Sniffing a Peg Break Series: Costly Saudi peg

Saudi Arabia has its currency pegged to the dollar at 3.75 Riyal per dollar since 1986, and this year might see the breakaway from this three decade old peg as the US Federal Reserve prepares to hike rates at a much faster pace compared to the previous two years. Since the Great Recession of 2008/09, Saudi Arabia’s Monetary Authority (SAMA) has kept the rates at 2 percent, which as of now provides sizable incentives to hold Saudi Riyal.

But if the Federal Reserve keeps to its commitment of three hikes in 2017, the interest rate differential would decline to just above 60 basis points from current 140 basis points. Without any increase in the interest rates, SAMA is likely to struggle to cope up with the dollars required to defend the peg. But, if the Central Bank chooses to lift rates, it would prove detrimental to the Saudi Arabia’s domestic economy, which is already suffering from lower oil revenues by drying up liquidity further.

The oil revenue plays a major role in Saudi Arabian banks’ deposits, which are currently dwindling, so an increase in interest rates would only lead to an increase in the already rising non-performing assets. At this point, it would be prudent to let the pressure ease on the peg by controlled devaluation rather than defending the costly peg.