Editor's Note

SUSRIS recently presented a report on a new phase in the Saudi Arabian economy's "Golden Era" by Brad Bourland of Jadwa Investments. Mr. Bourland is well known to SUSRIS readers who have had the advantage of reading the many reports he authored as Chief Economist of the Samba Financial Group in Riyadh, as well as exclusive SUSRIS interviews with him.

One of the themes discussed by Mr. Bourland in the "Golden Era" report was the question of the Saudi Riyal's peg to the American Dollar and monetary policy. The issue has been discussed often but became a hot button economic question in May when Kuwait's central bank parted company with its GCC partners and switched its exchange rate mechanism to a basket of currencies, in an effort to forestall import driven inflation. Kuwait's monetary policy change has led to speculation about currency pegs in the other Gulf countries, especially Saudi Arabia. Today we are pleased to provide Mr. Bourland's detailed examination of the Riyal-Dollar peg question in a report released by Jadwa in August. 

SUSRIS wishes to thank Jadwa Investments and Mr. Bourland for permission to share this with you. It is provided in two parts due to its length. Part two is circulated separately in email and posted online (click here for part 2 )

The Riyal�s Peg to the Dollar
Brad Bourland

There is a growing popular view that it is time to revalue (adjust upward) the Saudi riyal and possibly to follow Kuwait�s lead and end the currency peg to the US dollar. A weak dollar is being blamed for rising inflation and has made summer vacations more expensive. On top of this, oil prices are near all-time highs and the economy is booming, putting natural pressure on the riyal to strengthen. In our view however, the costs of changing the exchange rate far outweigh the benefits, particularly as imported inflation is an insignificant part of the current inflation story in Saudi Arabia. The main losers from a reevaluation of the riyal would be:

• The government: Oil revenues are earned in dollars and converted into riyals for budgetary spending. A revaluation would permanently impair the riyal value of oil revenues, reducing the size of the current budget surplus and accelerating the day when the budget falls into deficit. The value of the governments mostly dollar-denominated foreign assets, currently in excess of $240 billion, when converted into riyals would also be cut.

• The Central Bank (SAMA): SAMA has stated repeatedly and forcefully that there would be no change to the 21-year old exchange rate peg. Any move would therefore damage SAMA�s credibility and reduce confidence in the currency in the event of an oil price downturn or increase in the value of the dollar. Moreover, no central bank wants a sudden and sharp adjustment to the exchange rate, but small changes would have little impact on those hit by dollar weakness.

• Foreign investors: A more expensive riyal and the introduction of exchange rate uncertainty would discourage foreign investment, undercutting a major policy initiative.

• Local companies: Saudi companies that export would see their products become more expensive overseas, making them less competitive. Those whose goods compete with imports, such as many food products, building materials, and furniture, would suffer as imported products became cheaper. 

Changing the peg to the dollar may make sense over the long term, as the economy diversifies and the central bank develops a need for more independent interest rate setting tools. That time is not here yet, and changing the exchange rate primarily to chase movements in the dollar would now do more harm than good. The only chance of an adjustment to the riyal we can conceive in the current conditions would be as a means of spreading the oil windfall to local citizens, who are seeing their incomes eroded by rising inflation.

A stable exchange rate

The Saudi riyal has been effectively pegged at 3.75 riyals to the US dollar since 1986. The peg was introduced with the aim of stabilizing the internal and external value of the currency. The dollar was chosen because it is the currency that international oil transactions are invoiced in, and this remains the case. Oil accounts for the vast majority of budget and export revenues (91 percent and 88 percent respectively in 2006). In order to support the peg the central bank (SAMA) holds by law sufficient �foreign exchange convertible to gold� (principally short-term US dollar instruments) to cover the value of all printed riyals in circulation, the part of money supply known as �MO�. In fact, today SAMA holds foreign currency-denominated assets far in excess of that required to provide 100 percent coverage of the currency.

To date the peg has served its purpose and has supported economic performance. The stability of the internal value of the currency is measured by inflation 9high inflation erodes the riyal�s purchasing power). Between 1986 and 2006 inflation in Saudi Arabia averaged just 0.5 percent. External stability is measured by the �real effective exchange rate�, which takes into account the value of the riyal against the currencies of Saudi Arabia�s main trade partners. According to the IMF, the real effective exchange rate has been relatively stable apart from periods of significant dollar weakness in 1986-1987 and 2002-2005.

Oil market developments have occasionally led to pressure on the peg. In 1993 falling oil prices, combined with concerns about the budget and current accounts deficits, generated money market speculation that the riyal would be devalued. Similar speculation occurred during late 1998 and early 1999 owing to a combination of falling oil prices and an economic crisis in Asia that caused major exchange rate devaluations in that region. At that time, SAMA successfully intervened in the foreign exchange markets with its vast foreign asset position to maintain the stability of the riyal. At present, the pressure, not so much in the money markets but in the form of public opinion, is for an upward revaluation of the riyal or even for an end to the pegged exchange rate system.

