Saudi and GCC currencies: Drop the pegs while FX reserves still comfortable?
- GCC equities and sovereign bonds have outperformed oil exporter and EM peers ytd and FX rates are not under pressure
- But currency pegs mean fiscal policy (spending, tax, debt) take the strain of adjustment to shocks (oil price, Covid-19)
- Long-term, fixed and expensive FX rates inhibit diversification of exports and government revenue away from hydrocarbons
Seemingly little concern on GCC pegs from investors
Investors do not appear overly worried about currencies in the GCC. The performance of the region's equities and sovereign bonds are generally in line or better than oil-exporter peers and broader emerging markets.
Furthermore, forward exchange rates imply little difference from spot rates, and where there are devaluations implied, their size is minor compared to that seen in 2016 (when, prior to earlier this year, oil price last fell below US$30).
Deep enough sovereign pockets to sustain GCC pegs
The 5.5% fall seen in Saudi foreign reserves in March to a level not seen since 2011 prompted us to revisit the topic of the GCC currency pegs.
In our view, Saudi and the other GCC governments can sustain their currency pegs, should they wish to use the full extent of foreign reserves and sovereign wealth to do so, for longer than most investment managers can professionally bet against them. However, the capacity to support currency pegs is very uneven with Bahrain much weaker than others, on the measure of foreign reserves relative to money supply, and Bahrain, Oman, and Saudi, weaker than Kuwait, Qatar, and the UAE, on the measure of foreign reserves and sovereign wealth relative to money supply.
But, as the GCC's priorities change, so does the utility of the currency peg
The pegs have served their historic purpose: establish policy credibility and currency stability in an economic model built on lucrative hydrocarbon exports, small citizen populations, surplus immigrant labour, and deep sovereign wealth pockets.
However, in the short term, the pegs are a contributing factor to crushing economic growth, because fiscal policy (lower government spending, higher taxes, higher sovereign debt) takes on all the burden of adjustment to the twin negative economic shocks of the oil price fall and Covid-19. Given that oil price is unlikely to recover to fiscal breakeven levels and Covid-19 may permanently reduce total population (hysteresis effects from job losses are severe in a population where most of the population is transient, with the expatriate share of population ranging from 38% in Saudi to 87% in Qatar or UAE).
Furthermore, in the longer term, the pegs are no longer in the best interests of a region trying to wean itself off its reliance on hydrocarbons, public sector largesse, citizen welfare and an endless supply of expatriates.
By making imported labour, food items and luxury products more expensive, a currency devaluation would help to drive diversification of government revenue and exports away from hydrocarbons, incentivise the employment of domestic citizens and more sustainable consumption of imported food items, luxury products and utility services.
Currency reform should take place alongside reforms to fiscal policy (streamlining subsidies to non-competitive activities) and supply-side policies (social and education reforms). And the best time to reform currency is when there are sufficient foreign exchange reserves to do it from a position of strength, allowing time for the institutions finally empowered to conduct monetary policy (central banks) to establish their credibility.
In the same way that investors in Saudi and the GCC no longer assume the welfare state survives into perpetuity, they should also consider when, not if, the currency pegs are jettisoned.
De-pegging sooner rather than later and in a coordinated manner would mitigate risk of disorderliness: the VAT precedent concerns us
How orderly this process will be depends on how soon the authorities across the region start the process (ie when their foreign currency reserves are still comfortably high). It also depends on what is the degree of coordination between the six members of the GCC. Is the move synchronised in a planned manner and staggered in an unplanned one (the latter likely prompts fears of contagion even if a clearly weaker peg like the Omani Rial were to break first). Is the new currency regime very different for each country or different flavours of the same one: ie devaluation to a new lower peg, or a move to a currency basket that better represents the spread of the largest trading partners of each country, or a move to a fully flexible currency.
At the moment, the risk is high that de-pegging is put off for too long and occurs in an inconsistent manner; ie ultimately, and this may still be years away, a disorderly disruption looks more likely than an orderly one. The precedent of VAT across the GCC supports this conclusion.
Kuwait, GCC: The expat debate stirs again, 15 April 2020
GCC: Sovereign wealth warning from the IMF (again), 7 February 2020
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