Saudi-Arabia: Peg or Banking Crisis?

Oil exporters recycled their dollar in US treasuries

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.

US government bonds are the very centrepiece 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 were channelled into, among other things, US treasury bonds. When oil prices fell, oil exporters had to liquidate TSY holdings to cover capital shortfalls.

Fixed and flexible FX regimes

It is interesting to note that the more money and credit issued in the US the more foreign goods could be purchased by Americans and by extension the more foreign demand for US 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.

With dollars flowing into oil exporting countries it would be natural for the recipient exchange rate to appreciate whilst the dollar depreciate. 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.

FX Reserves vs. M2

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, id est money supply, exceed 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 have 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 are no immediate devaluation threat.