- Currencies of net resource exporters should rise and fall with commodity prices.
- Tightly pegged currencies do not carry out local & global adjustment and can get misaligned.
- Oil Boom and Bust cycles allow for tightly pegged currencies to manage volatility shock if spending prudence exercised during booms.
- An independent monetary and fiscal policy helps control spending and buying when consumers are indebted.
- Currently, consumer debt ratio in Saudi Arabia is around 12% of GDP, while it is close to 80% for Europe and 100% for the United States.
- Countries can manage deficit by accessing funds through debt markets (loans), equities markets (bonds), raising taxes or all three activities.
- Saudi Arabia has more than sufficient MO Reserves (the amount of money lawfully required in foreign reserves/assets to maintain the Peg).
- Sustained lower oil prices are straining Saudi Arabia’s fiscal and monetary systems creating current account deficits.
- The real exchange rate of LCU moves in sync with current account surplus/deficits. Higher the deficit, lower the Currency Value and vice versa.
- Saudi Arabia may be forced to abandon the peg or devalue the currency if oil prices do not rise in the near future.
- They may also voluntarily abandon the peg once they are well diversified or if they want to move away from dollar due to political reasons.
- A Peg Break will not directly lead to the crash of the US dollar but may lead to a regional economic tsunami and an onset of a long deflationary cycle.
- Commodity Prices are inversely coupled to US Dollar value, Stock Markets are positively coupled with commodity prices.
- A global recession caused due to macroeconomic factors will depress oil and commodity prices and force a peg break as well.
- Recycling and spend management of sovereign wealth funds away from the US Dollar will crash the US dollar.
- Peg Break or Peg Loosening is the most viable option for Saudi Arabia in the next 2-3 years.
- Once Saudi Economy is diversified and consumers and nation are indebted, need for an independent monetary policy may force a peg break.
- Peg break combined with politically motivated recycling of funds can crash the US dollar.
Saudi Arabia is facing a Trilemma (see below) on whether to keep or maintain the dollar peg in force since the last three decades. Oil prices have remained in the no recovery zone for much longer and are starting to bite. The kingdom is planning to float a public IPO for its crown jewel SAUDI ARAMCO, which as per insiders is valued much below the touted $ 2 Trillion Valuation. Our own Discounted Cash Flow models indicate a valuation of around $ 715 Billion. There have been rumors whether Saudis will abandon the Riyal-Dollar peg? There is also a lack of clear understanding of what will happen if and when the dollar peg breaks. Could A Saudi unpeg cause a US Dollar crash and how? Saudis have repeatedly rejected speculation on a potential peg break and have even banned structured options trading in Saudi Riyal recently. Is is time for a change ? Will Saudis voluntarily break the peg or be forced to abandon the peg? In this essay, we build various scenarios around this interesting subject.
Fixed Currency Regimes
Fixed Currency Regimes are countries who have chosen a fixed monetary value of its currency (LCU – Local Currency Unit) versus a chosen foreign currency. A large number of countries have chosen fixed currency peg versus the US Dollar or the Euro (see figure below). You will notice that there are many small nations in this list, while there are few large economies such as Saudi Arabia, United Arab Emirates as well.
For all these countries, the primary source of revenue is in US Dollars or Euros, so, pegging to US dollar creates stable economies as these nations can avoid volatility by piggybacking on stable currencies. Most of the African countries have pegged to Euros, while the Middle East is pegged to the US Dollar. Note that eventually, all pegs break. Recently China, Thailand, Kazakhstan, Azerbaijan and Argentina de pegged their currencies. When Thailand’s Baht was unpegged on July 2, 1997, Baht fell by almost 15%. Over next few weeks, the Indonesian rupiah, Malaysian ringgit, and Philippine peso depreciated between 30-50% and we came very close to an economic contagion in the South East Asia.On Aug 20, 2015, Kazakhstan’s currency Tenge plummeted by more than a quarter due to sustained oil slump. Within few months, Azerbaijan’s currency Manat depreciated by 48% against the US Dollar.
The biggest story in the “Float Game” was China when it unpegged Yuan from the US Dollar and after devaluing its currency pegged it against a basket of thirteen currencies amongst its various trading partners. Yuan depreciated by only 1.4% against the US Dollar, but the impact was much bigger as China trades in trillions of dollars of exports annually with its trading partners. I would re-emphasise here that all currency pegs eventually break and the impact of unpegging is a depreciation of the local currency versus the pegged currency (US Dollar/Euros). Hence, exports to the pegged currency country (US/Europe) become cheaper and imports from the US/Europe become expensive. Recently Donald Trump, the president of the United States has complained about the manipulation of the currency by China making international trade agreements unfair to the United States. He may be right, but US Dollar and the United States also gains during the peg period as US Dollar/Euro is considered more stable and investment flows into the country as well. For the countries that chose to unpeg and instead float their currencies, in the long term, it always turns out to be more advantageous. Historical study of currencies that have floated their currencies indicates that short-term suffering is offset by increased stability and lower currency risks.
Why do Regimes/Countries Peg their Currencies?
“Whose bread I eat, his song I sing” – German Proverb
There are many complex reasons why a country should choose to peg their currencies to more stable currencies. Some of them are :
- Maintaining competitiveness in exports with nations who export similar products.
- To maintain local stability in monarchies/dictatorships.
- To control inflation.
- To reduce exchange rate variability prior to a monetary union.
- To offset speculative attacks by Short Sellers.
- Seek Political Support of a powerful nation by buying back the nation’s debt (bonds).
