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Dr. Mohamed A. Ramady
Publication Date: 
Mon, 2007-10-01 03:00

In an unusual and frank press interview last week, the Saudi Arabian Monetary Agency’s Governor Hamad Saud Al-Sayari, reiterated, in unambiguous terms, SAMA’s determination to maintain the Saudi riyal’s current peg of 3.75 to the US dollar and sent an oblique message to would-be speculators betting on a Saudi riyal revaluation.

He said SAMA was “willing and able to intervene to support its current exchange rate policy, using many means”. The message was clear — for the immediate future, and irrespective of what other Gulf countries are doing, SAMA was staying put.

The decision by Saudi Arabia not to match the Federal Reserve’s decision to cut its Fed Fund rate by 50 basis points added further upside pressure on the riyal, but the message over the past weeks is that the Kingdom had no intention of revaluing the currency any time soon. SAMA apparently will maintain its official repo rate (the rate at which it repurchase-back government bonds from banks) at 5.50 percent and, if necessary, defend the 1986 riyal peg to the US dollar using the sizeable reserves the Kingdom has accumulated over the past few years should the riyal come under speculative pressure. This will involve buying dollars from riyals and then “sterilizing” the riyal liquidity though reverse-repos by its open market desk.

Speculative pressure seemed, once again, to come from offshore banks, just as in the prelude to the last Iraq war. This time, economic, as opposed to political considerations seemed to have motivated speculative purchasing of the riyal. The reason was obvious — the cut in US interest rates and the continuing weakness of the US dollar on the exchange markets.

SAMA has made it clear that a fixed peg meets the Kingdom’s economic needs for several reasons, chief of which are “investor confidence, and transparency in dealings,” and that most of the Kingdom’s external financial transactions were carried out in dollars, or linked to the dollar in one way or another. There are many arguments for and against fixed exchange rates, but SAMA is right in highlighting that fixed exchange rates maintains investor confidence in the currency, encourages domestic savings and long term investment planning, and discourages capital outflows.

It also reduces inflationary trends associated with devaluation pressures should these arise.

Arguments against a fixed exchange rate is that it does not allow for the implementation of an independent monetary policy, that fixed exchange rates cannot be used to adjust for external shocks and imbalances and that such a peg is also a fixed target for speculators.

The interesting aspect of current SAMA policy is that, in the words of the governor, “the Kingdom’s monetary policy was directed to the needs of the domestic economy” — in effect, SAMA would follow a monetary policy that is based on Saudi economic considerations and not dictated by other countries’ economic policies. An indication of this relative independence in monetary policy is that the premium spread of SAMA’s official repo rate over Fed funds is now at a high of 75 bp.

In addition to a higher than predicted inflation rate during 2006 and 2007 for both goods and services, SAMA has also had to deal in recent years with an asset price inflation on both stock market and real estate prices, although the stock market collapse in 2006 has eased pressured on that front. Maintaining a higher Saudi riyal premium reinforces the monetary agency’s desire to quell further domestic liquidity and easier credit lending to avoid further rises in real estate prices.

Revaluing the Saudi riyal might ease on current speculative pressure, but would do little to dampen on inflation because it is argued that little of the Saudi price pressure are exchange rate sensitive due to several key factors.

Domestic inflation is mostly internally driven by higher labor costs, due to certain skill shortage for the ongoing mega economic projects and other key sectors of the economy, or to high real estate prices in urban areas such as Dammam and Riyadh.

The compulsory employee medical insurance schemes now being implemented has added to company costs.

There is some imported inflation for key foodstuffs, such as rice, which have been affected by supply shortages from exporting countries, as well as higher priced European Union, Japanese and UK export to Saudi Arabia. These have been offset by cheaper US dollar denominated imports.

This will take time to work itself into the economy though, and will involve consumers switching to these dollar import substitutes. Until then, a key SAMA policy goal is to keep a close watch on domestic bank lending to some critical sectors that are deemed to be contributing to domestic inflationary pressures such as real estate.

Revaluation of the Saudi riyal might also affect the recent encouraging inflow of foreign direct investment into the Kingdom, and, more importantly, an appreciating riyal might reduce the riyal’s value of Saudi Arabian’s riyal denominated oil revenues and foreign reserves. As these reserves build up, this becomes more and more an important issue and a dilemma for the Kingdom, especially if the Federal Reserve were to cut its interest rates further.

While current SAMA actions might smack of a relative degree of a more independent monetary policy, in the final analysis it is the further action the Fed might take that could force SAMA to change direction.

For the time being however, those that are betting on a change in SAMA’s currency peg are in for a rude awakening, as SAMA has an almost unlimited ability to maintain and defend the current peg of 3.7500 to the dollar. Speculators should have learned from past experience by now, that in such speculative runs, SAMA has always come out on top.

(Dr. Mohamed Ramady is visiting associate professor, Finance and Economics at King Fahd University of Petroleum and Minerals.)

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