Abstract
Scholars have argued about currency pegging policy, and whether it is suitable for an economy or not. Based on Saudi Arabia riyal and the US dollar pegging, this essay critically evaluates theories and policy implications behind the two decades pegging of the riyal against the dollar. It also presents the argument of SAMA as well as why the government of Saudi Arabia believes that currency pegging is appropriate for its economic stability.
The study shows that pegging system is under pressure from the public as well as economists who want the government to revalue the riyal. They point at rising inflation and exchange rates of other currencies together with the depreciating value of the dollar as the main reasons to revalue the riyal.
However, the government maintains that inflation in the country results from domestic processes and not changes in foreign currency exchange rate. In fact, SAMA believes that pegging the riyal against the US shall persist while the US dollar is the global currency of commodities. Meanwhile, experts believe that revaluation of riyal shall happen in the near future.
Introduction
Currency pegging refers to “the act of indexing or fixing the exchange rate of one currency against another currency” (Hakes and Gamber 89). Currency pegging is a macroeconomic practice that aims to abridge international trade and lessen the rate of inflation of the pegged currency. This practice usually involves a major currency (mostly the US dollar) and another currency.
In order to sustain pegging of a local currency, the Central Bank has to trade its currency against the pegged currency. In addition, the Central Bank must maintain a large reserve of the foreign currency to enable it control the supply of its local currency.
The pegged currency must have some float. This implies that the buying rate remains fixed. Conversely, the selling price has marginal changes to enable other money traders buy and sell the dollar.
Pegging currency has some implications for the foreign exchange traders. For instance, the Central Bank takes an active role in the market and fixes the rate of exchange. This practice is also responsible for high liquidity in the market. It prevents a single trader from influencing the market and limits the major currency (Mishkin 71).
Literature Review and theories
Since 1986, the Central Bank of Saudi Arabia has pegged the Saudi riyal against the dollar. However, there are calls to revalue the Saudi riyal and end the practice just like in Kuwait. This is because of the weakening dollar. Experts claim that it is now fueling inflation and making commodities expensive (Mankiw 78).
Prices of oils have increased, and the economy has grown considerably. These factors have placed pressure on the government so that it revalues the riyal. However, any changes in the exchange rate of the dollar and riyal shall have negative consequences for several stakeholders.
First, the government shall bear negative consequences of revaluation. This is because earnings from oils are usually in dollars, which the country changes to riyal for the national budget.
According to Bourland, revaluation of riyal shall “permanently weaken riyal value based on oil revenues, reduce the size of the national budget surplus, and create a budget deficit” (Bourland 1). The government also has its assets in dollar denomination. Therefore, revaluation would reduce the value of these assets.
Second, the Central Bank of Saudi Arabia (SAMA) has categorically stated that the country shall not revalue the riyal against the dollar. This implies that such changes can hurt the credibility of SAMA, affect confidence of consumers in the riyal when oil prices drop or when the value of the dollar increases.
SAMA would not allow sudden changes on the rate of exchange. However, gradual adjustments cannot hurt many stakeholders affected by the weakening dollar.
Third, foreign investors shall also bear the consequences of revaluation. This is because of an expensive riyal and the introduction of exchange rate shall create uncertainties in the market. This act can discourage investments in the country.
Finally, Saudi exporting companies shall also bear negative impacts of revaluation because their products shall become expensive. This shall make such products to lack competitiveness. On the other hand, imports shall become cheap and still render locally produced goods to lack competitiveness.
Revaluation of the riyal against the dollar can make sense over a long-term basis as economy undergoes diversification and SAMA seeks for many avenues for independent rates.
However, the time to revalue the riyal is not now. Any attempt to change the fixed rate in order to reflect weakening dollar shall hurt the Saudi economy. Thus, the only alternative to ease the rising rates of inflation among the public can come from subsidizing prices of commodities using oil revenues.
Exchange Rate
For over two decades, SAMA has pegged riyal against the dollar at 3.75. This was a move to stabilize both internal and external value of riyal. SAMA chose the dollar because of its international usages in the oil trade. SAMA relies on sufficient “foreign exchange convertible to gold” (principally short-term US dollar instruments) to cover the value of all printed riyals in circulation” (Bourland 1).
Pegging the riyal against the dollar has served its purpose of “supporting the economic growth” (Bourland 1). It has controlled inflation in the country.
Experts have observed that the rate of inflation in the country has averaged 0.5 percent between 1986 and 2006. The IMF also noted that the country’s real effective exchange rate was stable. The real effective exchange rate considers the country’s currency against those of its trading partners.
