It has rarely been timelier for investors to embed a convex strategy within their portfolios, whether this be positioning for or hedging against out-sized, non-linear moves and trend changes within markets. The list of potential shocks grows ever longer and includes issues such as: a world economy struggling to sustain acceptable growth rates; the growing awareness of the downside risks to inflation in major economies; many policy-makers implementing ever more unorthodox monetary policies; the growing fear that the Fed has repeated the past policy errors of the BOJ and ECB in tightening monetary policy too soon. An additional risk factor, which will likely grow in importance, is the credit risk and secondary market implications of the collapse in commodity prices. Of particular focus for this note is the tension between the Saudi Arabian currency peg and the changed dynamics in the oil market where, firstly, the price of crude has become increasingly exogenous to OPEC members and, secondly, where Saudi Arabia appears to have changed supply policy in favour of preserving market share rather than the price of oil. For all the focus on Saudi Arabia’s current austerity programme designed to respond to the slide in oil prices, it is difficult to see fiscal policy being sufficient to remove the increased FX risk premium attached to the SAR-peg.
Chart 1. An increased SAR FX risk premium
The USD/SAR forward premium and the price of convexity
As oil prices have slumped, the risk premium attached to the Saudi Arabian Riyal peg to the USD (USD/SAR) has increased. The 1yr USD/SAR FX forward prices in a move in the 3.75 peg to 3.827, which implies a 2.04% move, and the premium has been as high as 2.60% in January. (Chart 1.) Of course, current levels of pricing would more realistically be the pricing in a certain percentage probability of a larger currency move rather than the market actually expecting that the new peg would be 3.827. After all, and as I discuss below, for Saudi Arabia to adjust a monetary policy anchor which has been in place since 1986 by just 2% would make little sense, with a far larger move likely to happen were the peg to be adjusted. As such, the current market pricing is the price of convexity, the cost of positioning for a non-linear currency move.
In looking at the appropriateness of the SAR-peg, it is important to first outline the structure of the economy and the drivers of macro-economic policy formation in Saudi Arabia.
Economic and market structure – the interplay of oil, FX policy and the real economy
Needless to say, the Saudi economy is dominated by oil revenue. Crude oil and refined refined petroleum products account for around 88% of Saudi Arabian exports. As such, Oil naturally dominates the balance of payments. Meanwhile, oil revenues also amount to over 90% of government revenue. Naturally, this implies that the external and fiscal accounts are highly sensitive to oil price fluctuations.
Chart 2. Saudi Arabia M2 growth – %, Y/Y
Source: FRED, SAMA
FX reserves naturally adjust to capital flows
The level of sensitivity is increased by the maintenance of the USD/SAR peg since 1986. The peg precludes the currency from adjusting to changing balance of payment flows, with the adjustment instead coming directly from movement of official FX reserve holdings. While the central bank speaks of only rarely intervening in FX markets since 1986, the reality is that the currency fix means that there is a natural and automatic adjustment of FX reserves to balance of payments dynamics, as is the case with a currency board. While the Saudi central bank (SAMA) has developed tools of monetary policy to try and smooth the domestic interest rate impact of FX reserve changes, it admits that control of the monetary base is difficult and that monetary growth tends to be very cyclical, based on oil receipts. The mid-to-late 1990s nadir in oil prices saw the monetary base contract in Saudi Arabia, while the period of the peak oil mania saw 25+% expansions of the monetary base, which coincided with the Saudi current account surplus rising to 25.5% of GDP in 2008. Broader monetary aggregates followed suit, as banks, awash with liquidity during periods of strong oil revenue, would expand credit. (Chart 2.) Hence the FX peg creates a natural pro-cyclical monetary element to oil revenues trends.
This pro-cyclicality naturally means that real GDP growth and inflation trends are driven by oil revenue dynamics. Low oil prices have a depressing impact on domestic demand and can be deflationary, and vice versa. (Charts 3 and 4.)
Chart 3. Saudi real GDP growth
Source: FRED, SAMA
Chart 4. Saudi inflation
Source: FRED, SAMA
The crucial stabilising impact of fiscal policy
However, fiscal policy plays a critical role in the Saudi Arabian economy in terms of providing an automatic stabiliser and smoothing the economic impact of oil price trends on economic growth. Quite simply, the government seeks to limit the expansion of aggregate demand into a period of high oil prices by running an ever-larger budget surplus and paying down debt. In contrast, during periods of oil price weakness, the deficit is allowed to blow-out and hence lower the consequent volatility of real GDP and inflation into large gyrations in export trends.
Chart 5 shows the impact of fiscal policy as a stabilising force with respect to domestic demand. In 2015, the Saudi budget deficit measured -21.7% of GDP compared to -3.4% in 2014. In contrast, in 2008 the budget posted a surplus of 29.8% of GDP.
