Saudi Arabia - The Inflation Alleviation Plan

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The Inflation Alleviation Plan
Brad Bourland,
Chief Economist & Head of Research Jadwa Investment

Editor's Note:

Today for your consideration we present a Jadwa Investment report on the Saudi economy and inflation, "The Inflation Alleviation Plan." The report is the latest in a series of insightful documents prepared by the office of Jadwa's Chief Economist & Head of Research Brad Bourland. Links to previous reports and related items below.

We thank Jadwa Investment and Mr. Bourland for producing these informative reports and allowing us to share them with you.

The Inflation Alleviation Plan
Brad Bourland, Chief Economist & Head of Research Jadwa Investment

Executive Summary
On January 28 the cabinet approved a 17-point plan to alleviate the impact of rising prices. The package will have positive results due to either higher wages or lower prices. It will be of greatest benefit to lower paid government workers because of salary increases. The measures will not eliminate inflation as a major concern, but will trim some specific price rises.

We estimate that the package of measures will cost the government SR13.5 billion in supplemental spending and foregone revenue this year and SR67 billion over the three years for which it is scheduled to last. Given our projection for the budget surplus of SR187 billion in 2008, these costs will not have a material effect on the state of public finances. The impact on inflation should be broadly neutral. The public sector pay rise is unlikely to prove too inflationary, and the reduced fees and charges and other measures will not have a pronounced impact on the overall inflation rate.

The strength of the 17-point plan is that it is generally restrained and employs a market-oriented approach to tackle some of the main causes of inflation. One drawback to this approach is that it takes time to have an impact on inflation. We therefore think that the government will examine more options to moderate inflation. However, in our opinion, there is no one policy that would have a decisive effect on inflation. Furthermore, many of the moves being publicly discussed would impact adversely elsewhere in the economy. We therefore think that the government will maintain its approach of taking small, targeted steps.

The Inflation Alleviation Plan
On January 28 the cabinet approved a 17-point plan to alleviate the impact of rising prices. The package will have positive results due to either higher wages or lower prices. It will be of greatest benefit to lower paid government workers because of salary increases. The measures will not eliminate inflation as a major concern, but will trim some specific price rises.

We estimate that the package of measures will cost the government SR13.5 billion in supplemental spending and foregone revenue this year and SR67 billion over the three years for which it is scheduled to last. Given our projection for the budget surplus of SR187 billion in 2008, these costs will not have a material effect on the state of public finances. The impact on inflation should be broadly neutral. The public sector pay rise is unlikely to prove too inflationary, and the reduced fees and charges and other measures will not have a pronounced impact on the overall inflation rate.

Rising prices throughout the Kingdom have eroded consumers’ purchasing power, prompting the government to act. On balance, we think that the response has been sensible, particularly as other governments in the region have awarded much larger rises in public sector pay or taken steps that, while popular, have minimal impact on inflation. In announcing five percent salary rises for 2009 and 2010 the government is clearly indicating that it expects inflation to remain around this level for the next three years. We nonetheless think that the government will take further steps to tackle inflation.

Key components of the inflation plan

Five percent will be added to the salaries of public sector workers in each of the next three years.
Social insurance benefits will be raised by 10 percent.
The government will absorb 50 percent of the cost of port fees, issuing passports, traffic licenses and transferring ownership and renewing the residency permits of domestic workers.
Government will continue to control the prices of basic commodities; these controls will be reviewed after three years.
A National Housing Agency will be established and the construction of public housing that has already received budgetary approval will be expedited.
The supply policy, which aims to diversify sources of supply of goods to ensure that local demand can be satisfied at reasonable prices, will be approved.
Steps will be taken to encourage greater competition, eliminate efforts by the private sector to control prices and monopolistic practices (the agencies system is to be reviewed) and increase consumer awareness.
The approval of the mortgage law will be expedited.
The pricing of medicines will be reviewed and the health insurance system examined.

How much will this cost?
We expect the new measures to cost around SR13.5 billion (0.9 percent of GDP) in supplemental spending and foregone revenue in 2008. Given our projection for the budget surplus of SR187 billion, these costs will not have a material impact on the state of public finances this year. We estimate that the total cost over the three years for which the package is scheduled to last will be SR67 billion.

The rise in public-sector salaries will be the largest item of new expenditure. We estimate that the government wage bill was around SR170 billion last year (latest available data, for 2006, put it at SR162 billion). A 5 percent rise (which is being backdated to the start of the year) would therefore increase the total government wage bill by SR8.5 billion in 2008. With further 5 percent rises pledged for the next two years, we estimate that the public sector pay package will cost a total of SR52 billion by the end of 2010.

According to the Labor and Social Affairs Minister, social insurance payments total around SR830 million per month. A 10 percent rise would therefore increase the annual cost to the government of social insurance by SR1 billion. Separate to the new package, the government also awarded assistance worth SR650 million for social security beneficiaries affected by recent cold weather.

