But what about Saudi Arabia’s budget deficit?

“Saudi Arabia Offers to Send Ground Troops to Fight ISIS”–This is further evidence that Saudi Arabia is not the least bit worried about the sustainability of its currency peg to the dollar of 3.75 riyal per dollar.  Despite a 2015 budget deficit of a whopping 15% of GDP due to a decline in oil prices no longer seen as transitory, the kingdom is preparing for further military expenses.

Clearly, the Saudis aren’t worried about their peg like investors are.  Arguably, nor should they be.  Their situation is not analogous to China and its steady currency devaluation. (Note, while a sudden, one-off devaluation is not my base case for either country, it certainly is more likely in China.)  China has a different set of battles than Saudi Arabia.  China wants to avoid the capital outflows and the ramifications for foreign-currency-denominated debt that are associated with a currency devaluation while also furthering its goals of renminbi (yuan) internationalization by continuing to progress to a more market-oriented economy.  While Saudi Arabia shares the former concern, it does not share the latter.

The Saudis are much more interested in regional power of all kinds (economic, military, and otherwise).  The dollar peg of the riyal provides economic stability to the Sunni kingdom and maintaining it will support companies with dollar debts and Saudi citizens’ purchasing power–important, if the kingdom is to maintain its social contract with its citizens of expansive government support for citizens’ economic welfare in exchange for a lack of individual freedoms.  Despite drawing down its foreign exchange reserves by over $100 billion in 2015, the Saudi government still has north of $600 billion of reserves, the third most in the world behind only China and Japan.  This alone is enough to cover four years’ worth of budget and current account deficits.  Four years is plenty of time for the current regional dynamics to shift in Saudi Arabia’s favor.

The short-term effect of this move: more fighting in the Middle East has the potential to slightly prop up the oil price without the need for a coordinated cut.  In the medium term, while the Saudi military will certainly fight ISIS in Syria, they will likely also attack the forces of the Iran-backed Shiite regime of President Bashar al-Assad, heightening tensions in Iran and Saudi Arabia’s already-weakening relationship.  This will only worsen prospects of a coordinated oil production cut among OPEC and non-OPEC nations to boost the price.  The Saudis are unlikely to agree to any production cuts without proof Iran is complying as well–an unlikely event given current tensions between the nations and Iran’s eagerness to return to international oil markets after the recent lifting of sanctions.  Thus, the Saudis will need an oil price recovery in the medium term or the regional leverage to shift in their favor so they can command a coordinated oil production cut.  At least for now, the kingdom has the savings to weather the current security and oil price concerns.

Nowhere in the government’s goal of being the regional powerhouse is a mandate for increasingly market-friendly reforms, as is the case in China; thus, as the central bank did last month, the Saudi government can simply stop speculation against the riyal (see figure).  The kingdom is after regional dominance and the erosion of Shiite influence; don’t expect them to let hedge fund managers get in their way.

riyal forwards

 

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