Chart 5. Saudi budget balance as a percent of GDP (and the IMF’s optimistic forecasts)
Source: FRED, IMF
The oil boom saw public debt repaid
Moreover, the fiscal boon that accrued during the period of high oil prices was used to retire government debt. (Chart 6.) Outstanding government debt in 2015 fell to 1.58% of GDP, down from 96.4% in 2002. In contrast, in the late 1990s, the government expanded its budget deficit and issued additional debt, with public debt rising from 74.3% of GDP in 1995 to 103.0% in 1999.
Chart 6. Outstanding government debt as a percentage of GDP
Saudi Arabia’s current economic challenge
The on-going slide in oil prices poses a considerable risk to the Saudi economy. The current account in the 12 months to January 2015 measured a deficit of USD22.4bn, compared to a surplus of USD76.9bn in 2014 and a record high of 164.8bn in 2011. As a percentage of GDP, this meant a 2015 current account deficit of 3.5% after a 2014 surplus of 10.3%. (Chart 7.)
Chart 7. Saudi current account balance and the IMF’s (unrealistic) projections out to 2017
Source: FRED, IMF
The current situation is believed to be considerable worse that this rather out-dated data would imply given the further large decline in crude oil prices since 2014, and that the current account deficit is far larger than 3.5% of GDP. Higher frequency data on FX reserves clearly implies that the current account deficit has ballooned: in December SAMA FX reserves measures USD647bn, which represents an USD84.8bn Y/Y decline. (Chart 8.)
Chart 8. SAMA FX reserves
Source: FRED, SAMA, Bloomberg
Domestic liquidity is tightening
The decline in export receipts is having a notable impact on domestic liquidity conditions. M2 growth is slowing and liquidity is tightening. In December M2 rose by a 5-year low 6.2% Y/Y, down from 14.6% growth a year earlier. Domestic money markets are also tightening, with a rising spread to USD rates. (Chart 9.) This trend has supported the rise in USD/SAR forward premium.
Chart 9. SAR money market rates are moving further above USD rates as FX reserve losses tighten domestic liquidity
Source: FRED, SAMA, Bloomberg
The potential Saudi policy response
Were we in a traditional cycle of oil price changes, the policy response of Saudi Arabia would follow its traditional pattern. Fiscal policy would be allowed to play it’s stabilising factor on the real economy, and the SAR-peg would remain an inviolate policy anchor, with any decline in FX reserves expected to be temporary and corrected once oil prices cyclically increased once more.
However, a wave of fiscal austerity measures that the government has announced over the past two months is a sign that the previous playbooks no longer apply. Most critically, there is awareness that the current decline in oil prices is not simply a self-correcting, cyclical downturn, but may be structural.
Reduced oil price elasticity to OPEC supply
Firstly, the expansion of non-OPEC supply means that the oil price is no longer the endogenous variable that it was previously considered. Periods of sharply higher oil prices would risk expanding non-OPEC supply by validating fresh investment in new supply such as fracking. The expansion of non-OPEC production limits the capacity of the cartel to drive oil prices higher by crimping supply: the scale of output decline by OPEC necessary to underpin a surge in the global price could have a deleterious effect on revenue despite higher oil prices given the lower elasticity of the price to OPEC supply.
“The stone age did not end through want of stones” – Sheikh Yamani, Saudi oil minister 1962-1986
Secondly, there is believed to have been a policy shift in Saudi Arabia in recent years. The government no longer targets the oil price but instead looks to try and retain Saudi market share. In the face of alternative sources of oil supply, this has seen capacity expand, which reflects the capacity of Saudi Arabia to be the lowest cost producer. While there may be geo-political underpinning to this policy shift (the return of Iran as an oil producer), there is also awareness that new sources of crude oil are continuing to grow, just as new technologies will increasingly reduce the reliance on fossil fuels. Higher oil prices will accelerate this trend of expanded non-OPEC crude driven energy. This concern has seen Saudi Arabia in recent years focus on increasing the capacity to extract crude oil and sell it into the market. This helps explain why Saudi Arabia has been investing so heavily in new extraction technologies and capabilities in recent years, which have seen it’s output capacity – and it’s willingness to use this capacity – consistently surprise the market.
The fiscal austerity response…
In anticipation of a long-drawn-out period of low oil prices, the government unveiled a series of fiscal austerity measures. Plans have been made for a consumption tax to diversify fiscal revenues, while subsidies for oil, electricity and water are being reduced. There has even been talk of a series of privatisations aimed at increasing revenue.
…is unlikely to remove pressure on the SAR-peg
While these measures are understandable in the current climate, it is nonetheless difficult to see austerity being sufficient to address the enlarged fiscal deficit, which is concerning investors:
- It will take many years to notably diversify the government’s revenue base from oil-related income, especially given the lack of a diversified structure to the economy.