Changes in the international prices of oil have placed pressure on the pegged riyal. For instance, in 1993, the international price of oil fell. There were also concerns relating to budget deficits. This generated speculations that the value of riyal shall fall. During 1998 and 1999, there were similar experiences due to “drops in oil prices and economic crisis of Asia” (Bourland 1).
However, SAMA used its vast foreign assets in order to control devalue and maintain strength of the riyal. Presently, this pressure does not come from market activities. Instead, it originates from public opinion. The public wants upward revaluation or an end to pegging.
Causes of pressure for revaluation
The market expectations and perceptions are responsible for calls for revaluation of the riyal. The public argues that the currency strength is not consistent with the rising prices of oil and strong economy growth of the country.
In addition, the weakening dollar makes the external value of “the riyal to reduce as inflation hurts its internal value” (Mankiw 78). Still, there are also regional forces (GCC members) and other global factors, which place pressure on the riyal.
The fair value of a currency is difficult to ascertain as most economists show. For riyal, it is not free-floating. Thus, it fair value based on the market forces remain difficult to establish. However, changes in the oil prices should provide ground for revaluation of the riyal. The country also has large account surplus, which demonstrates that pegging undervalues the riyal.
Saudi Arabia has “exceeded 20% of GDP for the last three consecutive years” (Bourland 1). Finally, the Big Mac Index puts it that the riyal is 36 percent undervalued against the dollar (The Economist 1). The index relies on prices of similar products across different countries and attributes the price differences to discrepancies in exchange rates.
Data from other trading partners have indicated that the value of riyal has fallen. For instance, the Euro, the British Pound, and other currencies depict these changes. Under these conditions, the free-floating exchange rates from forces of the market shall ensure that the riyal appreciates.
Strength against riyal among Saudi’s trading partners
Source: the Economist, January 12, 2012
These indicators show that pegging has created undervalued riyal. However, this should not translate to revaluation of the currency after two decades of pegging. Undervalued currencies usually drive competition and growth through encouraging export of products.
This implies that Saudi Arabia benefits from currency pegging. Still, SAMA must not revalue the currency because rates of foreign exchanges are not stable. The dollar might gain strength and create a weak riyal. In this regard, the argument for revaluation should follow “structural economic arguments rather than changes in the foreign exchange markets” (Bourland 1).
The rising inflation and exchange rate
In the recent past, Kuwait revalued its dinar. It argued that a weak currency was responsible for inflation. Thus, we can apply the same rationale to Saudi Arabia.
The decline in riyal has also come in a time of rising inflation. From 2003 to 2007, the rate of inflation in the country rose from 0.3 percent to 3.1 percent. The weak riyal led to high prices of imported products.
In this sense, upward revaluation of the riyal shall “reduce prices of imported goods and consequently, reduce inflation” (Hakes and Gamber 91). However, imports are not the main contributor to rising prices based on the following observations.
First, inflation in the Kingdom results from locally produced goods. This is because of economic growth in the country, which has forced prices of commodities to rise. Inflation mainly results from food prices. We have to note that increments in food prices are global phenomena and do not affect Saudi Arabia alone. In addition, food prices do not relate to changes in currency markets.
Prices of other commodities have also increased. Commodities, such as jewelry, gold, and silver, have increased in international prices. However, such changes have not affected majority, and they are not severe like in the case of food prices. Rent prices have changed due to increase in the number of expatriates in the Kingdom.
Analysts believe that exchange rates are not the main source of inflation in the Kingdom. The above tables capture various items and services from local and international markets to show that exchange rates are not the cause of problems. In fact, some locally produced goods and services have proved that inflation in the country does not arise from the currency pegging.
Trade data from other countries have also indicated that the dollar was not the source of inflation in the country. For instance, products from China have kept the rate of inflation low. China has increased its export to the Kingdom.
Data from SUSRI, 2007.
Revaluation of the riyal can result into “low prices in some commodities” (Hakes and Gamber 92). However, this approach cannot handle inflation effectively. This is because revaluation of the currency can increase disposable income among Saudis. However, stronger spending power can also create high prices as demands increase.
Changes in the values of foreign incomes and assets
The revaluation of the currency can lead to low earnings from oils and low values of other assets denominated in dollar. This implies that if the government increases the value of riyal, then its earnings from oil exports shall fall. The fall in earnings from oil exports can implicate the national budget of the Kingdom and create large deficits. Surplus in the national budget shall also decline as spending in public sectors increase.
Similarly, all foreign assets of the government shall also lose value based on upward revaluation of the riyal. The upward revaluation of the currency shall affect other sectors such as financial institutions, which may have foreign assets. Companies that also have assets valued in dollars shall also experience decrease in value of their assets because statements shall reflect valuations in riyal.