Why is there pressure for change?

Current expectations of a riyal revaluation have been driven by perceptions that the currency has become misaligned-persistently high oil prices and a strong economy should be strengthening the currency, but dollar weakness is causing its external value to deteriorate and inflation is eroding its internal value. Regional and global factors have provided further momentum for the speculation.

Determining whether a currency is out of line with its fair value is fraught with difficulty. For example, there is no clear consensus among economists about how to establish a currency�s �fair value�, particularly for a currency that is not free-floating and therefore does not have its rate set by market forces. Nonetheless, as the chart on the next page indicates, there appears to have been a structural shift in the oil price that has not been reflected in the exchange rate. Unsustainably large current account surpluses (Saudi Arabia�s have exceeded 20 percent of GDP in each of the last three years) are also generally an indication that a currency is undervalued. Finally there is the �Big Mac index,� compiled by the Economist magazine, which suggests the riyal is 30 percent undervalued against the dollar. (This index is based on the premise that prices for a product that is identical in terms of ingredients and labor and services required to assemble and distribute it � a Big Mac � should be equal across countries. Therefore, any price difference is attributable to exchange rate misalignment.) Other analysts using more complicated techniques arrive at a similar level of undervaluation. 

Another factor suggesting that the riyal is undervalued is its fall against some other leading global currencies, particularly the Euro and the British Pound. Under a free floating exchange rate system the huge inflow of foreign exchange would have almost certainly caused the riyal to appreciate. Instead, owing to dollar weakness, it has fallen. The chart on the previous page shows that Saudi Arabia�s �real effective exchange rate� has dropped by 21 percent since the end of 2001.

The table below shows that each of the currencies of the Kingdom�s main trading partners has strengthened against the riyal since the end of 2005:

It is thus reasonable to argue that the currency is currently misaligned, but does this mean that it would be sound policy to change it after 21 years at a fixed rate? We think not, at least not yet. As the export-led Asian countries have learned, a currency that is somewhat undervalued helps competitiveness and growth by encouraging exports while discouraging imports. Thus, Saudi Arabia�s economy fundamentally benefits from the current exchange rate. Also, foreign exchange markets move much more quickly than government policymakers, so any one-time adjustment of the riyal due to dollar weakness may backfire if the dollar were to strengthen suddenly. After decades of a pegged exchange rate, the rationale for change should be based on structural economic arguments, not movements in foreign exchange markets. We now turn to these economic arguments.

Inflation and the exchange rate

One of the most frequently heard current economic arguments for a change in the exchange rate is that the weak riyal is resulting in imported inflation. This is a major rationale put forward by Kuwait for its recent adjustments of the Kuwaiti dinar.

The fall in the riyal has coincided with a period of rising inflation in Saudi Arabia. Inflation has climbed from an average of 0.3 percent in 2003 to 3.1 percent in June 2007. A weaker riyal raises the local currency cost of imports not denominated in US dollars. The argument then follows that an upward adjustment to the riyal would cut the price of imports, reducing imported inflation. However, we do not believe that imported inflation is or will be a major factor behind rising prices in the Kingdom for the following reasons.

Inflation is concentrated in specific areas that are mostly unrelated to the price of imported goods. While the pick-up in inflation was caused by rising global commodity prices, local bottlenecks stemming from rapid economic growth are beginning to exert significant upward pressure on prices.

Food prices have been the main source of inflation so far this year. The food price rise is both a global and local phenomenon, but not related to the exchange rate. Jewelry price increases, captured in the �Other expenses and services� category in the table below, are related to the price of gold and silver, both dollar-denominated commodities whose local price is not affected much by exchange rates. Gold and silver prices hit 26-year highs last year. Regarding rents, an influx of expatriate workers stimulated by the economic boom and rapid growth in the national population has pushed up rents. As it takes time to construct new accommodation in response to shortages, rents are likely to become the leading source of inflation over the years to 2010. Rents are not affected by exchange rate movements.

Many retailers have chosen not to pass the higher cost of imported goods on to consumers to preserve market share. The table below shows the main imports from those countries whose currencies have strengthened significantly against the riyal (the Eurozone, UK, South Korea and India). Imports from these countries are primarily autos, mobile phone handsets, frozen poultry from France, rice from India, and aircraft from the UK. When it comes to imported autos, strong competition within the Kingdom means that car dealers do not appear to have passed on the full costs of the strong Euro. Instead the impact has been absorbed largely through margin compression by both local dealers and parent companies in Europe. Military aircraft imported from the UK have no impact on the inflation calculations. The mobile phone handset market is also competitive, and prices of these have in fact declined by 33.8 percent in the past 18 months, according to inflation data.

