Oil prices have dropped by 70 percent since June 2014. The Saudi Arabia’s foreign reserves have fallen from a peak of $746 billion in August 2014 to $635.5 billion near the end of last year, a 15 percent plunge, signaling that the Gulf kingdom is eating its foreign reserves quickly. The Saudi government’s budget witnessed a $98.5 billion deficient. The forward currency contract reached a record level and the credit default swap spreads have reached an alarming level. There is tremendous pressure on Saudi Arabia to untie its $3.75-to-$1 peg which it has held for nearly 30 years.
What will happen if Saudi Arabia is forced to abandon its currency peg from the U.S. dollar? While there will be domestic and global geopolitical consequences, the economic consequences of this move will be the most pronounced. Speculators have been waiting in line for a while and may have to continue to wait until 2017, when the currency is expected to get hit hard, rapidly. Given this potential devaluation, the coming imposition of value-added tax and excise tax and the removal of subsidies on petroleum products may lead to a huge surge in domestic inflation. A huge jump in domestic inflation will have implications for domestic political stability. There may also be a flight of capital, similar to what was witnessed in China recently, which will aggravate the devaluation. The Saudi stock market (Tadawul) will crash. Circus breakers will not help.
Regionally, the Saudi devaluation would lead to immediate devaluations in the currencies of the other Gulf countries that peg its currencies to the dollar. Inflation will spread throughout the Gulf region as its countries depend on imports for most of their needs. If this happens, it will be interesting to see how low the devaluation will go. The capital flight from the Gulf will be massive. The Gulf stock markets will crash.
There will be a global ripple effect of the devaluation on many financial markets. The first wave will hit the oil market hard. The oil price will overshoot down without a target. I cannot imagine a floor for the oil price if this scenario takes place. The commodity markets will move down in deep sympathy with the oil market.
The second wave of the ripple effect will be the global stock markets. The panic will lead to massive selling but this may not last as much as the selling in the oil market.
The third wave will affect the alignment of currencies. The devaluation would spread to the currencies of other oil exporting countries including the Russian rouble, the Mexican peso, the Norwegian krone, the Venezuelan bolivar, the Iranian riyal, the Nigerian naira, etc. The currency markets should take more time to settle downs than the stock markets because of the number of countries that can be affected by the currency devaluation.
The bond market will not be spared too. The Organization of Petroleum Exporting Countries and other oil and commodity producing countries will feel the ripple effect. They will be forced to cash their treasury securities to support their domestic currencies. This selling will resonate through interest rates and financial spreads.
If this scenario happens, the endgame will be a global economic recession which would kill any chances for global demand to strengthen and oil prices to recover. We are all in for the long haul!