Sniffing a peg break Series: Saudi peg to come under pressure as Fed ready to hike thrice in 2018

The latest minutes of meeting released by the U.S. Federal Reserve show that majority of the policymakers remain upbeat over economic growth and almost all members believe that inflation is likely to reach Federal Reserve’s 2 percent target in the medium term due to upside risks to economic growth and strong labor market, which means that the Federal Reserve is very much likely to follow through its forecast of three more rate hikes in 2018. Some analysts even predicting four rate hikes this year.

Well, that is troubling news for Saudi Arabia, whose currency Riyal is pegged to the Dollar at 3.75 per USD. Despite the U.S. Federal Reserve increasing interest rates five times since 2015, Saudi Arabia’s Monetary Authority (SAMA) has maintained interest rates at 2 percent. However, as the differential in official rates decline SMA will be forced to either raise rates or defend the peg using other means such as market intervention. Three rate hikes this year would put the U.S. federal funds rate higher than that of Saudi Arabia’s.

The problem is that defending the peg using forex reserve could prove to be an expensive strategy given the facts that the reserve has steadily declined since the oil price crash of 2014 and is now at the lowest level in seven years. On the other hand, raising interest rates could prove to be difficult too as it would mean tighter domestic credit conditions as a time when the economy is undergoing a recession, government’s budget deficit has remained large for three consecutive years, and loan growth has been negative since March last year.

The relatively viable solution is to loosen the peg but that might hurt global investors’ confidence on Saudi Arabia as the peg has not been disturbed in more than 30 years.