Fiscal policy is an important determinant of economic growth in any country. From the conventional neoclassical model of economic growth, increment in labor supply, changes in technology, and accumulation of both human and physical capital lead to growth in the economy. Therefore, if the adopted fiscal policy encourages savings or investment, the capital-output ratio changes, and thus the economy grows as it transitions to higher levels of output per capita.
On the other hand, endogenous growth models depend on other factors, such as government spending. For instance, in cases where the government increases its expenditure, the steady-state rate of growth rises in tandem with such changes based on positive spillover effects related to human and physical investments.
In Saudi Arabia, monetary policy is the function of the Saudi Arabian Monetary Agency (SAMA), and it has adopted an endogenous growth model whereby the exchange rate is fixed. According to Alkhareif and Qualls (2016), since 1973, Saudi Arabia’s foreign exchange has been characterized by the pegging of the Saudi riyal to either the US dollar or the special drawing rights (SDR). A fixed exchange rate, in this sense, means that the value of the Saudi riyal is tied to the US dollar or SDR.
The fixed exchange rate in Saudi Arabia has played a significant role in the economic growth of the country in a world where international markets for commodities, such as oil, are subject to price volatility among other factors. The purpose of this paper is to discuss how the fiscal and monetary policies under the fixed exchange rate in Saudi Arabia help the country to improve the living standards of its citizens. It also highlights the goals of the monetary and fiscal policies, how they are achieved, related challenges, and the available instruments to address the arising problems.
Fiscal and Monetary Policies under the Fixed Exchange Rate
There are different peg exchange rate regimes that countries can choose from when making fiscal policies. Saudi Arabia uses the fixed peg, also known as the conventional peg. Based on this regime, the value of a country’s currency is tied to another major currency of a pool of currencies. In the case of Saudi Arabia, the riyal is tied to the US dollar. SAMA officially cut ties with the SDR, which is a basket of currencies, in May 1981, which means the USD is the de facto foreign exchange currency.
However, the Saudi central bank is not legally bound to maintain the riyal’s peg at a certain rate forever. Therefore, the peg can be adjusted upwards or downwards in case misalignment becomes a major exchange issue. Alkhareif and Qualls (2016) argue that the central bank “can defend the peg, either through direct intervention in the spot and forward markets or indirectly, through monetary policy and domestic interest rates” (p. 6).
However, since the central bank can undertake various actions as defined in its list of functions, such activities are limited due to the free capital movements that characterize the market. This fixed exchange rate regime has several advantages, which Saudi Arabia capitalizes on to grow its economy and improve the living standards for its citizens.
The first advantage of this regime is price stability caused by the credibility of the currency that the riyal is pegged on, which is the US dollar. The objective of SAMA is to “issue and strengthen the Saudi currency and to stabilize its internal and external value” (Al-Jasser & Banafe, 2000, p. 204). With a stable USD/riyal exchange rate, public confidence is kept at high levels, which encourages capital inflows hence increased domestic investments.
This scenario grows the economy and improves living standards through the creation of employment. The government also realizes improved revenues from taxation, which in turn helps it provide services to the citizens, hence better living standards. Another advantage of pegging the value of riyal on the USD is that it leads to low interest rates in the country. This aspect, in turn, ensures that businesses can access credit to fund their capital needs and stimulate economic growth. Booming local businesses and the associated economic expansion are key indicators of better living standards through job creation, which gives the government the much-needed tax revenues to support service provision to citizens.
Apart from these advantages, SAMA applies different strategies to counter the problems associated with the fixed exchange rate. One of the major downsides of this system is susceptibility to currency crises, especially in cases where capital markets are liberalized to allow international flows (Almounsor, 2015). To address this problem, SAMA uses balance-of-payments considerations. SAMA applies corrective measures to ensure that the riyal is not overvalued or undervalued as factors that can influence monetary aggregates. For instance, “until 1982 the rate of monetary expansion was quite large reflecting massive development expenditures by the Government.