A closer examination of the cost of living index further illustrates that exchange rates are not the main problem in this regard. Prices of locally-produced and imported varieties of the same good are captured for 14 different items (principally, items of food, drink and furniture) in the cost of living index. For six of these goods, the prices of those produced locally have risen faster than imported versions; the reverse is true for another six goods, while for two the annual inflation rates are almost identical.

Trade data underplay the role of the dollar. The value of imports priced in dollars is much greater than just those sourced from the US as most international commodity trade is dollar-denominated and emerging markets with volatile currencies also tend to price their exports in dollars.

China�s growing role as a source of imports. Imports from China have more than tripled since 2002 and the country is now Saudi Arabia�s third largest supplier of imports, accounting for 9 percent of the total in 2006 (nearly double its share of just four years earlier.) This reflects China�s emergence as a center of low-cost manufacturing, the effect of which has held inflation down across the world, including in Saudi Arabia.

While a revaluation of the riyal would reduce some prices, it would not be an effective way of tackling inflation. Indeed, there are often many unintended consequences with exchange rate changes. For example, a revaluation would effectively lift disposable incomes, leading to stronger spending and perhaps higher inflation in some areas. 

Other economic considerations

In addition to not being a necessary of very effective means to tackle inflation, altering the current exchange rate arrangement would entail a number of other costs.

Reduction in the value of foreign earnings and assets. A revaluation of the riyal would cut oil revenues and the value of assets denominated in dollars when converted to local currency. For example, if the riyal were revalued upward by 20 percent, the government would be able to buy 20 percent less in riyal terms with its oil revenue. In 2007, we project oil revenues accruing to the budget at $135 billion. Based on the current exchange rate, these revenues can fund expenditures of SR505 billion. In the event of a 20 percent revaluation, the same oil revenues would only be able to finance spending of SR404 billion. If spending is unchanged, the lower revenue would result in a budget surplus of just 1.4 percent of GDP compared to our current forecast of 9.5 percent of GDP.

Our forecast is that government budget surpluses will decline over the next few years, as oil revenues level off but spending continues to increase. We forecast the budget to be roughly in balance in 2010. In the case of a significant revaluation, the elimination of the surplus would come sooner. 

With regard to foreign assets, assuming that 75 percent of SAMA�s holdings are dollar denominated, then a 20 percent revaluation would result in a loss equivalent to $36 billion (10 percent of GDP) when these assets are converted to riyals.

The banking sector would also see impairment of the value of its assets. As of June 2007, commercial banks net foreign assets were SR89.6 billion. Since the banks state their earnings in Saudi riyals, any earnings on dollar-denominated assets that are paid in dollars, such as coupons paid on bonds or sukuks, would be lower value when translated into riyals. 

Many other companies and sectors of the economy have large dollar assets or revenues that are in dollars. Since local companies generally prepare financial statements in riyals, any assets held that are dollar-denominated or revenues that are in dollars would be impaired in value in the case of revaluation. We know of no Saudi companies that would have the reverse benefit of an improvement in the value of their assets and revenues because they prepare financial statements in dollars.

Contradiction of official policy: SAMA has clearly and consistently stated its commitment to the existing exchange rate arrangement and has the means to fight off any speculation. SAMA net foreign assets totaled $243 billion at the end of June, equivalent to 130 percent of broad money supply (M3). To put it another way, SAMA can easily afford to buy every riyal in circulation in Saudi Arabia if the peg came under any pressure. Should SAMA decide that a change to the exchange rate regime is in order, then a communication plan to gradually and credibly prepare the markets and the public would likely precede it. Since this has not happened, we believe the policy remains firmly in place to keep the current rate and mechanism.

Damage to credibility: Credibility is vital for monetary policymakers to manage market exchange rate expectations successfully. Without it consumers and businesses lose confidence in the currency by becoming uncertain about its value and movements, and this hurts investment and ultimately economic performance. At present Saudi Arabia has a strong and credible exchange rate arrangement. Should the peg be altered abruptly after over 20 years of oil market and exchange rate cycles, this credibility would be dented. Not if, but when the time comes that oil prices fall land the dollar strengthens in global markets, then there would be strong market expectations that the riyal would be devalued.

Undermined non-oil competitiveness. A revaluation would raise the price of non-dollar denominated exports in foreign markets and lower the price ofnon-dollar denominated imports into Saudi Arabia. Both effects will undermine the competitiveness of locally-produced goods. A key policy tenet over time is to diversify the economy, and a major element of this is to encourage the growth of non-oil exports. In 2006, non-oil exports (mainly petrochemicals) accounted for 12 percent of total exports. The growth of non-oil exports would certainly be stunted by a significant revaluation that raised the cost of these exports to foreign buyers.

