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Saudi Arabia keeps the peg

Key Highlights: Central Bank Governor says USD peg will stay, Intervention is an option,If the Fed continues to cut rates, Saudi might be forced to follow
Market Focus
The Saudi Arabian Central Bank Governor stated that there is no change in the country's FX policy, and that the USD peg is staying. The comments were made in a press conference which was scheduled to discuss the country's economic overview. With the Saudi ryial (SAR) being the centre of attention, the press conference was a great opportunity for the governor to address the issue and calm the markets down. The intentions of the Saudi Central Bank ( SAMA ) can be summarised by the five following points.

1. There is no intention to change FX policy
2. The SAMA believes the USD peg offers some flexibility
3. Inflation is driven by rising international food prices
4. Domestic needs will underpin monetary policy
5. The SAMA is able to intervene in the FX markets

Delivering a strong unambiguous message was important, as speculation over the sustainability of the USD peg was rising. There are economic arguments to question the desirability of a USD peg. The speculation over the sustainability of the pegs was a result of these arguments. However, they are not the whole story.

Economics aside, when it comes to Saudi's FX policy, the intentions of the authorities are very important. Most of the recent increase in speculation was a direct result of the absence of any clear message by SAMA , but this has now changed. The economic arguments for reforming the current FX regime are still there, but the will to proceed with change at this time is not.

The comments have helped to calm the markets down. But even though the Governor addressed the issue of revaluation head on, some of his comments leave questions unanswered.

The unwillingness of SAMA to move on the exchange rate is clear. The fact that the governor explicitly mentioned that SAMA could intervene in the markets to defend the peg serves as a reminder. It is easier for monetary authorities to intervene to fight appreciation than to intervene in order to defend a currency that is facing pressure to weaken. In the former case, the central bank accumulates FX reserves, in the latter, it depletes reserves to a point where defending the exchange rate becomes impossible. Stemming the appreciation might be easier, but it is by no means a costless process. One has to just look at India and China. Even though they have no explicit pegs in place, the massive reserve accumulation is causing a rise in inflationary pressures.

SAMA is willing to defend the peg, but this does not address the underlying challenges. Inflation is rising, and because of the USD peg and capital mobility, SAMA is unable to control interest rates. This is a problem now, following the 50bps cut by the Federal Reserve. The problem will become more serious if the Fed cuts again. With the peg remaining in place, SAMA will have no other option but to cut. The Governor's comment that SAMA may not have to cut interest rates is watered down from earlier comments. There is a clear risk that SAMA will soon run out of options, and if the Fed continues to cut, rates in Saudi Arabia would have to fall.

The Governor also stated that food prices are driving inflation higher. Food prices are sensitive to exchange rate moves. With the peg staying and the possibility of rates heading lower there is a risk that inflation in Saudi Arabia would increase further.

We have been making a distinction between nominal and real exchange rates in many of our publications. The combination of rising inflation, Fed cuts, and USD peg suggests that the adjustment in the Saudi economy will happen via prices, rather than the nominal exchange rate. Ironically, if inflation rises further, the peg will fail to achieve currency stability. Higher inflation implies a real exchange rate appreciation. SAMA can indeed defend the nominal exchange rate. But the combination above suggests that whilst defending the nominal exchange rate, SAMA will be foregoing the real exchange rate.

Speculation for SAR revaluation has eased for now, but the economic arguments have not been addressed. If the Fed proceeds with more interest rate cuts this year, SAMA will run out of options. In a market characterised by capital mobility, It will either have to follow the Fed and cut, or abandon the peg. Given that there is no strong will to abandon the peg just yet, the adjustment in the SAR is likely to happen in real terms through higher inflation.

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