An upward spiral
Runaway inflation is not just impacting the profits of companies but is also creating an atmosphere of uncertainty about the future. Writes Mayank Singh

            (sultanate’s Consumer price index)
If you ordered a consignment from Naranjee Hirjee a year back, chances were that the company driver would take a van and drop off the order without bothering about the space the package occupied in a van or the distance he had to travel. All that has changed in the last year – the company has been bringing about logistical improvements like mapping the route so that more orders can be offloaded on a single trip and ensuring that vans deliver more orders per trip.

            
Al Khoudh Steel Furniture Industrial Company has started recycling raw materials. Shop floor workers who used to throw away a mother sheet after cutting an almirah door have started recycling the remaining portion for other furniture improving usage.

If you thought that Naranjee Hirjee has become a neo convert to kaizen or that Al Khoudh has started following the six sigma principle, think again. These new found efficiencies are measures to combat a monetary phenomenon – growing inflation. And they are not alone in this drive as the malaise is forcing a number of companies to tighten their belts.

Says Ajit Limaye, projects director, Al Turki Enterprises, “There are five M’s adding to our cost of processing – namely manpower, materials, machinery, money supply and management.” Limaye is not being merely alliterative but is echoing a serious concern facing corporate Oman.

Growing concern
A break-up of the numbers reflects the gravity of the situation – annual inflation in Oman accelerated to 11.56 per cent in March 2008 up from 11.11 per cent in February, an 18 year high. Oman is not the only country in the region to be affected by the problem. In Saudi Arabia inflation is at a 16-year high and in neighbouring UAE it has touched a 19-year peak.

The Sultanate’s consumer price index hit a new high of 120.6 points at the end of March 2008 according to Ministry of National Economy estimates, compared to 108.10 points a year earlier. The first-quarter costs for food, beverage and tobacco – which make up almost a third of the consumer price index – surged 18.5 per cent compared to March 2007 and rents are up by 12.4 per cent. The price rise has not only been eating into the purchasing power of the lower and middle class populace but has also started shaving off profits of companies across sectors in Oman.

The fact that a number of factors feeding inflation are beyond the control of the Sultanate’s market (or government) makes the situation far worse.

Prime drivers
A sharp rise in international commodity prices is proving to be a heavy burden for manufacturing and construction companies. Iron ore prices have shot up from $77.35 per dmtu (dry metric tonne unit) in 2006 to $140.60 per dmtu in Jan-Feb 2008. Aluminium is up from $2,570 per metric tonne in 2006 to $2,611 in Jan-Feb 2008. The price of cement has gone up by 30 per cent over the last two years.

Says Gautam Bose, general manager, Al Khoudh Steel, “A tightness of supply compared to demand due to a consolidation of the steel industry has changed the nature of the industry.” Mergers like Mittal Steel and Arcelor have made the steel industry more oligopolistic, reducing the bargaining power of individual companies. “Since our import volumes are small the bargaining power of companies in Oman is insignificant,” says Bose.

Growing steel prices have had a cascading effect on construction costs. It has also led to an increase in the cost of machinery such as excavators, tipper trucks and graders. So an excavator which cost RO55,000 in 2006 is now priced at RO75,000. Companies, on their part, cannot postpone these purchases as they have to execute a growing order book fuelled by the growth in infrastructure spending.
Transportation costs
With oil prices breaching new highs by the month (the latest being the $130 plus per barrel mark), there has been an across- the-board increase in production and transportation costs. Says Limaye, “As long as energy prices keep rising there will be no letting up in the inflationary engine.”

Freight costs have gone up on an average by 20 per cent over the last year. A mismatch in the supply and demand of shipping vessels makes matters worse. As the demand for vessels from the Far East go up (fuelled by rapid economic growth in China and India) there are less number of vessels to service this increased demand as shipping companies have traditionally concentrated on Europe and the US. “A rise in the handling fee of shipping agents and CNF (carrying and forwarding) rates in Dubai and Saudi Arabia have pushed up our costs,” says H F Bilimoria, group general manager, Naranjee Hirjee.

Servicing manpower costs
According to the Muscat Consumer Price index, the cost of food, beverages and tobacco in the capital region has increased by 16.8 per cent between January – February 2007 and the corresponding period this year. Rent, electricity, water and fuel costs are up by 11.5 per cent. And the general price index is up by 10 per cent.

As the cost of living goes up in the Sultanate most companies are being forced to pay more to retain their employees. The opening up of new opportunities and changes in the regulatory norms allowing employees to shift jobs is also forcing companies to spend more.

