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as external sources of inflation together condition the overallinflation environment, and in recent years, the pressure from theexternal and supply side factors have been significant, in the faceof rising demand in a fast growing economy. Strong annual nominalGDP growth and the high expansion in fiscal expenditure, which wasnecessary to sustain the growth momentum and the diversificationprocess, have exerted sustained demand pressures. In an openeconomy, the domestic demand pressure could often be relieved fromexternal sources of supply; however, it is the adverse external andsupply side factors that have become more prominent in exertingpressures on domestic inflation.
The extent to which the external environment has turned adverse inrecent years is manifested from the sharp increases in world food,metal and other commodity prices. This adverse trend also coincidedwith sustained depreciation of the USD, adding further intensity toimported inflation. Annual depreciation of the countrys importweighted Nominal Effective Exchange Rate (NEER) has been about 4 to6 per cent, and the cumulative depreciation since 2001 has beenabout 16.7 per cent up to the end of 2007.
Reflecting the impact of high inflation in many trading partners ofOman, particularly in the Middle East region, and the rising worldfood and commodity prices as well as large cumulative depreciationof the NEER of the RO, imported inflation generally remained muchhigher than the average inflation for the Sultanate. For example in2007, while the inflation in Oman was about 5.9 per cent, importedinflation (arrived at by dividing the value of imports by thequantity of imports) was about 15.4 per cent. In other words,despite strong imported inflation, domestic inflation remainedrelatively much lower. The domestic inflation trend was alsoconditioned by domestic absorptive capacity, i.e. the unavoidablecost-push impact associated with rising demand for all factors ofproduction to sustain the growth momentum in the country.
Demand of the private sector for expatriate labour was so strongthat over and above the additional increase of 85,925 in 2006,there was an increase of 127,734 in 2007 alone, and much of thisincrease also might have happened at higher costs. The impact ofthis high labour import at high cost not only contained the risk ofwage push inflation, but in the face of such large influx ofexpatriate labour, there was considerable pressure on the supply ofresidential accommodation, which was reflected in the rising trendin rent. The wage-rent spiral was a reflection of capacityconstraint in a growing economy.
A commodity wise analysis would reveal that annual increase inprices in just two items explain the major part in the inflationtrend in Oman in 2007. Food, beverages and tobacco, with 30.4 percent weights in Omans CPI, rose by 10.8 per cent, broadlyreflecting global price pressures on food items and commodities,and in fact price increases in these items in Oman were relativelyless than the comparable increases elsewhere in the world.
As per the Muscat WPI, prices of meat, fish, fruits, vegetablesand oils rose by 16.3 per cent in 2007, with dairy product pricesalso increasing by 10 per cent. The second important factorcontributing to the inflation trend, i.e. rent, with 15.3 per centweight in the CPI for Oman, rose by 8.5 per cent in 2007, under thepressure of spurt in demand for residential housing, resulting fromlarge scale addition to the expatriate labour force in the privatesector in both 2006 and 2007.
Both these components clearly suggest the importance of externaland supply side factors in Omans inflation process, and theresultant limited policy options that could be used effectively tocontain domestic inflation. High growth in demand for money andcredit has been a natural offshoot of high economic growth, andgiven the constraint on independent use of monetary policy arisingfrom the fixed peg of the RO to the USD, money supply and creditgrowth generally remained strong.
In 2007, the monetary condition was characterised by availabilityof ample surplus liquidity, as growth in money supply and creditremained far in excess of the demand underlying the growth innominal GDP. Recognising the need for appropriate monetarytightening, despite the constraint on independent conduct ofmonetary policy, the CBO has introduced two major anti-inflationarymeasures in the recent past: (a) the reserve requirement has beenraised from 3 per cent to 5 per cent, effective from February 2008(which would permanently impound about RO 160 million from thebanking system, and to that extent could curtail the ability ofbanks to lend to finance aggregate demand in the system); and (b)the volume of absorption of surplus liquidity from the bankingsystem through issuance of CBO CDs has been raised considerably,from about RO 500 million as at the end of October 2007 to about RO1,341 million as at the end of February 2008 (implying additionalliquidity absorption of RO 841 million over a period of just 4months).
When the excess liquidity from the banking system is mopped upadequately, that reduces correspondingly the scope for easyliquidity financing inflationary demand and asset price inflation.In June 2008, anti-inflationary monetary policy measures wereactivated further, with the decision to raise the reserverequirement from 5 per cent to 8 per cent and to tighten thelending ratio from 87.5 per cent to 82.5 per cent.
Imported inflation, driven by the sustained depreciation of the USDagainst major international currencies, has often been highlightedin many quarters as an important source of inflation in Oman, withaccompanying expectations that a revaluation of the current pegcould help in addressing the challenge of inflation. It is not hardto recognise that while many emerging as well as developedcountries have allowed significant appreciation of their currenciesagainst the USD in recent years, they continue to face inflationpressures.
When sources of inflation originate primarily from the supply side,whether internationally in the food and commodity markets, ordomestically in respect of rent, any revaluation could at bestentail a temporary salutary effect on inflation. The adverseeffects of the revaluation, however, could be severe and morepermanent. Moreover, under the pressure of supply shocks, asinflation reverts quickly to the higher level, there could bedemand for further revaluation, which in turn would make theexchange rate of the country highly unstable.
For an open economy like Oman, exchange rate stability is acritical component of the sound macroeconomic policy framework ofthe country, and any exchange rate instability not only would bedetrimental for investment and growth, but could also be a sourcefor speculative capital flows. Given the uncertain benefits of arevaluation in terms of the extent and duration of its favourableimpact on domestic inflation, the costs to the economy, however,could be numerous and more certain.
At the macro level, diversification is a key requirement to ensuresustainable export led growth in Oman, and a revaluation wouldseverely dent the diversification process. Most of the megaprojects involving large investments are export-intensive innature, and a revaluation could erode the export competitiveness ofthese projects. In recent few years non-oil GDP as well as non-oilexports have exhibited high growth, symbolising the progress beingachieved on diversification, and a revaluation could dampen thistrend.
On the import side, a revaluation could make imports cheaper, andresultant high growth in imports may exert severe pressures on thecountrys balance of payments. In 2007, Omans import growth wasalready as high as 46.6 per cent, and any revaluation could onlyworsen the balance of payments situation by encouraging cheaperimports.
One needs to recognise that as against the only major inflow offoreign exchange in the form of petroleum exports, there are largeoutflows of foreign exchange in the current account under import ofgoods, net services payments, remittances, and income payments, andthese outflows are also rising significantly in recent years.
At the more disaggregated level, a revaluation would involvecorresponding decline in RO revenue in fiscal accounts of thegovernment, whereas expenditure in RO may come under the pressureof the ratchet effect. In the absence of appropriate wage-priceflexibility, the adverse effect of any revaluation on the fiscalsituation could be permanent, and for an economy in which fiscalpolicy continues to be the driver of growth and investment, suchcontractionary fiscal effects of revaluation on the economy couldbe hard to avoid.
In the sphere of monetary policy also a revaluation per se wouldnot give rise to any monetary policy independence, and hence, theconstraints on independent use of monetary policy under a fixed pegwould continue. It is also important to take note of theinternational investment position of Oman, which suggests thatOmans foreign assets for all sectors of the economy exceed theforeign liabilities. Hence, any revaluation would have a largevaluation loss for Omans foreign assets, which are meant to beused in future for financing investment and growth in Oman.
Being an open economy which also depends on external capital,technology and labour to ensure faster economic growth anddevelopment, a significant part of the payments made to thesefactors of production are in RO, while considerable part of theseincomes are remitted outside the country, rather than being spentdomestically.
A revaluation would involve large proportionate outflow of foreignexchange from the country in the form of remittances andrepatriation of dividend/profits and technical knowhow payments,while also making Omanisation an even more difficult challenge toimplement as a revaluation could enhance the competitive advantageof expatriate labour vis-