Its inflationary impact was neutralized largely by an exchange rate policy aimed at facilitating cheaper imports (an overvalued riyal)” (Al-Jasser & Banafe, 2000, p. 206). Moreover, the Saudi government spends close to 70 percent of its proceedings from foreign exchange in the local market. The remaining 30 percent goes to direct foreign exchange expenditures (Almounsor, 2015). This strategy ensures net domestic spending by the government, which expands the money supply.
In addition, the Saudi Arabian case is unique given that it is a net exporter of oil. It thus follows that the government receives the largest part of the foreign exchange earnings. Therefore, fiscal policies play a bigger role in economic development as compared to monetary policies. The association between the two can be explained by the view that in a fixed exchange rate regime, like the one in Saudi Arabia, the government adopts the monetary policy of the US.
In this case, the monetary policy is subordinate to the fiscal policy due to the exchange rate regime coupled with open markets. Given the net exportation of oil, the outflow of foreign exchange has been oscillating between 85 percent and 110 percent of government expenditure (Al-Jasser & Banafe, 2000). Additionally, net riyal savings are converted into USD for investment in the short term. With the stable exchange rate (because it is fixed) of riyal against the USD, import rates are kept at a low level, which increases public confidence in the currency.
Ultimately, these strategies culminate in economic development in the country, which leads to improved living standards. The remaining question is how SAMA has managed to maintain the riyal pegged to the USD. If the strong relationship between the riyal and the USD is not maintained, serious currency crises will be experienced, and the benefits of the fixed exchange rate will be lost. Therefore, SAMA maintains a substantial reserve of liquid foreign currency assets to support the riyal/USD pegging.
The assets are primarily supplied through deposits by the government. Alkhareif and Qualls (2016) argue that these asset reserves provide the needed liquidity to defend the riyal and keep its credibility and discourage speculators. By the end of 2015, SAMA had maintained foreign reserves totaling SAR 2.3 trillion, which is a sign of the fundamental strength of pegging riyal to the USD and the associated credibility (Alkhareif & Qualls, 2016).
In summary, the fixed exchange rate policy in Saudi Arabia influences economic growth positively by reducing uncertainty about the future, which creates a good investment environment. Using compound annual growth rate (CAGR) and standard deviations of real GDP and inflation from 1986 to 2014, Alkhareif and Qualls (2016) found that Saudi Arabia performed better than all other GCC countries in the region. These findings show that the fixed exchange rate has been working as intended in the country.
Goals of the Monetary and Fiscal Policies
As mentioned earlier, in a fixed exchange rate regime, monetary policy is subordinate to fiscal policy. Al-Hamidy (n.d.) argues that, in Saudi Arabia, monetary policy is the same as its exchange rate regime. The goals of this policy are to ensure price stability, balance-of-payments, and public confidence. According to Al-Jasser and Banafe (2000), the policy objective is to “maintain the dollar/riyal exchange rate as stable as possible so that public confidence is maintained and the inflow of capital is encouraged for domestic investment” (p. 204). SAMA uses several strategies to ensure this stability.
First, it seeks to maintain the credibility and strength of the riyal by keeping a huge reserve of liquid foreign currency assets. Such reserves serve an important role in providing liquidity that is required to ensure a strong riyal/USD relationship. For instance, by the end of 2015, the government had made deposits (kept offshore either as investments in foreign securities or deposits in foreign banks) amounting to SAR 1162.5 billion, which was almost 25 times what it had in 1998 (Alkhareif & Qualls, 2016).
One benefit of this strong and stable association between the riyal and the USD is that in the end, Saudi Arabia avoids being exposed to high inflation rates. In other words, inflation in the country depends on the strength of the US economy. In this case, if the USD strengthens against another currency like the Euro by a certain margin, the riyal will also strengthen against the Euro by the same margin. Internally, the government ensures that the objectives of the monetary policy are achieved by controlling the growth of the money supply.
In the country, the overall budget balance is split into two – foreign budget balance and domestic budget balance. In this case, domestic budget balance, which is the difference between revenues and expenditure in the domestic market, affects money supply significantly as opposed to the overall budget balance (Nazer, 2016).