- More pertinently, given the presence of the SAR-peg, an enlarged fiscal deficit is an essential component of smoothing the real economic impact of lower oil prices. A fiscal austerity programme could merely mean that real GDP growth rather than the budget deficit takes a larger brunt of adjustment to lower oil prices. There may also be political and social factors that limit the amount of austerity and hence weaker economic growth, that the government may allow: Geopolitical concerns are keeping defence spending high, which could force domestic fiscal programs to take the brunt of adjustment; with 50% of Saudi Arabia’s population aged below 25 and with unemployment at a third, there are clear social risks stemming from austerity.
Government Debt/GDP could potentially return to 100% within 5 years
On a more positive note, as a consequence of the fiscal surpluses posted during the boom times for the oil market, the government has a considerable room for to increase it’s debt burden. While the 2015 budget deficit had ballooned to 21.6% of GDP deficit, the government has the capacity to run this level of deficit and fund it via debt issuance for quite a few years before aggregate debt/GDP levels rose to the 100% of GDP levels seen in the late 1990s. After all, the starting point is a government debt/ GDP position of close to zero. While the economy can withstand such a rapid increase in debt/GDP, the trend would nonetheless be expected to keep investors exposed to the SAR to require a higher risk premium.
External liquidity concerns – the more immediate challenge
Rapid FX reserve losses
Of greater, and more immediate focus than the fiscal position is the external liquidity position of Saudi Arabia. If the current account deficit is not corrected by an oil price recovery, then the current FX regime implies a continued loss of FX reserves. While a USD647bn FX reserve buffer is sizable and remains over 80% of GDP and nearly 4 times the annual import bill, the current trend points to a continued rapid decline in reserves which can swiftly erode this buffer given that last year, reserves declined by an average of USD7.1bn a month. Of course, Saudi Arabia’s external liquidity position needs to be placed in context: even if the current pace of FX reserve depletion continued for the next 2 years, reserves would still measure around 60% of GDP. However, the critical point is that at a time when concerns are growing about future oil receipts, a desire to maintain external liquidity would be understandable. An awareness of the need to diversify revenue streams and maximise income has been a boost to the development of sovereign wealth funds at many oil-producing countries.
A recession-induced improvement in the current account is an unlikely policy path…
While fiscal austerity related import compression could have a more immediate effect in improving the Saudi current account deficit, the political and social concerns noted above naturally limit the extent to which the government can pursue of policy of notably reducing the current account deficit by inducing a notable slowdown in growth/ recession.
…while for similar reasons, the currency-board type interest rate adjustment is unlikely to be allowed to occur
Of course, a currency board type arrangement such as the SAR-peg has theoretically the capacity to withstand any external liquidity shock if the monetary authority is tolerant of interest rates rising in lock-step with capital outflows: the level of domestic yields can rise to the level needed to compensate investors for the perceived FX risk of holding the currency, which limits FX reserve losses. However, for the same reason that fiscal austerity may not be the path to stable external accounts, a pronounced interest rate squeeze that would erode economic growth is also an unlikely, sustained response to any notable deterioration in Saudi Arabia’s external accounts.
A more realistic path to easing the external liquidity pressure in Saudi Arabia would be for the government to follow-through with it’s stated intention to privatise state assets. At the limiting extreme, in the unlikely case that the oil state oil producer, Aramco, were privatised, it’s IPO could quite conceivably be measured above USD1trn and over 3 times the current ~USD370bn market capitalisation of the Saudi stock market. A programme of equity divestiture does indeed appear likely over the coming years, which will ease pressure on the external accounts, although there are of course likely to be realistic limits placed on the nature and scale of privatisation targets. Aramco, for instance, remains a critical component of the state and even partial IPOs would first require changes to transparency. Interestingly, last month the authorities distanced themselves from a partial Aramco privatisation soon after the idea was first raised. It does not seem likely that privatisation will do more than ease Saudi Arabia’s external liquidity issues over the coming years.
Capital controls are not a viable option
As a brief aside, capital controls are not a viable option to address the external liquidity situation. The balance of payments deterioration in Saudi Arabia revolves around the current account deficit, and as such is beyond the remit of controls on investment capital flows.
FX policy options
FX-peg concerns likely to linger
Absent a positive external shock in the form of higher oil prices, the medium-term outlook appears for continued weakness in Saudi Arabia’s balance of payments and FX reserve losses. Moreover, a reduced stabilising role for fiscal policy will risk creating greater downside risks to GDP growth and creating disinflationary/ deflationary trends. While a long-term solution to the problem might involve finding ways to dramatically reduce the break even rate for oil – and the oil industry has an impressive track record of reducing costs when faced with adverse shocks – the coming years point to lingering concerns over the durability of the SAR-peg as it encounters the first real potential structural decline in oil prices. It is worth considering the options surrounding the SAR-peg.
