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.

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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.

Part of the solution is more likely to be raising rates to mirror the US dollar it is tracking, possible by around 1% over the course of the year, says Nick Beecroft, CEO at HP Economics.

And then there are tax rises.

Nick Beecroft,
HP Economics

“Saudi Arabia has only just started imposing taxation,” says Beecroft. “That is an important resource with a lot of revenue-raising potential, especially considering its healthy GDP growth. Yes, at -10% the fiscal balance is terrible at the moment, but it should not be too hard to bring it back into line.”

At the same time, it will almost certainly look to cut spending. It has already announced a privatization programme that will look to sell off various infrastructure assets such as airports, and if this does not raise enough capital it could always sell off part of Saudi Aramco, arguably the most valuable company in the world.

Simon Williams, chief economist for CEEMEA at HSBC, says: “Saudi Arabia is urgently looking for answers to the oil price slump, but these will be found in spending cuts, not the FX regime.

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Simon Williams, HSBC

“The peg, the source of confidence in the value of the currency, is the single-most powerful anchor for domestic policy, given its exposure to oil price swings, shifts in global trade and geopolitical risk. The peg’s credibility rests on its longevity.”

For all the pressure the riyal is under, speculation remains relatively limited compared with what might ensue if the Saudis buckled. Any future changes in the oil price would be met with increased trading activity around the currency, increasing the cost of defending a new peg.

If the peg was dropped altogether, the riyal would probably move in lockstep with the oil price, increasing volatility.

Williams says: “In the long term, currency liberalization might be good for the Saudi economy, but it is a long way down a long list of fiscal, monetary and market reforms.”

The riyal is also just one of a number of pegs under increasing scrutiny: the Danish krone, Czech koruna, the Hong Kong dollar and the Nigerian naira, as well as other Middle Eastern currencies, are all in the spotlight.