Submitted by Dromeus Capital
Tampering with free markets is rarely successful, including in foreign currency exchanges—and The Kingdom of Saudi Arabia may be the next nation to discover the limits of sovereign power. The oilexporting monarchy is burning up reserves in an expensive effort freeze a dated, 31-year-old currency peg of 3.75 Saudi riyals to the strengthening U.S. dollar.
But there has been an epic retreat of crude oil prices since June 2014, and yet the International Energy recently predicted that in 2016, “unless something changes, the oil market could drown in over-supply.” The ghost of OPEC-driven artificial price-hikes past is haunting present-day markets—businesses and consumers adapted with efficient use of oil, or alternatives, and producers globally drilled steadily. And freed of sanctions, Iran is ramping up production.
Moreover, the U.S. dollar is strong, up more than 25% from 2011 lows against a mixed-basket of currencies, and the U.S. Federal Reserve is the only major central bank now raising rates, rather than cutting or deploying quantitative easing. A more-muscular greenbank would increase pressures for even lower oil prices.
Unfortunately for Saudi leadership, the Kingdom is an economic one-trick pony, and only knows oil. The Saudi strategy to flood markets with low-cost oil and regain market share—and kneecap the U.S. oil shale industry—has cost the monarchy dearly, with the Saudi national deficit ballooning to more than 15% of GDP, justifiably regarded as a banana-republic scale red-ink gusher. Despite vast wealth, Saudi Arabia never developed a real economy, only a petro-fare state.
Though Saudi Arabia’s vaunted FX reserves provide an ample buffer for now, they have been shrinking swiftly—down by nearly one-sixth since August—even as oil seeks a bottom. Unless the Saudis take corrective steps, the outlook of cheap oil this year will slice Saudi FX reserves by about $18 billion monthly, perhaps more.
Given their monochromatic economy, the Saudi have two corrective choices:
- Sustained severe domestic budget austerity, delivered to a population now bred on subsidies and handouts, and still mindful of “Arab Spring.”
- Or, let the Saudi riyal float
A macro-prudential policy for most oil-exporting countries, including Saudi Arabia, is to let markets work and let currencies float, or perhaps adjust daily within a moving band, Sino-style. A cheaper Saudi currency would provide domestic stimulus, as more riyals would be gathered for oil sold, riyals which could then be spent in the Kingdom, alleviating stresses.
More than that, an artificial Saudi riyal-U.S. dollar currency peg essentially transfers to the U.S. Federal Reserve Board monetary policy-making that should be made by the Saudi Arabian Monetary Authority, their central bank.
The Saudi currency, by being pegged to the greenback and the much-larger U.S. economy, results in Saudi interest rates that mechanically mirror Fed decisions. As the U.S. central bank tightens, a monetary noose tightens on the Saudi economy, just when an easing bias is needed. One might ponder why the Saudis not only want to export oil, but also their monetary policy-making to the U.S. To be sure, the Kingdom has launched a few belated austerity measures, such as cutting always-unwise subsidies on fuel, water and electricity. But to date the monarchy primarily has opted go into debt in global capital markets, rather than to remove the corrosive peg.
Not surprisingly, speculators (like hunters) sense wounded prey, and already bets are being laid on a riyal devaluation. Although it is possible Saudi Arabia can afford to maintain its oil regime and U.S. dollar peg, this will come will escalating costs, financial and political, and one suspects the Saudi citizenry is not big on sacrifices. The Saudi safeguarding of FX reserves, without cutting the riyal-greenback cord, will require unrelenting austerity measures.
It is not a surprise that financial markets are leaning towards a cut of the riyal-U.S. dollar peg, as indicated by the “12-month forwards,” which indicate a pending devaluation.
To date, Saudi leadership has indicated it will defend the peg. Others have pointed out that as an importing nation, Saudi Arabia would have pay more for many goods and services, also a negative. Still, policy options for the Kingdom are very limited and the usefulness of the currency peg has faded, today more a relic than the sensible monetary-policy tool of an advanced sovereign nation. The odds, and good policy, favor the Saudi de-pegging of the riyal-greenback in 2016.
Lastly, it should be noted that Mideast central bankers operate within increasingly hostile domestic and geopolitical environments. Though beyond the scope of this editorial, the Saudis are evidently militarily enmeshed in Yemen and to some extent Syria, and are seen as conducting a wide-ranging haphazard proxy war against historic rival Iran, replete with aerial and naval blockades. Increased Saudi war and security preparations will, of course, boost spending in the already red-ink drenched Saudi national budget—and hike the pressure to de-peg the riyal.