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Is Saudi peg on the verge of breaking? – Falling oil prices and strengthening dollar bite

Katia Badr
Katia Badr
In January this year, the Saudi Arabian Monetary Authority (SAMA) issued a statement saying that the 1986 mandate which pegged the country’s riyal to the dollar was not under threat. Roughly a week later, SAMA restricted banks operating within its territory from selling forward contracts that are betting against the riyal.

While oil prices continue to fall and the US dollar continues to strengthen, that currency peg might appear vulnerable to some investors. Despite the Kingdom’s sizable foreign exchange buffers, which stand at $616 billion  as of December 2015, traders have been betting against the sustainability of the riyal.

Is the Kingdom of Saudi Arabia able and willing to maintain its currency peg? Or will it follow in the footsteps of its oil exporting counterpart Russia, who has the world’s largest foreign reserves, and de-peg its currency?

When an economy decides to peg its currency to a hard currency such as the US dollar, it is able to support trade flow by maintaining the competitiveness of its domestic products in foreign markets. The economy would also avoid exchange rate vulnerability and the adverse effects it would have on the stability of the economy. However, these benefits come at a cost.

To keep a peg holding, an economy constantly buys and sells its domestic currency through foreign reserve transactions. More than $100 billion of Saudi Arabia’s foreign exchange reserves have been depleted over the 11 month period between January 2015 and December 2015 as SAMA has been buying local currency at a feverish rate to keep its riyal nailed to the dollar. (Think: Supply and Demand).

Another burden of having a currency peg is that it would mean forsaking the unrestricted use of the economy’s monetary policy as a tool for growth and stability. While fiscal policy revolves around the level of spending in the economy, monetary policy regulates interest rates to incentivize individuals and businesses to either save or spend more and consequently speed up or slow down the economy.

Hence when Saudi Arabia pegs its currencies to the US dollar, the Saudi economy loses the liberty of implementing the monetary policies that would stimulate the economy to its advantage. A free currency float would help SAMA lift its oil-stressed economy by easing interest rates. However, the riyal’s peg means that interest rates in the Kingdom must mimic the Federal Reserves’ rate and keep the riyal fixed to 3.75 per US dollar. Consequently, the rising concern is that the Fed’s rate, which is tailored to serve the US economy, is not necessarily suitable for the Saudi Arabian economy.

Ever since the financial crisis, the United States has been easing its monetary policy; up until recently when the Fed hiked interest rates for the first time in nine years. SAMA quickly followed suit despite Saudi’s continuing struggle with low oil prices, consequently further straining the economy. The Fed’s tightening cycle in 2016 is expected to continue for at least another 4 years and Saudi Arabia is required to mirror this cycle if the country wishes to preserve its peg.

Bearing in mind that the oil-stressed economy would benefit from an easing in monetary policy and considering the Kingdom’s decreasing foreign reserves; what motivates Saudi’s policy in pegging its currency rather than following Russia’s footsteps?

In 2014, strong downward pressure on the ruble prompted Russia (Saudi Arabia’s oil exporting counterpart) to shift to a free currency float in order to free up its foreign reserves and bolster government revenues. This development took place despite Russia’s large foreign exchange reserves.

However, it is a different story for the Kingdom. In Saudi Arabia, oil revenues (priced in US dollars) account for approximately 85 per cent of export revenues (Russia: c. 66 percent in 2013 ) and government spending is composed largely of imports. Hence, it is doubtful that a devaluation of the riyal will do more good than harm. It will not bolster exports and it will not diminish imports. We also shouldn’t forget that the falling oil prices coincided with the sanctions imposed on Russia and became an additional catalyst of Russia’s economic crisis.

That being said, there is modest economic motivation for Saudi Arabia to de-peg the riyal. Additionally, such a move would also have a negative effect on SAMA’s credibility should it deviate from its current policy; which is a disincentive by itself to keep SAMA away from such a decision.

Studies  suggests that the Kingdom’s remaining buffers are able to sustain the peg for the next few years and the economy is far more shielded now than it was in the 1980s and 1990s when oil prices were at a much lower level. Although the Kingdom has to slow down its excessive spending and introduce budget cuts, Saudi Arabia has saved an ample amount of its oil wealth to keep the country firmly grounded. Public debt is among the world’s lowest, with a gross debt-to-GDP ratio estimated at less than 7 per cent in 2015 (2014: 2 per cent, ranked the lowest Government Debt to GDP worldwide), whereas in the 1990s, it was over 100 per cent of the GDP.

The decade-low oil prices have unarguably put the sustainability of oil-exporter pegs in the spotlight. However, the likelihood of a de-pegging of the Saudi riyal in the foreseeable future is close to zero and the likelihood of devaluation is low. The drawbacks of de-pegging the currency outweigh the positive aspects and Saudi Arabia can afford to take a solid stand in protecting its peg, at least for another 4 years.

This view may not be shared by all traders in the market, which was apparent with the USD-SAR forward pricing recently sky rocketing. However, many traders seek to capitalize on cases such as Russia’s to be their next de-pegging prey and make profits out of their bets. What these traders fail to comprehend is the divergence in the economic motivations that are driving these two different economies.

By Katia Badr, CFA – Member of CFA Society Emirates

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