Effects of Pegging the Saudi Riyal to the Dollar

Paper Info
Page count 8
Word count 2468
Read time 10 min
Subject Economics
Type Essay
Language 🇺🇸 US

Saudi Arabia presents an important case for studying inflation as the country has an extremely open economy with almost no restrictions on the movement of funds and goods. As the Saudi government undertook an ambitious project of boosting up the infrastructure with the earning from high oil prices in the 1970s and 1980s, domestic spending had been drastically increased. Saudi Arabia has experienced high levels of inflation in the seventies through eighties. Recently inflation and the cost of living in the country reached an all-time high (EIU). The reason behind the inflation is believed to be supply bottlenecks. This was due to a rampant increase in government expenditure. Though the government immediately took measures for the well-being of the people such as tax cuts and abolishing taxes. Apart from this, the government also allowed bulk imports of certain goods in order to check the continuous price increase. Further, the measure to relate Saudi Riyal against US Dollar reduced the inflation in the country largely. However, today many believe that inflation is rising in the country as the domestic currency is pegged to the US Dollar (Phillips 12). And due to the international financial crisis, inflation is on the rise in the country. Despite recurring fear among economists that pegging of Riyal to a constantly weakening US Dollar would increase inflation in the country, the domestic currency remains pegged to the Dollar (Vilupolananda; Reuters). This section explains the nature of inflation and supports the thesis that the inflation faced by Saudi Arabia is mainly imported inflation.

What is Imported Inflation?

Imported inflation is simply defined as inflation being imported from other foreign countries (Katz 1). Specifically, the increase in price levels is due to an increase in the prices of imports. If the countries’ imports are mostly raw material, this increase in the price of inputs will be reflected in their final output price creating inflation. Another special case for defining imported inflation is currency depreciation. The depreciation of the value of the currency will increase the demand for this currency to buy foreign imports. This will lead to an increase in this good domestically.

Globalization and international interdependence magnify the problem of inflationary prices for imports. A special case for imported inflation is represented by currency pegging and dollarization. Countries with currencies pegged to the United States dollar may suffer from imported inflation despite their economic conditions or their balance of trade. They suffer mainly from the depreciation of the dollar which will eventually lead to the decrease of the purchasing power of their own currencies. In order to offset this decrease, the prices of exported oil will increase. This will lead to a continuous circle of price increases worldwide. Oil is considered as a major input for all products, any increase in its price will lead to imported inflation in the importing countries and they will export their products for higher prices and that goes on.

Fluctuations in the Dollar and Interest Rates

Historically, the United States dollar has been fluctuating against all the major currencies in the world. The dollar interest rates were changing to serve the best interest of the United States. The Federal Reserve was intervening to manipulate the values of the dollar in the international exchange markets. The use of monetary policies was obvious in these interventions. Since 2008, the interest rates on the US Dollar were kept at very low rates in order to boost the economy. The current rate on the Fed Funds is being set on a historical all-time low at 0.16%.

In Saudi Arabia, the exchange rate has played an important role in monetary policy as it has helped in stabilizing prices. The policy faced in the country is an intervention policy wherein the fixed exchange rate regime influences the foreign exchange flow and the interest rate difference between riyal and dollar. This in turn has a dual effect through two areas – first is the direct effect that occurs due to arbitraging of interest rates, and the indirect effect is through current account transactions (Al-Bassam 11). Fixed exchange rate has an effect on imported inflation (Katz 4). The main aim of the government is to contain the volatility in the forward market by pegging Riyal to Dollar (al-Jasser and Banafe 211).

The stress on exchange rate control and its importance in the monetary policy of the country demonstrates the influences of a shift from the money supply rule to stressing it the on interest rate. Further, it is believed that that the inflation is the country is not related to domestic short-term interest rate (al-Jasser and Banafe 211) clearly demonstrating an influence of factors other than domestic ones that are driving inflation in the country. Countries like Kuwait followed similar policy as Saudi Arabia, but they dropped their peg to dollar due to the soaring fear of inflation and switched to currency basket. However, the decline in the strength of dollar induces the fear of soaring inflation in the Saudi economy. Given these concerns, this paper conducts an empirical research on the effect of devaluation of US Dollar on Saudi Riyal.

