Saudi Arabia will spend more than SR12 billion ($3.204 million)  in subsidising food prices, on top of an estimated SR7.9 billion in indirect subsidies, such as water, electricity etc., according to an analyst.

Budgeted subsidies are on the rise in Saudi Arabia, though are much lower on a per capita basis than in the late 1970s. It is a cost which the Government is fiscally capable of supporting over the next three years – and is willing to meet, said Dr John Sfakianakis, chief economist of SABB, in a study.

Clearly, the impetus for these subsidies and the lowering of custom duties is rising inflation in food prices, which is socially sensitive and requires careful manoeuvring. Food inflation can leave people hungry – and the reason is simple: a greater portion of income per head in Saudi Arabia is now allocated to the purchase of food, he said.

"Speculation thrives in times of tight supply and strong demand, but we strongly believe that the issue of food inflation is neither temporary nor transitory. On the other hand, prices might not continue to climb exponentially, but they will not subside to the levels to which we were previously accustomed to," he said.

Reducing or eliminating food tariffs on key staples is the best option, says Sfakianakis. The revenue loss from reducing tariffs is not significant for Saudi Arabia and the fiscal implications are not grave. However, long-term subsidies, especially in the food sector, are inefficient – and also provide fiscal distortions and governance imbalances – rising food prices do make governments in the region wary, he said.

The rice subsidy, for example, benefits those on low and high incomes alike; and to encourage high long-term subsidy support is not fiscally prudent, with direct subsidies providing a more targeted approach under the umbrella of a social safety-net policy to cover half a million Saudis. Across-the-board subsidies can lead to supply distortions and smuggling, as has been the case with wheat and flour over the past few months. Lastly, food-related subsidies, once in place, are difficult to remove – as disposable incomes adjust to different spending patterns and consumer opinion on prices, he said.

In an environment of rising food prices, governments should also not be tempted to increase wages to combat food inflation, as wage-price spirals in the private sector may develop, fuelling further inflation.

In addition, we should take into account the Giffen goods paradox, whereby food price increases can lead to changes in consumption behaviour. This may lead to rising demand for a particular product when the price increases. In the context of food, the Giffen paradox applies particularly to staple items, where a price rise can leave low-income groups unable to afford more expensive foods and, therefore, more likely to increase their consumption of the staple.

"Imagine, for instance, a person with sufficient income to consume chicken and rice. Certainly, the rice is much less expensive than the chicken. But if the price of rice suddenly doubles, Giffen theory suggests that the person would budget to consume more rice and less chicken, because – despite the increase – rice would still be the cheaper food. The end result would be that rice consumption increases, despite the rising price," he said.

Optimists argue that supply shortages will not last beyond 2009, as farmers begin to increase their capacity in the food staples that have rallied and prices become attractive to agricultural investors. Speculation in food commodities will eventually fade, say the optimists, and a new equilibrium will be found. On the other hand, a less optimistic view is that there will be no significant improvement in the stock levels of key food products over the next decade; that price volatility will continue; and that potential or actual shortages will persist, as the world consumes more food.

"We<