- To distort investors moral decision-making related to peripheral issues such as human rights, freedom of speech etc.
Countries that decide on fixed currency pegs are usually dominant exporters to the countries whose currencies they chose as fixed standards. It allows countries to maintain competitiveness versus other players in exports to the pegged currency state. You will also note that the fiscal and monetary policies of these countries are not matured, the political systems are opportunistic and riddled with corruption/vested interests. Hence, the independence of the monetary policy authorities is questionable. There are sustained pressures and incentives to inflate the money supply, which can lead to uncontrolled inflation and significant negative effects on the local economy. By pegging the currency to a more stable currency, the local country is essentially importing the monetary policy of the stable currency state. In Petro-dollar states, which are controlled by monarchs or dictators, there is always a sustained pressure to maintain stability at home. Currency pegging is one way to keep the economy fairly stable so as to avoid local Arab Springs.
In March 1979, the European Exchange Rate Mechanism (ERM) was introduced by European Monetary System (EMS) to avoid fluctuations in partner state currencies before rolling out Euros as a single currency for the region. The ERM can also peg currencies to Gold in some cases, but, is mostly used to peg to more stable currencies. Exchange Rate Mechanisms are also used to maintain local pegs as we will discuss in the next section. In 1997/1998, market overreaction, structural and policy distortions led to a massive speculative attack on the local currency of Hongkong and Malaysia. Speculative attacks on currencies occur using forward trading (options). Hongkong and Malaysia pegged their currencies to the US Dollar to fend off the speculative attacks and the move essentially sent the short sellers packing. More recently, Bank of Canada increased interest rates strengthening the Canadian Dollar to fend off against a massive speculative attack on the Canadian Dollar. As we can see, there are many ways to fend off speculative attacks such as increasing interest rates, however, temporary currency peg is the last option when everything else fails.
There are two more cases where currency pegs are preferred by nation states and they are the result of more implicit policies which are rarely discussed publicly. The first case is when dictatorships or oligarchs are looking for significant political support from powerful countries. They use the massive foreign exchange reserves to essentially finance the debt of the bigger nations by buying their bonds and treasuries. In conflict-ridden states, such as in the middle east, there is also the additional benefit of spending most of those foreign exchange reserves in purchasing military -industrial supplies from the more powerful nations. The bigger nations such as UK and USA have much to lose if the currency is depegged both in terms of increased inflationary pressures as well as reduced revenue of the mammoth military-industrial apparatus.
Finally, an area that I have avidly studies i.e. unconscious decision making is rarely discussed anywhere. Investors tend to become very selfish when they stand to personally gain significantly in their monetary actions. As the Wall Street crisis has amply demonstrated, the fine line between ethics and morality is the quickly breached when investor sentiment gets distorted. When Investors, specifically powerful organized groups perceive personal gains from supporting regimes with questionable human right policies of the minorities, they tend to relegate the negativity others perceive around global human rights issues. To articulate this in layman terms, when our money is invested in a nation state which is considered oppressive, repressive or evil in some ways by others, we pacify our moral awakening by convincing ourselves that things are not so bad. We consciously and mostly in a self-serving manner introduce a favorable bias in our opinions to our benefit. As discussed elsewhere, once we start the process, our frontal lobes are bypassed and we take decisions completely controlled by sub-personalities which are on a self-serving spree of immediate gratification. We relegate our moral awakening using a large toolkit in our repertoire, however, we start with perceiving ourselves to be more rational and others as overreacting to simple issues. As such, pegging a currency can also have the unintended effect of unconsciously tinkering with the unconscious perceptions, inferences, judgments, and decisions of influential policy makers as well corporate mammoths. It is also important to highlight a reverse corollary here i.e. when politicians in the more powerful states take a hardline position on the usually neglected transgressions of the fixed currency regime, then, the rulers of the fixed currency regimes may perceive no benefit from maintaining a peg. During the final years of Obama administration, the murmur around Riyal-Dollar unpeg amplified. Obama foreign policy involved reproach with Iran as well taking a hardline position on Saudi Arabia’s Yemen misadventures and discreet funding for various extremist groups.
In most cases, the motives for pegging a currency are complex and involve a multitude of reasons rather than a single reason. The net exporters to a country that choose to peg with their foreign currency also inevitably will refinance debt issued by these countries as sovereign bonds or treasuries. The pegged currency states are forced to calibrate their foreign policy considering the possibility of a fire sale of their treasuries by net exporters. Countries that chose to peg against a more stable currency usually will unpeg voluntarily only due to a significant political shift in policy, but, predominantly, the unpeg is forced i.e. there are no better alternatives for the nation states. On this basis, it is fair to say that most fixed exchange regimes are forced to abandon the peg due to economic headwinds than political ones. Our premise is that more peg breaks are in the offing as we head into economically troubled waters.
Why do some countries use “Pure Free Float” vs Fixed Exchange Systems
Pegging the currencies to a more stable currency has its advantages for net exporters of a particular commodity such as Saudi Arabia. However, most countries chose not to peg and instead “pure free float” their currencies. As with those who chose to peg, there are multiple reasons why countries chose not to peg. However, the core reason can be explained by an international economic principle known as “The Unholy Trinity” or “The Impossible Trinity” also called Trilemma (see Figure below – Enlarge to see Larger Image). In laymen terms, this policy can be translated as “You cannot have your cake and eat it too“.