Effect of US Dollar on Saudi Inflation

This section will demonstrate the effect of weakening and strengthening of US Dollar on Saudi Riyal. A regression analysis is done on the inflation rates in Saudi Arabia from 1999 through 2010 with Federal interest rates, exchange rate of Euro, Pound, and Yen for the period. The analysis presents a strong relationship between Saudi inflation and the other parameters.

The preliminary analysis is done on the effect on Saudi inflation by exchange rate of Riyal to US Dollar and the inflation in the US. This is presented in table 1 where a regression of Saudi inflation rates since 1971 through 2010 is regressed by exchange rate of Riyal and inflation rate in the US. Table 1 demonstrates that the analysis is statistically significant at 99 percent significance level (0.004 is F value). The R square value is 66 percent implying that the chance of the event to occur is high. The regression equation derived from the analysis is presented below:

SInf = -2.23 + 1.25Riyal + 2.56USInf – 0.06USGDP – 1.55USInt (1)

Equation 1 demonstrates that inflation rate in Saudi Arabia is totally influenced by exchange rate and economic fluctuations in the US. The exchange rate has a positive effect on inflation. When the exchange rate is high, inflation is high, which is indicated by a positive intercept. Intuitively, when exchange rate of Riyal against US Dollar is high, indicating a lower value of Riyal vis-a-vis US Dollar, inflation increases and vice versa. Therefore, inflation is strongly affected by exchange rate. Further, inflation in the US has a strong positive effect on Saudi economy. Thus, when there is an increase in inflation in the US, the inflation in Saudi Arabia also increases. In addition, the GDP growth rate in the US has a negative effect on the inflation in Saudi Arabia. Therefore, as US economy grows faster, it increases its exports to open Saudi market, and Dollar becomes stronger. This eventually devalues Riyal that is pegged to dollar, which increases exchange rate, therefore, increasing inflation. Federal interest rates in the US have negative effect on the Saudi inflation. Interest rates are increased in order to reduce money supply in the economy. When rates are reduced in the US, as it was done as a measure to combat financial crisis recently in the US, there was an increase in the money supply in the economy, therefore reducing the value of US dollar. This in turn reduced the value of Riyal as it is pegged to US dollar and any devaluation of dollar would immediately reduce the value of the domestic currency. This in turn and therefore increased inflation in the economy as prices soar.

Table 1: Regression of Saudi Inflation and Riyal exchange rate with dollar and US Inflation

Regression Statistics
Multiple R 0.61
R Square 0.37
Adjusted R Square 0.29
Standard Error 7.21
Observations 38
ANOVA
df SS MS F Significance F
Regression 4 996.64 249.16 4.79 0.004
Residual 33 1715.59 51.99
Total 37 2712.23
Coefficients Standard Error t Stat P-value Lower 95% Upper 95% Lower 95.0% Upper 95.0%
Intercept -2.23 58.23 -0.04 0.97 -120.70 116.24 -120.70 116.24
Riyal 1.25 15.08 0.08 0.93 -29.43 31.94 -29.43 31.94
USInf 2.56 0.74 3.45 0.00 1.05 4.07 1.05 4.07
USGDP -0.06 0.57 -0.10 0.92 -1.23 1.11 -1.23 1.11
USD Int -1.55 0.53 -2.92 0.01 -2.63 -0.47 -2.63 -0.47

Effect of devaluation of US exchange rate with other currency on Saudi Inflation

Table2 provides the data since 1999 through 2010 for the analysis. Federal Reserve rates are annotated as FF, exchange rates for Euro, Pound, and Yen are annotated as Eu, Pou, Yen, respectively. The last two columns were for Inflation in US (USInf) and Saudi Arabia (SInf).

Table 2: Data on exchange rates and inflation rates since 1999 through 2010

Time Period FF Eu Pou Yen USInf Sinf
1999 4.97 1.0653 1.6172 113.7342 2.2 -1.2
2000 6.24 0.9232 1.5156 107.804 3.4 0.5
2001 3.88 0.8952 1.4396 121.568 2.8 1.7
2002 1.67 0.9454 1.5025 125.2204 1.6 1
2003 1.13 1.1321 1.6347 115.9387 2.3 0.5
2004 1.35 1.2438 1.833 108.1508 2.5 0.8
2005 3.22 1.2449 1.8204 110.1069 3.2 0.4
2006 4.97 1.2563 1.8434 116.3121 2.5 1.9
2007 5.02 1.3711 2.002 117.7623 2.9 4.1
2008 1.92 1.4726 1.8545 103.3906 3.8 9.9
2009 0.16 1.3935 1.5661 93.6827 -0.3 5.1
2010 0.18 1.3261 1.5452 87.7817 1.4 5.7

