SAUDI ARABIA RIYAL AND THE US DOLLAR
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Course: ECN500 Module 11
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Introduction
A pegged exchange rate is an exchange rate system where one currency’s worth is tied to that of another currency. The Saudi Riyal has been pegged to the US dollar since 1986 at the rate of SAR 3.75 per US dollar as stated by Riyadh M., William A., and John H. (2017). Saudi Arabia depends on oil revenue for most of its national budget as it is an oil-based economy. Therefore, it pegs its currency to the US dollar in an attempt to avoid wavering currency values and eliminate the lack of certainty in the international markets. This also helps the country to resist currency appreciation. Another major reason for pegging the Saudi Riyal to the US dollar is to reduce the countries over-dependency on its oil revenue. Pegging, therefore, aims at diversification of its economy and better growth rates. Pegging the Saudi Riyal to the US dollar has over the decades inspired conflicting views among people, with others vouching for it while others insisting it brings more harm than good. Therefore, this paper looks into the advantages and disadvantages of pegging the Saudi Riyal to the US dollar.
Advantages
Good for trade ventures of the country
Pegging the Saudi Riyal to the US dollar helps give stability to foreign exchange costs needed for any trade type. This stability allows those in businesses to set costs before undertakings. This helps the businesses to save a lot of money as their money can be well accounted for.
Attracts foreign investors
The stability that stems from pegging the Saudi Riyal to the US dollar opens up the country to foreign investment. These foreign investors lead to general economic growth within Saudi Arabia while also achieving diversification. The profits accrued become even higher due to the multiplier effect.
Ensures low levels of inflation
Pegging the Saudi Riyal to the US dollar helps prevent the devaluation of the Saudi Riyal. By doing this, the fixed exchange rate helps prevent import prices from rising and maintain competitiveness in the international export market. This, therefore, ensures that companies that depend on imports do not increase their prices. This prevents inflation within the domestic market.
Helps maintain the stability of the currency
Pegging the Saudi Riyal to the US dollar helps prevent its value from swings. These foreign exchange swings have adverse effects on an economy and its growth, as shown by Richard L. (2020) in the article “Pegged Exchange Rates: The Pros and Cons.” This, therefore, protects the Saudi Arabian economy from financial swings, which reduces the chances of an economic setback.
Helps keep the Riyal’s exchange rate low.
Pegging the Saudi Riyal to the US dollar keeps the exchange rate for the Riyal. This helps the goods from Saudi Arabia have competitiveness in the international market. This competitiveness internationally leads to higher profits. These higher profits are a result of conversion rates. When profits are converted back to the domestic currency, they are seen to be significantly higher.
Provides certainty
The exchange rate does not change for a long time; therefore, it does not encourage speculation among those involved in the economy. This builds certainty and confidence among traders as they are assured of longer periods of a fixed value for the Saudi Riyal.
Disadvantages
Needs large capital reserves
Because the Saudi Arabia government is engaging in buying or selling the domestic currency, they require large capital reserves. Having these large reserves may have devastating economic implications. They can lead to economic slide effects such as higher inflation, as stated in an article by Richard L. (2020)
Limits control of the Central Bank
Since the Saudi Riyal is pegged to the US dollar, Saudi Arabia’s central bank has little control over basic policies involving the currency. This is because the Central bank has to follow interest rates set by the US. This is the case even when Saudi Arabia is experiencing a boom, but the Central bank cannot increase these interest rates.
The system is rigid
The Saudi Riyal cannot react easily and fast to economic shocks. Being pegged to the US dollar does not allow Saudi Arabia to devalue due to economic shocks. This shows how the exchange rate lacks flexibility when reacting to economic shocks.
Leads to the establishment of black markets
The establishment of the official peg, for example, SAR 3.75 per US dollar, may be done. However, in some cases, there is an inadequacy in the number of dollars domestically. This may lead to the creation of various unofficial pegs in the streets, for example, SAR 6.50 per US dollar. This is what is considered the black market. This is as shown by Elena H. and Dan B. (2016) in the article “One move almost always sets off chaos in the currency market.”
May make the country vulnerable to speculators.
Since the Saudi Riyal is pegged to the US dollar, it may be a target for speculators. These speculators may short the Saudi Riyal leading to a decrease in value. This decrease in value forces the Central bank to dig into their reserves, and in the case where Saudi Arabia lacks enough reserves, the currency’s value will have taken a great hit.
Conclusion
In conclusion, pegging the Saudi Riyal to the US dollar has both advantages and disadvantages, affecting both the country as a whole as well as the entrepreneurs within the country. However, by pegging the Saudi Riyal to the US dollar, the Saudi Arabia kingdom has ensured its economy’s stability in the long run. It will also allow Saudi Arabia to diversify its economy and steer clear of overdependence on its oil revenue.
Saudi Arabia has dominated the petroleum sector worldwide and even produces up to 10% of the oil in the world. Therefore, increases or decreases in the oil prices would have significant impacts on the Saudi Arabian economy. An increase in global oil prices would cause inflation due to increased costs of petroleum-based goods. It will also lead to increased costs of inputs, high-interest rates, and a lower gross domestic product. Production of goods locally will increase due to the availability of the oil. This would consequently lead to a decrease in the number of imported goods. The effect of this would be a balance in the number between exports and imports. The economic implications of this would force the Saudi Arabian government to invest in other sectors.
References
Elena. H. & Dan. B. (2016). One move almost always sets off chaos in the currency market. Business Insider. https://www.businessinsider.com/what-is-a-currency-peg-2016-8?IR=T
Richard. L. (2020). Pegged Exchange Rates: The Pros and Cons. Forex trading strategy & education. https://www.investopedia.com/articles/forex/08/pegged-vs-floating-currencies.asp
Riyadh, M., William. A. and John H. (2017). Has the Dollar Peg Served the Saudi Economy Well? International Finance and Banking. https://pdfs.semanticscholar.org/2d6b/12e0548fc8559a19dbb07d290942c321a2c9.pdf