Market pressures build on Saudi riyal but peg looks unbreakable

Solomon Teague
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Trading bets against the Saudi peg have jumped since the collapse in oil prices, despite the Kingdom’s sizeable FX reserves cushion.

Saudi riyal-R-600

The Saudi riyal has been under considerable pressure as the price of oil has fallen. Forward prices for one and two years are at their weakest levels, suggesting the Saudi Arabian Monetary Agency (SAMA) has been buying local currency at a feverish rate to maintain its peg and keep the spot price stable.

Saudi Arabia does not only have the money to defend its currency peg, it also has a firm grip on its local market, which it has tightened, according to Bloomberg, by clamping down on banks selling options on riyal forwards.

SAMA is understood to have contacted commercial banks privately and instructed them not to offer options on FX forwards, which on Wednesday was already easing the pressure, with riyal forwards falling from their highs.

Traders have developed a taste for blood, having claimed a number of high-profile currency-peg scalps in 2015, including in Switzerland, Russia and Kazakhstan. A small but not insignificant number have evidently been looking around for their next victim, with some concluding the Saudi riyal is a prime candidate.

War chest

However, many believe such traders are overestimating the pressure they can exert. SAMA has massive dollar reserves of more than $623 billion, according to IMF figures in December, constituting a massive war chest.

Many had thought Russia’s pockets would be deep enough to withstand the pressure from traders, but SAMA’s resources are in a different league, giving it the fire power to bankrupt any trader attacking the peg, for a considerable period of time.

Accordingly, trading of the Saudi riyal is still limited, involving a relatively small number of traders at mainly opportunistic hedge funds.

Yet the riyal is undoubtedly under considerable pressure, the price of oil dipping below $30 per barrel (p/b) this week. And while SAMA has the resources to defend its peg, doing so is likely to prove expensive. Saudi Arabia is reported to have used 10% of its FX reserves defending it last year.

The peg has withstood similar pressures before. In the 1990s the price of oil fell below $10p/b, amid similar expectations the riyal would have to devalue. More recently, in 2008 when Brent peaked at around $147p/b, stoking inflation, Saudi Arabia was under pressure to revalue the riyal upwards.

Andreas Konig-large
Andreas König, Pioneer
Andreas König, head of FX, Europe at Pioneer Investments, does not think the removal of the peg is likely in the short term, so the trade does not look attractive enough to put on a position at the moment.

However, Pioneer did trade against the peg in 2007/08, he says, when the pressure was to strengthen and it was hard to justify pegging it to a weak dollar.

"Back then the Saudi central bank was in an easier position because there is no limit to how much local currency you can sell," says König. "Now it is trickier. They may have large foreign currency reserves, but there is a limit."

SAMA’s ability to defend its peg is not the only thing putting managers off this trade. Technical challenges such as the opacity of the market, local nuances such as the lack of trading on Fridays, its illiquidity and the prevalence of locals with more insight into conditions on the ground form a barrier to entry for non-specialists.

It is also an expensive trade. The cost of carry means for one-year forwards there is an approximately 2% fall in riyal priced in, so if the peg was removed it would require a 2% fall for the trade to break even. For six months there is a 1% fall priced in. So while the trade would probably pay off if the peg was moved, it is expensive to speculate on the position.

It is therefore a question of whether SAMA will be willing to meet the cost of maintaining the peg. A devaluation would initially ease pressure on the Kingdom by increasing the price they receive for oil in local currency.

However, the purchasing power of that currency abroad would diminish, while growth would likely fall and inflation rise.

It would also ignite the fuse on a debt time-bomb. Saudi corporates have long tapped US dollar liquidity in the debt markets, with the peg giving them confidence its value would not spiral upwards due to currency moves.