economic growth, with a focus on maintaining positive real GDP and price stability to maximize socioeconomic benefits and minimize the risks.

  • Revise the mandates of existing institutions and help them build capabilities to contribute to the creation of a persistently stable macroeconomic environment. These must aim for further integration and develop coordinating mechanisms, to set policy at national, regional and global levels.

In the face of the GCC's inflation challenge, it is tempting to hope that the region's policymakers might get some guidance from the institutions responsible for global economic stability. Lately, however, those institutions have not inspired confidence in terms of their ability to anticipate and head off economic or financial crises. “Indeed, the challenge for the GCC countries is not just to create their own macroeconomic stability frameworks, but to make sure these frameworks are integrated and coordinated regionally and globally. There need to be formal ways in which the region's central banks interact—with each other and with central banks outside the GCC,” argued Najjar.

Creating such a framework will take a lot of brainpower, leadership, and political will to pull off. “But with the economic and financial crises around the globe, the effort is more important than ever—and the rewards will be worth it,” concluded Shediac. Emerging economies like the GCC are creating wealth at a rate that has captured the world's attention. By instituting macroeconomic stability frameworks, these countries can go a long way toward protecting what they have built.