SAMA policy complications
For more than two decades, the country has pegged the currency against the dollar. On several occasions, SAMA has stated consistently and categorically that it shall not review the current fixed rate of exchange. In addition, SAMA insists that it has mechanisms of fighting off any speculations arising from pegged the rate.
SAMA has enough assets, which can afford to “buy all riyal in circulation if the pegged currency is under pressure from economic forces” (Bourland 1). This implies that the country has to prepare the market for many years for such changes. However, it has not happened. Therefore, the policy of currency pegging shall remain firmly in place in order to maintain the pegging system.
Protecting the currency credibility
Credibility is crucial in money market. Thus, policymakers must use it to protect the currency as well as the exchange rate. The lack of credibility in a currency market can make traders lose confidence in the currency. This is because of uncertainty regarding the value of currency.
Eventually, the loss of credibility can affect investment and economic performance of the Kingdom. Thus, the country cannot afford any abrupt changes to the currently pegged exchange rate. However, the strength of the dollar and decrease in global prices of oil can also devalue the riyal.
Protecting locally produced commodities
Revaluation of the riyal can result into high prices of products, which do not use the dollar as a benchmark. Still, prices of import products valued in other currencies shall decline. On the other hand, prices of locally manufactured products shall rise.
This shall undermine the competitiveness of local products. The country can diverse its economy and encourage the growth of other sectors rather than the oil export. Any revaluation of the riyal shall raise prices of exported goods.
As the country records positive economic growth, imports shall increase, and the public shall have confidence in the market. Any revaluation of the riyal shall result into an increase in imports. Thus, imports shall be cheap as exports become expensive. This shall reduce the competitive ability of local products.
Foreign Investment
Revaluation of the riyal shall reduce foreign investments in the Kingdom. This is because foreign investors shall deal with unstable and expensive riyal. In addition, the readjustment of the pegged rate shall create uncertainty in the foreign exchange market.
This situation can deter any form of foreign investment in the country. The country has promoted its foreign investment agenda under the pegged currency. This implies that the country’s agenda of attracting foreign investments cannot be successful if it reviews the riyal.
For foreign investors, pegging the currency has created a long-term stability. This has eliminated risks associated with the capital value, which results from free-floating exchange rates. The dollar has also presented cases of volatility. However, this does not imply Saudi Arabia should revalue its currency.
Increased Volatility
Changes in international oil prices have created a volatile situation in Saudi Arabia. This implies that the exchange rate has also experienced volatility in the Kingdom.
The country has relied on large dollar reserves and the pegged exchange rate in order to control volatile situation, which arises from fluctuating oil prices. Any move to abandon the pegging system can expose the riyal to further volatility.
This implies that many oil traders cannot rely on riyal as a currency of exchange. Therefore, country must gradually plan and implement any plan of abandoning the riyal pegging or revaluation of its currency.
Other arguments for revaluation of the currency
Initially, the GCC had planned to have a single currency by the year 2010. This initiative has faced many hurdles. According to some economists, this scenario may force the Kingdom to revalue its currency (Bourland 1). These economists claim that GCC member states can readjust their currencies in preparation for the launch of the GCC single currency.
However, some believe that the GCC member states shall peg the GCC currency to the dollar whereby the riyal shall have a fixed rate. Later, the GCC member states may include a basket of currencies that show their trade relationships.
Still, the Kingdom and other states like Qatar have claimed that as long as the dollar stays in the global financial system as the currency of price commodities, they shall continue to peg their currencies to reflect this.
Some economists argue that pegging currencies create global imbalances in trade. However, global imbalance results from large gaps in trade between countries. In this case, one country saves excessively as another one spends excessively. This is the case of the US and China whereby the latter is responsible for large trade deficit between them.
China has also pegged its currency against the dollar. Revaluation of currencies usually reduces the gap in trade imbalances among countries. This act normally encourages such countries to increase imports and reduce the gap. As a result, the existing trade imbalances decline.
Negative impacts of pegged currency
First, pegging currency has created conditions in which it is difficult to balance the trade between the two countries. Free exchange rates usually balance imports and exports between trading partners. For instance, in a situation whereby there is a trade deficit, there is an increasing demand for foreign currency as prices of foreign commodities increase.
Thus, the foreign products shall not be attractive to domestic consumers. Consequently, it creates a trade balance. On the other hand, if we have a pegged currency, creating a trade balance is difficult. This is because a fixed rate of exchange does not provide an opportunity for the government to devalue currency. This implies that prices of domestic products shall remain high.
Second, under the current prevailing economic conditions, it has become difficult to print additional money in order to stimulate the economy with a pegged currency. Printing additional money may benefit the average household. However, it cannot tame the rising inflation and costs of basic commodities.