The “unholy trinity” is a principle where policy makers can only choose two out of three policy directions i.e. Free Capital Flow, Fixed Exchange and Monetary Autonomy. Basis this, countries which chose to peg their currency and maintain a fixed exchange rate (loose peg or tight peg) can either chose Free Capital Flow or Independence in monetary policies. The two choices available to countries like Saudi Arabia are :
a) Fixed Exchange Rate with Capital Mobility – In this chosen scenario, the policy makers lose the ability to set an independent monetary policy. As highlighted by Milton Friedman, the noble prize winning economist and well explained in this video , changes in interest rates through the control and manipulation of the money supply would be offset by capital movements in response. Capital movements will lead to pressure on the fixed exchange rates and to maintain the peg, policy makers would be forced to control and manipulate the money supply (by buying or selling Local Currency Units – LCU’s). The simple act of controlling the money supply will now impact interest rates in the opposite direction, counteracting the original action of the policy makers.
b) Fixed Exchange Rate with Monetary Autonomy – In this chosen scenario, once the fixed currency regime decides to maintain a peg, it on boards the monetary policies of the fixed currency state.In Saudi Arabia, where Riyal is tightly pegged to the US Dollar at 3.75 Riyals per Dollar, as the Federal Reserve increases interest rates in the United States, Saudis will have to follow suit. Of course, they can choose not to do so, however, the resultant difference between the interest rates of two currencies will be exploited by arbitrageurs (financial agents looking for risk-less profit). If the country raises the interest rates on LCU (Local Currency Unit), it is sacrificing local growth as businesses will find it more expensive to borrow money. As the volume of foreign exchange reduces, it creates FX deflation and subsequent LCU deflation. The central banks have to take some action. If they do not raise interest rates, the money deflation can create banking crisis as it happened in the Asian Financial Crisis on 1970’s. If they do raise interest rates, they sacrifice local growth to maintain the peg. It is a catch 22 situation. An easier way is to de-peg and let the currency float freely.
Due to the above reasons, many developed countries which have a diversified economy chose the “pure free float”. There are historical studies of cases where countries unsuccessfully tried to beat the Trilemma and spectacularly failed. The Mexican peso crisis (1994–1995), the 1997 Asian financial crisis (1997–1998), and the Argentinean financial collapse (2001–2002) are stark examples of the evil power of the unholy trinity in global economics.
As consumers and nations becoming indebted, countries use monetary policy independence to control spending and buying. In Saudi Arabia, the indebtedness of consumers is around 12% of GDP while the overall indebtedness of the nation is around 34% of GDP versus more than 100% Debt to GDP ratio for the United States and around 80% for the United Kingdom. As Saudi Arabia diversifies and becomes more indebted, they will have no choice but to rely on an independent monetary policy. It is more likely that they will voluntarily break the peg in such a case, however, it will take anywhere from 2-5 years for this scenario to evolve.
How do Countries maintain a Peg
I am using an analogy on currency pegs first used by Paddy Hirsch of Marketplace APM, which aptly explains how countries maintain a peg and I will use the same analogy to build up on the currency peg demise argument.
Let us assume that there are two sailboats (independent nation states) in the ocean (global economy). One of the sail boats is owned and operated by a financially sound and powerful experienced sailor who also has the best toolkits and technology available at its disposal. Let us call this boat the “Marker Boat”. The experienced sailor is akin to a country which has matured fiscal and monetary policies while the second boat is looking to gain from following the first boat by piggybacking on its trajectory and movements. Let us call the second boat the “Lag Boat” as there is a small lag time between the actions of the first boat and second boat. The “Lag Boat” chooses to maintain position relative to the “Marker Boat”. It does so by lifting the sails and accelerating when it is lagging behind or by lowering the sail to engineer a drag when it suddenly surges ahead due to a multitude of reasons beyond its control.
In essentially choosing to maintain pace with the “Marker Boat”, the “Lag Boat” is importing and onboarding the the various forces being experienced by the “Marker Boat”. On top of these imported forces, the “Lag Boat” also has to consider its own unique design and operating constraints. If there is a significant mismatch between the design and operating constraints of both, the sync could break after significant damage to the “Lag Boat”. Remember that it is the “Lag Boat” that has chosen to follow and sync with the “Marker Boat”. If it becomes challenging to maintain the pace, at some point in time, the ” Lag Boat” may have to simply give up trying to maintain Sync.
In economic terms, if the local currency starts gaining strength against the pegged currency, the “Lag Boat” country starts selling its own currency and starts buying more foreign exchange reserves. This trading leads to increase in the supply of the local currency in the market while reducing the supply of the foreign currency. The foreign currency strengthens while the local currency weakens. In an alternative situation, when the local currency loses strength against the foreign currency, the country starts buying more local currency while selling foreign exchange reserves. It leads to weakening of the foreign currency while strengthening the local currency.Using the analogy from the sailboats, we must remember that once a peg or fixed exchange rate is set, it requires constant work to maintain the peg. Usually, it means that the country needs to have significant foreign exchange reserves to play the market and maintain the peg. FX Reserves are akin to the fuel and power for the boat and the control system (s) which allow smooth navigation in the waters. As soon as a country runs out of foreign exchange cushion (as it happened with Baht in Thailand), the country is forced to abandon the peg or face an economic Armageddon.
