The slump in oil prices this year has prompted some investors to rekindle bets against Gulf nations’ currencies, putting longstanding pegs to the dollar under pressure.
Bahrain, Kuwait, Oman, Qatar, Saudi Arabia and the United Arab Emirates — together, the Gulf Cooperation Council — have kept their currencies glued to the dollar since the 1970s. That has meant mirroring US interest rates and tweaking reserves regularly to keep the pegs in place as a cornerstone of their economies. Previous efforts by hedge funds to bet on a potentially calamitous break have failed, as GCC countries have always shown they have sufficiently huge reserves of dollars to keep the pegs in place.
But some believe this time may be different.
“The precipitous decline in oil prices has reignited apprehensions surrounding the sustainability of FX pegs in the GCC region,” said Ehsan Khoman, head of Middle East and North Africa research and strategy at MUFG Bank in Dubai.
If a peg were to break, that would add a “very unwelcome” layer of uncertainty to the world’s capital markets, which are already reeling from the coronavirus crisis, said Kamakshya Trivedi, co-head of global FX, rates and emerging markets strategy at Goldman Sachs.
Analysts say the risk that one of these pegs breaks remains low, but investors are starting to test their stability, particularly in the case of Oman. The Omani rial collapsed to an all-time low against the dollar in forward markets last month, with investors pricing in 5 per cent loss over the next 12 months. On Friday, these contracts were implying a fall of 4 per cent. Investors expect the Saudi riyal to fall 0.4 per cent, which is still the most negative bet for two years.
Charles Robertson, global chief economist at investment bank Renaissance Capital, estimates currencies in the Gulf are between 10 and 20 per cent overvalued.
Pressure stems from oil prices, which have halved since January due to a combination of coronavirus lockdowns sapping demand and a price war started by Saudi Arabia, the world’s largest oil producer.
Oman is facing the greatest pressure. Last month, Standard & Poor’s cut the country’s credit rating and assigned it a negative outlook, noting that if Oman has difficulty refinancing its debts, confidence in the rial’s peg to the dollar would diminish. Moody’s this month changed its outlook on Saudi Arabia from stable to negative, noting that “the government’s balance sheet has weakened since the previous oil price shock in 2015-16”.
According to the IMF, oil prices need to be above $80 a barrel for the Saudi government to balance its budget, and above $90 for Bahrain. With prices just north of $30 a barrel now, budget deficits are expected to surge — especially as countries reduce production after an international deal struck last month.
This leaves most GCC countries with “significantly wider domestic and external financing requirements”, said Bilal Khan, head of economic research for Middle East, North Africa and Pakistan at Standard Chartered. Saudi Arabia is already running down its currency reserves, and implementing austerity measures.
Oman’s central bank governor told reporters in April that the country was “strongly behind the peg” and had the means to defend it. The Saudi central bank has also reaffirmed its commitment to the policy.
Peg breaks remain a long shot due to the region’s large foreign currency reserves — Saudi Arabia still has nearly $500bn left. Mr Khoman said Gulf states’ central bank reserves and sovereign wealth fund holdings are enough to pay for 68 months’ worth of goods and imports. Stronger states also have the financial firepower to help weaker neighbours, as they have done in the past.
Implied prices for the Saudi riyal have remained stronger than in past oil crises, but Mr Trivedi thinks this is likely to change. “The topic of GCC pegs is a focus for clients and there is a lot of conversation about this,” he said.