By Luis Durani*
The Saudi Riyal has been pegged to the US Dollar for the past 30 years, but this may all soon change as the volatile oil markets will force them to abandon the fixed currency and devalue.
These types of mumblings have arisen before especially after the 2007/2008 subprime mortgage collapse. But this time the political and economic dynamics of the region have shifted and the Saudis will most likely uncouple their currency with the dollar. This devaluation is yet another battle in the long currency war that countries have been waging with each other since 2008.
What Has Happened So Far
Since 2014, the price of oil has dropped more than 60%, deemed to be one of the worst downturns in decades. When oil was at its peaks, new methods were being researched to help with its extraction. One of the most successful approaches was fracking. This method helped usher a new era for oil production. One of the consequences was that the US became an oil producer but the impact on global oil market would be devastating. Basic economic laws took hold, with an oversupply and weakening demand due to the languishing global economy, prices began to plummet.
Many initially thought the downturn was momentary and would be easily rectified by the Saudis, the largest holder of oil reserves. The Saudis could reduce production and prices would rise back up but instead they continued with full production. The Saudi intent was two-fold; regain market share rather than profits by making all other producers (mainly shale producers) go bankrupt and second coerce the Russians, whose national oil revenues comprise a large part of the state’s income, into some kind of bargain on Syria .
This policy backfired. The price of oil has dropped to levels that were not even contemplated by the Saudis and it is rattling their economy. They are beginning to experience large deficits. The Saudis have been forced to reel back their economic subsidies as well as implementing new taxes to close their budget deficits . The large foreign reserves that the Saudis have accumulated in the last several decades are being burned through in order to maintain the pegged Riyal’s value . Despite their large foreign reserves, the Saudis can sustain only a few years before a major currency crisis if it continues with the current fixed rate.
Currency Devaluation – Its Coming
At the moment, the Riyal is pegged at 3.75 to the Dollar. Ever since its introduction about 30 years ago, the fixed currency has been pivotal in safeguarding the Saudi economy from the fickleness of oil prices, which constitutes the overwhelming preponderance of the state’s income . Inflation is tightly controlled by tying the currency to US monetary policy. In addition, the pegged currency provides protection from the turbulent oil market by allowing the Saudi government to acquire copious amounts of foreign reserves when oil prices are high and protect it when oil prices drop.
But with the US Dollar growing stronger and the price of oil nose-diving, pressure is building on the Saudis to do something with the Riyal. Even though the Saudis have fared through similar currency issues before, tough times call for tough measures. A country usually devalues their currency for the following reasons:
- To Boost Exports – local products are made cheaper as the currency depreciates against other currencies
- Close the Trade Deficit – With a devalued currency, exports increase and imports will decrease resulting in a favor balance of payments
- Payoff Sovereign Debt – If a country issues lots of debt, a devalued currency allows the country to pay off the debt quicker over time
What Does it Mean
If the Saudis go forward with the devaluation, it will lead to further financial and political instabilities. But one major rationale for devaluation is the potential additional revenues the Saudis can achieve even in the current dismal oil market. Based on financial analysis, the Saudis require the minimum price of oil to be approximately $50-60 Dollars per barrel to ensure the nation’s budget remains balanced. But with oil prices dipping below $30 Dollars per barrel, the Saudis will be forced to take some sort of fiscal action soon. The oil revenues are denoted in US dollars but the nation’s internal monetary matters are handled in Riyals. Devaluating the Riyal would mean “more” national revenue, which would help remove the financial strain in the short-term.
For a country like Saudi Arabia to engage in a currency devaluation can be interpreted as an economic attack, which would result in other nations partaking in such tit for tat devaluations . Such an action will further slowdown the global economy. But the Saudis might not be worried about such retaliations, since the beginning of 2016; the Chinese economy has been off to an abysmal start. Many speculate that the Chinese will soon cease supporting its currency, the Yuan, and will engineer a currency devaluation itself . If that measure is taken, the Saudis will find themselves justified to remove the fixed rate and devalue the Riyal.
As oil prices continue to tumble, the Saudis find themselves cornered to make a pivotal choice, which will affect the trajectory of the region and potentially the world forever. The Saudis can either reduce oil supplies or devalue its currency. While the former option appears to be the simpler path, the Saudis appear to be reticent and gambling that the longer they hold out, the more market share they would receive. With a burgeoning deficit and rapidly decreasing foreign reserves, the only other option is to devalue the Riyal, which will set off an economic chain reaction. The currency war that started in 2008 appears to be entering a new phase as oil prices continue to tumble.
About the author:
*Luis Durani is currently employed in the oil and gas industry. He previously worked in the nuclear energy industry. He has a M.A. in international affairs with a focus on Chinese Foreign Policy and the South China Sea, MBA, M.S. in nuclear engineering, B.S. in mechanical engineer and B.A. in political science. He is also author of “Afghanistan: It’s No Nebraska – How to do Deal with a Tribal State.” Follow him for other articles on Instagram: @Luis_Durani
This article was published by Modern Diplomacy.