The government showed the way by announcing a salary increase of seven to 43 per cent for its employees in 2007. Most companies have followed the government’s lead and increased staff salaries. To cite a few examples – Oman Cables Industry’s (OCI) HR costs went up by 25 per cent in 2007 while Al Turki’s wage bill is up by 20 per cent. Says M M Vaidya, general manager (commercial) OCI, “The HR challenge is a small thing that is having a big impact.”

However, pay hikes address just one part of the problem. “Attracting talent to the manufacturing sector is difficult as it is not seen as a happening sector. Secondly, most people who come on board take at least one year to learn the ropes before they start contributing in a meaningful way,” says Vaidya. This makes the cost of selecting and retaining people in such an industry an expensive proposition. Employing new people on higher salaries forces companies to increase the salaries of their existing staff to maintain parity, which in turns adds to their wage bill.

With India’s economy growing at close to nine per cent per annumn it is getting increasingly difficult to attract people from the subcontinent – the traditional market from where most companies have been recruiting in the past. This has added to the woes of local companies. The enhanced spending on infrastructure within Gulf countries has intensified the competition for locally available talent making matters worse. Says Limaye, “We are paying 20 per cent more for people who are half as talented as before. And with people changing jobs frequently there are times when we feel that we are running a huge training centre.”

It’s all about the money
A depreciating dollar has led to a decline in the purchasing power of local currencies in the GCC as most of them have dollar pegged currencies. In the last three years the dollar has declined by 25 per cent against the Euro, nine per cent against the Yen and 19-20 per cent against the Pound Sterling. Says Dr Sohail Issa Magableh, economic advisor, Directorate General of Research and Development, Capital Market Authority, “The depreciation in the local currency coupled with the influx of petrodollars due to increased oil prices are the two main reasons contributing to inflation in Oman.”

The erosion of the value of the dollar is forcing companies to pay more for importing goods. For example if the dollar has weakened by over 10 per cent against the Euro in the last one year or so, companies importing food products or industrial goods from Europe have been forced to foot this additional ten per cent cost. Says C K Khanna general manager, corporate, Bahwan Engineering Company, “We have been doubly hit as not only have the prices of equipment and construction materials gone up, but we are also being forced to pay more on account of the change in exchange rates.”

Given this scenario there have been suggestions about revaluing or de-linking the Rial from the US dollar. The lead taken by countries like Kuwait and Syria to de-link their currencies from the US dollar in 2007 has added weight to such an argument.

The government, on its part, has categorically denied any such corrective action. A Central Bank of Oman (CBO) document titled, ‘Inflation Concern and Policy Options’ prepared by the Central Bank of Oman states, ‘The fixed peg of the RO to the USD has certainly been one of the sources of imported inflation, but neither revaluation, nor any alternative exchange rate regime could be helpful in addressing the inflation concern, particularly as the external and supply side sources of inflation continue to persist…For a small economy, stability of exchange rate is critical for growth and investment and a revaluation option could entail more costs than the inflation related marginal benefits.’
This document rules out any possibility of a revaluation of the Omani Rial and puts the onus back on companies to shoulder the burden of a declining dollar.

On the demand side, the two factors fuelling inflation are the strong fiscal expansion due to favourable oil prices and a concurrent growth in money supply and credit. The value of oil exports from the GCC region reached close to $700bn in 2007 giving it a four per cent share of world exports. This cash flow has engendered its own problems of plenty.

Corrrective measures
Taking cognisance of the problem the government has initiated a number of policy measures. In an effort to control the increased money supply the CBO has increased the reserve requirement for banks from three to five per cent in February 2008. This is expected to take out RO140mn from the banking system thus curbing the ability of banks to lend and finance aggregate demand in the system. CBO has also been mopping up money through certificate of deposits (CDs). The amount collected through CBO CDs has gone up from about RO500mn at the end of October 2007 to around RO1,341mn in February 2008.

Says Ali Hamdan Al-Raisi, senior manager, economic research and statistics, CBO, “The credit growth in the economy between March 2006-07 has been to the tune of 46 per cent, while the economy has grown by over 12 per cent. This shows that a lot of credit is going in for speculation or into unproductive sectors.”

The government has been making efforts to contain spiralling rents. It introduced regulatory norms like a 15 per cent ceiling on rent increases for a two-year period in 2007. As landlords found ways to bypass the legislation, a committee was formed under H E Saif bin Mohammed al Shabibi, the Minister of Housing to suggest further measures to ameliorate the situation.