There is a significant complexity in the way a country establishes and then manages its pegs. We have the soft peg (pegged within bands) and the hard peg (fixed exchange rate that rarely changes). Under the soft peg system, we have the “Pegged within Bands” system where the currency is allowed to float within a narrow band range. We also have the “Crawling Peg” system, where the exchange rate is announced at a pre-decided period and then enforced. Then, there is a hybrid peg system named as “Crawling Band” system in which rates are pre-announced but also allowed to fluctuate within a narrow range. Finally, we have a tight peg or hard peg where their exchange rate adjustments are rare (as with Saudi Arabia for the last three decades). Compared with the free floating currency, which adjusts upwards or downwards based on market forces automatically (imagine a drifting boat, occasionally controlled, but, mostly autonomous on ocean waters which rise and falls with the tides). The fixed peg (Pegged within Bands, Crawling peg and Crawling band) is also called “Managed Exchange Rate” process or “Dirty Float” as countries have chosen to engineer a float versus allowing a free currency float. Applying it to the sailboat analogy, a country could choose two or more boats as an average benchmark against which they will maintain the pace. Alternatively, they could announce before the start of the race that they intend to maintain pace with a boat and allow for a fluctuation (lead or lag) as the race commences.
Finally, I want to provide an analogy from systems engineering, an area I have professionally worked in for many years prior to shifting careers twice. Using analogies from shock absorbers, a shock absorber has many moving parts and they are designed to absorb shock from various forces while maintaining stability (within a tolerable range) of the equipment on which they are installed. If you design a shock absorber so that the upper end is tightly held and degree of movement is restricted (as in tight peg), then the shock will transfer to the other moving parts which must be designed to offset for this extra load.
Using the above analogy, if a country decides to maintain a tight peg in-spite of significant forces consistently bombarding the economic system, the shock will transfer from the fixed end (Pegged Rate) to the real economy. It will lead to domestic pain. In such cases, over time, the shock from the domestic side will keep increasing and the system caves in unable to deal with real or nominal shocks. Therefore, while choosing a pegging system, most economists and policy makers cannot foresee how an interconnected system will respond to varying degrees of forces as economics is more of a social science rather than statistical science. Specifically, as discussed elsewhere, economists and policy makers suffer from significant prediction failure and lack of foresight when the range of forces impacting a system is unique or sustain themselves over long periods. As discussed elsewhere, prediction over a long range or in bizarre systems i.e Hyperforecasting © is a challenging skill to acquire.
What happens when a Peg Breaks
Could a Saudi De-Peg cause a US Dollar crash? Will there be a global economic tsunami? Will US Dollar remain unaffected by the unpeg? What will happen to the stock markets? What will the impact on Commodity Markets and the price of Oil? Will Oil price crash as well? Prince Prince Alwaleed Bin Talal, a Saudi billionaire has said that a Riyal/Dollar unpeg is the last resort. He may be both right and wrong as we will discuss below.There are a lot of theories out there of the impact of a Peg break on a local and global economy. Many are incomplete or focus on the reductionist view of the macroeconomics. I am making an attempt to summarize a more holistic conceptual model of a peg break and as I learn more, I will return back and update this post.
Using the same analogy of sailboats in the ocean, we will now go into some detail about the consequences of a peg break. Firstly, as we used the sailboat analogy for the sake of simplicity, we also assumed (implicitly) that the “Marker Boat” is not affected by the actions of the “Lag Boat”. The reality, however, is very different as our global economy is more interconnected than it has ever been in this history of the world. In the large global ocean (global economy), there are many other boats, some are free floating, some are marker boats and others are lag boats. There is a complex interconnected relationship between all these boats as goods flow between all these boats. If goods flow was unidirectional i.e.export intensive countries only exported goods to the reserve currency state, things would be much simpler. However, as we know, resource exporters are investing in treasuries of reserve currencies and also holding significant FX reserves on their balance sheets. The free floating currencies impact each other while the pegged currencies influence each other most significantly.
As such, there is a massive indirect influence of currency movements on both pegged as well as unpegged currencies. As already discussed, two main “Marker Boats” in the world are “US Dollar” and “Euros”. These marker boats are influenced by a range of market factors, but mainly an upward/downward adjustment when fixed currency regimes buy or sell the “Marker Boat” currencies to maintain the peg. While continuing to maintain the peg, some countries may downward adjust the fixed exchange rate. In one such scenario, let us assume that Saudi Arabia chooses to devalue Saudi Riyal from 3.75 to 3.80. Without doing anything else, for the existing dollar reserves, the country now inflates the number of riyals in its local banks by printing more currency. More money in the system without any significant change in micro economic situation will lead to temporary inflation which, if uncontrolled may lead to hyperinflation as is occurring in Venezuela. Imports from the United States become expensive while exports to the United States become cheaper. We have a situation where there is a trade deficit between Saudi Arabia and the United States of America. Let us now understand what happens in the global marketplace or at the macro economic level before we build a case for an eventual de-pegging of Riyal-Dollar peg if market conditions remain unsuitable.
There are two ways to devalue the local currency against the pegged currency. One is to maintain the fixed exchange rate while devaluing the local currency. The second is to free float the local currency which may lead to devaluation or appreciation of the local currency. In cases where there is a rapid depletion of foreign reserves, a free float condition will also lead to devaluation or depreciation of the local currency versus the pegged one. As a currency devalues against a pegged currency, the immediate impact is domestic inflation which causes misery for domestic spenders, specifically, if the country relies on imports for day to day needs. All imports become expensive and food and general goods become more expensive. The short-sellers take immediate notice and there is an increase in Saudi Riyals forwards market as well as interest rate swaps (IRS). To read how an interest rate swap works, please check out this excellent video presentation.
If too many speculators keep joining the doomsday bandwagon, the nation-state has to offset the forwards market downwards speculation. One of the ways is to increase domestic interest rates to curb inflation, strengthen the currency and beat the short-sellers. Increasing interest rates is bad for local businesses and banks and impacts forward investment in projects. Over time, there is a cyclical impact of short-term inflation followed in due course with deflationary pressures. The country may get stuck between inflation and deflation i.e. stagflation.