Table 1 demonstrates that inflation in Saudi Arabia has been continuously increasing since 2006. Table 3 demonstrates the regression analysis done on inflation is Saudi Arabia. As table 3 demonstrates the regression, equation that can be derived from the analysis is as follows:

SInf = -17.32 + 0.18FF + 36.56Euro – 28Pou + 0.17Yen + 1.82USInf (2)

The regression is of high relevance and highly probable as the value of R square is high at 93 percent. The overall analysis is statistically significant at 95 percent level of significance. Equation 2 demonstrates that inflation in Saudi Arabia is significantly influenced by inflation in the US, Pound, and Euro. It has a negative relationship with changes in exchange rates of Pound vis-a-vis US Dollar. Therefore, when Pound becomes stronger, weakening the US Dollar, this declines inflation in Saudi Arabia. On the other hand, when Euro is stronger, inflation is also higher indicating a decline in value of US Dollar, and therefore that of the Riyal as it is pegged to dollar. Therefore, when currencies like Euro become stronger, devaluing US Dollar, this increases inflation in Saudi Arabia.

Table 3: Regression Analysis

Regression Statistics
Multiple R 0.93
R Square 0.86
Adjusted R Square 0.74
Standard Error 1.60
Observations 12
ANOVA
df SS MS F Significance F
Regression 5 91.19 18.24 7.13 0.02
Residual 6 15.35 2.56
Total 11 106.55
Coefficients Standard Error t Stat P-value Lower 95% Upper 95% Lower 95.0% Upper 95.0%
Intercept -17.32 9.95 -1.74 0.13 -41.67 7.03 -41.67 7.03
FF 0.18 0.35 0.51 0.63 -0.68 1.04 -0.68 1.04
Eu 36.56 8.93 4.09 0.01 14.71 58.41 14.71 58.41
Pou -28.00 8.35 -3.35 0.02 -48.42 -7.57 -48.42 -7.57
Yen 0.17 0.09 1.86 0.11 -0.05 0.39 -0.05 0.39
USInf 1.82 0.65 2.79 0.03 0.22 3.43 0.22 3.43

The regression analysis suggests that inflation in the US and domestic inflation has a positive relation. Intuitively, this can be explained as follows. With an increase in inflation in the US economy, prices of goods increases in the country. Therefore, goods demanded less, as observed in 2007 financial crisis with low consumer demand. Import prices also increases, cost of production increases, affecting manufacturing that reduces production in order to reduce their inventory cost. Therefore, eventually there is a lower supply of goods that drives up prices. As Saudi economy has close trade relation with the US, and their relation is mostly through oil-trade, there is a decline in demand for oil as the completely manufacturing sector and domestic demand for goods has reduced. This affects goods prices, as one major source of income of Saudi exchequer is affected with lower demand from the US. This consequently increases prices in the domestic economy, increasing inflation.

From another angle, it can be observed, a higher inflation in the US devalues US Dollar, which consequently reduces the value of Riyal as it is pegged to the US Dollar. As other currencies become stronger, devaluing US Dollar, Riyal is also affected adversely. This therefore, increases prices, as fewer commodities can be purchased with a devalued currency, therefore, driving up inflation.

Fixing Saudi Riyal to the US Dollar causes this problem of high inflation in the domestic economy. The fixed exchange rate policy contributes to the Saudi inflation in dual manner. First, a pegged Riyal forces the Saudi Arabian Monetary Agency (SAMA) to match their interest rates with that of the Federal Reserve. The regression demonstrated a positive relation between FF and SInf indicating that as US declined their interest rate, so did Saudi Arabia, which, though a good policy for the US economy that was experiencing a weak economy, was a terrible policy for Saudi Arabia as this increased costs and drove off inflation. Second, a pegged Riyal to Dollar increases the cost of imports as Dollar weakens against Euro (as demonstrated in the regression analysis, table 3). This also contributes to an increase in inflation in Saudi Arabia. The main issue in case of Saudi monetary policy is that it never aimed at price stability with a fixed exchange rate, therefore, continually importing inflation (Siebert 59).

