The Saudi Riyal Peg Is Safer Than Forward Contracts Imply

Photographer: Charles Crowell/Bloomberg News

The recent spike in U.S. dollar/Saudi riyal forward points has prompted speculation that Saudi Arabia may abandon the riyal peg to the U.S. dollar, but the country’s fundamentals and abundant reserves don’t justify such a move, writes Bloomberg strategist Mark Cudmore.

One-year USD/SAR forward points spiked over 3,000 percent in the five months leading up to a closing peak of 650 on November 24. And they are still trading at 475 now. While this move seems dramatic, it is important to note that 475 points is only equivalent to a 1.3 percent move in spot USD/SAR over the next 12 months. That means, the market is pricing in only a small chance of a devaluation after previously pricing in no chance.

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Foreign exchange reserves may have fallen by about $95 billion over the 12 months to Oct. 31, but they still total around $648 billion. The rate of the reserves' decline is likely to slow as the budget deficit is set to shrink to 16 percent of the gross domestic product in 2016 from 19.7 percent of GDP in 2015, the current account balance is set to return to a surplus from 2.4 percent deficit in 2015, and the economy continues to grow at a stable pace. 

The peg is very important for the country's crucial geopolitical alliance with the U.S. It has been practically in place for nearly 30 years, and during periods of much greater stress, when oil prices were lower, and when Saudi Arabia had much less foreign exchange reserves than it does now. Devaluation has always been perceived as the option of last resort, and there seems to be no reason why this time is different.

Still, traders may be tempted to speculate on the riyal being devalued because it’s a cheap bet, and not because they have a high conviction it will transpire. The potential loss is small if nothing happens, while the payout may be very large on the slim chance the riyal is devalued. That's because, if Saudi Arabia lets the peg go, it would probably allow USD/SAR to move significantly higher, as there is no incentive for only a small riyal depreciation that would just increase speculative pressure on the currency without securing any major economic advantage for the country. This can make the risk/reward analysis of the trade seem attractive, especially if it's only a small part of a large portfolio.

NOTE: Mark Cudmore is an EM strategist who writes for Bloomberg. The observations he makes are his own and are not intended as investment advice.

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