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 one is circulated separately in email and posted online (click here for part 1 )

The Riyal�s Peg to the Dollar
Brad Bourland

Part 2

Policy option

Looking at all the arguments for and against a change, we think the best policy option for the time being is to do nothing. However, the time will come eventually when it will make sense for Saudi Arabia to move away from the dollar peg. The two main reasons for an eventual change would be first, that the economy will have diversified significantly away from dollar influences, and second, that the government will need independent interest rate setting tools as businesses and individuals become more indebted.

We do not see these fundamental conditions in place for many years. Economic diversification is a gradual process and the oil market is likely to remain dollar-denominated for a long time to come.

Less discussed is the eventual need for independence in setting interest rates. With a pegged currency, SAMA currently has little flexibility to move interest rates away from those set by the central bank (Federal Reserve) in the US. Should SAMA let interest rates diverge from US rates, players in the money markets quickly enter the market to take advantage of the arbitrage (opportunity for a riskless profit) that this situation creates, and the markets bring interest rates in Saudi Arabia back into line roughly with those in the US.

The ability to independently set interest rates is an important policy tool for containing inflation in developed countries. For this to work, however, there has to be significant indebtedness of local businesses and individuals so that their borrowing and spending habits can be affected by adjustments to interest rates. That is not currently the case in Saudi Arabia, where both corporate and individual debt is much lower as a percent of GDP than in developed countries. For example, consumer debt in the Kingdom stands at about 12 percent of GDP, while in the US it is about 100 percent of GDP. Total indebtedness in Saudi Arabia is just 37 percent of GDP. Adjusting interest rates in the US fairly quickly has an impact on the amount of liquidity in the economy and on spending behavior. But this is not yet the case in Saudi Arabia. Thus, even if the Kingdom currently had full interest rate setting independence, adjusting rates would still be a largely ineffective tool for fighting inflation. In addition, as discussed above, current inflationary pressures are due to local bottlenecks, mainly in real estate, and not liquidity conditions. Eventually removing the peg to the dollar would give SAMA the freedom to adjust interest rates to a level it considers right for the local conditions.

One alternative is to peg the riyal to a trade-weighted basket of currencies. Under such an arrangement the riyal would move in line with the currencies of its major trading partners, reducing the scope for imported inflation and giving some latitude to set interest rates independently. This was the route taken by Kuwait, which dropped its four-year old peg to the dollar in May and resumed managing its currency against a trade-weighed basket (with a heavy dollar weighting). The disadvantage is that markets and the public do not easily understand the concept of a peg to a basket of currencies, and in the Kuwaiti case, the basket currencies and their weightings in the basket are not publicly disclosed, which reduces transparency of the arrangement and the efficiency of markets in understanding and trading the currency. Since mid-July, the Kuwaiti central bank has revalued the dinar five times and devalued it seven times, in line with moves in the dollar during the period. We do not think the introduction of this uncertainty and volatility would be helpful to the Saudi economy.

A pure free float is theoretically the goal to ultimately achieve, where the markets set the exchange rate against all other currencies independently. Given the Kingdom�s connection with the oil market and associated volatility, this is not likely to be practical or positive for economic growth for a long time. Our view is that, for the time being, the current exchange rate and mechanism serve the Kingdom well, so it is best left alone. 

Part 1 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]  

Head Office
Phone: +966 1 279-1111
Fax: +966 1 279-1571
P.O. Box 60677, Riyadh 11555
Kingdom of Saudi Arabia
http://www.jadwa.com

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]