This is because consumers will not be willing to spend money on expensive domestic products. This implies that the demand for foreign products shall increase. Still, a lack of trade imbalance because of pegging system shall force the domestic production to fall and cause recession.
Third, defending the pegging system is usually a difficult task. Saudi Arabia may resort to agent measures in order to make trade possible if the dollar continues to weaken rapidly. Some of these measures may include artificial strategies to reduce the rate of inflation, increase taxes, and reduce supply of money in the market.
The strategy provides the government with an opportunity to raise incomes from taxes and allow consumers to purchase local products. These strategies are not sustainable because they lead to high taxes, which make the cost of running a business an expensive activity. Unemployment may come because of high rates of taxes. In addition, foreign companies may move to other areas with low costs of running a business.
Fourth, there are also political reasons, which influence currency pegging among countries. For instance, China’s action towards the dollar may result from the battle for supremacy as an alternative source of global currency. However, in some case, the pegging may be away of forging a strong alliance between countries through their trade.
This is the case of Saudi Arabia and the US. This system has enabled the two countries to maintain strong relationships despite the Gulf turmoil. However, the situation cannot allow the Kingdom to fix its riyal against other major currencies like the Euro, the GBP and others. In addition, the current may also find it difficult to abandon pegging in its financial policy.
Policy Implication
From various points of view, it is appropriate for Saudi Arabia to continue with the pegging policy. However, as market conditions and pressure mount on the riyal, it will be necessary to implement changes to pegging policy gradually. The two main factors, which shall cause revaluation of the riyal, are diversification of the Kingdom’s economy and the need for independent systems to set the rate of interest as businesses acquire autonomy.
However, revaluation of the currency shall take many years because economic diversification is a slow process. Still, the oil market shall operate under the dollar currency for many years to come.
The country cannot adjust its interest rate due to its pegged currency. It has to rely on interest rates as the US Federal Reserve provides. This creates limited flexibility in controlling interest rates. If the country deviates from the US rates, then financial institutions can take advantage and make profits from a risk-free opportunity.
The ability to set or control interest rate is “a way of managing inflation in many countries” (Hakes and Gamber 92). However, this requires involvement of local individuals to enhance their spending habits in order to “create impacts in adjusted interest rates” (Hakes and Gamber 92).
In the Kingdom, consumers’ debt uptake is still low. Probably, abandoning pegging system shall encourage the uptake of credit facilities because the government shall have the freedom to adjust the interest rates in a way suitable for the local economy.
The government should also consider distributions of oil revenues by subsidizing costs of basic commodities like foodstuff to its citizens.
The government should also consider pegging the riyal to “a trade-weighted basket of currencies” (Bourland 1). From this policy, the riyal shall match the rate of its trading partners and reduce cases of imported inflation. However, this approach is complex, and the public may not readily understand it. In addition, it can create a volatile situation for the economy of the Kingdom. Thus, it is not a favorable approach.
The ultimate aim may be to achieve a free-floating currency in which market forces influence the rate of the currency. However, given the volatility in the international oil prices, any further fluctuation from foreign market exchanges shall create uncertainty in the market. Therefore, the only viable option for Saudi Arabia is to maintain its pegging policy.
Summary and Conclusion
Saudi Arabia is under pressure from economists and the public to revalue its riyal against the dollar or abandon the pegging policy altogether. This is due to weaken of the dollar in foreign exchange markets, increasing rates of inflation, and the rising value of currencies of trading partners. However, Saudi Arabia is not ready to break this policy after two decades.
We can argue that changes in foreign exchange rates are not appropriate reasons to adjust the riyal against the dollar. However, some economic factors should make the country to consider the pegging policy. In its defense for pegging policy, Saudi Arabia argues that rising inflation does not relate to changes in the foreign currency market. Instead, it originates from domestic activities.
In addition, inflation in the country mostly affects domestic products rather than imported products. The Kingdom has also stated that it has appropriate mechanisms to handle rising inflation or a weaker dollar. The Kingdom believes that pegging currency has many benefits than its revaluation. Thus, pegging the riyal against the dollar has achieved its purpose.
Works Cited
Bourland, Brad. The Riyal’s Peg to the Dollar. 2007. Web.
Hakes, Davide and Edward Gamber. Study Guide for The Economics of Money, Banking, and Financial Markets. New York: Prentice Hall, 2009. Print.
Mankiw, Gregory. Macroeconomics. 7th ed. New York: Worth Publishers, 2010. Print.
Mishkin, Frederic. Economics of Money, Banking, and Financial Markets. 9th ed. New York: Prentice Hall, 2009. Print.
The Economist. The Big Mac Index. 2012. Web.