On the other side, the US dollar spikes which have a negative correlation with commodity prices leading to a stock market crisis. A strong US dollar also has a deflationary impact on the domestic economy. Other fixed currency regimes follow the course and there is a likelihood of currency wars as others starting free floating or devaluing their currencies versus the pegged currencies. As most commodities and oil is priced in US dollars, oil and commodities become expensive, leading to a drop in demand and the eventual drop in oil and commodity prices. Short-sellers again appear on the horizon and start shorting commodities and oil.
The trade deficit with United States spikes and soon enough, local production falls while consumption remains same and the United States undergoes major deflationary cycle which is propped up by reduced interest rates. As we have already discussed in the “Return of the Great Depression 2.0”, faced with a deflationary pressure, the monetary policy of United States will go through the bin crashing the US dollar and increasing the risk of sovereign bond default, leading to the surge of cheap money in the country. Soon enough, if currency wars start, it could lead to major global conflicts (wars) and hyperinflation caused Depression. Using the schematic diagram titled “Fixed Currency Regime Breakdown“, one can invert the scenario where the LCU appreciates versus depreciates.
A breakdown in long established currency pegs (forced or voluntary) leads to an interconnected tsunami across the global economy. In 1997, when Thailand was forced to devalue their currency versus the US Dollar, the contagion spread throughout Asia toppling currencies and governments across the region. Even emerging economies from Russia to Brazil felt the impact of the tsunami thousands of miles away.
Since Thailand pegged the Baht to the US Dollar, the weaker US dollar led to double digit growth within multiple sectors in Thailand. Within few years, the US Dollar started strengthening reducing export volumes and forced to maintain the peg, there was a rapid depletion of foreign exchange reserves. Faced with devaluation pressures, Thailand increased interest rates on the Baht. Combined with reduced exports, guaranteed exchange rate, real estate investors heavily borrowed in US dollar to prop up the property market. As the foreign currency debt ballooned and the property market indicates signs of overheating, economists and politicians painted a rosy picture. At the same time the property bubble burst, Thailand moved from a big surplus to a major deficit. Faced with a potential devaluation of the local currency, investors abandoned the Baht and non-retail investors followed in lock step leading to a field day for short-sellers. Thailand launched a massive war against the short sellers, first by cutting off Baht funds access (as Saudis have done recently) and quickly followed by rapid depletion of foreign reserves to prop up the local currency while maintaining the peg. On 2nd July 1997, Thailand admitted defeat, unpegged its currency versus the US Dollar and experienced a 20% depreciation of the Baht. Indonesia, South Korea, Malaysia tried to cope with the currency crisis in nearing Thailand, but they were too late. Investors lost a lot of money, a couple of banks collapsed and it marked the onset of a regional recession. It took nearly ten years before the region could get back on its feet. In the case of Thailand, the weakened US dollar was the canary in the cave. For net exporter countries, a strong US dollar and a weak US Dollar both can act as a catalyst for disaster in different situations.
Once again, as we have discussed in detail in the post on “Economic Depression“, governments and economists alike use a variety of tools to manage inflation and deflation across local and global economies. A currency peg break has the potential to pose both challenges in quick succession. Borrowing from the same article, I would also like to emphasize again that economists and political leaders did not foresee the Baht crisis. The poor prediction rate of a significant economic tsunami is always missed by those whom we consider being the smartest. As discussed in hyperforecasting, foxes are smarter than hedgehogs when it comes to predicting global interconnected events. A similar situation is occurring with potential currency unpeg in the Middle East. It is not a question of “If”, it is a question of “When”.
Fixed Currency Regimes, Net Exporters & Sovereign Welfare Funds
We have already discussed how a currency unpeg can rile the markets starting with appreciation or depreciation of the LCU. Another key issue is unique to fixed currency regimes and net exporters of commodities. Commodity prices experience boom and bust cycles and during booms, the net exporters have large current account surplus which is usually parked in Oil Stabilisation Funds or Sovereign Wealth Funds (SWF’s). The net effect of boom cycle is that the rich become richer and poor become poorer. As we have highlighted in the post on tech bubble bursts, boom-bust cycles redistribute wealth back and forth between the rich and poor. Some even claim that the rich and the influential create these boom bust cycles to their advantage. The rise in oil prices redistributes wealth from consuming countries to producing countries creating a current account surplus with producers and a current account deficit with consumers. Net exporters with fixed currency regimes also resist appreciation of their currencies through significant intervention. These surplus petrodollars are spent on domestic consumption, lent to foreign borrowers or re-invested in US Dollar denominated assets. Once we combine cheaper labor rates with undervalued currencies and a current account surplus, the net exporters not only hold massive sway over the financial markets (due to accrued surplus) but also undermine the competitiveness of the net consuming countries. Most of the surplus funds were held in US dollars for many decades, however recently there is a preference to diversify the holdings into US dollar equivalent of a basket of other stable currencies. Fixed currency regimes with surplus funds can impact the global markets in many ways even without a unpeg, however, there are two specific ways they can disrupt the market if they want to.
a) Spend Management of Sovereign Welfare Funds
b) Weighted Distribution of currencies in the Holding Funds
Ask anyone and they will tell you that they would love to deal with a problem of having too much money and not knowing what to do with it. However, there is a paradox of the plenty in which having way more than we need can lead to “Dutch Disease” and other intended consequences. A similar problem is faced by all Sovereign Welfare Funds which suffers from the paradox of the plenty, specifically for petrostate dollars such as Saudi Arabia and Norway. When fixed currency regimes give up an independent monetary policy in a trade off between volatility and inflation, it seems a new advantage helps them offset the restraints placed by the “Economic Unholy Trinity”. How these countries decide to spend or recirculate these billions of dollars in surplus funds can massively impact global markets and in some cases be extremely disruptive for the markets. Saudi Arabia and other Gulf sovereign funds had predominantly deposited these excess funds in American banks which lent it to Latin American countries leading to the Latin American Debt Crisis. A portion of these wealth funds was also used to refinance the debt of the commodity consuming countries by way of buying bonds and treasuries. Pegging to the dollar helped reduce currency conversion risks, so, it made a lot of sense when most of the assets and holdings were in US dollars, US dollar denominated assets and US dollar bonds and treasuries.
