Iraqi Dinar Discussion Board

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Gulf rate cuts could accelerate inflation

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There's only one way to fix inflation rate if you can't raise interest rates, raise the exchange rate. Their hand is being forced to reval. if dollar peg is maintained. IMO

Gulf rate cuts could accelerate inflation

By Babu Das Augustine, Banking Editor
Published: January 24, 2008, 00:06

Dubai: Gulf central banks' decision to cut interest rates following a similar move by the US Federal Reserve is expected to aggravate the already high inflation in the region and renew calls for currency revaluation.

The Fed, citing a weakening economic outlook and increased downside risks to growth, slashed rates by an aggressive 75 basis points (bps) on Tuesday.

Data out of the US has been weak recently, especially on the employment front, and the fall in stock markets has the potential to further dampen confidence, and reduce private consumption and investment.

"Real interest rates in the GCC were already negative and today's rate cuts will place them further into negative territory," said Monica Malik, an econ-omist with EFG Hermes.

Given the GCC currency pegs to the dollar, Gulf countries had to track US interest rate moves, although the differential between US and GCC interest rates has varied historically. The UAE Central Bank matched the Fed by cutting the repurchase (repo) rate by 75 bps to 3.5 per cent yesterday.

Higher risk

"With real rates sinking deeper into negative territory and the Middle East still recording strong domestic-led growth, increasingly lower rates run the risk of pushing inflation higher," Deutsche Bank said in a note.

Kuwait reduced rates by a lesser 50 bps, bringing its discount rate to 5.75 per cent and the repo rate to four per cent. Although Kuwaiti dinar is pegged to a basket of currencies, Kuwait indicated that it has cut lending rates to keep them in line with market rates and to avoid any systemic risk linked with the higher central bank lending rate.

Central Bank Governor Shaikh Salem Abdul Aziz Al Sabah admitted that it was a difficult decision, but said the gap between the dinar yields and interest rates on deposits in other currencies, including the dollar, had grown too wide.

"The aim is to reduce any negative effects that could result from the unjustifiably high margins Kuwaiti dinar deposits offer versus the main currencies," Shaikh Salem said in a statement carried by the official news agency KUNA.

Saudi Arabia, Bahrain and Qatar cut deposit rates by 50 basis points each. Saudi Arabia, Bahrain and Qatar continued their policy of reducing the reverse repurchase (deposit) rate, while keeping the repurchase (lending) rate on hold. The Saudi Arabian Monetary Agency (SAMA) also cut the reverse repo rate by a lesser 50 basis points to 3.5 per cent while keeping the repurchase rate at 5.5 per cent. In addition, SAMA raised the commercial banks' reserve requirement with SAMA to 10 per cent of deposits from nine per cent.

"The fact that a number of GCC countries reduced rates by a lower amount and/or kept lending rates on hold highlights that following the US' aggressive cuts are painful and that local central banks are trying to reduce the degree of monetary loosening," said Malik

With the GCC economic fundamentals remaining strong and economies booming, the interest rates are too low. The level of economic activity on the ground and credit growth and liquidity in the banking sector will remain strong in the GCC. These factors will continue to add to inflationary pressures.

Limited impact

Although some GCC central banks have been keeping lending rates on hold in an attempt to reduce the monetary stimulus of the interest rate cut, this policy will have only a limited impact on stemming credit growth. Firstly, given the strong level of liquidity in the banking sector, borrowing from the central banks is limited. Secondly, interbank rates are lower than central bank lending rates. That will also reduce the incentive for commercial banks to borrow from the central banks.

Based on the weakening economic data the Fed clearly hinted that further rate cuts are likely to come, which will result in similar moves in the Gulf.

"The committee will continue to assess the effects of financial and other developments on economic prospects and will act in a timely manner as needed to address those risks," the Fed in a statement after the rate cut on Tuesday.

"We think the Fed will maintain that easing bias for the next few meetings at least. Inflation risks do not appear high on the Fed's list of things to worry about at this point," Standard Chartered Bank said in a statement.

http://www3.gulfnews.com/business/Economy/10184313.html