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Oil slump may cause Saudi Arabia to abandon its dollar peg

Discussion in 'Fundamental Analysis' started by FXStreet_Team, Dec 29, 2015.

  1. FXStreet_Team

    FXStreet_Team Well-Known Member Trader

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    FXStreet (Mumbai) - The plunge in oil prices in the last on year can be attributed to the global oil glut largely the result of OPEC’s decision to pump record volumes with the objective to defend market share and eventually drive out US shale producers. There remains a strong possibility that crude prices will further fall in 2016. With oil prices touching multi year lows, the richer gulf nations have begun to feel the pinch. The IMF had warned in October that Saudi Arabia will likely run out of money within five years unless it adopts drastic measures of reform. Saudi Arabia, which championed the market share strategy, ran a deficit of 367 billion riyals (€91 billion billion) or 15 per cent of GDP in 2015. The riyal dropped in the forwards market to its lowest since 1999 following a sharp increase in budget deficit. The riyal suffered on fears that Riyadh may have to abandon its peg to the US dollar.

    Khalid Alsweilem, the former head of asset management at the Saudi central bank (SAMA) flagged the concern that if the oil slump drags any further, which it likely will, Saudi Arabia will be forced to give up its dollar exchange peg. He told the Telegraph “if the reserves keep going down as they are now, they will not be able to keep the peg,” he told The Telegraph. He has warned “If anything happens to the riyal exchange peg, the consequences will be dramatic. There will be a serious loss of confidence”. He has stressed that Riyadh does not have strong enough reserves to cushion losses suffered from lower oil prices for too long.

    Saudi Arabia’s deficit jumped to 367 billion riyals in 2015, up from 54bn riyals the previous year. Remittances by foreign workers have led to the capital loss of another $36bn a year. Foreign reserves and assets fell to $647bn from a peak of $746bn in August 2014. It is feared that the public debt to GDP ratio will reach 140pc by 2030 and the deficit will continue to be in double digits. The figures spell bankruptcy for Saudi Arabia. Bank of America estimates Riyadh’s deficit could rise to as much as $180bn if oil prices settle near $30 a barrel. This situation will then push the riyal peg to breaking point.

    12-month forward contracts on the Saudi Riyal reached 730 basis points over recent days. This is the highest level reached since the worst days of last oil crisis witnessed in February 1999. Traders closely watch these contracts to gauge the current level of stress that a particular currency has. The current scenario suggests there the coming days might see rise in capital flight from t Saudi Arabia as the riyal comes under regular attack by hedge funds and speculators in the region.

    As seen in the previous weeks, number of oil states was forced to give up their currency pegs. The Azerbaijan was the latest country to abandon its currency peg. Azerbaijan’s currency manat crashed by a third on 21st December post the central bank’s decision to abandon the currency peg.

    Why the dollar peg is essential for Saudi Arabia?

    For almost three decades now the dollar peg has acted as the anchor of Saudi economic policy. Giving up the peg will raise questions on its credibility. Forcefully lowering the value of is currency will imply that the crisis can no longer be controlled by political authorities. This in the process will heighten disputes within the royal family. Already, Saudi authorities have been compelled to resort to measures which they had shied away from for this long to combat record deficits.

    According to Dr Alsweilem, the Saudi Arabia championed market share strategy might prove to be a big gamble for Riyadh. He believes “The thinking that lower oil prices will bring down the US oil industry is just nonsense and will not work.” Optimists feel that the current oil policy is a repeat of the mid-1980s era when Riyadh had adopted pursued the same strategy and succeeded in curbing non-OPEC investment. They are confident that like last time, this strategy will work bring about recovery in prices.

    Contrary to what optimists think, Dr Alsweilem thinks it is highly unlikely that the current strategy will help to curb prices. The shale revolution, he feels has resulted in giving rise to several mid-cost swing producers in the US. As per the latest OPEC report, these producers are completely able to keep drilling at $50bn a barrel. Also, US shale frackers can decide to increase or decrease production rather quickly. Dr Alsweilem stated “There is an overwhelming feeling among many in Saudi Arabia that this crisis is just cyclical and that it will reverse soon, so everything will be OK. But the danger is that what is happening is structural, and that means a country like Saudi Arabia can’t just sit still”.

    Prince Mohammed bin Salman has stepped up efforts to transform Saudi Arabia’s oil-based economy. Riyadh is looking at non-oil revenue raising methods including tax and privatisation. Saudi Arabia also aims to slash the budget deficit to 326 billion riyals. Riyadh plans to liquidate assets held abroad and issue bonds. Budget projects spending in 2016 has been brought down to 840 billion riyals, from 975 billion riyals actually spent in 2015. The confidence of financial markets in Riyadh can be restored only if it manages to stick to its proposed measures.
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