LONDON, 29 September 2007 — The appreciation of the Saudi riyal against the US dollar during September, which saw the riyal at its highest against the greenback in 21 years, has fueled speculation whether the riyal will indeed maintain its peg to the US dollar or whether it will be revalued to a more realistic level to maintain the balance between the two currencies and therefore trade between the two countries.
While the interest rate, exchange rate and currency policy of a country are essentially issues of monetary and fiscal sovereignty, the Gulf Cooperation Council (GCC) countries, save Kuwait, did agree in 2003 to maintain the peg their currencies had to the US dollar. This was supposedly in preparation for GCC monetary union by 2010.
Most analysts now believe that this dream of monetary union is unachievable by 2010. Oman has already said that it would opt out of monetary union if it went ahead in 2010. Kuwait broke ranks in May 2007 when it depegged the Kuwaiti dinar from the US dollar and pegged it to a basket of major currencies to include the yen and the euro, which incidentally has similarly appreciated sharply against the US dollar. Kuwait defended its action saying a weaker dollar was driving up inflation by making imports more expensive. Since the depegging on May 19, the Kuwaiti dinar has appreciated around 2.5 percent against the US dollar.
In fact, there are signs that inflation is causing havoc with the dollar zone GCC economies. Saudi inflation hit a seven-year high of 3.83 percent in July as rents rose at their fastest pace since at least 2004, and a currency pegged to a sliding dollar helped drive up the cost of food imports. Inflation in Qatar, the world’s largest producer of liquefied natural gas, hit a record 14.81 percent in March before falling back to 12.8 percent in June. Inflation in the UAE, the third-largest Middle East oil producer, hit a 19-year high last year of 9.3 percent.
It is inevitable that currency traders will be driven into a frenzy of speculation because this is the nature of the beast — chasing hot money where it appears.
The problem for countries such as Saudi Arabia, UAE, Oman and Qatar — all big oil and gas producers — is that the US dollar serves effectively as a currency reserve for the above economies, whose dominant exports — oil and gas — are denominated of course in the US dollar. This is a double-edged sword. When the dollar is strong, everybody benefits from the currency upside. But when the dollar is weak, it puts pressure on the dollar-pegged currencies to revalue to bring parity with the downside effects of the weakening US dollar, such as potentially fueling inflation in the US.
Saudi Arabia, Bahrain, Qatar, UAE and Oman, have repeatedly ruled out any change in their exchange rate policy with respect to the US dollar.
But in reality the pressure from the US Treasury and Federal Reserve on SAMA to revalue the riyal against the US dollar must be mounting. The danger is that the GCC currencies’ refusal to revalue against the US dollar may further fuel erosion of confidence in the US dollar itself. This especially at a time when the Federal Reserve last week decided to cut the dollar interest rate by 50 basis points to 4.75 percent. SAMA recently declared that a 5.25 percent interest rate of the riyal against the US dollar is a realistic peg.
There is however a precedent which SAMA could consider. Malaysia has been faced with the same dilemma since the Asian financial crisis of 1998. It has until recently resisted the temptation of depegging the Malaysian ringgit from the US dollar.
However, Bank Negara Malaysia, the central bank, has allowed the ringgit to revalue within certain ceilings, which is based on the movements of rival currencies in the region, especially the Chinese yuan, the South Korean won, the Singapore dollar, the Japanese yen and the Hong Kong dollar.
This is to pre-empt any of these countries getting an advantage in trade and other relations with the US as a result of currency and exchange rate policies and manipulations. Malaysian Minister for International Trade and Industry Rafidah Aziz is adamant that Malaysian exports to the US and other dollar zone markets should not move up at a disadvantage in terms of the value of the ringgit against the US dollar. The rinngit recently has adopted a more free float pegging to the US dollar and a basket of currencies including the euro and the yen.
SAMA like the other dollar zone GCC countries must act decisively to pre-empt any wild speculation on the local currencies with regards to revaluation or depegging. The uncertainty has already fueled a frenzy of speculation on the riyal precipitated by a gamble on whether SAMA would revalue or not.
SAMA Gov. Hamad Al-Sayari has repeatedly ruled out revaluation, saying inflation at a seven-year high is mostly due to domestic factors such as rents rather than higher import costs. Saudi Arabia has pegged its currency to the dollar at the same value since 1986 and has rarely moved out of step with US interest rate movements. Because oil revenues are earned in dollars and converted into riyals for government expenditures through the budget, a revaluation of the riyal would impact on the riyal value of oil revenues, reducing the current budget surplus. The value of the government’s mostly dollar-denominated foreign assets, currently in excess of $240 billion, when converted into riyals, would also be cut. Similarly, the value of Saudi bank assets will also be strongly affected.
But money market vagaries can assume a momentum of its own which could be damaging to an economy. The Asian financial crisis and the “Black Wednesday” when the UK was forced to leave the European Exchange Rate Mecahnism (ERM) are just two recent examples.
Some analysts may be on the right track when they stress that keeping the riyal interest rate unchanged is the first step toward changing the riyal’s peg to dollar. The question that remains is what is SAMA’s priority — to preserve the peg at all costs; not to revalue at any cost; but allow interest rates to fall?
A more expensive riyal will affect Saudi exports and dampen the enthusiasm for FDI flows into the Kingdom. This could undermine the Kingdom’s goal of becoming among the top ten most attractive destinations for foreign investment in the world by 2010.
The most likely scenario is that Saudi Arabia will resist any measures which will result in volatility and sudden changes in the status quo. At best a change in the interest rate would suffice, but changing the peg to the dollar may make sense over the long term, as the Kingdom’s economy diversifies. However, for that to happen SAMA also has to assume a more independent monetary policy role.