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Why does Saudi Arabia peg to the dollar?

by Brad Setser
October 27, 2005

Subtitle: China's currency regime is not the only impediment to global adjustment.

Consider these two graphs (follow the links):

Oil, in dollars

And the export revenues of Gulf oil exporters, in dollars.

Canada also exports a lot of energy.  Lots of autos too.  The "unfair" competitive advantage created by national heath care has made Ontario the new Michigan.  But Canada's currency still tends to move in line with commodity prices – see this graph.  If I had a bit more time and technical skill, I would invert so it could be more easily compared with the oil price graph.  But you will have to use your imagination.  Trust me: it now takes more US dollars to buy both a barrel of oil and a Canadian dollar.

That is how the world should be.  The currencies of commodity countries should rise as commodity prices rise.  Now look at the Saudi currency v. the dollar.  It is basically flat (check the scale).  Saudi Arabia pegs to the dollar at a rate of 3.75 riyal to the dollar. 

Stephen Jen is certainly right to note that rising oil prices have shifted the world's current account surplus to the Middle East and Russia.   Saudi Arabia and Russia are likely to each run current account surpluses of around $100 billion this year – not that much less than China.

And relative to GDP, there is no doubt that the world's biggest current account surpluses are now found in the world's oil exporters.  Japan's surplus is actually shrinking.  The same is true of most of non-China Asia.  India and Thailand are looking at current account deficits.    According to the IMF, the surplus of Russia and the Middle East will surpass the combined surpluses of the Asian NICs (Korea, Taiwan, Hong Kong, Singapore) and emerging Asia (China plus).

And Saudi Arabia is not alone.  Many other oil exporters also either peg to the dollar or intervene heavily to resist currency appreciation.  Those pegs, like China's peg, are impediment to global adjustment.  In real terms, the currencies of many oil exporters has followed the dollar down since 2002 – the dollar has rallied this year, but its rally still pales relative to its overall slump v. the euro.  That depreciation – at least of their broad nominal exchange rate — has come even as oil revenues are way, way up.

I have long argued that it does not make sense for China, a country with a large current account surplus, to peg its currency to currency to the dollar, the currency of a country with a large current account deficit.  That same logic holds for Saudi Arabia.

Oil exporters would be better served if they pegged their currencies to another commodity currency – say the Canadian dollar.  Then, their currencies would rise along with oil prices, and fall along with oil prices.   And they would not import the monetary policy of an oil importer, which may not be right for an oil exporter.

That would help these countries' economies adjust to fluctuations in commodity prices.  See Jeff Frankel's proposal to peg to the export price (The Canadian dollar can be thought of as a proxy) and his specific recommendation for Iraq.  Saudi Arabia might want to take notice.

And should oil prices remain high and the dollar resume its slide (contrary to Mr. Jen's forecasts) to help reduce the US trade deficit, it certainly does not make sense for the currencies of oil exporters to get weaker.  These countries generally speaking need to spend more, not less – and a sliding currency reduces their external purchasing power. 

I agree with the Treasury: the IMF has not paid enough attention to exchange rate pegs that impede effective global adjustment.  That applies to the currency regimes of the oil exporters every bit as much as China.   There are not domestic pressure groups in the US demanding an appreciation of the riyal, but, unless the profits of Exxon Mobil and the Saudi royal family fall, the riyal needs to rise as much as the renminbi.

Two caveats.  Oil economies are different, and their management does pose some unique challenges.  Since the government of oil exporters often controls the country's oil export receipts rather directly, the government budget plays a bigger role in the creation of a national savings surplus than in a country like China, where export receipts are private and central bank intervention is absolutely crucial.  Two, building up an external buffer of hard currency assets in good times is one way to help protect an economy from the fluctuations in oil markets.   But a good idea can still be taken too far.  If, as the market now expects, oil prices will remain high for some time, simple arithmetic suggests that the oil exporters will have to play a role in global adjustment.   They are the ones with the biggest surpluses right now.

23 Comments

  • Posted by Michael Robinson

    They’re not allowed to sell oil for any currency except dollars. Is it possible this has something to do with it?

  • Posted by bsetser

    I suspect you can sign a contract to pay for oil in any currency you want — but the spot market certainly clears in dollars and most contracts are in dollars, and that probably has something to do with the prevalence of dollar pegs in oil countries. Still, I don’t think there is a technical barrier to a non-dollar peg. The dollar peg even sort of worked in the mid 80s — oil up, dollar up. But now?

