JEDDAH, 7 April 2005 — The Saudi Arabian Monetary Agency (SAMA) raised its official borrowing rate last week by 50 basis points to 3.0 percent in a move to curb surging money supply. This repo increase followed the Fed’s quarter percentage point rise on March 26, thus widening the spread between the Saudi riyal and the US dollar rates by another 25 basis points.
Broadly speaking, Saudi interest rates track those in the US, given the peg of the Saudi riyal to the US dollar at SR3.75 since 1986. The Fed’s decision for tightening the monetary policy was in line with what the market was expecting, as the focus and concerns have shifted towards inflation. Although long-term inflation in the US remains well contained, the short-term pressure on inflation has picked-up and pricing power is now more evident.
Arguably, the medium-term inflation embedded in the US bond yield is estimated in the range of 2.5 percent to 3.0 percent. However, with the US real GDP growth approaching 4 percent, the widespread feeling is that the Fed Fund’s rate still remains low at 2.75 percent.
Meanwhile, the forward curve indicates that the Fed’s fund rate is at 4.25 percent a year from now. Allowing for the traditional tendency to over predict upward moves, another 1 percent rise in the US rate is expected over the present tightening cycle. Accordingly, the Saudi interest rate will also rise by another 1 percent over the same period, assuming SAMA will resort to its normal policy in applying the same percentage increase.
Although it is unlikely, but if SAMA opts for its most recent decision by adjusting rate by twice the percentage point increase on the US dollar rate, then Saudi interest rate will rise, consequently, by 2 percent over the same period. While this recent move may not affect the continued surge in equity and real estate prices, increasing interest rate by another 1 percent to 4 percent toward the end of 2005 will surpass Saudi stock market average dividend yield of 1.75 percent, thus providing rather limited incentive to switch to certificate deposits.
Moreover, corporate companies, generally borrowing at floating rates in Saudi riyals, will face not only the risk of US interest rate hike but also the risk of an increase in the spread between SAMA’s repo rates and Fed’s fund rates. However, rates on fixed-rate loans are bound to rise but rather less sharply than floating rates. If the banks’ under-growing competition in consumer loans do not push rates up, rising cost of funding to banks, ultimately, will adversely affect their margins, especially if SAMA chooses to raise rates more aggressively than the Federal reserve.
(Dr. Said A. Al-Shaikh is chief economist at the National Commercial Bank, Jeddah.)
