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The prolonged rout in oil has left Saudi Arabia's long-standing peg of its currency to the dollar at its most vulnerable point in more than a decade.

For almost 30 years, the kingdom has held the riyal at a fixed exchange rate and that has brought stability to government finances. Ninety percent of the government's revenue comes from oil, which is priced in dollars.

But fewer dollars are coming in now, straining a budget that is committed to generous subsidies and public-sector wages. Abandoning the peg would make those dollars stretch further when converted to a local riyal, because without the peg, the riyal would weaken.
What's more, to hold the peg, Saudi Arabia spends billions of its dollars buying riyals in foreign-exchange markets.

With oil trading around $36 a barrel, some investors and Saudi Arabian businesses believe the government will succumb to the pressure and let the peg go--something long regarded as unthinkable. That is a minority view, but one that is growing in popularity.
This week, the number of riyals that forward contracts can buy for a dollar in a year's time surged to a 16-year high.

"We have a new economic reality in the Gulf region, with oil prices so much lower," said Michael Cirami, a portfolio manager at Eaton Vance. "That requires an adjustment."

Mr. Cirami isn't betting on a weaker riyal, but he thinks Riyadh could shift its policy in the next few years.

The debate over the Saudi peg underscores how the oil-price rout has upended conventional wisdom in economies linked to crude.

OPEC's supremacy, for instance, has been eroded and rich oil states have fallen into budget deficits.

The riyal is fixed at roughly 3.75 to the dollar, and one-year forward contracts were buying the greenback for 3.822 on Tuesday, close to the high of 3.8235 hit on Monday. The moves reflect both speculators betting on a weaker riyal and some local businesses hurrying to lock in better rates, analysts say.

The price of oil has fallen by more than half since the middle of 2014, forcing the kingdom to run a record deficit of nearly 367 billion riyals ($98 billion) last year. Last week the government laid out billions of riyals in budget cuts.

Meantime, Saudi Arabia and Iran have intensified their diplomatic spat over the kingdom's execution of a dissident cleric. That clash could push Saudi Arabia's defense costs up while it is already fighting an expensive war in Yemen and supporting allies in conflicts elsewhere, analysts say.

To prop up its currency, the kingdom is buying the riyal with the dollar reserves accrued during years of high oil prices, analysts say. Those reserves fell to $635.2 billion at the end of November, down 15% from a peak of $746 billion in August last year, according to the latest central bank data.

It is impossible to say how far the riyal would fall were the peg to be removed, but a decline likely would be far greater than the 2% devaluation implied by the forward rates.

Many economists said the Saudi government will keep spending dollars to avoid devaluation, which would come with uncomfortable long-term consequences. Households and businesses have debt in foreign currencies, and payments costs would rise if the local currency falls. Consumers also would have to pay more for imports, from cars to luxury goods.

That could be a tough path for the government, local analysts said. Saudis already are angered by cuts to subsidies in the state budget.
"Speculation over a devaluation of the Saudi riyal has mounted in the past few days, but we think such a move is likely to be used as a last resort," said Jason Tuvey, Middle East economist at Capital Economics. "In light of the potential political ramifications, this is something that the authorities will be extremely keen to avoid."

During last week's budget announcement, Saudi officials gave no indication that they were considering a change to the peg. But some analysts are reluctant to take the dismissals at face value. Officials at the Swiss National Bank, for instance, publicly backed the franc's link to the euro mere days before the bank stunned markets by abandoning it a year ago.

In recent months, two oil-rich nations also have abandoned their dollar pegs.

Azerbaijan scrapped its peg to the greenback in December and its currency quickly lost half its value. Kazakhstan, another economy dependent on natural resources, let its currency float freely in August and saw it lose more than a quarter of its value in one day.
China has also moved to devalue the yuan since the summer as it grapples with slowing economic growth.

"The last year has shown us that when economic fundamentals change, pegs break," said Peter Kinsella, an emerging-market strategist at Commerzbank in London.

Write to Tommy Stubbington at [email protected] and Nikhil Lohade at [email protected]

Credit: By Tommy Stubbington And Nikhil Lohade

Question:

1. How did Saudi Arabia benefit from pegging the riyal to the U.S. dollar?

2. Why is Saudi Arabia under pressure to abandon the riyal-dollar peg?

3. What is Saudi Arabia doing to prop its currency?