Saudi Arabia should drop the riyal's peg to the dollar and consider “alternative exchange rate regimes'' if inflation persists and the Gulf single currency is delayed, the International Monetary Fund said. For the moment, most IMF directors say the advantages of the peg outweigh the disadvantage of temporarily higher inflation, the IMF said in a report published on its website today. Still, some recommended reviewing the peg immediately. Inflation in Saudi Arabia accelerated to above 10 percent in April, after averaging less than 1 percent between 2003 and 2007. The Kingdom ruled out plans to drop the riyal's peg to the dollar, insisting that the pick-up in inflation is largely caused by domestic factors, such as a housing shortage. “Directors observed that the peg of the Saudi riyal to the US dollar has provided a credible anchor that has contributed to macroeconomic stability,'' the IMF said. “If, however, inflation should persist and the Gulf Cooperation Council monetary union be delayed, they recommended to consider also alternative exchange rate regimes.'' Kuwait, the only one of the six Gulf Cooperation Council, or GCC, states to have dropped its currency's peg to the dollar, said inflation accelerated to a record 11.4 percent in April, before slowing to 11.1 percent in May. A 2010 deadline for the creation of a regional currency was thrown into doubt after Oman pulled out last year and Kuwait dropped its dollar peg. A draft of the Monetary Union Agreement, which provides a legal framework for the currency, will be passed to finance ministers in Jeddah in September. Inflation is the “main challenge'' to the Saudi authorities in the coming period, the IMF said. “In view of the limitations imposed on interest rate policy by the currency peg, fiscal restraint will be critical,'' it said. Discussing the annual economic report on the Kingdom, the IMF stressed that the macroeconomic performance in 2007 was strong as the real GDP grew by 3.5 percent, sustained by strong and broad based private non-oil sector growth (6 percent), especially in construction, retail trade, transportation and communication services despite the fact that inflation accelerated during 2007 and reached a historical high of 10.5 percent year-on-year in April 2008 driven by domestic demand pressures (especially rents) and higher import prices (mostly food). “Higher oil prices contributed to a large current account surplus of $96 billion (25 percent of GDP) despite a surge in imports. The surplus was used to build up the net foreign assets (NFA) of the central bank $301 billion (19 months of imports). “The fiscal surplus declined to 12.3 percent of GDP due to higher-than budgeted spending and to a temporary decline in the proportion of oil receipts transferred from the state oil company (Saudi Aramco) to the budget owing to higher investment spending. Spending was driven mainly by capital expenditures and a higher wage bill. Monetary policy was accommodative, given the peg to the US dollar, and despite efforts to sterilize the build up in NFA. Broad money grew by 20 percent in 2007, similar to 2006, but private sector credit growth more than doubled to 21.4 percent. The central bank sought to contain the expansion in monetary aggregates by raising reserve requirements in late 2007 and early 2008. “The stock market rebounded in 2007 with an increase in the main stock exchange index (TASI) by 44 percent during 2007, following a major correction in 2006. However the TASI followed global markets downwards in early 2008. Anecdotal evidence suggests that real estate prices increased by double digits in 2007. “Structural reforms contributed to an improvement in investor confidence, record foreign direct investment (FDI) inflows, and strong non-oil private sector growth. A major reform and investment program has been launched to address weaknesses in education, health, utilities, and the judiciary. “The outlook for 2008 remains favorable. Real GDP growth is projected to reach 5 percent with a rebound in oil output to 9.2 million barrels/day and a further acceleration in non-oil growth. Reflecting higher oil prices, a record current account surplus of US$191 billion (35 percent of GDP) is projected despite continued strong import growth. The overall fiscal surplus is expected to more than double to 30.4 percent of GDP, and public debt is envisaged to shrink further to 11 percent of GDP. Inflation is projected to peak around 10.6 percent in 2008, exacerbated by rising imported commodities and domestic supply constraints, but to ease in subsequent years.” IMF'S Executive Directors welcomed the continued strong growth performance and highly positive external financial position, and concurred with the authorities' plans to expand oil production and refining capacity to support global oil market stability. They agreed that Saudi Arabia's medium-term economic prospects appear bright, with continued strong inflows and propitious conditions for the further development of the non-oil sector. At the same time, inflation, fuelled in large part by rising food import prices and infrastructure bottlenecks, has accelerated recently, and poses the main challenge for the authorities in the period ahead. Directors emphasized that the macroeconomic policy mix should aim at sustaining job-creating growth while preserving domestic and external stability, with a critical focus on containing inflation. In view of the limitations imposed on interest rate policy by the currency peg, fiscal restraint will be critical. Directors observed that strengthening prudential measures to contain credit growth will also help to reduce demand pressures. Directors recommended that public expenditure focus on investments in infrastructure, education, and public services, with a view to diversifying the economy, encouraging job creation, and reducing dependence on oil income over the medium term. Introduction of a value-added tax would help diversify fiscal revenues away from oil and gas. While recognizing that many elements of this strategy are already in place, directors urged the authorities to further tighten current spending, in particular for wages, and to target more narrowly large implicit water and energy subsidies. They also recommended anchoring one-year budgets in a rolling medium-term fiscal framework, and further improving the availability of fiscal data. Directors encouraged the authorities to develop a long-term strategy of accumulating foreign assets beyond stabilization purposes, so that the benefits of the current oil wealth can be shared with future generations. Directors took note of the staff's finding that the Saudi riyal appears to be undervalued, given sizable terms of trade gains. At the same time, it was noted that the riyal is starting to appreciate in real effective terms due to higher inflation, and increased absorption through higher imports will reduce the current account surplus. Further expansion of oil production will help global oil market stability. __
