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Earlier this year, a sleepy, little-watched, financial gauge sprang to life. The moribund forwards market for the Saudi riyal suddenly started pricing in speculation that the world’s largest oil producer could be forced to abandon its 30-year peg to the US dollar.
The market expected a 12-month forward exchange rate of SR3.85 to the dollar, a 2.7 per cent devaluation from the SR3.75 level that has, in essence, held since 1986. Nothing on this scale had been seen for almost 17 years.
Even if those betting on a devaluation have since seen the currency gain strength as the oil price has modestly recovered, there are still pressures on the riyal — and indeed on other Gulf currencies too. Oil’s low has blown holes in budgets across the region.
For now, says Jason Daw, head of Asian foreign exchange strategy at Société Générale, the riyal has breathing space: “Higher oil prices have significantly reduced speculative pressure on the riyal. Forward points have dropped like a stone alongside the mini-rally in oil.”
The Saudi speculation focused on the damage to the country’s finances caused by low oil prices, which have sharply hurt government revenues and pushed the budget deficit up to about 22 per cent of gross domestic product, according to the central bank; rating agency Moody’s expects Saudi Arabia’s deficit to be $88bn this year. Further deficits are almost inevitable if oil prices remain low.
One potential solution to this reserve spending would be to devalue the riyal, which would increase government revenues in local currency terms, narrowing or closing the budget deficit entirely. This would also rebalance the current account, which swung to a deficit last year.
However, Jean-Michel Saliba, Middle East and North Africa economist at Bank of America Merrill Lynch, believes Riyadh would be reluctant to abandon its peg because “at least a 50 per cent move is needed to make a dent to fiscal imbalances”.
The Saudi government has funded this deficit by drawing down its deposits at the central bank, reducing Riyadh’s foreign exchange reserves by $132bn, to $602bn, in the year to January 2016.
Kuwait, Qatar and the United Arab Emirates have sufficient sovereign wealth fund assets and central bank reserves to maintain spending at current levels for decades with oil at $50 or even $30, according to Bank of America.
However, Oman and Bahrain would run out of money in two or three years, although they could potentially extend this by issuing debt. They need oil prices to be at least $80 a barrel to balance both their fiscal and external accounts, far above the break-even levels elsewhere in the Gulf.
Analysis by Citigroup suggests that, if oil prices were to average $33 a barrel this year, rising to $55 by 2018, both Oman and Bahrain would have financing requirements of at least 60 per cent of GDP over the next five years, without the resources that Saudi Arabia and Kuwait have.
Luis Costa, emerging market currency and credit strategist at Citi, argues that “the lack of a credible reform path” in Bahrain “is placing further pressure on the fiscal story” with public debt likely to rise to around 75 per cent of GDP this year. This puts the country at risk of a downgrade to junk.
Mr Costa argues that Oman’s banking sector is exposed to deposit flight, given its high dependence on public sector deposits, “which are obviously drying up”. Oman had foreign reserves of $16.7bn in January (27.8 per cent of GDP), with BofA estimating that its largest sovereign wealth fund has a further $13bn.
Simon Quijano-Evans, chief emerging markets strategist at Commerzbank, also picks out Oman and Bahrain, with the latter likely to post a fiscal deficit of 16-20 per cent of GDP this year. “Oman and Bahrain have less than two years of FX reserves to cover their budget deficit if they continue at this rate [assuming oil prices of around $40].
“If they want to keep the pegs in place, they are going to have to pay for it.”