Since 1986, the Saudi riyal has been pegged to the US dollar (SAR 3.75 per USD). This aspect means that the Saudi monetary policy is based on a fixed exchange rate. Therefore, the riyal trails the USD in all aspects. For instance, if the USD increases in value, an equal rise in the riyal’s value is noted and vice versa.
This fixed exchange rate regime has several benefits for Saudi Arabia. First, it means that the riyal is stable, and thus the public confidence increases resulting in increased investments and growth of the economy. However, this exchange regime requires Saudi Arabia to have huge reserves of foreign currency to support the riyal/dollar peg.
This requirement has not been a problem for Saudi Arabia because it is a net exporter of oil. Therefore, oil revenues (paid in USD) play an important role in strengthening the country’s foreign currency reserves, which are mainly invested overseas or deposited in foreign banks. However, oil prices are subject to volatility and any change affects Saudi Arabia’s economy positively or negatively. This paper discusses the changes that Saudi Arabia faces, from a currency standpoint when oil prices rise and fall.
Rising Oil Prices
The Saudi Arabian Monetary Agency (SAMA) is responsible for handling foreign exchange earnings from oil. When Saudi Arabia exports oil and receives revenue in USD, all the money is deposited with SAMA. This body then decides how to allocate the dollars. The petrodollars so received are invested in the foreign currency reserves to give the riyal enough liquidity to support its peg to the USD. In case there are deficits in the local market, SAMA employs different intervention measures to inject money into the economy and cover the deficits (Alkhareif, Barnett, & Qualls, 2017).
Therefore, in cases oil prices go up, SAMA has a surplus of foreign currency, which is deposited in overseas banks or invested in other investment vehicles in the US and other countries. Therefore, the riyal’s liquidity in the international market strengthens, which means its price value remains stable. Under such circumstances, the public and investors have confidence in the riyal thus they invest more in the economy. Therefore, the first effect of rising fuel prices is the strengthening of the riyal’s value.
In other words, rising oil prices redistribute wealth from consumers to producers, in this case, Saudi Arabia. Under the free-floating foreign exchange regime, this aspect would require the Saudi riyal to be overvalued, thus the benefits of high oil prices would not be felt. However, as mentioned earlier, Saudi Arabia has a fixed foreign exchange regime.
Therefore, whenever these surpluses are experienced, instead of overvaluing the riyal, SAMA uses different strategies to address the situation. First, excess petrodollars are directed towards increased government expenditure in the domestic market, thus stimulating economic growth. Second, SAMA can lend money to foreign borrowers or re-invest in USD-dominated assets.
In addition, with a stable riyal due to rising oil prices, the inflation rate is low because exports are more than imports. It should also be noted that SAMA intervenes to control the amount of money in circulation, thus regulating inflation during such times. With a booming economy and thriving businesses, interest rates come down. Similarly, as noted earlier, a stable riyal leads to increased investment in the local economy.
Given that the riyal is pegged to the USD and there is an assured strong backing of that relationship by the huge amounts of foreign currency reserves, investors can predict the future with some degree of certainty (Noira, Amor, & Rault, 2018). Increasing investors’ confidence means more investment and trade increases in the local economy. Businesses thrive under such circumstances and trade volumes go up because the government is spending on the domestic market and a growing economy means that consumers have purchasing power.
Falling Oil Prices
Despite the strong position of the riyal/USD peg, this relationship is highly dependent on oil prices. Saudi Arabia is a resource-based economy meaning that it depends mainly on oil exports to support its economy.
As argued earlier, petrodollar revenues are used to strengthen the country’s foreign currency reserves, which are needed to give the riyal liquidity and maintain its strong pegging position with the dollar. However, when oil prices start falling, it means that the foreign currency reserves start dwindling. Under such circumstances, SAMA experiences deficits in the balance of payments (Alkhareif & Qualls, 2016).
This scenario threatens the position and strength of the riyal relative to the USD. Therefore, SAMA has to take intervention steps to ensure that the reserves are not exhausted. The first step is to advise the government to cut its spending in the domestic market. This intervention measure has adverse effects on the economy, as the government is the largest spender, hence the most significant source of cash flow in the market. With decreased government expenditure, trade volumes go down because businesses experience cash flow constraints.
Similarly, the currency value of the riyal is threatened with becoming weak due to decreasing liquidity caused by dwindling foreign currency reserves. Interest rates go up under such a situation as banks become cautious to lend to struggling businesses. Banks also experience cash flow problems and they may not have enough money to lend out.
Inflation is also likely to go up under such circumstances due to the falling value of the riyal. However, some of these negative effects of falling oil prices have not been experienced in their extreme status because SAMA uses different strategies to ensure that the economy remains within reasonable operation limits (Mahmood & Alkhateeb, 2018).
For instance, the Saudi government borrows heavily to cover any deficits in the balance of payments, thus cushioning the economy from experiencing such extreme conditions. The government is also trying to diversify the economy to other non-oil-dependent sectors to ensure that, in case of falling oil prices, the economy is not exposed to extreme shocks.
Conclusion
The Saudi monetary policy is based on a fixed foreign exchange regime whereby the riyal is pegged on the USD. As such, the riyal is not subject to the extreme price volatilities exposed to currencies under free-floating regimes. This system requires SAMA to maintain high volumes of foreign currency reserves to give the riyal the needed liquidity to retain its strong relationship with the USD.
Therefore, in case oil prices are rising, SAMA invests the surplus of petrodollars in foreign markets, re-invests in dollar-backed assets, or increases government spending on the domestic market. These factors work in concert to ensure economic growth, huge trade volumes, low-interest rates, and low inflation rates.
However, with falling oil prices, the situation is reversed as the foreign currency reserves start diminishing. Therefore, the government cuts spending, which has a ripple effect in the domestic market leading to a shrinking economy, reduced trade volumes, high inflation, and high interest rates as argued in this paper.
References
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.
Alkhareif, R., Barnett, W., & Qualls, J. (2017). Has the dollar peg served the Saudi economy well? International Finance and Banking, 4(1), 145-152. Web.
Mahmood, H., & Alkhateeb, T. Y. (2018). Asymmetrical effects of real exchange rate on the money demand in Saudi Arabia: A non-linear ARDL approach. PLOS ONE, 13(11), 1-12. Web.
Noira, R., Amor, T. H., & Rault, C. (2018). Oil price fluctuations and exchange rate dynamics in the MENA region: Evidence from non-causality-invariance and asymmetric non-causality tests. The Quarterly Review of Economics and Finance, 73, 159-171.