  • Posted by Hans

    stephen jen: “Exchange-rate based solutions to global imbalances will be even more challenged. Should the G7 invite oil exporters to G7 meetings and scold them for not revaluing their currencies? Unlike China, these Middle Eastern countries are pegged to the dollar. Should the US Treasury’s currency manipulation report also include the Middle Eastern countries?”

    heh :P

    btw, it’s not only a shift to the ME! “The world’s five biggest oil companies are expected to collectively report record-breaking third-quarter earnings of almost $28 billion beginning this week. Don’t expect to hear a lot of crowing.

  • Posted by bsetser

    Jen certainly knows that China’s basket peg looks (for now) a lot more like a dollar peg than a real basket peg. But yes, the Treasury should be paying attention to dollar pegs in oil exporters as well as basket pegs that look dollar pegs, and the IMF even more so. The Treasury naturally pays more attentiont to “manipulation” that directly impacts US industries, the IMF should focus more on policies that impede effective global adjustment — that is part of its purpose, to look at issues that have a big global impact but don’t impinge as directly on us interest groups.

  • Posted by TI

    The oil exporting countries cannot let their currencies rise because they don’t want to destroy their domestic economies. The currency appreciations should be rather radical to have any effect in this oil price situation. Take Russia: it is an industrial country and a considerable revaluation of the rouble would mean quite a shock for domestic and exports producers. Russian products are not very competitive and this would be the end.

    Nobody wants to be a new Argentine – to rely on oil revenues flowing and importing everything cheap. Even the ME oil producers think nowadays about oil depletion and their future after oil. Even when they are not fearing the end of oil they fear price fluctuations. It is better to buffer the oil money in currency reserves.

  • Posted by bsetser

    TI — fair point on Russia, though at some point, with oil at its current level, Russia may not be competitive in some other industries. Disagree on the middle east. The will have oil for a long time, as their oil runs out global oil runs out so prices will rise, and many don’t have much of a manufacturing sector to worry about losing. the real question is whether they should spend as if the long-term price of oil is 15, 20, 30, 40, 50 or 60. right now the market says 60 and they are spending as if the oil price is less than 30. i would not say spend at 60. but they should spend a bit more than they do now. I am not saying no build up of foreign assets, only a smaller buildup. and letting the currency fluctuate has the nice virtue of having spending move up and down with the currency and thus with oil — it is an automatic adjustment mechanism (to lapse into jargon)

  • Posted by Guest

    another one from jen :D

    Asynchronous Demographic Trends and the Dollar: Demographic trends have supported the dollar. I hold the view that (1) the sustainability of the US C/A deficit is a function of the rest of the world’s savings and investment pattern, and (2) the rest of the world’s savings behaviour is significantly affected by their demographic trends. The dollar’s resilience may be due in a large part to Asia’s necessity to maintain high savings rates for demographic reasons. In a way, the resilience of the dollar, in the face of a massive C/A deficit, is due in large part to developments outside the US. Whether the dollar will correct significantly, therefore, will also depend on how quickly the external conditions change.”

    cheers!

  • Posted by Guest

    nice to see another focus then china

    but please don’t yoke russia or nigeria with the gulf sheiks

    as to the 30 dollar spending line

    that is general knowledge :

    alternatives make sense above that line

    remember the saudi’s
    and their little gulf buddies
    want the world to know
    they can live
    on oil prices
    low enough to croak
    the alternatives

    keeps every one smart
    thinking
    oh no
    not that risk
    bingo
    no heavy investment
    in alternatives

  • Posted by Alex

    I think there is an important point that is missing here. At least with the Saudis there is a strong strategic relationship that its had with the United States that has existed for decades.

    When the Mullahs overran Iran with and the Shaw was overthrown that relationship solidified even further. We were the security umbrella that protected the house of Saud.

    During Desert Storm I the United States also intervened to protect its interests in the region as well as Saudi Arabia from an Iraqi attack.

    The Saudis also strengthed the US by funneling their petrodollars into US fnancial institutions during the 70′s.

    It was a happy relationship. Unfortunately the house of Saud is now rocked by violent internal dissent.

    The United States relationship with Saudi Arabia is not just an economic one its a very close political one as well.

    Saudi Arabia also helped the United States when it persuaded the rest of OPEC to price oil in dollars during the 70′s after the breakdown of the first Bretton Woods accord. This created a huge demand for dollars.

    No dollars no oil.

    The relationship with the United States and the house of Saud is an intense one on a political,economic and military level.

    This issue is a predominatly political with strong economic overtones.

