Saudi Riyal Shakes with Crude Fall, Link to Dollar Weakens

“A de-peg of the Saudi riyal is our number one ‘black-swan’ event for oil in 2016,” said Bank of America 

Saudi Arabia’s currency regime is at risk of blowing up if oil prices fall further and the US dollar spikes higher, Bank of America has warned.

The Saudi strategy of flooding the world with oil in a bid to drive out rivals may be hard to square with the country’s fixed dollar-peg, which is increasingly under scrutiny by currency traders as the US Federal Reserve prepares to raise interest rates.

Saudi Arabia’s foreign exchange reserves still provide an ample buffer, but they have been falling fast, the Saudi Riyal is in trouble.

Should Brent crude oil prices drop to $30, the foreign exchange reserve drain could accelerate to $18bn per month. Saudi Arabia may face a critical choice: cut oil supply, or de-peg.

The 12-month riyal forward contracts – watched by experts for signs that traders are betting on a collapse of the peg – has spiked violently to 535 from just 13 points in June.

This is even higher than the peak after the 9/11 terrorist attacks in New York, and is approaching extremes seen in January 1999. Credit default swaps pricing bankruptcy risk has jumped to 153, the highest since the global financial crisis.

A devaluation by China would leave the Saudis badly exposed and might ultimately force their hand. This de-peg of the Saudi riyal is our number one ‘black-swan’ event for oil in 2016, says Bank of America.

The 30-year old dollar peg is the weak link in Saudi strategy. It matters more than dissent within OPEC as the cartel prepares for a stormy meeting in Vienna on December 4. To varying degrees, Algeria, Venezuela, Nigeria, Iraq, and Iran all want production cuts to stabilize the market.

Russia has been able to cushion the effects of the oil price crash by letting the rouble fall from 32 to 65 against the dollar since mid-2014. This protects oil revenues of the Russian state in local-currency terms.

Saudi Arabia is taking the blow head-on, and is facing an extra tourniquet effect as Fed tightening pushes the global dollar index to a 12-year high. The central bank’s holdings of foreign securities fell $23bn in October. They are down $90bn since February. Foreign reserves are still $647bn but not all is usable.

The Saudi government has had to cancel a raft of infrastructure projects and push through drastic spending cuts to rein in a budget deficit near 20pc of GDP. It denies reports that contractors are not being paid.

Bank of America warned that a break-down of the Saudi dollar-peg would send the riyal tumbling, with major knock-on effects. “Oil could collapse to $25,” it said in a client note.

The report said it is the lesser of evils for Riyadh to trim oil output and nudge Brent crude prices back over $50 rather than risk a currency crash. Most experts say devaluation would devastate the political credibility of the Saudi dynasty, already facing criticism at home as the war in Yemen drags on.

Russia abandoned its peg long before reserves ran out, partly because the defence of the rouble imported vicious monetary tightening. Kazakhstan ditched its dollar peg in August. But the riyal may be a harder nut to crack.

The Saudi peg is the bedrock of financial policy and will not be surrendered lightly. Any attempt by speculators to mount an attack is likely to fail.

Speculators should bear in mind that the Saudis revalued their currency upwards in the 1980s to catch traders off guard, inflicting painful losses to teach a lesson. The Saudis then devalued later once they had made the point.

The dollar link has been pivotal in the modern history of the country.

The question is whether the Saudis deem the peg to be so important that they would rather abandon their current OPEC strategy, if push comes to shove.