There is a growing opinion in Saudi Arabia indicating that the time has come to amend the riyal exchange rate versus the dollar by raising its value, and to abandon the twenty year-old policy of pegging the Saudi currency to the American currency. The rise in inflation as a result of the collapsing of the dollar, oil prices hovering near their highest levels, and a flourishing economy are factors creating pressure to strengthen the riyal.
However, in analyzing the pros and cons of un-pegging the Saudi riyal from the US dollar, a report by the Saudi Jadwa Investment Company (JIC).  says the costs of an exchange rate change far outweigh the disadvantages of keeping the pegging system in place, especially since imported inflation constitutes but a small fraction of the current wave of inflation in Saudi Arabia. According to the report, the largest groups that would be harmed by the rise in the value of the riyal versus the dollar are the [Saudi] State, the Saudi Arabian Monetary Agency (SAMA, which acts as Saudi central bank), foreign investors and local companies. Introducing a higher rate of exchange for the riyal will immediately reduce the amount of foreign currency reserves held by SAMA.
The report points out that SAMA has repeatedly announced that it has no intention of changing the current foreign exchange system. If it were to do otherwise, its credibility would be harmed and there would be a decline in confidence in the riyal. Furthermore, the central banks do not usually introduce sharp or sudden changes in exchange rates, while minor changes will produce a limited impact. From the perspective of the foreign investor a higher value of the riyal will increase costs and cut into foreign direct investment.
According to the IMF, the riyal exchange rate of 3.75 riyals to 1 US dollar remained relatively stable apart from periods when the dollar was significantly weak during the 1986-1987 and the 2002-2005 periods.
The Falling Riyal and Inflation
One of the economic arguments for a change in the exchange rate is that the weak riyal is resulting in imported inflation. This is a major reason for Kuwait's decision to raise the exchange rate for its dinar against the dollar.
The riyal's fall happened to coincide with a period of rising inflation in Saudi Arabia, from an average of 0.3% in 2003 to 3.1% in June 2007. But a weaker riyal raises the cost of imports in other currencies and not in dollars. The argument goes that raising the value of the riyal would cut the price of imports, which in turn would reduce the imported inflation. JIC does not believe that inflation has or will have any relation to rising prices in Saudi Arabia. This is due to the fact that inflation is focused on specific areas that have mostly nothing to do with the price of imported goods.
Plans for the GCC single currency system to be implemented at the beginning of 2010 were another reason put forward to justify a change in the exchange rate system. As Saudi Arabia would have to eventually change its exchange rate upon joining the single currency system, there were speculations that a change in the exchange rate was going to occur, anyway.
Exchange Rate and its Impact on Costs
JIC’s view is that changing the current exchange rate is not only unnecessary or the best means to fight inflation, but it would entail many other costs:
Reduction in the Value of Foreign Earnings and Reserves: A rise in the value of the riyal would cut oil revenues and the value of dollar-denominated assets when converted to local currency. If the value of the riyal gets raised by 20%, for example, the value of Saudi Arabia's purchases through its oil revenues would decline by 20% in riyal terms.
JIC's forecast is that government budget surpluses will decline over the next few years, as oil revenues stabilize and spending continues to increase. The budget would be roughly in balance in 2010.
The banking sector would also face difficulties in its assets’ value. Since the banks state their earnings in Saudi riyals, any earnings from their foreign assets are paid in dollars, such as bonds or sukuk (Islamic bond) earnings, which would be of lower value when converted into riyals.
There are a large number of companies and various sectors of the economy that have large assets or revenues that are denominated in dollars. Since local companies generally prepare their financial statements in riyals, any assets held in dollars or revenues earned in dollars would be damaged in case of raising the value of the riyal.
Contradiction with Official Policy: SAMA has clearly and consistently expressed its commitment to the policy of the existing exchange rate and has the means to defend it against speculation on the riyal. Due to its net foreign assets of $243 billion at the end of June, SAMA can easily afford to buy the last riyal available in circulation in Saudi Arabia if the peg policy came under any pressure.
Damage to Credibility: At the present time, Saudi Arabia has a strong and credible exchange rate system. Should the peg get suddenly changed after more than 20 years of oil market and exchange rate cycles, this credibility would be damaged.
Undermining the Competitiveness of the Non-Oil Sector: A raise in the value of the riyal would raise the prices of the non-dollar denominated exports in foreign markets and lower the prices of the non-dollar denominated imports into Saudi Arabia. The effects of both situations will undermine the competitiveness of goods that are produced locally. The diversification of the local economy is one of the most important pillars of economic policy in Saudi Arabia. One of the most important elements of this policy is to encourage non-oil exports (primarily petrochemicals), which were about 12% of total exports in 2006.
Reduction in Foreign Investment: Increasing the value of the riyal would make it more expensive for foreign investors, and the adjustment to the peg would create an uncertainty in the exchange rate which might deter foreign investors. Saudi Arabia’s goal is to become among the top ten most attractive countries for foreign investment in the world by 2010. Raising the value of the riyal and the uncertainty in the exchange rate would damage the country’s efforts.
By analyzing the arguments in favor and against a change in the exchange rate, JIC’s view is that Saudi Arabia's best policy option at the present time is to keep maintaining its riyal exchange rate versus the US currency despite the dollar's recent weakness. But, the time will come when it will be logical for the Kingdom to disengage itself from the dollar peg. The main reasons to head towards such a change is that the economy would be significantly diversified away from the influences of the dollar and the government would need independent tools to determine the interest rate at a time when the debts of businesses and individuals would have become higher than at the present time.
 al-Sharq al-Awsat, London, August 22, 2007. The article originally appeared in Arabic and excerpts from the article were translated by the staff of www.memrieconomicblog.org
 Authorized by the Saudi Financial Market Authority