Dr. Mohamed A. Ramady
Publication Date: 
Mon, 2006-05-22 03:00

Currency fluctuations, especially for a currency of international reserve such as the US dollar are of major concern for all trading nations. This is none less so far Saudi Arabia which has pegged its currency the Saudi riyal firmly to the dollar for the last quarter of a century, inviting bouts of speculative pressure against the Saudi riyal from time to time. These speculations have been adeptly managed by the Saudi Arabian Monetary Agency (SAMA), but what does the future hold?

The USA has been running some very serious budget and trade deficits for many years, something its leading trading nations have benignly tolerated, but are now voicing some concern. These concerns are not unfounded — the most recent sharp falls in the price of the US dollar triggered the worst one day falls in the European, Japanese and Indian stock exchanges. Common sense tells us that economies, like people, must pay for their way in the world, and cannot go on forever increasing their debt and importing more than they are exporting, without causing major structural imbalances to their standards of living or currency values.

At the moment, the US current account deficit — the trade in goods and services — is financed to all intents and purposes by the reserves of Japan, China and, to some lesser extent, by the increasing dollar dominated reserves of the oil producing countries. How long this act of seemingly advanced and enlightened self-interest will last, remains to be seen. In the short term, the countries that are the most nervous about the dollar’s decline and the large trade imbalances of the USA are the ones that seem to be caught in a catch 22 situation. They are like a grocery owner who extends credit to a customer (the USA), only to be bankrupted if the customer stops buying from them.

The American administration has signaled that they are happy for the dollar to decline, by not aggressively “talking up” the dollar, as the days of massive central bank intervention to support currencies on the markets are over. Just ask the Bank of England who still bristles at the mention of sterling speculators such as George Soros in the late 1970’s. Given the massive size of the foreign exchange markets today, it is doubtful whether central banks could make an effective intervention again, like the managed downward float of the dollar in the 1980’s under the so-called Plaza Accord.

A falling dollar would benefit the US economy by making US exports cheaper and help to reverse the $700 billion trade deficit with the rest of the world. This could increase US imports, adding to inflation fears and causing US interest rates to continue rising as witnessed for the past two years. In turn, such a move would reduce exports to the USA and cause a slowdown in the economies of the fastest growing countries in the world such as China, India and hurt the recovery of the euro zone economies. In turn, this would dampen demand for oil and push down prices for oil producers, unless oil prices are still going to be underpinned by an “Iranian fear” premium.

The rest of the world has a role to play too, to avoid a freefall that will hurt everyone. Some have opted to diversify their currency holdings into the Euro and other major currencies, while some oil producers such as Iran and Venezuela have talked about pricing their oil exports in euros rather than dollars. However large the oil exports of these two nations, they pale into insignificance when compared to global trade flows originating in dollars. Other countries have decided to take their own measures and China has quietly allowed it currency to appreciate against the dollar to just fewer than 8 yuan and has signaled that it is also willing to allow to currency to appreciate further against the dollar.

What of the euro zone? If the dollar falls, then other currencies must appreciate, but whose? The EU, which is just coming out of a prolonged recession of some of its key economic members such as France, Germany and Italy, will be resistant to see further appreciation above the 1.30 level for the dollar to the euro. Further appreciation of the euro to 1.35 levels will influence the pace of the European Central Bank’s interest rate tightening cycle, unless the stronger export led performance of key EU members continues, despite higher oil prices. The Japanese are also reluctant to see a further appreciation of the yen, which could hit their exports.

But major exporters to the USA have also another reason to feel vulnerable with the dollar’s decline. These countries central bank assets are mostly held in US Treasury bonds, and the fall in the dollar sees a fall in the yield on such assets. In buying these bonds, these foreign governments are in effect underwriting the “twin” US budget and trade deficits.

The recent fall in the dollar’s value, and the turbulence on the Saudi stock markets have raised, once again, rumors of a possible Saudi riyal revaluation against the dollar. Such speculations are unfounded for several reasons, and those who try to speculate against the Saudi riyal will see that SAMA will stand firm, as it did in other speculative bouts during regional crises of the 1990/91 and 2003 periods. The reasons for no revaluation are simple. First, a higher riyal will not help investors who have lost on the recent crashes of the Saudi stock market, since the valuation of the assets has been riyal denominated. Second, Saudi Arabia remains a dollar based economy with the majority of its exports, despite diversification drives, being dollar denominated. A currency revaluation would not offer major changes to its exports. What has been more noticeable is that the Saudi share of non-dollar imports have continued to rise, despite the fall of the dollar. As such, Saudi consumers and importers have adjusted to the fall in the dollar value.

The Saudi riyal revaluation rumors seem to have been sparked by the so-called “revaluation” of the Kuwaiti dinar last week. However, this is not technically correct as the Kuwaiti dinar operates its dollar pegged exchange rate within a 3 percent band that includes other major currencies. The 1 percent Kuwaiti dinar revaluation was then comfortably within the 3 percent band float. The above does not mean that when the Gulf Cooperation Council decides on the final pegging of the GCC unified currency, it might not adopt a different dollar denominated pegging band than at present. For the time being, the fate of the “sick dollar” is a matter of concern to all economies of the world. The situation is such however; that it is like a group of relatives watching over a very ill patient, and yet no one wants to be anointed as a successor should the worst happens. The mighty dollar is here to stay for quite a while yet ....

(Dr. Mohamed A. Ramady is visiting associate professor finance and economics at King Fahd University of Petroleum and Minerals.)

Main category: 
Old Categories: