Saudi Arabia Riyal Devaluation Highly Unlikely
BMI View: A devaluation of the Saudi riyal is highly unlikely. Such a move would carry few economic benefits and come at the expense of social stability. More importantly, the Saudi authorities easily retain the means to defend the peg, and comparisons with Kazakhstan or other emerging markets are overblown.
Speculative bets that Saudi Arabia might devalue the riyal to strengthen oil revenue in local currency terms have risen sharply in recent days, driven by a combination of concerns over the health of the Saudi economy and stock market, and global turbulence stemming from China's decision to devalue the yuan. Beijing's move has prompted other central banks including Kazakhstan and Vietnam's to follow suit, and has triggered a broad sell-off across emerging market currencies. One-year forward contracts for the Saudi riyal briefly rose to 375 points on August 20 - their highest level since 2003 - before climbing down slightly.
Our view is that a Saudi devaluation remains highly unlikely, for a multitude of reasons:
- A devaluation would provide few economic benefits. Most of Saudi Arabia's exports are oil or hydrocarbon-related products, and exchange rate movements have only a limited impact on competitiveness. Moreover, the country has limited domestic manufacturing capabilities, reducing the exchange rate elasticity of demand for imports. In particular, demand for capital goods and construction materials is far more influenced by the government's fiscal policy stance than by the real exchange rate. Any gains in terms of oil export revenue would therefore be offset by a higher import bill.
- The Saudi central bank (SAMA) retains significant firepower to defend the currency peg. Foreign exchange reserves amounted to USD672.1bn in June 2015, equivalent to 97% of GDP and approximately 30 months of imports. While the government has been burning through this arsenal since the start of the year to finance its large budget deficit, we expect increased bond issuances and gradual steps towards fiscal consolidation to partly ease the pressure on reserves over the coming years. While we project reserves to continue declining until a recovery in global energy prices begins to materialise in 2018, the import cover will remain above 18 months throughout our forecast period.
- The deterioration in trade dynamics is bad, but can be withstood. We forecast the current account to swing into deficit (of 4.3% of GDP) this year, after an annual surplus of 17.6% of GDP between 2010 and 2014. However, the high level of foreign reserves and the limited risks associated with Saudi Arabia's capital flows mean that we do not expect this deficit - which we see narrowing over the coming years - to present any significant problem.
- The Saudi authorities regard the peg as crucial for both macroeconomic and political stability. The current exchange rate of SAR3.75/USD has been in place since 1986, and has survived worse crises - including significant appreciatory pressure in 2007-2008, when US monetary policy easing and rising oil prices stoked high imported inflation in Saudi Arabia. In spite of the constraints posed by the peg to monetary policy flexibility, the link ensures a degree of stability to businesses and households. Perhaps more importantly from the (traditionally risk-adverse) regime's point of view, a devaluation would directly hit Saudis' purchasing power and fuel social discontent.
- Saudi Arabia is not Kazakhstan. The Central Bank of Kazakhstan (CBK)'s decision to allow a record weakening of the tenge on August 20 by transitioning to a free-float exchange rate regime arguably helped to fuel the spike in speculative SAR devaluation wagers on the same day. The similarities between the two countries are easy to spot: both remain dependent on oil exports, and the Kazakh authorities had promised to defend the tenge several times since the end of 2014. Yet the differences are also significant. Kazakhstan is tied to Russia and China for trade and is therefore particularly exposed to a lower rouble and yuan; the CBK already devalued its currency as recently as 2014; and other export industries such as steel and chemicals exist, creating political pressure for a devaluation.