Lots of discussion around Gulf states breaking their $ pegs. Pegs have kept Gulf currencies stronger than if they had freely floating exchange rates, so what are they protecting?

1/17

Firstly Gulf states aren't all in the same boat. Oman and Bahrain are the weakest in terms of fiscal position and foreign reserves. They also have $ pegs, whilst Kuwait is the only Gulf state that pegs to a basket of currencies (though $ has the largest weight).

2/17

Gulf imports as % GDP are high compared to large Emerging Markets such as Brazil, China, India, Russia because the Gulf states doesn't produce enough domestically of what they consume and incomes/capita are skewed by generous social contracts. So they happily import.

3/17

When foreign exchange reserves a plentiful and growing they easily cover import bills. However when oil export revenues fall and reserves stop growing, continued imports will over time deplete foreign reserves which can force a peg to break & the exchange rate to re-price.

4/17

Maintaining a strong currency when oil prices are low supports purchasing power but comes at the expense of two key medium term priorities:
a) non-oil export revenues (still too low)
b) sectors reliant on foreign inflows (hospitality, a key part of diversification plans).

5/17

If the Saudi Riyal—like oil prices—were much weaker today, import bills would be higher and volumes lower. For vital, imports with non-elastic demand this can cause economic and social problems. The top import in 2018 was food at 12% of total. Medicine was 4%.

6/17

High food prices are notoriously bad for social order, just ask Egypt. But ask what is more efficient and sustainable? Maintaining a strong currency for all imports or subsidising segments of the population most at risk with their food & medicine bill?

7/17

2nd largest 2018 import was road vehicles 9% of total. Vehicle imports typically come through local exclusive distributors that collect generous rents for being at the right place 50+ years ago. Lower demand for their products is unlikely to create systemic risks.

8/17

Vehicle imports can be partially replaced by better public transport systems, freeing up more oil for export, lowering import dependence, not to mention improve air quality and lower CO2 emissions.

9/17

As the global reserve currency, economic crises tend to strengthen the $ and pegged Gulf currencies, subsidising merchant classes, preserving their rents & protecting their considerable amassed wealth. Living standards for the merchant class aren't at risk.

10/17

A weaker currency makes local production cheaper for export. It can make FDI more attractive. It encourages domestic consumption of domestically produced goods over imports. Over multiple business cycles it supports economic diversification and export-friendly policy.

11/17

The pegs today are at odds with the push to growing tourism and reforms to support non-oil growth and private sector employment. Pegs reinforce the status quo instead of catalysing change.

12/17

A devaluation would make imported blue collar labour expensive for Saudi. It would need to adjust by employing more of its own citizens in such roles despite initial social resistance. Saudisation of the retail sector however has been been quite smooth to date.

13/17

Capital flight keeps policy makers up at night. Systems that are stable for decades then suddenly change have unintended consequences. Stability begets instability. A sharp, steep devaluation could cause further capital flight, hard to slow without significant cost.

14/17

Re-pegging to a basket of currencies as Kuwait has done could be an interim solution, and the lesser evil. It allows more exchange rate flexibility and better reflects Saudi imports if the Euro and Chinese Yuan were included.

15/17

Because of $ pegs and free capital flows, Gulf economies have to import US monetary policy. The more energy independent the US is, the less its business cycle is synchronised with Gulf oil exporters, meaning passive monetary policy and $ pegs become less appropriate.

16/17

Gulf trade with China grows relentlessly as the US continues signalling disengagement from the region. China exports more to Belt & Road countries than it does to the US. Times are changing, perhaps currency policies will too, if not today, maybe tomorrow... insha'allah.

17/17