However, in the more recent years, these wealth funds, specifically the funds held by monarchies or dictatorships in the Gulf have become less transparent. In addition, the spend management revolves around diversifying these funds into startups and venture capital, Emerging Markets, Europe and China which increases pressure on the pegged currency i.e. the US Dollar. In the past, these middle eastern SWF’s have come under increased scrutiny while trying to invest in national interest assets in the United States and elsewhere. The Dubai Ports Worlds controversy raised a national security debate in the United States when an investment arm of the Dubai government bid for the purchase of a company operating around 22 American Ports. P&O Ports, a British company which had taken over leases of various port operations in the United States had been acquired by Dubai Ports World. After the controversy, Dubai Ports World sold its holding interest to an American company. Over time, these SWF’s have diversified their investments away from the US dollar and if they suddenly divest of all US dollar holdings, the US dollar can potentially crash. There has been a recent push to improve transparency and governance around these secretive SWF’s, however, increased transparency will not fundamentally change the power vested in the decision makers around legitimate spend management of their own money.
SWF’s hold liquid funds as well as dollar equivalent assets in their kitty. A move away from the US dollar as Russia is doing, can be done by diversifying the spend management but also by playing with the weighted ratios of various currencies and assets held by these funds. There have been concerns that a fire sale of US treasuries or US assets influenced by political objectives can put US dollar under additional pressure and potentially crash the dollar. A sharp drop in US dollar will push investors away from US Treasuries, spike interest rates and lead to deflationary pressures within the country and eventually the global markets. Inversely, if petrodollars are spent in global bond markets, bond yields drop and consumer spending is supported in oil importing nations.
In summary, the act of currency unpeg may rile the regional or global markets, but more damage can be caused by the recycling and spend management powers of decision makers controlling these Sovereign Wealth Funds.
Riyal Dollar Peg – A History, Situational Analysis, and Possible Scenarios
The end of Brenton Woods Agreement
The Riyal Dollar peg succeeded another historical event i.e the Brenton Woods Agreement. The Brenton Woods Agreement was created in 1944 between allies of WWII nations and the agreement replaced the Gold Standard with the US Dollar. The agreement was finalized in Brenton Woods, New Hampshire and also led to the birth of IMF (International Monetary Fund) as well as the World Bank. The member countries decided to peg their LCU (Local Currency Units) against the US Dollar which was pegged to Gold. As discussed before, the mechanism for maintaining the peg was to adjust the supply and demand of LCU’s in the open market. As we highlighted elsewhere, it was a watershed moment in this history of global economics when the gold standard was partially abolished and Fiat currency would be ruling the world for the next few decades once the gold standard was fully abolished. Under the agreement, most of the global currencies were pegged to the US Dollar, while the US Dollar was pegged to Gold at $ 35/Ounce. Any country could exchange dollars for gold or vice versa.
Ironically, the reason for the shift from the Gold Standard to the Fiat currency was the hyperinflation caused by going off the gold standard, flooding the markets with printed money leading to a Global Depression and the stock market crash in 1929. The Brenton Woods agreement was a hybrid between maintaining a gold standard as well as ability to print money. The agreement allowed for adjustment of currency values and offered security from the IMF in terms of bailouts when things went south for a member country.
The Brenton Wood agreement collapsed in 1971 due to stagflation. The collapse was set off due to the same problems that caused the Global Depression i.e overprinting of money. As the US dollar was pegged to gold, the United States had to maintain a 1:1 ratio of Dollars and Gold. However, to manage budget deficits and to kick-start the economy, the US government started offering cheap credit with low-interest rates using printed money. Soon enough, the volume of US dollars in the system exceeded the products and services revenue as well as the gold reserves. Long before countries asked for gold in exchange for dollars as per the original agreement, the US dollar value had depreciated due to mismanaged fiscal and monetary policies within the United States. To make matters worst, the Americans exported their inflation using the same cheap money to other countries by offering them cheaper interest rate loans and in many cases zero interest rate loans. Eventually, the Brenton Woods agreement collapsed and the Federal Reserve completely abolished the gold standard.
The period also coincided with the discovery of oil in Saudi Arabia and the commencement of the dollar peg policy first followed by SDR peg and then a hard peg to the US dollar. It all happened at a time when the rest of the major global currencies started free floating versus the US dollar. Saudi Arabia took a decision to initially loosely peg with the SDR (Basket of Currencies) and then with a hard peg versus the US dollar. The strategy served Saudi Arabia quite well as they managed many boom and bust resource cycles successfully.
