Originally published on January 7, 2019 on The Irrational Observer.
Saudi Arabia has had a pegged currency since 1987 with the US dollar. That means that post 1987 at any given time 3.75 Saudi riyals can be exchanged for 1 US dollar. This was possible by holding a large reserve in dollars, where Saudi currently holds $500 billion which uses as intervention in the market of exchange rates.
How does it work?
Suppose the US dollar (USD) has weakened against the Saudi Riyal (SAR), so that the current exchange is 3.71/$1. The Saudi central bank will use its reserves denominated in SAR and buy USD. This weakens the SAR and increase the demand for USD pushing the exchange towards 3.75/$1.
The opposite scenario works the same way. Assume that the Riyal has depreciated against the dollar, such that the exchange would be 3.83/$1. The Saudi central bank would then use up its foreign reserve to purchase SAR, creating demand for the SAR and as a result appreciate the SAR back to 3.75.
Why peg?
The choice to peg to the dollar has been linked to gains from economic integration and efficiency. Where economic integrations means the growth of market linkages in goods and services between two countries, in other words the extent of trade links. The greater the degree of economic integration between markets in two countries, the greater will be the volume of transactions between the two, and the greater will be the benefits the home (Saudi) country gains from fixing its exchange rate with the base country (USA). As integration rises, the efficiency benefits of a pegged currency increase.
Another important component of pegged currencies relies heavily on the symmetry between economies. A fixed exchange rate can be costly when country-specific shocks are not shared with both countries resulting in (asymmetric shocks).
- As symmetry rises, the stability costs of a pegged currency decrease.
- As Asymmetry rises, the stability costs of a pegged currency increases
| US Scenario BASE Currency | Saudi Scenario Home Currency | |
| US GDP + | SAUDI GDP + | Symmetry |
| US GDP + | Saudi GDP – | Asymmetry |
| US GDP – | SAUDI GDP – | Symmetry |
| US GDP – | Saudi GDP + | Asymmetry |
Symmetry is not necessarily tied to GDP per say, in reality many elements can influence shocks that could potentially make countries more or less symmetrical. To summarise, the importance of integration and symmetry is vital in assessing the benefits of a pegged currency decision. The graph below highlights this very nicely.
The Impossible Trinity
Now let us dive into policy decisions regarding the exchange rate management. The below picture illustrates different policy goals, achieving all 3 is impossible.
Goal 1: Fixed Exchange Rate: We know what this means
Goal 2: Capital Mobility: This refers to the freedom of capital (money) moving in and out a country
Goal 3: Monetary Autonomy: This means that decisions regarding monetary policy is independent. In essence decisions about the level of interest rates (cost of borrowing) is self-governing.
Countries can only chose 1 side of the triangle policies. Each policy has its benefits and costs and highly depends on the country’s position in trade and monetary management.
The Saudi Case
To keep the peg, Saudi needs to forego monetary autonomy. The graph below showcases the Interest rate set in the US (Fed Funds Rate) and Saudi interest rate (Reverse repo rate). As can be seen, they are highly correlated. The reason for this is interest rate parity, which is a no-arbitrage condition representing an equilibrium state where investors are indifferent to interest rates available on bank deposits in two countries. So that means Saudi has sacrificed monetary autonomy to implement a fixed exchange rate and capital mobility. If SAMA’s policy rate decision not to follow closely the US Fed rate, then, pressures on the peg would emerge as a result of more likely capital in- or outflows.
Ever since the oil plunge in 2014, the symmetry between Saudi and the US has been growing apart (Asymmetry rises). The US economy has been growing and the Federal Reserve has been taking monetary actions to cool the economy down. (See below)
| date | Fed Rate |
| 12-19-2018 | 2.500 % |
| 09-26-2018 | 2.250 % |
| 06-13-2018 | 2.000 % |
| 03-21-2018 | 1.750 % |
| 12-13-2017 | 1.500 % |
| 06-14-2017 | 1.250 % |
| 03-16-2017 | 1.000 % |
| 12-14-2016 | 0.750 % |
| 12-16-2015 | 0.500 % |
| 12-16-2008 | 0.250 % |
The opposite is happening in Saudi, the economy is undergoing major economic and social reform to diversify the economy away from oil and higher interest rates reduces the willingness of businesses and consumers to borrow. Which makes investments more expensive and overall not pro-growth.
A paper published by SAMA by Algahtani in 2015 found the following implications of a rise in interest rate. Where they found that an increase of 1 percent increase in the interest rate, leads to a decline in the GDP by -0.090 percent in the second quarter 2 and by -0.095 percent in quarter 3.
The graph below depicts Saudi’s assets held by SAMA, which includes the foreign reserves used to absorb exchange rate fluctuations. As can be seen a significant decrease in the end of 2014. This can happen because the government is running a deficit and using the reserve to finance the deficit, or because downward pressure on the SAR forced SAMA to use its reserves in USD to buy SAR to keep the peg.
For Saudi Arabia, speculation about the possibility of depegging its currency from the US dollar may be premature, but it has provided an opportunity to analyse the costs incurred to maintain the peg, and whether different strategies exist to the current policy choice. While the advantages of maintaining the peg are plenty, so are the costs.
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