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Saudi Riyal-Dollar Peg: Economists Sound A Note Of Caution
By S. Vilupolananda
09/28/2011

Saudi Arabia is likely to keep a long-standing peg between the riyal and the dollar despite recent weakening of the U.S. currency and fears that this could fuel inflation, according to regional economists and market analysts who also cautioned that a stronger riyal might deter new investments in the Kingdom.

Commodities are priced in the U.S. currency and its weakness in recent years has helped boost demand from investors in other currencies. The U.S. is also a key market for Gulf oil producers.

Divergent views about exchange rates and inflation in Gulf countries have appeared in regional media since the Swiss National Bank shocked markets early this month with its decision to peg the franc to the euro and to buy unlimited amounts of foreign currencies to curb its appreciation.

Some business travelers and decision-makers in the region have also been suggesting that Kuwait’s decision in 2007 to peg the dinar to a basket of currencies might have helped the Gulf state to shield its economy from the dollar’s fluctuation.

But Paul Gamble, head of research at the Riyadh-based Jadwa Investment, told Arab News that Kuwait’s record of fighting inflation "has been no better than Saudi Arabia’s in recent years." Kuwait’s currency is still very closely linked to the dollar, he pointed out.

Reuters reported recently that Kuwait’s annual inflation eased to an 11-month low of 4.6% in July and edged up only slightly from the month before on higher food and transport prices. Analysts quoted by the news agency said they expect price pressures to stay muted in Kuwait.

A Jeddah-based economist said that Kuwait had actually paid for its basket in terms of less liquidity. "The Saudi and other pegs are simpler, more transparent and easier for markets to work with," said Jarmo T. Kotilaine, chief economist at Saudi Arabia’s National Commercial Bank (NCB). He pointed out that weaker dollar will drive imported inflation when imports are denominated in currencies other than dollars.

He added: "It is not clear that de-pegging from the dollar would help much in containing inflationary pressures, especially since the only conceivable intermediate step would probably be a Kuwaiti-style basket which would still be heavily dollar-dominated." Kotilaine said the ability of the euro to protect from inflation is questionable in view of its own structural challenges." Even the yen faces longer-term risks while the emerging market currencies are still not true trading currencies," he pointed out.

"Under the circumstances, not much is likely to be gained from switching away from the dollar pegs and a lot would be lost in terms of reduced transparency and efficiency, as well as policy consistency and credibility," Kotilaine said.

Commenting further on the currency debate, Gamble of Jadwa hinted that de-pegging the riyal would probably push inflation lower over the short term. He said a fully floating riyal would be an attractive currency for foreign exchange traders - so large inflows would cause the riyal to strengthen, lowering the cost of imported goods. "However, it would also undermine the non-oil economy and introduce much greater volatility, which would deter investment," cautioned Gamble.

"If the peg was adjusted so that the riyal is strengthened against the dollar there would be a one-time fall in inflation owing to lower import costs, but this move would have many negative impacts elsewhere in the economy," Gamble said. Ultimately, he said the exchange rate is not an appropriate tool to tackle inflation and it would probably have little impact on it.

As market observers analyzed the emerging market trends, Saudi Arabian Monetary Agency (SAMA) Gov. Muhammad Al-Jasser reiterated earlier the determination of Gulf states to forge ahead with their plans for a single currency despite the global debt crisis. "I have heard doubts (expressed about the single currency) only in the media. It is untrue," Al-Jasser said following a meeting of regional central bank governors in Doha.

Financial markets declined in recent weeks as investors grew increasingly unnerved by the ability of euro zone leaders to solve the debt crisis that has engulfed Greece, Portugal and Ireland and now threatens Italy and Spain. Many U.S. indicators also point to stalling growth.

But Gamble said there had been no impact from the economic troubles in the U.S. and Europe on the Kingdom’s currency peg.

Reacting to money market developments, Khan H. Zahid, vice president and chief economist at Riyad Capital, said: "A euro zone debt crisis would most likely lower the euro’s value against the dollar and thus against the riyal, and that may also hurt euro zone imports from the Kingdom."

Estimates from ratings agencies and the IMF suggest that this year’s inflation rate in the Kingdom could be in the range of 5.5% to s6%, up from 5.3% in 2010.

Recent government data showed that annual inflation eased to 4.8% in August and monthly price growth halved to 0.5% as a rise in housing and transport costs subsided.

Inflation in the Gulf is expected to creep higher this year on robust global commodity prices, a weak dollar and increased government spending, Reuters reported.

Commenting on consumer concerns about possible price increases and higher living costs amid global economic uncertainty, Gamble explained that there was no domestic pressure on the value of the riyal. Inflation is being driven by a combination of factors, he pointed out.

"Rents are one of the main source of inflation, caused by a shortage of accommodation, a rapidly growing population and a reduction in the average household size. International commodity prices, particularly for foodstuffs, some construction materials and precious metals are the other main source of inflation. Given the size of government and consumer spending this year, the lack of other inflationary pressures is notable," Gamble said.

"The global debt problems have not had much impact on inflation in the Kingdom. By causing the global economy to slow, they have pulled down commodity prices and so reduced inflationary pressure," he added.

Gamble said the dollar is still regarded as a safe haven despite the credit rating downgrade and this has also put downward pressure on inflation.

Source: Arab News, Saudi Arabia, September 28, 2011. Changes were made in keeping with the editorial policy of www.memrieconomicblog.org

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