Reining in inflation
The flurry of measures initiated to check Oman’s inflation is likely to yield mixed results

Oman’s inflation hit a 16-year high in December due to domestic demand and global supply shocks. The authorities have moved to alleviate the immediate pain, but in the longer term, a currency adjustment may be at least a part of the key to finding a policy mix better suited to the country’s economic profile.

In December, Oman’s inflation rate reached 8.29 per cent after accelerating for the seventh consecutive month. Food and beverage prices, which make up around a third of the basket of goods and services used to calculate the Sultanate’s consumer price index, increased to an annual rate of 14.4 per cent, having risen to 12.6 per cent in November. Meanwhile, rents, which make up around 15 per cent of the basket, grew by more than 11 per cent by the end of December.

Inflation is caused by a combination of “demand pull” and “supply shock” factors, both of which are today present in the Omani economy.

On the demand side, the high global oil price has caused an inflow of liquidity into Oman, as it has to other oil-producing countries. The price increase has been steep and has happened relatively suddenly quadrupling over the past six years. It has been impossible for the supply side, in terms of goods, services, housing and infrastructure, to keep pace.

Oman also has the additional demand factor of a quickly increasing population, due both to organic growth and an influx of expatriates. The country’s fertility rate is 5.7 children per woman, which coupled with immigration leads to a population growth rate of 3.2 per cent, compared to less than 0.2 per cent in the European Union, according to external estimates. The population growth increases demand for imported construction materials and foodstuff, not much of which the Sultanate produces itself.

Global factors
There have been several strong supply shocks to the Omani economy as well, many of them global. Firstly, world food prices increased rapidly last year due to climatic factors (drought in some major food producing countries, floods in others) and changing consumption trends (increasing demand for meat from emerging markets, and therefore a shift from cheaper and more land-efficient crops). Secondly, commodity prices as a whole grew quickly last year on the back of construction booms in the developing countries, particularly due to China’s insatiable demand for inputs such as steel. This has, of course, affected Oman as it tries to provide homes (and shops and offices and public buildings) for its fast-growing populace and for meeting its infrastructure needs that are a prerequisite for its diversification efforts.

Countries in the Gulf have also come under some wage pressure, partly as a result of higher food and fuel costs. Additionally, Oman’s tighter labour legislation at the bottom end of the income spectrum and demand for highly skilled professionals at the top have driven wages upwards. The most controversial source of inflation in Oman and throughout the Gulf, however, is the depreciating US dollar. All the Gulf Cooperation Council (GCC) countries hard-peg their currencies to the greenback, with the exception of Kuwait, which switched to a basket of currencies in May last year – but is still thought to use the US currency for the bulk of its trade basket.

Dollar peg
Oman’s inflation rate has been doubly affected by the dollar peg. The dollar’s fall against currencies of the countries from which the Sultanate sources most of its imports (for which the US accounts less than 6 per cent) has increased the cost of these goods to consumers using the rial. The greenback’s 10 per cent drop over the past 12 months has impacted Omani importers, who given the increase in consumer demand have passed much of the effect directly on to purchasers.

Furthermore, the dollar peg effectively obliges the Central Bank of Oman to mirror the US Federal Reserve’s interest rate movements. As the US economy has been slowing – potentially into recession – and in the wake of the subprime lending crash, which has led to large write-downs and a drying up of interbank lending, the Fed has understandably been cutting rates aggressively. This may be the right policy for the US, but it is absolutely not for Oman, for the reasons listed above. The peg, for all its benefits, not only forces the Sultanate to surrender the main level of monetary policy that can be used to control inflation, but also surrenders it to an authority having the responsibility for an economy heading in the opposite direction.

What to do to contain inflation?
The government is understandably reluctant to rein in fiscally. Cutting spending could mean compromising the much-needed infrastructure spending to promote diversification; the Sultanate would also not wish to compromise its attractive taxation climate to choke off demand. The authorities have responded with a flurry of other measures, which are likely to lead to mixed results. Public sector wages have been increased in an attempt to boost purchasing power, and subsidies and price controls have been brought in, while the central bank has offered certificates of deposit (CDOs) to soak up liquidity and has increased the minimum reserve requirement (MRR) banks must keep in their vaults in proportion to the loans they dole out.

Right steps?
The salary increases – which go up to 43 per cent - seem a rather odd way of fighting inflation, specially as we have seen that wages are arguably a key contributor to inflation. The urge to help the population struggling with high rents and food prices is entirely understandable, given the large revenues the government is earning from oil exports, which it is keen to distribute to public sector workers. However, it is more likely to fuel inflation in the medium term; increasing the ability of people to pay for food and accommodation (and therefore demand) while a tight supply of both is only a recipe for price increases.

The subsidies announced on flour and set to be introduced on other goods will help keep control inflation to an extent, but will distort the market – and when they are removed further down the line, there is likely to be an inflationary spike. Additionally, increases in food prices often have a disinflationary effect on services and higher-end goods, as people divert their spending away from these to essentials. However, if subsidies are well targeted at the poorest, and clearly temporary, they may indeed be justified until food prices level off again.

Rent caps are another issue. While regulations to prevent unscrupulous landlords short-changing their tenants are worthy, capping rent rises unrealistically may be counterproductive. If rents are suppressed and not allowed to rise to market levels, curtailing the profitability of property ownership and letting, the incentive to build new property to be rented out is lessened. This will restrain supply, not allowing it to rise to meet demand and alleviate price pressures.

Finally, the central bank can only do so much to restrain inflation. CDOs will soak up only a limited amount of liquidity and the central bank itself has stated that a rise in MRRs takes time to feed through into the economy; growth is such that the effects, as with the last raise, are not as great as might be wished for. Oman, like many other countries, will have to bear out the effects of international inflation that has been exacerbated by its own growth. There is no miracle cure and the authorities seem to have concluded that short-term inflation is a price worth paying for development and currency stability.

Nonetheless, the current spate of inflation has highlighted the disadvantages of the dollar peg. Oman has wisely indicated that it will not abandon the system wholesale; to do would only add little more pressure on the greenback. Oman also has no history of monetary independence to steer it. However, in the medium to long-term, the sustainability of an arrangement that devolves monetary policy to the authority in charge of an oil-importing, slowing economy like that of the US, is open to question. A gentle shift to a currency basket can be the start of a cautious move to a monetary situation more suited to the strong, mature trading economy that Oman seeks to become.
 

Top^