As mentioned earlier, the government, not the private sector, receives the largest part of foreign currency in the form of revenues from oil exports. Therefore, to maintain a strong riyal/dollar peg, the proceedings are added to the foreign deposit reserves and thus money supply does not change. However, to increase the money supply in the local market, part of the foreign revenues from the sale of oil can be injected into the domestic market, which raises currency circulation and demand deposits. Therefore, by maintaining huge reserves in foreign deposits to give the riyal the liquidity it needs to remain strong against the dollar and regulating domestic money flows, the Saudi government achieves the monetary policy objectives of ensuring price stability.
The major challenge of the fixed exchange rate in Saudi Arabia is the requirement to have huge foreign reserves to give the riyal the necessary liquidity. The country depends on oil revenues to maintain such deposits. The problem with this arrangement is the falling prices of oil in the international markets. Saudi Arabia is currently facing this problem since oil prices started falling in 2013. According to Pinto (2018), “from June 2014 to January 2018, oil prices plummeted from $115 per barrel to $68 per barrel, a 41 percent decline…reaching a low of $28 on January 19, 2016” (para. 1). This scenario creates a balance of payment deficit in which the Saudi foreign assets are dwindling.
The shrinking foreign deposits affect the strong relationship between the riyal and the USD. A weakened riyal has inflationary effects in the domestic market thus the government has to take mitigation measures through reduced spending, raising non-oil revenues, or borrowing to cover the revenue-expenditure gap (Nazer, 2016). Another challenge with the fixed exchange rate is that speculators can short their dollar positions for short-term profits given that uncertainty in the future is minimal.
Therefore, to address these challenges, the Saudi government can utilize some instruments at its disposal. First is the minimum reserve policy whereby banks are under statutory obligation to keep a certain percentage of customers’ deposits with SAMA. This way, banks retain enough liquidity to cover customers’ deposits thus ensuring a stable domestic budget balance. In return, the government will not need to invest part of oil revenues in the domestic market, which might affect its strong foreign deposits (Alkhareif, Barnett, & Alsadoun, 2017).
The second instrument is the issuance of government bonds to encourage open market operations and control credit by allowing the central bank to influence the liquidity positions of local banks. Therefore, in case of banks require additional reserves, SAMA uses overnight repos with banks, which is a very short-dated repurchase of the bonds. Once the repos mature, SAMA withdraws them and restores reserves that had been used. On the other hand, if there is a surplus in the market hence the need to absorb bank reserves, SAMA uses reverse repos to acquire reserves from banks, which are then sold back to the banks after the market corrects itself.
Finally, the government can focus on other strategies including some of the Saudi Vision 2030 provisions to shift the country’s overreliance on oil to other sectors, in which case it will ease pressure on foreign assets in case oil prices plummet further (Alkhareif et al., 2017). Moreover, the government can increase its borrowing to close the revenue-expenditure gap without affecting its foreign deposits and assets.
The fixed exchange rate in Saudi Arabia allows the government to ensure a thriving economy, which in return improves the living standards of the citizens. The riyal is conventionally pegged to the USD and this aspect ensures its stability and public confidence.
A stable riyal means that increased capital inflows and local investments hence job creating and economic growth. With the fixed exchange rate, monetary policy is subordinate to fiscal policy, and in Saudi Arabia, the two terms are used interchangeably to mean the same thing. The goal of fiscal policy is to ensure a stable relationship between the riyal and the USD. However, such policies are faced with the challenge of having to maintain huge foreign deposits and assets, which could be affected adversely by falling oil prices. Nevertheless, the government has various instruments to address these challenges as discussed in this paper.
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Al-Jasser, M., & Banafe, A. (2000). Monetary policy instruments and procedures in Saudi Arabia (BIS Policy Note). Web.
Alkhareif, R. M., & Qualls, J. H. (2016). Saudi Arabia’s exchange rate policy: Its impact on historical economic performance (SAMA Working Paper, 16/4). Web.
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