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Saudi Authorities Panic As Speculators Drive Currency Down

Saudi Stock Exchange

With Saudi Riyal forwards plunging back below 3.81, dramatically weaker than the current peg, Bloomberg reports that Saudi authorities are cracking down on currency traders as speculation mounts that the world’s biggest oil exporter won’t be able to maintain the riyal’s peg to the dollar as revenue plunges.

Saudi Arabia ordered banks in the kingdom to stop selling some products that allow speculators to bet against its currency peg just days after demanding information from lenders on the offerings, according to people with knowledge of the matter.

The Saudi Arabia Monetary Agency sent a circular to banks this week saying that dollar-riyal forward structured contracts are banned with immediate effect, according to sources asking not to be identified because they are not authorized to comment publicly. Forward foreign-currency transactions backed by actual goods and services will still be allowed, the people said.

The regulator, also known as SAMA, has asked lenders for details on derivative deals dating to January, saying they hadn’t informed the central bank about some products. An e-mailed request for comment to the agency outside of normal office hours on Friday wasn’t immediately returned.

"The directive shows the continuing disconnect between the Saudi foreign-exchange policy and market expectations," Raza Agha, VTB Capital’s chief economist for the Middle East and Africa, said by e-mail. "SAMA appears committed to the exchange-rate peg despite the cost to foreign-exchange reserves, large fiscal deficits and consensus forecasts that see only a very gradual rise in oil prices."

SAMA ordered banks to stop selling options contracts on riyal forwards at a meeting in Riyadh on Jan 18., people with knowledge of the matter said, which explains the surge in the chart at that time, but it appears funds have found another vehicle to implement their bets.

It makes sense, since as Bawerk.net's Eugen von Bohm-Bawerk explains, the Saudis have two tough choices:

1) Maintain the peg, control price inflation through continued deflation of the money supply and get a full-blown banking crisis; or

2) Alternatively, reflate the money supply, increase speculation in riyal forwards, devalue and get massive price inflation through the extremely important import channel.

During the reign of the mighty petro-dollar standard, it was necessary for major oil exporters to recycle their dollar holdings back into the dollar-based financial system to maintain their self-imposed exchange rate pegs. U.S. government bonds are the very centerpiece of this elaborate system and it is thus no surprise to see the dollar price correlate well with overall OPEC TSY holdings. In other words, when oil prices were high, oil exporters amassed a capital surplus that was channeled into, among other things, U.S. treasury bonds. When oil prices fell, oil exporters had to liquidate TSY holdings to cover capital shortfalls.

(Click to enlarge)

It is interesting to note that the more money and credit that was issued in the U.S., the more foreign goods could be purchased by Americans and by extension the more foreign demand for U.S. TSYs rose. The savings glut proposed by Bernanke was, and still is, nothing more than exported dollar inflation. There were no savings glut, but rather an indirect form of QE long before QE became an official policy. Home equity withdrawal lines through commercial banks, based on phony asset appreciation promoted by an accommodative Federal Reserve policy stance, increased Americans purchasing power, which inevitably leaked into global markets. Growing financial imbalances were exacerbated by the fact that there were no functioning pricing mechanisms to correct these flows. Related: Colombian Oil Patch Needs $70 Billion To Survive

With dollars flowing into oil exporting countries it would be natural for the recipient exchange rate to appreciate whilst the dollar depreciates. However, many oil exporters have pegged their exchange rate to the dollar so no such effect took place. Instead, local monetary authorities bought up dollars by inflating their own local currency to maintain the pre-set price. As the chart below shows, in a fixed exchange rate system pegged to a freely floating, and thus rapidly inflating and deflating, currency the LCU will have to inflate and deflate accordingly. With no price effect to soften the impact, any change in demand will be borne by supply. Compared to a flexible exchange rate regime, the inflation and deflation of the LCU will have to be larger with a fixed price of the LCU in relation to the dollar.

(Click to enlarge)

In the boom time it is easy to adjust as the monetary authorities can inflate the LCU to buy up dollars and create the consequent phony boom in the domestic economy. Local businesses thrive, credit is plentiful and asset prices rises. Very few complain.

However, as the dollar deflation takes hold the very opposite effect must by necessity occur. To maintain the exchange rate peg monetary authorities must buy up LCU through sales of previously accumulated dollars.

The key metric to watch for dollar dependent economies with exchange rate pegs is the value of domestic money supply (at the fixed dollar price) relative to FX reserves. If domestic claim to dollars, ie estimated money supply, exceeds FX reserves it is highly likely that the monetary authorities will be forced to devalue in order to realign the two metrics. If we look at an economy like Saudi Arabia, where there has been a lot of talk about devaluation, we find that there are more than enough FX reserves to cover the outstanding money supply. Since there will be no positive effect from a devaluation, there is no immediate devaluation threat.

(Click to enlarge)

However, at current trends the FX reserves will drop below M2 by late 2017 or early 2018. Current trends do not lead to very pleasant outcomes for the Saudi economy because the domestic money supply is and will continue to deflate. This will expose internal malinvestements, which will show up as increasing NPLs in the banking sector, which in turn will lead to further deflation.

It is thus tempting for the Saudi government to reflate their economy by pushing more Riyals into the system; but this runs the risk of exacerbating the possibility of devaluation as the money supply will soon exceed falling FX reserves.

As with most of the rest of the world, the Saudis have become path dependent; 1) maintain the peg, control price inflation through continued deflation of the money supply and get a full-blown banking crisis; or 2) alternatively, reflate the money supply, increase speculation in riyal forwards, devalue and get massive price inflation through the extremely important import channel. Related: Eagle Ford Halts Decline As Texas Oil Production Spikes

This obviously begs the question; at what oil price can the Saudi’s mange to muddle through without ending up in either 1 or 2. At today’s price of around $50 per barrel Saudi Arabia will burn through USD90bn worth of reserves per year.

(Click to enlarge)

This means under a mild deflationary scenario FX reserves will fall below M2 by early 2018; even with a 10 percent cost reduction. At $60 and an only 2 percent reduction in cost, Saudi Arabia will probably not have to worry about severing the peg.

(Click to enlarge)

Unless prices continue upwards, it will be interesting to see which route, and which risks, the Saudi government is willing to take on. For now it appears route 1 is the preferred one, but as the banking crisis escalates we expect a gradual movement toward route 2. Unless oil prices spikes back to $60 per barrel plus, and save the day. We doubt it!

Finally, given the ban on FX products - and the seemingly inevitable de-pegging discussed above - one potential way to play the devaluation is via CDS...

(Click to enlarge)

In fact, as the FX ban comes into play, it's clear CDS are starting to become more active and more indicative of Saudi stress than forwards.

By Zerohedge

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Leave a comment
  • Pounce on June 06 2016 said:
    Awesum article...I hope the dumb Saudis lose and we win! USA! USA! USA!
  • aceibis on June 08 2016 said:
    Maintaining the peg against US currency at all costs ranks right up there with maintaining market share at all costs. Both are cornerstones of the Saudi strategic plan to leverage their limited oil reserves until the carbon era draws to a close, which by their estimate is max 35 years. By that time the plan is that they will have diversified and modernized their economy and society to the point where the kingdom can function when oil is no longer a viable commodity. Any fallback from this position could prove to be a disastrous setback unless there is an absolutely compelling alternative for achieving the same end

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