External impact – import compression, particularly of discretionary consumer items
On the external front, Saudi’s lack of a diversified economy would mean that a weaker currency would be unlikely to see a rise in export volumes that could have a consequential effect on economic growth, while import bills will increase for large parts of the economy that rely on sourcing products from overseas. However, the higher SAR cost of imports would have the effect of lower import absorption – especially of discretionary consumption items – which would see an improvement in the external accounts.
An indirect fiscal austerity policy on consumers
More consequently, in SAR-terms the export receipts from crude would increase, providing a revenue boost to the government. If government expenditures were not indexed to the new, higher inflation rate – and the government would have to ensure that in SAR terms expenditure on salaries, etc were not adjusted to compensate for the higher import costs – then the devaluation would in essence be improving the budget balance and implementing an austerity policy on consumers. A notable currency adjustment could have the impact of reducing the budget deficit, and were a maxi-devaluation large enough, to restore the fiscal deficit to a surplus absent an increase in the price of oil, albeit at an increasingly heavy cost to consumers.
The possible need for subsidies on non-discretionary consumer items.
A fly in the ointment would be that the price of some imported non-discretionary consumption items would increase, most notably food. As such, the fiscal gain may need to be partly offset by increased fiscal subsidies on food items in order to limit the squeeze on household incomes at the lower end of the income spectrum, which would be problematic to the government given the demographic and unemployment situation.
Limited dual equilibrium risks from currency weakness
It is also worth noting that Saudi Arabia has a sizable net foreign asset position, and while there are plans for the government to increase Eurobond debt issuance, current foreign debt gearing of the economy and corporate sector is low. (Total external debt in Saudi Arabia is just 14.9% of GDP). This is important as currency weakness can actually tighten monetary conditions for economies where corporates have a high foreign debt position and thereby encounter increased debt financing costs in local currency terms. An economy can be even weaker after a period of currency weakness if these circumstances apply, and it is this very “dual equilibrium” problem which makes so many emerging market currency crises so prolonged and sizable.
A float or a deval?
If there were to be a currency adjustment, moving to a floating SAR might be a better outcome than a simple repeg. Domestic liquidity conditions would be insulated from the vicissitudes of oil prices as monetary policy became endogenous while FX reserves would be preserved. Into periods of weak oil prices, the SAR could also naturally adjust to levels that helped to better balance the fiscal position. The cost would of course be a more volatile external environment for corporates, but given the lack of a diversified economy and the dominance of a USD-based industry, this drawback could in theory not be a binding constraint to policy action.
SAMA already has a functioning money market in place
There are question-markets about how prepared SAMA and the banking/ corporate sector would be to administer a floating currency. However, the relevant infrastructure and technical knowledge can be established fairly swiftly, especially as SAMA already has the basic ingredients in place – a well functioning money market which encompasses repo/ reserve repo operations, FX swap intervention capacity, SAMA bills and what will be a rapidly a growing government debt market.
Chart 10. The stresses on the USD/SAR peg have rewarded long gamma strategies in recent months.
A re-peg runs the short-term risk of accelerated FX reserve losses
A re-peg/ deval would be a simpler adjustment to administer and could be implemented more swiftly. This would still incur the risk of a re-peg not being large enough to adjust the external and fiscal accounts, but it would nonetheless provide economic benefits at a time of intense pressure on the external and fiscal accounts. One risk of course would be that by breaking the near 30-yr old peg Saudi Arabia would experience a considerable degree of capital flight initially as FX risk started to impact more fully on portfolio decisions which could imply an initially accelerated pace of FX reserve losses. (This also argues against a minor FX peg change as the pay-off would be asymmetric: limited fiscal and current account benefit from a moderately weaker SAR; tighter domestic liquidity conditions as the incorporation of FX risk into investment decisions initially increased capital outflows and FX reserve losses). However, over the medium-term a sizable re-peg could be assumed to make the external and fiscal accounts more sustainable.
SAR-peg concerns likely to persist
In summary, Saudi Arabia is faced with a challenging confluence of trends: a structural decline in oil prices and a currency peg that is pro-cyclical. The medium-term outlook is for a notable degree of fiscal deterioration, slower economic growth and lower levels of FX reserves. In contrast to past periods of lower oil prices, the government’s decision to embrace fiscal austerity is going to mean greater downside risks to growth and price stability, as the traditional fiscal stabilisers do not work to their usual extent. Concerns in the market that the current macro-economic policy framework in Saudi Arabia is not optimal in the current climate are likely to persist. This argues for a continued risk premium being attached to the SAR-peg, which will represent the cost of hedging/positioning for portfolio convexity amid concerns that there has been an increased risk of an outsized move in the SAR.