  • Posted by Gcs

    commonly held view expresssed above very well:

    “Saudi Arabia also helped the United States when it persuaded the rest of OPEC to price oil in dollars during the 70′s after the breakdown of the first Bretton Woods accord. This created a huge demand for dollars.
    No dollars no oil”

    but just above brad had written here:

    “I suspect you can sign a contract
    to pay for oil in any currency you want”

    brad you need to bang home
    your point

    some folks seem to think
    if opec prices in dollars
    the US dollar becomes
    a necessary reserve currency
    that is
    if you want to insure you can buy
    your foreign oil supply

    in fact the wide scale holding of dollars in official reserves
    has no easy logical explanatory model
    other existing currency candidates always look as good or better
    and yet….that clear fact remains staring back
    at we egg heads and it scares some of uz ’cause by any know analytic approach
    it’s ……………”irrational”
    as in
    it don’t seem optimal
    and when that light dawns….watch out

  • Posted by Groucho

    Does Saudi peg to the dollar or does the dollar peg to Saudi oil? What is the correlation between the dollar vs other key currencies and the price of crude? I’m guessing that the dollar and crude should move together. Is this correct? Wouldn’t this mean that the Saudi peg is to their own commodity and only by coincidence to the dollar? I’m probably way off base here but I was just wondering.
    Clearly the US wants oil priced in dollars and I imagine will do anything and everything to keep it that way.

  • Posted by bsetser

    02-04 — $ falling, oil price in dollars rising, oil price in euros rising but not as much.
    05 — $ rising, oil in $ rising, oil in euros really increasing.

    saudi pegs to the dollar, not oil. that really hurt their domestic economy in 98/99 when the dollar was strengthening and oil (in dollar terms) tanked.

  • Posted by Emmanuel

    I’d be a little more cirmcumspect about equating the performance of the Canadian dollar and the Saudi riyal with regard to commodity prices. True, I posted a while back about how the Canadian dollar’s performance closely tracks that of commodity prices. Although I didn’t run a correlation, the point does come across in the charts that from 2000-2004, the loonie’s performance mimicked that of commodity prices.

    However, you also need to take into account the fact that Canada sends 80% of its exports to the US, whereas Saudi Arabia sends “only” about 40% of its exports to the US. The implication may be that Canada is comparatively more dependent on US markets, hence in need of greater currency flexibility to absorb external shocks emanating from its biggest export market.

    On the whole, though, Dr. Setser gets the points right. It’s just that it may be the case for unpegging the Saudi currency is less immediately compelling.

  • Posted by bsetser

    I think “what” the saudis’ export (basically 100% oil) matters more than “where” they export — the key for the saudis is the $/oil price. my argument would be that the saudis need a bit more currency flexibility to manage shocks from the oil market — the saudi’s largest market. I also suspect they need a revaluation as well as “flexibility.”

  • Posted by TI

    Saudia-Arabia has plans to become the world hub for petrochemical industy. This means refining and also fertilizers from natural gas, plastics etc. So they do have inustralization plans and hence a need to keep some currency stability.

    When we see how volatile the oil prices are, it is easy to understand that the Saudis want to keep up some stability. Small exchange rate changes are insignificant in this context and large ones would be very destabilizing. The small Gulf states have invested a lot to commercial and tourism services and huge revaluations would hurt. The oil producers try to diversify their economies and need currency stability and buffers.

    All oil producers have very bad experiences of volatile oil prices. Saudi economy was a mess after the previous oil boom and bust in the ’70s and beginning of the ’80s. Oil prices may fall as a result of a global recession. After all, the dollar peg seems quite rational. Besides they have enourmous dollar nominated portfolios already and want to keep them safe, too.

  • Posted by cranagh

    people peg to the dollar because of its size, not because of its strength or current value. there is a difference between the psychology of a reserve and the psychology of taking a long or short position. if bernanke has ‘helicopter’ money – perhaps china, japan, and others have ‘stinger’ money. the ability to shoot down inflation by triggering slump.

    gillies

  • Posted by bsetser

    TI — would argue that letting the riyal move with oil would help reduce oil related maco volality. What should worry the saudis is volatility in the riyal/ oil price. since the dollar/ oil price is volatile, pegging to the dollar means lots of volatility in the riyal/ oil. Sometimes the dolla rises when oil sinks (98 for example). that poses real problems for the saudis. if the riyal rose v. the dollar when oil rose v. the dollar, there would be less volatility in the riyal/ oil price — the price that matters. check out the frankel piece i linked too.

    finally, for petrochems, what matter most i suspect is the gap between the dollar price of feedstocks (oil/ gas) and the dollar price of the output. the riyal/ dollar won’t matter for that. it matters for labor intensive manufacturing, not for capital intensive chemicals. and if the saudis are willing to sell their feedstocks to their petrochemical plants at below market prices, their petrochem plants will do just fine … indeed, there is a certain logic to doing petrochemical stuff close to the petrol, even w/o access to below market feed stocks. save on the transportation. and the saudis have plenty of capital.

    no worries there, as far as i am concerned!

