JEDDAH, 28 November 2007 — Despite the twin challenges of inflation and a strong currency due to robust growth and healthy economic outlook, the Saudi Arabian Monetary Agency (SAMA) expected to keep the riyal’s peg to the dollar in place as the costs of altering the peg greatly outweigh the benefits.
The Riyadh-based Jadwa Investment said in its latest report that pressure had mounted on the riyal last week and it was trading at SR3.705 against the dollar, the strongest level since the peg was introduced in 1986 and well above its official rate of SR3.75.
The one-year forward rate, which measures what the market expects the riyal/dollar exchange rate to be in one-year’s time, hit SR3.585 against the dollar, meaning that some market participants were betting on a strengthening of 4.4 percent, the report said.
Brad Bourland, chief economist and head of research at Jadwa Investment, said “SAMA has moved to quell an unprecedented bout of pressure on the riyal’s peg to the US dollar. A cut in interest rates paid on deposits at SAMA on Nov. 24, making it less attractive to hold riyals versus dollars, has reaffirmed SAMA’s commitment to the peg but has been unable to push the riyal back from a 21-year high against the dollar. By itself, the interest rate cut has clearly not been enough to end the speculation on the peg, but it is an important sign to the market that SAMA remains committed to the current exchange rate arrangement after a period of uncertainty. However, lower interest rates are likely to have adverse consequences for inflation.”
The Jadwa report said the bulk of the pressure on the riyal is coming from the offshore market, with banks in Dubai, Bahrain and London conducting relatively small deals at levels well above the official rate. Saudi banks, which are responsible for most riyal transactions, have modestly adjusted their rates, but not by as much as the offshore banks.
If the dollar strengthens in international markets, then Jadwa expects the pressure on the riyal to abate.
However, should the dollar continue to decline and SAMA prove unable to address a substantial and persistent differential between the dollar/riyal market rate and the official rate, SAMA might begin a series of gradual adjustments to the exchange rate itself, as it did during the rise and fall of oil prices during the 1970s and early 1980s. Bourland said “in any case, we anticipate no change in the policy of pegging to the dollar, versus another currency or basket of currencies.”
The Jadwa report said reducing interest rates is the simplest way to ease pressure on the currency over the short term, but such a move would add to inflationary pressures that are already becoming a problem.
SAMA cut the reverse repo rate by 50 basis points (0.5 percentage points) on Nov. 24, lowering it to 4.25 percent. Saudi banks quickly followed suit, lowering the rate of interest they pay on riyal deposits to 4.00 percent, some 60 basis points below the rates they are paying on dollar deposits. This effectively achieves SAMA’s goal of making it relatively less attractive to hold riyals on deposit than dollars.
To help deal with inflationary concerns, SAMA raised the commercial bank reserve ratio for current accounts from 7 percent to 9 percent in early November.
“SAMA will now take a period of time to observe the foreign exchange market reaction to its latest interest rate move before taking further action. In the few days since the cut, there is little sign that the riyal has moved back toward the official rate; in fact, it touched a new low on Monday. The cut is, however, a clear sign that SAMA remains committed to the current exchange rate and the peg,” Bourland said.
