A pledge by the US central bank to hold interest rates very low for two more years could prove inflationary, while the recognition of institutional failures in the eurozone is probably pushing the adoption of a GCC single currency even further back, Jadwa Investment said in its new report Tuesday. Although for much of this time, very low interest rates have been appropriate for Saudi Arabia with inflationary pressure low and little growth in bank lending, however, "the case for keeping interest rates very low in the Kingdom for another two years is less compelling," Jadwa noted. Despite the likelihood that inflation will ease from the end of this year, the source of inflation will shift from international forces (primarily higher prices of foods and other commodities) to local ones, as government spending and bank lending accelerate, the report added. Higher interest rates are more effective at tackling inflation caused by local economic conditions. There are other policy tools that could be used, such as price controls, adjustments to bank reserve requirements or debt sales and purchases to manage liquidity, but these tend to be less effective than interest rates. Inflationary pressures would worsen due to a weakening of the dollar. On a trade-weighted basis the dollar has been little changed this month, as dollar assets have retained their safe haven status, though there have been large moves against some currencies. Once confidence in the health of the global economy revives, it is likely that the dollar will fall. Furthermore, if the Fed decides to adopt another round of quantitative easing (probably by buying long-term government debt), this could also potentially add to dollar weakness. A weak dollar and very low interest rates, combined with inflationary pressures and healthy economic growth within the Kingdom could lead to pressure on the exchange rate peg, the report said. The Fed's move has important implications for Saud Arabia, owing to the riyal's peg to the US dollar, Jadwa report said. The peg means that interest rates in the Kingdom are closely aligned with those in the US. As there are no controls on the movement of capital into or out of the Kingdom, should any significant differential open between Saudi and US interest rates, this would likely trigger a flow of funds into the Kingdom if local rates were much higher than those in the US and vice versa, Jadwa stressed. Moreover, Jadwa report said eurozone tensions are likely to impact on the progress toward a single currency within the GCC, as the model used by the EU is the basis for the GCC's approach. An increasing number of eurozone countries are requiring support to meet debt repayments at the same time as all member economies are slowing. With austerity measures introduced across the region, voters are questioning why they should make cutbacks to help other member countries, the report noted, adding that recent developments highlight the need for greater financial burden sharing. One approach, the issuance of bonds underwritten by all member countries, was recently dismissed by the French and German leaders. Nonetheless, it is likely that there will eventually be more cooperation on fiscal policy that leads to a formal system of budgetary transfers into a central revenue pool. Such an institutional arrangement appears essential for the effective functioning of a regional single currency, but we do not think the GCC will be any more inclined to adopt it than eurozone members. GCC countries have struggled to agree to a formula to distribute customs revenues since the introduction of a customs union in 2003 and argued the hosting of the regional central bank, which does not augur well for the need for greater financial cooperation. Noting that conditions on global financial markets remain volatile, with "increasing likelihood of a return to recession," the report said "in the short term, the volatility on global stock markets will hit investor and business confidence in the Kingdom." The Saudi stock benchmark Tadawul All Share Index (TASI) moves fairly closely in line with global markets and has fallen by 7.4 percent so far this month. Although the TASI now looks attractively valued, it added, more volatility on global markets is likely. New data releases will be monitored closely and investors remain concerned about the willingness and ability of policymakers to tackle the economic issues they are facing. Jadwa nonetheless believed that though a global recession will be avoided, a period of slow growth is imminent.
