By Rob L. Wagner
5 February 2016
Jeddah – As Saudi Arabia grapples with implementing radical measures to boost its economy in the wake of plunging oil prices, economists cast a wary eye to whether the US Federal Reserve’s interest rate hike in December will have an effect on the kingdom’s economy.
The likely answer is it will have little or no immediate impact on the Saudi economy but that does not mean there will not be fallout by the end of 2016.
“Right now there will probably not be a strong effect but we will have to see what happens in the second half of 2016,” said Turki H. Fadaak, a research and advisory manager for Albilad Investment Company in Jeddah.
The Fed raised interest rates 0.25% in December, the first increase in nearly a decade. The agency rejected an increase on January 27th but has indicated that there might be “gradual” increases ahead.
The rate hike could play a role in the Saudi economy because the riyal is pegged to the US dollar and Saudi banks traditionally follow Fed action with their own rate hikes. In December, the Saudi Arabian Monetary Agency increased its reserve repurchase rate from 0.25% to 0.5%, matching the Fed rate hike.
Fadaak said he was cautiously optimistic the hike would have minimal repercussions on the Saudi economy.
“Implementing the repurchase by the monetary agency is just an adjustment to go along with the rate increase on the American dollar and will have no direct effect on investments or attracting investments from foreigners,” Fadaak said.
However, there is a ripple effect. The US dollar is exceptionally strong with the euro losing about 1.1% of its value and the British pound about 0.5% against the dollar since January 1st. A strong dollar, coupled with the rate hike, is affecting US manufacturers exporting products, which have become more expensive and thus more difficult to sell.
Ehsan M. Ahrari is adjunct research professor for the Strategic Studies Institute, Army War College in Pennsylvania and tracks Saudi domestic policies. He said low oil prices and a rising Fed rate may force Saudi Arabia to choose between reducing oil output and removal of the riyal-dollar link, which is an extreme long shot.
“First, (Saudi Arabia) might have to at least trim oil production,” Ahrari said. “Second, it will have to consider de-pegging the riyal from the dollar. The latter option would send shock waves through the world economy and will also have deleterious effects on the Saudi economy. Trimming oil production appears most promising and least harmful but I have doubts that the Saudis would take that route.”
Ahrari said the problem was “the decision to flood the oil market is taken by Saudi Arabia to compete with Iran, which is “devoid of economic rationality”.
In other words, a strong US dollar, a higher interest rate and low oil prices could wreak havoc on the economy of Gulf countries with shrinking liquidity. If the cost of funding loans by banks increases due to this combination, then foreign and Saudi investors would stay away because funding projects would become cost-prohibitive.
Fadaak, however, said the economy region-wide was growing, which reduces the threat.
“The rate increase will not affect local consumption in a great way because the economy (in the Gulf region) at this stage is expanding and there are no fears of a shortage of liquidity or from the negative effects of decreased government spending, especially in relation to bank loans,” Fadaak said.
It is difficult to determine the role Saudi Arabia plays in this scenario but the timing is awkward as the government embarks on its austerity programme to make up a 2016 budget deficit of about $97 billion, about 15% of the country’s gross domestic product (GDP). It has already raised gasoline and electricity prices, a sales tax is planned and Riyadh is likely to privatise government hospitals.
Although Saudi Arabia is facing new challenges in closing the budget deficit, it does have experience in dealing with oil gluts. In 1986, crude oil prices fell to less than $10 per barrel — about $22 in 2016 dollars — due largely to reduced demand. Initially the kingdom cut production and tried to keep prices up. By the mid-1980s, it reversed and increased output while cutting prices. The result was a slow but steady recovery that lifted Saudi Arabia out of debt.
Saudis are using a similar strategy today. “I believe the decreases in oil prices were the main motives for today’s economic reforms,” Fadaak said.
Ahrari noted that the opposite strategy is needed today. “Trimming oil production might push the price of oil closer to $50 per barrel but it will take a while,” he said. “I am not certain whether the Saudis would do that barring any political agreement with Iran to do the same. However, it does not look like there is any public move in that direction from either side.”