We estimate that the halving of fees for passports, traffic licenses and transferring ownership and renewing the residencies of domestic workers for three years will cost the government around SR3 billion per year. The absorption of 50 percent of the cost of port fees for three years will reduce government revenue by around SR1 billion per year (note that port fees do not affect customs tariffs and therefore the move does not affect the GCC customs union).

The additional spending and revenue foregone will knock around one-third off the surplus of SR40 billion projected in the 2008 budget. However, this was based on a conservative oil price (estimated at $45 per barrel for Saudi oil; $49 per barrel for WTI). Using our oil price assumption ($72 per barrel Saudi crude, $76 per barrel WTI) we forecast a budget surplus of SR187 billion in our budget report (“Saudi Arabia’s 2008 Budget,” December 2007). We had noted that “the government would take steps to offset the impact of rising inflation” and factored these into our calculations, so we are maintain our forecast for the budget surplus.

Impact on inflation
We think that the new government measures will have a broadly neutral impact on inflation. The public-sector pay rise is below the current rate of inflation and is therefore unlikely to have much impact on inflation. Lower charges for government services, port fees and various measures to tackle anti-competitive behavior and increase consumer awareness may reduce the price of some goods, but will not have a pronounced immediate impact on overall inflation. Accelerating housing construction should ease the rise in rents over the longer term.

At 5 percent, the pay rise for government workers is below the current rate of inflation, which was 7 percent in January. We therefore do not think it will have much impact on inflation. Public sector pay deals are generally a guide for private sector employers.

Skill shortages in some areas of the private sector are forcing up wages by well above 5 percent, however many expatriate workers are on fixed contracts with limited bargaining power, so we are not concerned about inflationary pressure from this source. The additional 5 percent rises in 2009 and 2010 are slightly above our forecasts for average inflation for these years, but the gap is not significant enough for us to be concerned about their impact on future inflation.

The impact of government pay rises on inflation

Many people believe that raising public sector pay is a simple way for the government to compensate for the impact of inflation. Citizens throughout the GCC have pushed for much higher wages and in some cases have received them -- government wages were increased by up to 43 percent in Oman and federal employees in the UAE got a 70 percent pay rise.

However, pay rises should be driven by adjustments for the current rate of inflation and improvements in worker productivity. Raising them beyond this level will actually stimulate further inflation. This is because much of the pay rise will be spent and this increase in demand will feed through into higher prices. The 15 percent government pay rise in August 2005 probably contributed to the current period of rising inflation (the inflation rate has risen in 25 of the subsequent 29 months).

It is difficult to judge how the reduction in port fees will filter through into inflation, as it depends on the actions of the agents that the imported products will pass through before they reach the final consumer. Distributors, wholesalers and retailers are all likely to try to absorb some of the reduction in port fees by increasing their profit margins and thus not lowering prices to fully reflect the fee cut. Furthermore, port fees only account for a small proportion of the price of the final product. By volume, 97 percent of imports enter Saudi Arabia through the Kingdom’s ports, but total port fees are only SR2-2.5 billion, compared with a total import bill of SR306 billion last year. Moreover, imported inflation has only been a small contributory factor to the overall rise in inflation in Saudi Arabia. Therefore we think the reduction in port fees will not make much of an impression on the cost of imports.

Lower fees for various government services will be directly captured in the inflation numbers (each is included in the “other expenses and services” component of the cost of living index). The weight of these components is not provided, but it is likely to be relatively small given that “other expenses and services,” which constitutes 8.8 percent of the cost of living index, also includes jewelry, hotels and personal hygiene items (such as toothpaste, shampoo and soap). Again, we therefore think that this measure will have a minimal impact on inflation.

Assessing the effect of other steps announced is trickier. Tackling anti-competitive behavior by retailers and wholesalers should lower inflation (particularly during Ramadan), but it is not easy to categorically prove that the necessary collusion on prices is taking place or to stimulate greater competition. Forcing retailers to display the prices of all items for sale should encourage consumers to shop around for the best prices. Efforts to heighten consumer awareness are also likely to reduce the scope for exploitation by unscrupulous retailers. We think this combination of policies is likely to lower prices for certain items, mainly foodstuffs, but the impact will vary around the Kingdom and will not be that pronounced on overall inflation.

We also think that the introduction of the supply policy will not have much impact on inflation. Once the supply policy is approved, a supply department will be established within the Ministry of Trade and Industry. Its main task will be to monitor demand and supply conditions for different commodities in local and international markets with the aim of diversifying sources of supply to ensure that local demand can be satisfied at reasonable prices. The department would coordinate with other government agencies such as, for example the Ministry of Agriculture if the need to increase output of locally produced agricultural products was determined. We think this policy is unlikely to have much impact on inflation, as we believe the long response times (particularly if it involves planting new crops) will severely limit the flexibility to respond to price increases in a quick and targeted way.