The committee has suggested a number of amendments such as non eviction of tenants for three years for residential property and seven years for a commercial property. It has also recommended a seven per cent annual cap on rents. Once implemented these measures are sure to bring a degree of comfort to beleaguered companies and their employees.

Changing mores
Companies, on their part, are also working to make the best of a bad bargain. Says Raisi, “The total factor of productivity in Gulf countries is very low. Most companies are not raising productivity by training, education or the application of technology but merely by adding more labour.” While this charge may have a ring of truth, the onslaught of inflation is forcing companies to improve work processes. Most companies have started working on a two pronged process – lowering the cost of operations and bringing in new efficiencies.

Al Khoudh Steel has embarked on a value engineering process to combat rising prices. Says Bose, “Value engineering is a process by which we redesign a product in such a manner that it does not deteriorate its functionality while reducing its costs.” One way of doing this is through automation or industrial engineering. The process improves throughput and reduces the rejection rate for products. To cite an example – Al Khoudh has started packaging two tables in a packaging carton in place of one. Since most orders are in multiples of 10s or 20s, the costs of packaging have come down as a result.

To bring about more efficient utilisation of space, the size of the racks on which the final products are stored have been reduced. “These racks were oversized compared to the height of the products, so the top racks were always lying empty. We cut short the size of the racks which has enabled us to mount more racks per square metre,” says Bose.

Al Turki has been working on streamlining its forecasting process. Says Limaye, “We are working on anticipating the rise in prices so that our risk estimates get refined.” The company is also upgrading its IT infrastructure by implementing SAP and other software’s like Primera V6. Online recruitment software helps Limaye to see peoples CV’s online and respond to them.













 

OCI too has gone in for an ERP system (Baan) which is helping it to bring down its input costs. The company is exploring the option of going into sectors like oil and gas where the price realisation is better. The company was approved as a supplier by Shell global in 2007.

OCI is also in favour of popularising benchmarks for commodities such as steel and aluminium so that it can pass on the costs to the consumer. Says P R Ramakrishnan, general manager (sales and marketing), OCI, “The customer is ready to pay for the rise in copper prices because there are internationally recognised benchmarks for it. There is a need to popularise such benchmarks for other commodities like steel, aluminium etc.”

A rogue phenomenon
The imperative to control inflation can hardly be overstated. Rising prices can lead to investment uncertainty as companies and individuals may hold back investments if they cannot get a fix on the cost escalation that they may have to incur in future. “We do not want to take on long projects as it is difficult to know what the price of inputs is going to be over the next five years,” says a CEO of a construction company. Entrenched inflation can impact FDI (foreign direct investment) adversely.

Taking note of the rising incidence of inflation in the Gulf, the International Monetary Fund has suggested that Gulf countries slow down the pace of their development by calling off a few large projects. The fund feels that a slowing down will ease inflationary pressures.

Like other states in the region Oman’s economy has been riding the crest of a six-fold oil price rise in the last six years. The sultanate’s economy expanded to RO15.51bn ($40.29 billion) in 2007. Says Magableh, “A reduction in the rate of economic growth in some economies is very important as the current pace of economic growth is leading to undesirable effects.”

His viewpoint, however, is contested by a number of other economists. Says Raisi, “This is unacceptable as the country needs to grow and diversify its economic base for which infrastructure development is important.” Thus the government is unlikely to slow down the pace of economic growth. According to the CBO paper – “An expansionary fiscal policy is essential for faster growth and economic diversification. Given the growth inflation trade off, the current policy emphasis is not to sacrifice growth, but to compensate the public for inflation induced loss in purchasing power.”

Looking ahead
External factors are unlikely to turn favourable soon as, on the demand side, rising per-capita income in emerging market economies, bio fuel demand and speculative demand for commodities as an alternative to bonds and stocks (in the face of falling interest rates and lacklustre stock markets) could continue for sometime. On the supply side, global warming and adverse weather conditions could affect crop production, artificial price controls used by some countries to curb current inflation could also weaken an appropriate supply response.


Inflationary expectations feed inflation. This is especially true for pricing commodities and services as any adverse inflation expectation could lead to a further escalation of prices. This self-perpetuating nature of the problem can be a real source of worry for policy makers and companies alike.

As the US economy slows down corporates are hopeful of inflation getting checked in the medium to long term. Says Bose, “There will be a worldwide slowdown in demand as industry cannot take any extra cost beyond a point, so while inflation will continue it will come down from double digits to single digit.” With the initiatives being taken by the government and the growing international efforts in this direction corporates are looking forward to such measures bringing some respite soon. Till then companies will have make to do with value engineering and cost cutting exercises.
 

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