A Visual Depiction of the Saudi Economy
It will really help to create an over-simplified visual model of Saudi Arabia’s economy and I have created a process flow in the below figure (Enlarge to see Larger Image). The idea for this visual depiction was inspired by a paper written by Sivram Krishna titled “Can a country really go broke”
Saudi Arabia has a population of 32.28 million out of which 49% are expat workers. The Kingdom follows a tax-free regime for expats and citizens, however, recently, there have been talks of VAT, Progressive Taxes and even budgetary cuts for various projects. Citizens get free health and education benefits in addition to other subsidies, while expats pay a meager amount through various company paid insurance covers for medical treatment and other benefits. As highlighted in the visual depiction of the Saudi economy, oil exports results in an inflow of US dollars. A portion of the export revenues is held with the SWF (Saudi Sovereign Welfare Fund) and the budgeted dollars are converted to Riyals by SAMA (Saudi Arabia Monetary Authority). SAMA is the equivalent of the Federal Reserve in the United States and further allocates these Riyals for domestic consumption. Saudi Arabia works as a consumption economy where most of the domestic use goods are imported i.e automobiles, food, garments, fresh water, transportation and telecom equipment, medical and other equipment and even construction equipment and material for development. As such, it is estimated that around 40% of the Saudi Riyals circulated by SAMA are funneled back into export expenses. In accordance with regulations, SAMA also has to maintain Riyal equivalent short term dollar instruments convertible to Gold to maintain the peg.
As there are no additional sources of revenue and monetary policy is synced with the Federal Reserve (US), negative dollar balances may lead to additional withdrawals from SWF or spending cuts and positive dollar balances will lead to a surplus in the sovereign fund and increase in discretionary spending.
Now, let us discuss what happens when oil prices fluctuate. Saudi Arabia’s economy is completely reliant on the export of Crude Oil and related products. 90% of exports are crude oil driven and contributes to 80% of the budget. As Saudi Riyal is tightly pegged to the US Dollar, a drop in oil prices results in reduced export contributions to the kingdom’s revenue while a spike in oil prices leads to increased FX reserves and discretionary wealth for non-budgeted spending. In normal circumstances, where exporters have free floating currency mechanisms (US and Canada), the currency of exporters should rise and fall with the rise and fall of crude oil price. Using an example of trading of oil between US and Canada, where the US buys heavy crude from Canada, one can see that the currency and crude oil is dancing in sync.
If we use the same correlational economics for Saudi Arabia, the Riyal should rise and fall with the Crude Oil benchmark price. However, as the currency is pegged, the kingdom can resist appreciation when the oil price rises. With respect to the global economy, the Saudi Riyal becomes misaligned. When the oil price crashes as has occurred many time in the last 100 year, the kingdom faces significant challenges as its revenues drop and the budgetary cuts start biting the local economy. However, as Saudi Arabia has maintained significant surplus during the good years. it can keep defending the peg in the hope that a new boom cycle will start which will offset all its previous losses.
Boom Bust cycles have repeated themselves with significantly predictability and continuity in the past. However, this time may be really different. Sustained low oil prices are straining the Saudi reserves and its economy.
It has forced the kingdom to start thinking of listing 5% of Saudi ARAMCO in the market and seek other ways to finance its economy rather than rely on oil exports. Till 2000, things were going well, however, an unannounced competitor showed up on the horizon. The progression in technological capability allowed Shale Oil producers to economically extract oil out of tight crevices leading to an increase in oil supply to the global markets.
The Shale Battle 1.0 and the Self Inflicted Pain
In 2011, Saudi Arabia had around $ 800 billion FX reserves, zero debt and a surplus of 20% of GDP. In a self-induced pain where Saudis launched a massive attack on the Shale producers, Iran and Russia by pumping up crude supply leading to a drop in oil prices. The premise was that in anywhere from 18-24 months, the heavily indebted shale producers would switch the lights off, fade into obscurity and crude oil price will start floating back at $ 100/bbl. As the Saudi policymakers learned quickly, they could not have been more mistaken in their assumptions. By 2015, the Saudi economy circled from a 20% surplus of GDP to 15% deficit of GDP. While the FX reserves were depleting, for the first time in the history of the petrodollar state, Saudis were indebted by around 15% public debt while the currency reserves had reached $ 600 Billion. If you have ever lived with zero debt and a healthy balance sheet, you would have noted that the relative stability in case of an economic disruption such as a job loss or major illness is more manageable. For those who are indebted, any volatility can throw them off the curve way sooner. The Saudis are moving from a healthy balance sheet to a more precarious economy as they travel ahead in time.
As highlighted earlier, Saudis maintain a tight peg with US dollar at 3.75 Riyals per dollar and reinvest some of that money to refinance the US debt by way of buying treasuries. As the oil prices dropped and the export revenue dropped, Saudis had to use up their treasury holdings and FX Reserves to maintain the peg. Using data from US Treasury Office, one can note the dropping trend from late 2015 onwards. When the sale of these treasuries in the market to maintain a peg is gradual, the nominal and real shock to the US economy is minimal. However, as large clusters (more countries) join the trend accelerating the sale of US Treasuries, the impact will be felt by the United States economy. Due to the whiplash effect in any globally interconnected system, there is a lag period before which the impact of micro-currents is felt by those further away from the scene of the impending disaster. As such, if such an impact is felt strongly, the United States government may use foreign policy, fiscal/monetary tools, sanctions to mitigate the impending disaster. Sanctions on oil supply from Venezuela, the breakdown of Iran nuclear agreement or manufactured crisis in the middle east may be some options available to deal with a significant devaluation of the US dollar.
