If Saudi Arabia Abandons Its Currency Peg, Investors Should Worry

 | Dec 21, 2015 | 12:30 PM EST
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There is no week like the Christmas-shortened week to give bad news to the markets, and it looks like the breaking of another currency peg will almost go unnoticed: Azerbaijan just abandoned its currency's peg to the U.S. dollar, sending the manat 48% down vs. the greenback.

The move, the second such measure to be taken by a Caspian oil producer after Kazakhstan scrapped the trading band for the tenge back in August, has intensified speculation about whether the world's biggest oil exporter Saudi Arabia will end up being forced to abandon its own currency peg vs. the dollar.

Azerbaijan's reasons for abandoning the currency peg were a desire to preserve its foreign exchange reserves -- which were being eroded by the need to sell U.S. dollars just to keep the exchange rate stable -- and to boost the country's competitiveness abroad, in other words to make its exports cheaper.

Simon Quijano-Evans, emerging markets analyst at Commerzbank, points out that short-term suffering when abandoning a currency peg, in the form of higher inflation pressures and challenges for local banks that lent money in foreign currencies, is rewarded down the line by more stability.

"A continued sense of denial re: energy prices, coupled with a draining of foreign exchange reserves, just increases pressure for a more 'uncontrolled' release of a peg, at some stage," he said.

Source: Commerzbank

In fact, Azerbaijan was not even in such a bad position, if we look strictly at budget and current account deficits -- the so-called "twin deficit" problem: Countries with large deficits are seen as more vulnerable to currency crises, because a correction could happen sharply.

Saudi Arabia, as the chart shows, is in a much more vulnerable situation. It needs oil prices of more than $90 a barrel to balance its budget, and at more than $60 to eliminate its external deficit. International Brent crude prices hit an 11-year low of $36.18 a barrel earlier today, and are forecast by analysts to hover around $55 a barrel next year.

Analysts at Societe Generale point out that the kingdom's strategy to squeeze U.S. shale oil producers by pumping oil to the maximum is paying off, but not without hurting it. "Saudi Arabia's budget deficit has widened to 22% this year, and it has already spent almost $100 billion of its foreign exchange reserves," the analysts said.

Even so, it's not like Saudi Arabia will scrap the currency peg tomorrow. It still has foreign exchange reserves to cover the twin deficits for four and a half years if the deficits remain at 2015 levels, according to Quijano-Evans.

Neil Shearing, chief emerging markets economist at Capital Economics, believes "the fears that the dollar peg will be abandoned are overdone." Still, Saudi Arabia will pay a hefty price if it wants to keep it. Shearing expects the country's GDP growth to halve to just 1.5% next year, and drop further -- to 1% -- in 2017, as fiscal spending is cut to keep the deficit in check.

However, if Saudi Arabia does decide to abandon the dollar peg, investors should be worried. It would be the country's way to show it is ready to do "whatever it takes" to defend its supremacy in the oil market -- and therefore, it would signal that low oil prices are here to stay for a long time.

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