Fighting the inflation hydra
Oman’s fight against inflation has been intensified, showing just how seriously the authorities take the problem and its impact on Omanis. The key to easing medium-term price pressures, though, may lie in global factors as much as domestic strategy

By Oliver Cornock

In the first quarter of 2008, Oman’s inflation hit an 18-year high of 10.6per cent according to a statement from the Ministry of National Economy, and jumped even further to 13.2 per cent in the year to May. Inflation has been driven by a number of factors, both international and domestic.

Global prices have been driven upwards by the rising cost of fuel, food and other commodities. Crude oil has hit $135 a barrel by some measures, pushing up transport costs, which feed through across the economy. Food price inflation has been stimulated by changing consumption trends (more meat being eaten, for example), climatic factors and the headlong rush to cultivate biofuels in North America and Europe. Meanwhile, an emerging market construction boom, particularly in China, has been instrumental in increasing the price of construction materials, including steel.

A handful of domestic (or at least regional) factors have also contributed to Oman’s inflationary spike. The Sultanate, like its Gulf neighbours, has experienced an influx of liquidity over the past few years thanks to soaring oil earnings, contributing strongly to demand pull. Economic success has gone hand-in-hand with credit growth, increasing the narrow money supply considerably. According to a June 11 report by the Central Bank of Oman (CBO), the level of outstanding credit rose to $19.4 bn in the year to end-August, an increase of 49.7 per cent in the last year, with loans to the private sector accounting for 94 per cent of this total.

Another demand pull dynamic is demographic. The population has also been increasing quickly – by 3.2 per cent last year, according to the CIA – due to the fast-growing National population and an influx of expatriates drawn to the thriving economy. Somewhat more controversially, it is apparent that Oman’s dollar peg is also contributing to inflation. The rial’s peg to the greenback effectively obliges the CBO to shadow the US Federal Reserve’s interest rate policy. Given the US slowdown and credit crunch, the Fed has been assiduously cutting rates in recent months in an effort to stimulate growth. At the time of writing the Fed’s rate stood at 2 per cent, down from 5.25 per cent in mid-September 2007. While this policy may suit the US, it is the opposite to what the Omani economy needs – namely moderate increases to rein in exuberance.

Furthermore, with the dollar dropping steadily in value over the past three years, imports priced in other currencies (particularly in euros) have increased in price. These include many staple goods, so the impact has been keenly felt by ordinary Omanis.

In response to soaring inflation, the government and CBO have introduced a raft of measures aimed at easing consumers’ pain and cooling prices. In February, a round of wage increases for government employees was announced, with pay packets rising by up to 43 per cent. At the same time, state pensions were boosted by between 5 per cent and 35 per cent. Subsidies on a range of goods were also increased – with wheat now subsidised to the tune of $64.95 a tonne (wheat futures for July hit $300.93 a tonne on the Chicago Board of Trade [CBOT]).

On June 9, the CBO upped its side of the fight against inflation by tightening lending conditions. The bank increased the minimum reserve requirement (MRR) to 8 per cent from 5 per cent and cut the maximum lending ratio (also known as the loan-to-valuation ratio [LVR]) from 87.5 per cent to 82.5 per cent. Meanwhile, it lowered the interest rate ceiling from 8.5 per cent to 8 per cent.

The MRR obliges commercial banks to keep a certain proportion (in this case 8 per cent) of their deposits in a non interest-bearing account with the central bank, meaning that it cannot be lent out. Therefore, theoretically at least, it tightens the narrow money supply by mopping up a degree of liquidity. The LVR limits the amount that a bank can contribute to a customer’s investment – i.e. Oman now requires the borrower to stump up at least 17.5 per cent of the required cash. Lowering the MVR should reduce the attraction of borrowing, again constraining credit growth. Finally, an interest ceiling caps the rate at which banks can lend out, in theory making lending less appealing. The CBO is deploying these policy tools to fight inflation.

However, whether these moves will be enough to restrain price growth is questionable. Increasing the MRR is becoming a popular policy for countries experiencing inflation, particularly those with currency pegs. The requirement’s efficacy as a counter-inflationary device can be limited though. Foreign banks can circumvent the MRR by booking clients’ loans with their mother institutions or other overseas branches, therefore moving them off the local balance sheet. Meanwhile, local banks can suffer from the increased cost of lending.

The LVR cut should be a more effective tool, but its impact may be somewhat mitigated by the CBO’s simultaneous decision to increase the limit on home mortgages as a proportion of banks’ loan portfolios from 5 per cent to 10 per cent. As the CBO stated, this move reflects a growing demand for housing finance, and further down the line could help stimulate the construction industry, increasing Oman’s currently tight residential property supply. In the short term though, easing housing loan regulation may run counter to a broader anti-inflationary strategy. What is clear though is that the CBO is doing its best to address inflation, and its moves should tighten lending a degree at the lower-value end of the retail market at least. Additionally, the positive side of the coin is that Oman’s banking system is robust and dynamic enough not to suffer unduly from the new limits.

Like many emerging markets, Oman is facing sharply rising prices due in part to its own success and a degree of inflation is seen as an acceptable corollary of impressive growth, which the government is understandably reluctant to sacrifice. To a large extent, inflation has also been driven by external pressures, and so as these ease, the Sultanate should also see price growth moderate. With improved harvests in the MENA region, food prices are expected to stabilise. Worldwide, agricultural output may have been boosted in the medium term by higher prices and waning enthusiasm for biofuels. An increase in supply internationally should help moderate Oman’s imported food costs. The global economic slowdown may cool inflation somewhat by moderating demand, while not seriously hurting economies like Oman’s, which is growing quickly enough to cushion the impact of the West’s lacklustre performance. Furthermore, the Fed may now be looking to raise interest rates after US consumer price index (CPI) jumped 1.1 per cent – a 26-year record – in June. This would help tighten up the Sultanate’s monetary policy.

Finally, with many new residential projects in the pipeline, Oman’s housing shortage should ease, cooling one of the major domestic inflationary pressures. While the government has moved to ensure that the inflationary spike does not hurt the less well-off disproportionately, the CBO has worked to tighten lending where it can, commendably, but possibly with limited effect. Over the next year, external pressures should ease, cooling major causes of imported inflation. Internally, bottle necks should begin to ease too, all of which should go a long way to returning Oman’s price growth to normal levels.

The author is Regional Editor, Oxford Business Group


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