Recommendation and Conclusion

The possible solution to this problem is de-pegging of Riyal to Dollar (Feldstein 9). One option could be connecting Riyal to a basket of currencies with a strong currency like Euro as had been adopted by Kuwait in 2007 or switch to a market based “floating” exchange rate (Hamada 24). Though relating to a basket of currencies would reduce the cost of imports, but would still limit the independence of the SAMA to take up direct inflation-control monetary policy measures. On the other hand, a floating exchange rate would allow SAMA to take anti-inflationary monetary policy. However, this may bring in uncertainty among investors regarding the value of Riyal and therefore reduce potential inflow of funds in the country. Another probable solution could be to peg the currency to export prices, which is suggested for primarily oil-exporting countries (Frankel 55; Setser 1). This can be done by setting the price of Riyal against dollar by setting it against the daily price of a barrel of oil in terms of dollar. This is said to have both the advantages of fixed and floating exchange rates. Further, Saudi Arabia has failed to target inflation through its monetary policy, due to its fixed exchange rate regime (Al-Hamidy 325). This needs to be changed.

References

Al-Bassam, Khalid A. “Domestic and External Sources of Inflation in Saudi Arabia: An Empirical Study.” Economic and Admn., 13(1) (1999): 3-30. Print.

Al-Hamidy, Abdulrahman. “Monetary policy and measurement of inflation: prices, wages, and expectations.” BIS Paper No. 49. 2009. Print.

al-Jasser, Muhammad and Ahmed Banafe. “Monetary Policy Instruments and Procedure in Saudi Arabia.” 2010. BIS. Web.

EIU. “Cost of living hits a 20-year high.” EIU ViewsWire. 2008. Print.

Feldstein, Martin. “Saudi Arabia should ditch its dollar peg.” Financial Times. London (UK) 2008: 9. Print.

Frankel, Jeffrey. “Iraq’s Currency Solution.” The International Economy (2003): 54-59. Print.

Hamada, Koichi. “Economic Consequences of Pegging to the Dollar in a Multicurrency World.” Review fo International Economies, 10(1) (2002): 16-25. Print.

Katz, Samuel I. “”Imported Inflation” and the Balance of Payment.” Discussion Paper No. 32. 1973. Print.

Phillips, Michael M. “Saudi shift on currency?; With link to dollar, Gulf states now face imported inflation.” Wall Street Journal. 2008: 12. Print.

Reuters. Saudi Arabia worried about inflation, peg to stay. Web. 2011.

Setser, Brad. The case for exchange rate flexibility in oil-exporting economies. Policy Brief. Washington DC: Peterson Institute for International Economics, 2007. Print.

Siebert, Horst. “Pegging the interest rate does not guarantee price stability.” The UI (2008): 59. Print.

Vilupolananda, S. Saudi Riyal-Dollar Peg: Economists Sound A Note Of Caution. 2011. Web.

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EduRaven. (2022, April 25). Effects of Pegging the Saudi Riyal to the Dollar. Retrieved from https://eduraven.com/effects-of-pegging-the-saudi-riyal-to-the-dollar/

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EduRaven. 2022. "Effects of Pegging the Saudi Riyal to the Dollar." April 25, 2022. https://eduraven.com/effects-of-pegging-the-saudi-riyal-to-the-dollar/.

1. EduRaven. "Effects of Pegging the Saudi Riyal to the Dollar." April 25, 2022. https://eduraven.com/effects-of-pegging-the-saudi-riyal-to-the-dollar/.


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EduRaven. "Effects of Pegging the Saudi Riyal to the Dollar." April 25, 2022. https://eduraven.com/effects-of-pegging-the-saudi-riyal-to-the-dollar/.

References

EduRaven. 2022. "Effects of Pegging the Saudi Riyal to the Dollar." April 25, 2022. https://eduraven.com/effects-of-pegging-the-saudi-riyal-to-the-dollar/.

1. EduRaven. "Effects of Pegging the Saudi Riyal to the Dollar." April 25, 2022. https://eduraven.com/effects-of-pegging-the-saudi-riyal-to-the-dollar/.


Bibliography


EduRaven. "Effects of Pegging the Saudi Riyal to the Dollar." April 25, 2022. https://eduraven.com/effects-of-pegging-the-saudi-riyal-to-the-dollar/.