Regarding imports, we already forecast that imports will surge over the next few years as megaproject implementation gets underway and general confidence in the economy improves. A revaluation would increase the inflow of imports. We expect the current account surplus to decline steadily over the next few years from $95 billion in 2006 to $37 billion in 2010. This erosion of the current account surplus would likely accelerate in the case of a revaluation as imports became cheaper and exports more expensive.

Reduced foreign investment. The introduction of a more expensive riyal to foreign investors and exchange rate uncertainty caused by an adjustment to the peg would act as a deterrent to foreign investment. Even with oil prices and foreign exchange earnings at high levels, the Kingdom continues a policy, spearheaded by SAGIA, the investment promotion arm of the government, of strongly encouraging foreign investment. The Kingdom has a goal of becoming among the top ten most attractive destinations for foreign investment in the world by 2010. Revaluation and the introduction of exchange rate uncertainty would undercut this policy initiative.

Heightened volatility. Foreign exchange markets have from time to time focused on Saudi Arabia as a candidate for exchange rate volatility due to the Kingdom�s dependence on the oil industry, which itself experiences deep cyclicality and volatility of prices. Saudi policymakers have fended off this speculation by holding large dollar reserves and steadfastly defending the pegged exchange rate. A major reason the riyal is not yet a suitable candidate for floating freely is that if it were, the riyal would likely move in rough tandem with global oil prices, which remain highly volatile. For example oil prices dropped from $78 per barrel to $52 per barrel, a 33 percent fall, over a few months late last year, and have since rebounded to $77 per barrel, a 48 percent climb. Because of this volatility of oil markets and the outside perception that the riyal should be an �oil play� in foreign exchange markets, any change in the peg to the dollar would have to be carefully and gradually managed to contain excessive volatility. 

A variety of economic arguments have been put forward to justify an adjustment to the exchange rate regime. These include the following:

GCC single currency: A single currency for the GCC is planned for 2010. Although preparations have experienced a variety of setbacks recently the timetable has not been revised. As Saudi Arabia would have to permanently fix its exchange rate upon entry to a single currency (at very least to other GCC currencies and possibly to the dollar or a basket of currencies), there has been speculation that there would be an adjustment to the riyal in the interim.

Global imbalances: The Saudi riyal has become caught up in a broader debate on �global imbalances�. The imbalance is between countries perceived to be saving excessively (measured by a large current account surplus) and those spending excessively (a large current account deficit). Should the savers (China and the leading oil exporters) alter the way in which they invest their surpluses it could undermine the borrowers (principally the US). One way of narrowing the gap between the savers and the borrowers is a revaluation of the riyal, as this would encourage Saudi Arabia to spend more on imports, so reducing its current account surplus and (provided the imports were from the US) lowering the US current account deficit.

Part 2 of this report is provided in a separate email and online (Click here).

For comments and queries please contact:
Brad Bourland
Head of Research
[email protected]  

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Disclaimer of Liability (from Jadwa.com) 

Unless otherwise stated, all information contained in this document (the "Publication") shall not be reproduced, in whole or in part, without specific permission of Jadwa Investment.

Jadwa Investment makes its best effort to ensure that the content in the Publication is accurate and up to date at all times. Jadwa Investment makes no warranty, representation or undertaking whether expressed or implied, nor does it assume any legal liability, whether direct or indirect, or responsibility for the accuracy, completeness, or usefulness of any information contained in the Publication. It is not the intention of the Publication to be used or deemed as recommendation, option or advice for any action(s) that may take place in the future.

SUSRIS thanks Jadwa Investment and Mr. Bourland for permission to reprint this document.

About

Brad Bourland is head of research at Jadwa Investment, Riyadh.  From 1999 through 2007 Brad was the Chief Economist at Samba Financial Group, formerly Saudi American Bank, in Riyadh, where he published regularly on issues related to the Saudi and global economies and the world oil market. He appears frequently in the domestic and international media and is a regular public speaker. Before joining Samba, Brad spent an 18-year career as diplomat, economist, and manager with the U.S. Department of State. During the last three years of his diplomatic career he was in Riyadh as the American Embassy's First Secretary responsible for financial affairs, where he analyzed the Saudi economy for the U.S. Government and conducted financial aspects of US-Saudi relations. Brad has his BA and MA magna cum laude from the University of Utah, and is a CFA (Chartered Financial Analyst) charterholder.

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About Jadwa Investments

Jadwa Investment is a Saudi Closed Joint Stock company operating under the supervision of the Saudi Arabian Capital Markets Authority (CMA). Under the CMA decision published on August 21, 2006, Jadwa was awarded a license to offer all types of investment services including: dealing, managing, custody, arranging and advising.  [more]