  • Posted by Anonymous

    Brad, you need to be more appreciative of history when assessing the world situation. While I agree with your basic assumption that one can adjust a currency in a non-dollar manner (peg or no peg), history and institutional forces have shaped these relationships. There are a huge number of potentially viable pegs, but how many are as “transparent” as the dollar. Not many.

    I will assert that you often fail to employ economic principles like Transaction casts or Agency in your reasoning. These concepts have been around long enough for you to feel comfortable and apply. Cracking the cover of a Williamson or North text may help inform this conversation.

    A model of some type would also be great. Reasoning from economic primitives while interesting, is not sufficient to provide material insight.

  • Posted by TI

    OK, we should ask the Saudis themselves why they want to peg their currency to the dollar. They must have some reasons to this. I think this kind of economy they have behaves rather weirdly… I could guess they see it so that domestic economy should be isolated as much as possible from the oil prices volatilities. This they do with a peg and parking the oil money in T-bonds and elsewhere. They would probably think that it would be useless to try to use their relatively small domestic economy as a buffer for cushioning the effects of oil price changes. This would happen if they started to float their currency. A 10% revaluation or devaluation is considered a significant one, and a 20 – 30% a big one. But oil prices can change much more. Who would like their currency to jump up and down like that? Of course, they could change the exchange rate somewhat, but I think they prefer the stability with a peg more. I could even suspect that they don’t see the riyal as an independent currency – it only the local name for the dollar…

    I think this discussion is a little desperate. Everybody else should save the American economy by revaluations. They will and can not do that. It would not help. The US has not the ability to export away from its deficit and obviously not the will to kill it by killing imports. It seems that the question is not any more about a foreign trade imbalance but rebalancing the whole US economy in the global context.

  • Posted by bsetser

    anonymous — models are not my forte, but do read the Jeff Frankel paper i linked too. more than enough links. As for transaction costs, well, remember that the Saudis invest all their dollars through intermediaries (increasing transaction costs) for more security — they obviously prioritize many things other than minimizing transaction costs.

    TI –if any Saudi wants to write me with an explanation, i am all ears.

  • Posted by TI

    Here is the official stand on the Saudi dollar peg:
    http://www.sama.gov.sa/en/news/2004-10/3.pdf

    In essence they say about the same as I said above: the reasons are the dollar denominated assets and non-oil exports, interest rates etc.

    Here is a Saudi opinion on the dollar peg:
    Impact of Dollar’s Fall on Kingdom
    “For a thorough evaluation of the impact of switching from dollars to euros, the Kingdom needs to consider four key aspects of it “dollar-peg” policy together: (1) Pricing of oil in dollars. (2) the Saudi riyal (and riyal interest rates) peg to the dollar. (3) the country’s trade pattern vis-à-vis dollar and non-dollar economies, and (4) the country’s overseas net financial asset position in dollar vs. other currencies.”
    http://www.arabnews.com/?page=6&section=0&article=55642&d=6&m=12&y=2004

    This how Kuweitis say it:
    Kuwait moves to a US dollar peg | Economic Review
    “Currency regime aside, KD-$ stability derives from to the denomination of oil revenues in US dollars, as well as a major part of the country’s foreign assets, not to mention the important volume of imports from the US. This stability will be supported in the future by the country’s strong current account position and sizeable foreign reserves.”
    http://www.ameinfo.com/16604.html

    The Persian Gulf states (GCC) have a common currency anchor in the dollar. The statements above tell that the concern is for stability of their domestic econmies and exports, as expected.

    Norway is an example of the indirect way oil money flows to the economies of the oil exporting countries. The government roaylties go the oil fund and only the income of the assets in the fund is used. This way the income is stabilized. But this makes the the exchange rates quite independent of the actual oil price.

  • Posted by Susana

    i have been searching about “benefits of pegging the saudi riyal to the us dollar” but im doomed, i found nothing but coz most of saudi exports are valued in dollars, as the oil is priced in dollars, …. this is so annoying, anyone could help?

  • Posted by Anonymous

    There is a simple political answer for why the peg exists: US Currency Stabilization. With the Vietnam war costing us around $500 Billion and our gold reserves only worth around $30 Billion, Nixon had to find an answer. In 1971 Nixon switched our dollars from gold backed($1 = 1/35 oz. gold) to “fiat money.” This way he could print enough money to pay for the war. We also produced enough oil domestically to only import a fixed percentage of foreign oil (25%). OPEC wanted that cap lifted, we wanted SOMETHING to back our dollars. Once we lifted our importation cap, OPEC agreed that oil MUST be purchased in American dollars… no matter where from. “Oil backed dollars” instead of “gold backed dollars” is the result, we just call it a “peg.”