- International Monetary Fund. Middle East and Central Asia Dept.
- Published Date:
- October 2008
The MCD region faces the twin challenge of managing continued inflation pressures while addressing the growing downside risks from the global credit crisis. Many central banks have already raised policy interest rates in response to rising inflation. However, policy responses so far have been modest and interest rates generally remain negative in real terms, particularly in countries where the exchange rate is heavily managed vis-à-vis the U.S. dollar, suggesting some tightening of policies would be appropriate. At the same time, policymakers in the region should stay alert to downside risks from the slowdown in advanced economies and the increased stress on financial markets.
To contain inflation pressures, countries should implement policies appropriate to their particular circumstances, but which would generally include tighter monetary and fiscal policies in many countries and greater exchange rate flexibility.
In countries where growth is above trend and the exchange rate regime is flexible (e.g., most CCA countries), further tightening of the monetary policy stance should be considered if inflation persists, while some nominal appreciation of the currency would provide useful support for monetary tightening. In some countries where the financial sector is less developed and monetary transmission mechanisms are weak, monetary tightening could be achieved through raising reserve requirements.
Countries whose exchange rates are pegged to or heavily managed vis-à-vis the U.S. dollar should adopt fiscal restraint. Raising reserve requirements is an option, but raising interest rates in these countries would encourage larger capital inflows, further complicating monetary management. Fiscal policy should balance the need to contain inflationary pressures with that of investing in critical infrastructure. Such policies would be particularly relevant in Egypt, the GCC, and other oil-exporting countries.
Countries with widening external imbalances underpinned by capital inflows (e.g., Jordan and Lebanon) should follow a mix of tight policies to reduce external vulnerability. Fiscal consolidation should continue, though mainly through expenditure restraint and reductions in explicit and implicit subsidies, though some emerging market countries may need to consider revenue measures, as well.
In all countries, it will be important to prevent inflation expectations from becoming entrenched. A number of countries have raised wages in 2007–08, and this semblance of a wage-price spiral may have already affected inflationary expectations. In the period ahead, policymakers should particularly resist political pressures for higher wages and subsidies, which could be detrimental to macroeconomic stability.
Strengthen the financial sector’s resilience to the global turmoil
The region’s financial sector needs to become more resilient and flexible to reduce effects from the global credit crisis. In particular:
Continued efforts are needed to strengthen banking systems. Rapid credit expansion has not only added to inflationary pressures, but has also led to a higher level of nonperforming loans in some countries. If these issues are not addressed, banks may experience liquidity difficulties, and in some cases, impaired solvency. Already, banks in some countries are experiencing liquidity strains, which will require close attention from the authorities. In this context, countries—notably in the GCC—should coordinate their policy response in order to limit cross-border effects from individual country actions.
Similarly, prudential regulation should be tightened to promote appropriate lending standards and reduce loan concentration. Banking supervision should be strengthened to ensure appropriate loan classification and adequate provisioning, and improve banks’ capacity to assess risk. The supervisory authorities should conduct regular stresstesting and encourage banks to do the same to help identify risks and manage them appropriately. Inefficient state banks, which continue to dominate the banking sector in several MCD countries, should be restructured and privatized.
Policymakers should also closely monitor developments in real estate prices and assess vulnerabilities of the financial system to property market corrections. The rapid rise in real estate prices in some countries risks becoming a bubble fueled by credit expansion. If such a bubble deflated, there could be serious repercussions for the financial sector, leading to a slowdown in economic activity. The appropriate policy response to strong growth in real estate prices would need to include strengthened prudential measures for financial institutions and measures to bolster lending standards.
Reassess exchange rate policies
The depreciation of the U.S. dollar and the acceleration in commodity prices through the first half of 2008 have raised questions about the appropriateness of exchange rate pegs for several countries pegged to the U.S. dollar, and notably for commodity exporters. The improvement in these commodity exporters’ terms of trade has implied a rise in their “equilibrium” real exchange rates—an increase in the price of domestic goods and services (“nontradable” goods) relative to tradable goods. But for countries linked to the U.S. dollar, adjustment toward this higher equilibrium could only be effected through higher overall inflation. The burden of containing inflation has therefore rested on fiscal policy, forcing governments to restrain expenditure even though they could afford to spend and there has been a need to invest in infrastructure.
An exchange rate revaluation might have helped prevent this problem by lowering imported inflation. However, for some of these commodity exporters, notably the GCC, a revaluation would also involve some disadvantages, the most important of these being the risk of disrupting progress toward the GCC monetary union planned for 2010. Valuation losses on official overseas assets would also be incurred. The recent correction to commodity prices and the recovery in the U.S. dollar have, for the moment, weakened the case for revaluation. But if the currency and commodity price trends seen through the summer of 2008 were to resume, or if inflation were to accelerate, then the case for maintaining the exchange rate pegs would need to be carefully reassessed. Countries with flexible exchange rate regimes should allow their currencies to respond more fully to market movements by reducing central bank intervention.
Consolidate public finances by phasing out subsidies
With oil prices likely to remain high for the foreseeable future, MCD countries should move gradually toward market-based pricing of petroleum and food products, combined with targeted measures to help the poor. Reducing subsidies would not only allow demand to respond to changes in prices, but would also improve the efficiency of resource allocation and improve equity, while supporting fiscal sustainability. Studies find that fuel subsidies tend to be inefficient as a means of poverty alleviation as they are poorly targeted, with benefits accruing primarily to higher-income households. Therefore, well-targeted safety nets would be a more effective policy instrument to protect the most vulnerable from rising inflation, while ensuring a sustainable fiscal position.
Continue investment in oil, expand investment in non-oil
In oil-exporting countries, reforms are needed to foster greater investment in oil. These include efforts to ensure that investment regimes are stable and predictable, and that they facilitate the establishment of an orderly, predictable, and transparent market through improved data dissemination on demand and supply conditions. In parallel, these countries should implement structural reforms that contribute to building competitive non-oil sectors. Such a task is particularly urgent in countries facing imminent declines in oil production (e.g., Oman, Syria, and Yemen) and those that are vulnerable to fluctuating commodity prices with a limited cushion to absorb shocks.
Consolidate macroeconomic improvements
Over the medium term, domestic policies in MCD countries should aim at consolidating the gains in growth and financial balances that have been achieved in recent years. The macroeconomic performance of the past few years provides an opportunity to address the long-standing problems of unemployment and poverty in the region. To attain these objectives, governments will need to improve the investment climate and lower the cost of doing business, reduce the size of the state in the economy, improve labor market flexibility, and reform the educational system to reduce the “skills gap” in most MCD countries. These reforms should help to improve standards of living through a steady rise in per capita income and a continued reduction in unemployment.