National Bank of Dubai

Should GCC Countries Opt for Inflation Targeting Policy Regime: Implications for the Banking Sector

Inflation targeting (IT), as a promising monetary policy framework, has been explicitly adopted by 24 countries, including 16 emerging market and developing economies. With the success of obtaining the desired results, IT has been gaining popularity and therefore more emerging market and developing countries that include GCC countries are likely to adopt IT in the years to come. Under inflation targeting policy (ITP) regime, the main objective of monetary policy is to attain and preserve a low and stable rate of inflation. ITP sets a target for inflation,
communicates the target and explains the policy framework to the public. This
approach promotes both price stability and well-anchored inflation expectations. ITP has facilitated control of inflation and made monetary policy more transparent and accountable. ITP favourably improves the competitiveness of the economy, financial market and business environment and has substantial impacts on the banking sector. GCC countries, like many other countries, have not explicitly endorsed inflation targeting policy. However, they obviously continue to pursue a policy framework that targets lowering inflative rates and stabilising their level,
though with limited success. In this article, Dr C. Kannapiran, discusses as to whether GCC countries should opt for inflation targeting policy regime and if so what are the implications for the banking sector of such a regime in the GCC region.

Performance of top 15 banks in the GCC countries (2006) and Inflation rates * ROA = Return on Assets **ROE = Return on Equity Source: SICO Research, Company, Bloomberg, Reuters.

Inflation in the GCC
Economic fundamentals in the GCC region suggest that GCC region will have to live with an increasing inflationary trend (less than 3% in 1994-2004 to around 8-10% in 2005) in the years ahead. There are three main drivers of inflation in the GCC region:

Currencies of GCC countries are pegged to the US dollar. Continued depreciation of the US dollar against other major currencies is one of the main contributors to higher imported inflation, as much of the region's imports originate from Europe and Asia;
Skyrocketing rental rates, with its feed on effects on all other sectors, especially in Dubai and Qatar, considered the most important domestic driving factor behind the rise in prices;
Monetary and fiscal factors, such as high liquidity, low interest rates (negative real interest in Qatar and the UAE), expansionary government spending and strong money supply growth in the GCC, are adding to
inflationary pressure.

Impacts of Inflation
Real GCC regional economy growth could slowdown due to galloping inflation, particularly in the UAE and Qatar. Basically, higher inflation adversely affects the competitiveness of the GCC regional economy and hampers the diversification of the economies due to difficulties in attracting foreign direct investment. Higher inflation is likely to affect the prospects of the GCC emerging as a major industrial centre. The greatest challenge facing the GCC governments, therefore, is their ability to manage the escalating inflationary pressure. Higher inflation level is increasing the cost of living in the GCC region more so in the UAE and Qatar. A Cost of Living Survey by Mercer Human Resources places Dubai as the 25th (from 73rd position in 2005) most expensive city in the world in 2006, out of 144 cities ranked. Sectors that are targeted by diversification efforts (such as tourism and financial services) are likely to become less competitive. Small businesses may closedown because the cost of doing business is very high or they might migrate away from the GCC region to cheaper locations in the Middle East. Furthermore, skilled expatriates (constitute the majority of the work force) might leave the GCC region because of the increasing cost of living. Now coming to the Banking sector, its stability and sustainability is heavily interdependent, among other factors on low and stable inflation. As presented in the table, the return on assets (ROA) and return on equity (ROE) for banks are higher in KSA and Kuwait where the inflation is moderate, compared with higher inflation countries like UAE and Qatar. Central banks formulate and implement the banking, credit and monetary policy to ensure price stability, and to support the stability of the economy and financial sector. Evidence is mounting that inflation is harmful even at fairly modest rates because of the way it adversely affects the banking sector and investment. Sustained economic growth and viable banking sector operations can only be achieved with price stability.

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