Saudi Arabia: On the Riyal Peg

Published on May 27, 2016
SGH Insight
There is virtually no chance Saudi Arabia will change its three-decade old peg of 3.75 riyals to the dollar, as we have written before (SGH 11/25/15, “Saudi Arabia: A Devalued Riyal Peg Highly Unlikely”). Contrary to some market beliefs, there is nothing to be gained in budget revenue through a devaluation as it would only mean higher import costs, likely higher inflation, and probable capital outflows, nor would exports become more competitive when the primary export is dollar-denominated crude oil.
Market Validation
(Bloomberg 6/3/16) Saudi Arabia ordered banks in the kingdom to stop selling
some products that allow speculators to bet against its currency peg just days
after demanding information from lenders on the offerings, according to people
with knowledge of the matter.

The Saudi Arabia Monetary Agency sent a circular to banks this week saying
that dollar-riyal forward structured contracts are banned with immediate
effect, said the people, asking not to be identified because they are not
authorized to comment publicly. Forward foreign-currency transactions backed
by actual goods and services will still be allowed, the people said.

Key Takeaways:

•    Saudi authorities will not devalue the riyal or adjust its dollar peg until the Saudi economy is vastly more diversified from its reliance on crude oil sales.

•    Devaluation on the eve of the National Transformation Plan would be politically counter-productive, while budgetary gains would be offset by higher import costs and capital outflows.

•    Recent speculation is fueled by proposed IOUs to contractors, discrepancy between SAMA reported reserves and UST disclosures, and is likely to persist.

The Saudi Arabian Monetary Agency’s new governor, Ahmed al-Kholifey, made a brief call yesterday afternoon to the state-controlled al-Arabiya network to assert Saudi Arabia has no plans to change its riyal exchange rate policy.

He should be taken at his word, but at the same time, the markets may be hearing from him more often.

*** There is virtually no chance Saudi Arabia will change its three-decade old peg of 3.75 riyals to the dollar, as we have written before (SGH 11/25/15, “Saudi Arabia: A Devalued Riyal Peg Highly Unlikely”). Contrary to some market beliefs, there is nothing to be gained in budget revenue through a devaluation as it would only mean higher import costs, likely higher inflation, and probable capital outflows, nor would exports become more competitive when the primary export is dollar-denominated crude oil. ***

*** A riyal devaluation would also be politically counter-productive with the Kingdom about to unveil its “National Transformation Plan,” Deputy Crown Prince Mohammed bin Salman’s ambitious plans to wean the Saudi economy off its “addiction to oil.” Only when the Saudi economy becomes more diversified will Riyadh consider a different exchange rate regime. But as long as crude oil remains the Kingdom’s primary source of export earnings, the peg will stay in place, and SAMA has the ample means and experience to defend it. ***

*** Recent speculation seems to be based on the belief Riyadh is facing new budgetary pressures as evidenced by reports the government may issue bond-like IOUs instead of cash to contractors. There has also been some speculation the US Treasury disclosure of only $116.8 billion in Saudi treasury holdings may indicate the Kingdom has less cash on hand than assumed. And there are likewise doubts over the Kingdom’s ambitious economic reforms, which may mean the speculation against the riyal may persist for some time. ***

Defending the Riyal

The riyal has been pegged at 3.75 to the dollar since June 1986 and has held through the two Gulf wars, through extreme swings in oil prices, budget surpluses and deficits, and foreign reserves.

There is invariably a build-up in speculative shorts in the Saudi riyal, especially in the forwards market, whenever oil prices decline, and with it, the level of foreign reserves drop. When the Kingdom ran persistent budget deficits in the 1990s, it was a more frequent and larger-scale battle. And in 2007 and 2008, the reverse was true: the betting was for a riyal revaluation when oil prices were rising to their last peaks touching $140 a barrel — it does seem a lifetime ago — and Riyadh was running massive budget surpluses and surging foreign reserves while the US dollar was weakening and the Federal Reserve was cutting interest rates.

In each case, speculators lost their bets, and SAMA takes considerable pride in never having lost against the currency shorts, and has almost always booked a profit when its own positions in the forwards market were eventually unwound.