Brad Setser and Cole Frank of the Council on Foreign Relations recently published interesting data around “external breakeven point” in an equivalent of price/barrels of oil. In short, they term “external break-even price” as the price of oil/barrel that covers a country’s imports and brings the current account into balance. They further state that “technically, it is the oil price that balances the current account, so oil exports need to equal the non-oil current account deficit—meaning remittances, dividend payments, interest income, and non-oil exports all enter in“.
Before we dive into the numbers, I want to remind you of an another well-known concept that “Expenses will always rise to meet your Income“. I am sure most of the readers who have been lucky enough to make more than they require for subsistence needs have experienced this. As the income increases, we tend to become more spendthrift and throwing caution to the winds, start spending on discretionary spending.
A surplus in FX reserves exactly landed Saudi Arabia in the same predicament. Rather than using the surplus to diversify their economy for so many years, they indulged in adventures in the Middle East, maintaining domestic peace and buying influence across political and financial circles around the world. All of this was done without any real investment in the productive labor of the country where more than 60% of the population is below 30 years of age. To their credit, as discussed elsewhere, they are attempting to diversify their economy. However, it may be a case of too little, too late to the party. As one can see in the chart, Saudis have remained frugal till 2000, but after that, the increase in expenses seems to be more discretionary rather than due to inflation. Once again, the nation still indulged in cautious spending and had a significant surplus in their reserves kitty before 2000. Once the oil prices dropped in 2015, ironically by their own actions, it was not matched by a proportional reduction in spending. The did try to reduce spending by cutting back salaries and wages, however, quickly realized that it may create a major unrest domestically, so rolled back the policies.
Looking at another chart by Brad Setser and Cole Frank, we can notice that there are few countries below the breakeven line (dotted), while many are above the line. Norway, Kuwait, Iran, Russia and even Nigeria remain below or close to the breakeven line. Venezuela is already experiencing an internal rebellion which can be considered a smaller version of a problem waiting to impact others at a much bigger scale.
In 2015, Kazakhstan’s currency plummeted versus the pegged Dollar and they were forced to abandon the peg. Oman’s dollar peg is under increased pressure as lower priced oil becomes a new normal. Algerian Dinar has already been devalued multiple times since early 2015 and Turkmenistan, which maintains a crawling peg with the US dollar is experiencing its own currency troubles. On the other hand, with sanctions as blessings in disguise, Iran and Russia have much lower “external breakeven points” and have successfully diversified their economies. The real challenge for Saudi Arabia is asymmetrical warfare from Iran proxy wars in neighboring Yemen and Syria where Saudi spending may be dis-proportionally higher than the spending by adversaries. As already emphasized elsewhere, the Saudis are taking the bait and getting involved in more and more expensive defensive/offensive actions in the region, which may be designed to slowly bleed its reserves and trigger a local uprising in the kingdom.
Basis the above information and using key points discussed in “Saudi ARAMCO Valuation – Hands on Valuation based on DCF Model” as well as “ARAMCO IPO- Great Opportunity or Riddled with Risks“, we have carried out an alternative futures scenario analysis. The result is five different scenarios. If the crude oil prices float back up to the $ 80-100/bbl and prices remain stable at-least for 18-24 months, the prospect of a Riyal-Dollar divorce will fade away. If the prices remain between $ 50-$ 60/bbl, there are worst case scenarios that may play out. As you can see in the time series, as diversification will take some time, the best case scenario is only likely to play out over a long period of time (4-5 years), while the worst case and other alternative scenarios have a higher potential of playing out as we move ahead in time. Looking at the charts from CFR Institute, Saudis have an external breakeven point between $ 60-$ 70. However, if US Dollar strengthens without a relative depreciation of Riyal, the breakeven point will shift much higher.
Scenario 1 (Best Case Scenario)- Crude Oil jumps to $ 80-100/bbl and/or Saudi economy diversifies. Saudis maintain Dollar Peg.
Scenario 2 – Saudis launch Shale Battle 2.0 after being unable to influence oil price upwards, Oil crashes to $ 25-30/bbl. Unable to maintain the peg, Saudis launch hard peg break. It is quite possible that after trying hard and failing to force OPEC into compliance, Saudis may suddenly decide to launch Shale War 2.0 in which they significantly cut production and shock the commodity markets. Oil could crash to $ 25/bbl and there could be unintended consequences of a major conflict in the Middle East. American policy shift may also occur. In such a scenario, Saudis may be forced to hard break the peg or to be forced to abandon the peg to maintain domestic stability. Already Saudis are trying this approach is a more limited way.
Scenario 3- Public Debt crosses 50% of GDP, Atleast 25% of Saudi ARAMCO IPO floats. Subsequent gradual unpeg of US Dollar. In this scenario, the first attempt would be to borrow as much as they can and then to weaken the US Dollar, start unpegging gradually first pegging Riyal with a basket of currencies and then free floating the Riyal. As Saudis unpeg against the dollar, neighbors will follow suit and they should be careful not to create a commodity crash as the US Dollar strengthens and then crashes over time.
Scenario 4 – Saudi economy successfully diversified and/or Crude Oil jumps to $ 80-100/bbl. Saudis gradually unpeg the fixed exchange rate and shift to Loose Peg against the US Dollar.
Scenario 5 (Worst Case Scenario)- Oil crashes to $ 25-30/bbl due to a global recession and.or a major geopolitical conflict break out (war with Iran or North Korea). Saudi Arabia forced to abandon Dollar Peg suddenly.
We continue to carefully watch how the market forces evolve and how Saudis will respond to those forces. They would definitely like to maintain the “Best Case Scenario”, however, there may be many black swans which will surface in the next few years.
Related Article : Saudi Arabia Currency Devaluation next on Reform Agenda
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