The review of medicine prices was first announced last year and the government had already taken steps to ensure a reduction in the price of 1,400 medicines from early February. Again, while this will help moderate inflation, medical care accounts for just 2.3 percent of the cost of living index, so the overall impact will not be great. According to the Ministry of Health, a health insurance scheme for Saudi nationals will be implemented this year. This had previously been held back by the lack of insurance companies, but is more practical now that 25 have received licenses over the last few years. Final details of how the scheme will operate are not yet available.

The policies we find most encouraging are in the real estate sector. Rent has been the main factor pushing up inflation in Saudi Arabia over the last year -- rental inflation stood at 16.7 percent in January -- as an inadequate supply of property compared to strong growth in demand has pushed up rents. The new package contains some measures that will help gradually alleviate real estate supply bottlenecks. For instance, construction of public housing will be accelerated. Around SR10 billion has already been allocated for this task and further large budgetary allocations will be awarded in the coming years.

In addition, the program calls for the urgent approval of the mortgage law, which has been awaiting final ratification for some time. Most Saudis rent their property, so rising rents have eroded spending power. Encouraging greater home ownership through the provision of mortgages will reduce exposure to rents (mortgage payments move in line with mortgage interest rates, rather than rents or property values). Introducing mortgages makes home ownership possible for a large section of the population who cannot afford the current practice of paying outright for property. It has other economic benefits such as enhancing saving and promoting financial market development, and possibly some social ones.

While the measures announced last month will have some targeted benefit they will not have a great impact on total inflation within the economy. Overall, therefore our forecast for average inflation in 2008 remains unchanged at 4.7 percent.

What more is likely?
The strength of the 17-point plan is that it is generally restrained and employs a market-oriented approach to tackle some of the main causes of inflation. For example, rather than putting a cap on rents, it calls for more rapid construction of accommodation, which will help ease the underlying shortage of property. One drawback to this approach is that it takes time to have an impact on inflation. We therefore think that the government will examine more options to moderate inflation, including:

More subsidies and price controls: Subsidies (payments to producers to keep prices below what they would otherwise be) and particularly price controls (where goods have to be sold at a fixed predetermined price) should have an immediate impact on inflation by preventing further increases in the prices of goods. However, these are a bad idea as they create distortions within the economy. For example, placing a limit on how high the price of a good can rise will discourage its production if the price of the necessary inputs is also rising. In addition, price controls can be relatively easily be avoided, as other countries in the region have found where rent caps have encouraged landlords to take properties off the market for a short period before offering them after very slight modifications for much higher rents. Nonetheless, the size of the budget surplus gives the government plenty of scope to introduce more subsidies (such as those recently introduced for rice and baby milk).
Containing money supply growth: While rent and food price inflation are both the result of specific and separate circumstances, rapid growth in money supply would spread inflation throughout the economy. The government has already tried to slow growth in lending to the private sector (which increased by 21.4 percent in 2007) by raising the commercial bank reserve requirement, and we think that further such rises are likely. While the banks are still reasonably liquid, at over 80 percent the average loan-to-deposit ratio suggests that lower interest rates will not stimulate a lending boom. Greater issuance of government debt would also absorb some of the liquidity within the banks and help moderate credit growth. Growth in government spending (the other main contributor to money supply growth) has been reasonably controlled, but for a real impact on inflation the government should consider cutting spending. This is highly unlikely in the current circumstances, but restraint is important. For instance, a further upward adjustment to public sector pay would only fuel higher inflation.
An adjustment to the exchange rate: There is some support for the view that revaluing the exchange rate would end the inflation problem. Such a move would lower the price of imported goods, but we feel it is inappropriate for tackling inflation and will generate far more costs than benefits (our view on the exchange rate peg is outlined in our August 2007 report, “The Riyal’s Peg To The Dollar”). We believe that the government also does not see the merit of an exchange rate adjustment.

There is no one policy that would have a decisive effect on inflation. Furthermore, many of the moves being publicly discussed would impact adversely elsewhere in the economy. We therefore think that the government will continue to take small, targeted steps.

To view the PDF version of this article, click here.

February 2008
For comments and queries please contact:
Brad Bourland
Chief Economist and Head of Research
jadwaresearch@jadwa.com
Head office:
Phone +966 1 279-1111
Fax +966 1 279-1571
P.O. Box 60677, Riyadh 11555
Kingdom of Saudi Arabia
http://www.jadwa.com

Reprinted with permission of Jadwa Investment.

About Brad Bourland
Brad Bourland is head of research at Jadwa Investment, Riyadh. From 1999 through 2007 Brad was the Chief Economist at Samba Financial Group, formerly Saudi American Bank, in Riyadh, where he published regularly on issues related to the Saudi and global economies and the world oil market. He appears frequently in the domestic and international media and is a regular public speaker. Before joining Samba, Brad spent an 18-year career as diplomat, economist, and manager with the U.S. Department of State. During the last three years of his diplomatic career he was in Riyadh as the American Embassy's First Secretary responsible for financial affairs, where he analyzed the Saudi economy for the U.S. Government and conducted financial aspects of US-Saudi relations. Brad has his BA and MA magna cum laude from the University of Utah, and is a CFA (Chartered Financial Analyst) charterholder.

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