Saudi government spending boom raises inflation risk

Inflation is set to rise in Saudi Arabia this year as the government unleashes another bumper budget, but it is unlikely to spur the central bank into action unless bank lending or other domestic pressures surprise on the upside.

For now, inflation in the world's No 1 oil exporter looks relatively restrained in the face of record spending.

Last year the government spent 804 billion riyals ($214 billion), the highest ever, and has announced a 690bn riyal budget for this year, as it seeks to boost education, health and infrastructure, partly in response to the uprisings seen in other parts of the Middle East. Inflation, though, has eased slightly, to 5.2 per cent in October-November, according to the latest data.

Unlike a spending spree before the global financial crisis in 2008, which helped send inflation to a record high of 11.1 per cent in July 2008, this time round, a stronger dollar and weak global demand will cap import prices and keep inflation in check below 7 per cent this year, analysts say.

But risks to that scenario are emerging, not least the kingdom's propensity to spend well above budget when the oil price is firm above $100 per barrel.

With its currency pegged to the dollar, Saudi Arabia needs to keep its interest rates in line with US rates, which are expected to stay low. That leaves only fiscal policy and curbing credit growth as its main tools to control inflation.

In the past decade the government has overshot its annual spending plans by an average 23 per cent, which would imply spending of 849 billion riyals this year, up 6 per cent from last year.

Spending in 2011 was 39 per cent above target and 24 per cent higher than in 2010, its fastest growth in a decade, reflecting uneasiness about social tension in the region. Saudi Arabia has seen only limited protests by the Shi'ite minority in its oil-producing Eastern Province.

Loan growth, one of the drivers of inflation in 2008, is another potential risk factor as it has been slowly accelerating after stalling in 2009 following the global financial crisis.

Growth in bank lending to the private sector hit a 31-month high of 10.7 per cent year-on-year in November, although that was far below a 27.1 per cent jump in 2008 as a whole.

"While the pick-up in inflation is likely to be significantly below that seen in 2008, several of the key drivers of the 2008 spike are in place and others could emerge," the International Monetary Fund said in September following regular consultations with Saudi Arabia earlier in the year.

"One potential concern ... is the buildup of liquidity in the banking system and the risk that it will translate into much higher credit growth in the months to come," it said.

Money supply (M3) is also growing at double-digit rates, averaging 13 per cent growth in January-November 2011, though again that was far less than nearly 22 per cent growth seen in the same period of 2008.

The Saudi central bank has told the IMF it could adjust policy by raising reserve requirements or lowering loan-to-deposit ratios to prevent excessive credit growth if needed.

Analysts, however, say the bank will be reluctant to clamp down on credit growth unless loan growth approaches 20 per cent.

"At the moment, the central bank is still keen on encouraging credit growth because a lack of availability of credit is something that has been holding back the economy," said Paul Gamble, research head at Jadwa Investment in Riyadh.

"I still do not see it is going to that kind of level where it could be particularly inflationary," he said.

Reserve requirements on deposits that can be withdrawn any time are currently at 7 per cent and are at 4 per cent on time and savings deposits. The private sector loan-to-deposit ratio stood at 80.1 in November, down from 86.8 in 2008, according to central bank data.

The IMF has said fiscal spending is the one area where inflationary pressure is greater now than in 2008, although the authorities have been largely successful in sterilizing it through increased issuance of central bank treasury bills.

"Those factors (credit growth and fiscal spending) are inflationary, and PMIs show wage growth and also some capacity constraints, which would also imply higher inflation in 2012," said Liz Martins, senior MENA economist at HSBC in Dubai.

"However, comparing 2012 with the last time Saudi Arabia had really troublesome inflation in 2007/08, the dollar is stronger now, and credit growth, albeit improving, is much weaker," she said.

The spending spree in 2007/8 was propelled by excess cash after oil prices tripled within 18 months to $147 a barrel.

This year, Brent crude is expected to average around $106 a barrel, according to a Reuters poll, well above the estimated break-even price of $85 in the 2012 budget, giving the government room to increase spending and wages further.

Finance Minister Ibrahim Alassaf said last month that the economy probably grew by a stronger-than-expected 6.8 per cent last year, and labour cost inflation in the non-oil private sector stayed close to a four-month high in December, a purchasing managers' survey (PMI) showed.

Analysts expect economic growth to slow to 4 per cent in 2012.

The global economic slowdown, weaker commodity prices and a stronger dollar are putting a break on inflation in the kingdom, which imports 90 per cent of its food requirements.

"With the U.S. economy expected to outperform European economies struggling to contain the sovereign debt crisis, we would expect the U.S. dollar to strengthen," Samba Financial Group said in a December report.

"This will help dilute any inflationary pressures in the GCC (Gulf Cooperation Council) from exchange rate movements."

Still, even 5 per cent inflation is relatively high for a country where inflation was virtually non-existent in the two decades prior to 2007/8, averaging just 0.5 per cent annually between 1980 and 2006.

Continued appreciation of the dollar is by no means certain and will not alleviate structural inflation caused by a housing shortage. That is pushing up rents by nearly 10 per cent on an annual basis, although that is less than half a 23.7 per cent rise seen at a peak in July 2008.

The government has set aside 250bn riyals, not included in the budget, to build 500,000 homes over the next 5-10 years, after population growth in the country of 27 million averaged 2.7 per cent a year in 2006-2010, according to the World Bank.

"In Saudi Arabia, you have a structural (inflation) driver in terms of a housing deficit, which will take years to fix," said Jarmo Kotilaine, chief economist at National Commercial Bank in Jeddah.

"So you still have rentals going up, not as fast as they did at one point, but still, we are talking basically double-digit year-on-year growth," he said.