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February 5, 2016

Little Impact Seen on Saudi Economy from US Fed Rate Hike

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By Rob L. Wagner

The Arab Weekly

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.”

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