The logic of the shorts is built primarily around an assumption a fall in oil prices and the opening of deep or persistent budget deficits might lead to a devaluation in order to close the budget gap. But the logic is fundamentally flawed in the unique circumstances of Saudi Arabia, mostly in that its primary source of export revenues are its crude oil exports that are priced in dollars, while its economy is heavily dependent on imports of products and services, the bulk of which is also priced in dollars or in dollar-bloc currencies.

Thus, there is nothing to be gained on the budget front in that whatever is gained in accounting terms in balancing the budget is quickly lost in the higher cost of imports by both the private and public sectors. And because the exports are already denominated in dollars, there is no competitive gain in higher export earnings through a devaluation as might be the case in most other emerging market economies.

Riyals in circulation are backed 100% by foreign reserves set aside under Article 6 of the Kingdom’s currency laws, with the banking system’s operational demands for dollars met through SAMA’s dollar sales. What’s more, Saudi banks tend to be highly liquid, with SAMA-imposed liquidity and loan to deposit ratios. SAMA itself keeps the vast bulk of its foreign reserves in dollars and in short term treasuries for maximum liquidity.

SAMA’s intervention when needed usually goes no further than spot checks for prices with dealers, or it can go further in questioning the domestic banks on the size of their open positions, trading volumes, or origins of the transaction. Only twice during the current peg has SAMA intervened directly for an extended run in size, in 1993 and 1998, but in both instances it totaled less than $1 billion and the positions were unwound after the forward contracts were settled at a decent profit.

“The Kingdom has the capacity to protect the exchange rate,” al-Kholifey noted in his remarks to al-Arabiya.

Persistence of Speculation

SAMA may, however, find itself being forced to intervene more often in the coming months, or years, for that matter.

It is unusual for devaluation bets to pick up when oil prices are rising, as they have been since their low under $30 in February. But the speculative positions at present are being equally driven this time by broader questions over the prospects for Saudi Arabia’s ambitious plans to reform and diversify the economy away from crude oil sales, the political implications of reducing subsidies and social spending, or finding new ways to tax via “fees” without any corresponding political liberalization.

Questions likewise abound to what extent the Kingdom’s powerful religious establishment will accept the social as well as economic changes being aggressively promoted by the Deputy Crown Prince.

And sometimes SAMA’s own indirect verbal interventions can backfire by fueling more not less speculative punts against the riyal. In the last few weeks, SAMA has been questioning the banks on the purposes behind recent short term structured forward currency products, which has come off as more heavy-handed than normal.

To a large extent, it has not limited the size of speculative positions, but is driving the trades offshore and has already widened the spread between the closely regulated onshore riyal market and the looser albeit less liquid offshore market.

Perhaps the more interesting aspect of the market rumors and thinking propelling the speculative shorts against the riyal was the recent confusion over the true size of SAMA’s foreign reserves: in contrast to SAMA’s foreign reserve total in March 2016 of $576 billion, — most of which, perhaps as high as 80% or more, is understood to be in dollars and most of that in risk-free treasuries — the US Treasury finally disclosed recently in its official tally of the Kingdom’s total treasury holdings that they totaled only $116.8 billion, and most of it was in maturities of ten year or longer notes and bonds.

But while the discrepancy has fueled the suspicion the Saudis do not have the vast foreign reserves they purport to have, the explanation for the difference in the reported numbers is found elsewhere, namely, in SAMA’s diversification of its portfolio, not out of dollars, but away from placements with the Federal Reserve Bank of New York or US-based custodial and commercial banks or portfolio managers.

That is, to say, to keep their dollar assets outside the potential legal reach of US authorities for the private lawsuits making their way through the US courts over an alleged Saudi complicity in the 9/11 terror attack — wherein US lawyers are threatening to seize Saudi government assets where they can get to them.

But another reason, we understand, is an uneasiness the Saudis, like many Sovereign Wealth Funds and managers of official reserves, are increasingly feeling over the reach of US authorities in using the international financial infrastructure like the dollar payment and clearing system, for foreign policy objectives.

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