Two quotes from a Reuters news story piqued our curiosity yesterday. The quotes were from participants who attended a road show in London for Saudi Arabia's new $17.5B bond offering.
One investor stated: "They said they would defend the peg to the last dollar..."
Another said: "There was an impassioned defense of the currency peg ... They said it suited the structure of the economy they have, but on the other hand they were pretty clear they wanted to have a different structure in 15 years, which means they really won't need the peg by then."
There has been much debate about Saudi Arabia's potential devaluation of the Saudi riyal, something that came to the forefront of the news when PointState Capital's Zach Schreiber presented the idea at the Sohn Conference earlier this year. Schreiber's thesis is that at $50 oil, Saudi Arabia will burn through $80B-$100B in foreign-exchange reserves per year, and within two to three years it will "hit a wall," thereby necessitating a devaluation.
In looking at the issue as part of our analysis of where we think oil prices could go, we believe a devaluation of the riyal is unlikely for a few reasons:
1. Saudi's foreign exchange reserves, although having drawn down significantly in the past two years (i.e., 23% lower than at its peak in 2014) were still at $550B. Credit Suisse has noted that the foreign exchange reserves also do not include U.S. Treasury holdings that could potentially total $100B. Combined, both represent close to 100% of Saudi Arabia's GDP in 2015.
2. The political costs would be too high. Devaluation would likely lead to inflation, hitting the populace with price increases at the same time as the government's austerity measures, further eroding the government's popularity just when the new regime has begun introducing reforms.
3. Economically, the devaluation would also lead to capital flight, as investors and locals pull money out of the country. This would be particularly inauspicious as Deputy Crown Prince Mohammed bin Salman's plan (i.e., Vision 2030) calls for just the opposite -- a substantial and prolonged investment in Saudi Arabia.
4. Increasing oil prices stemming from the recent sentiment shift among OPEC and non-OPEC producers to collectively try and manage oil prices again will lift government revenue and reduce the deficit and erosion of foreign reserves.
5. New bond offering will allow the government to continue its fiscal spending, thus reducing some pressure on foreign reserves. This, however, is temporary and short-lived, although investor confidence in the bonds could translate to higher confidence in the Saudi economy and riyal.
In addition to the reasons above, we think Saudi Arabia has already planned to introduce a new currency, one that could take away some of the scrutiny on the riyal, quell the talk of devaluation, and explain that curious second Reuters quote -- the shares of Saudi Aramco. We'll explain.
The Real Riyal
Saudi Arabia depends on oil revenues for 80% of its budget, so Saudi Arabia goes where oil goes. The strength of the riyal, however, essentially rests on two factors, the price of oil and Saudi Arabia's foreign reserves. Touch the latter, and the investment community begins to question your solvency and the value of your currency. Thus, listing shares of Saudi Aramco will give the kingdom an additional form of capital liquidity, one that's more malleable and flexible than the riyal.
We believe the shares of Aramco are almost a "new and improved riyal" because unlike the riyal it not only factors in oil prices, but it shifts the focus from foreign reserves to actual reserves. This will allow Saudi Arabia to better control the value of this currency.
Once the shares of Aramco start trading, Saudi Arabia can manage the company's profitability --- i.e., either on the top line (leading OPEC to help set oil prices) or the bottom line (reducing operating expense) and/or increase its asset values (e.g., by booking additional reserves). These actions taken separately or as a whole can bolster the company's share price, which is akin to strengthening the currency.
Moreover unlike typical exports, for oil, there's a balance between production and price. Given oil's inelastic demand and the current supply/demand balance, if Saudi Arabia were to cut production by 5%-10%, total revenue would still increase as the gain in the price per barrel would almost certainly offset any decline in production. For Aramco, which will report earnings quarterly, this will translate to a spike in profitability and, in turn, share price, giving the kingdom a very responsive currency.
If successful, this currency can actually appreciate independently of the U.S. dollar, unlike the riyal, thereby decoupling from the historic peg. Selling more Aramco shares at a higher price post-IPO will then allow Saudi Arabia to reinvest larger sums of capital domestically, as the higher share price (i.e., "stronger new-riyal") allows Saudi Arabia to purchase more riyals domestically.
The shares are also more flexible because they can be sold quite easily once listed to fund domestic initiatives. In contrast, if foreign reserves are depleted materially, investors once again raise questions about an impending devaluation.
Lastly, the IPO and future sales of Aramco shares will bring in an infusion of fresh cash to the country. This influx of capital strengthens both the currency and relieves pressure on the kingdom to tap its existing foreign reserves to fund the fiscal budget or a portion of Vision 2030. The massive investments will also spur additional foreign investment, as the projects excite investor sentiment.
So, at this stage, we believe the risk of Saudi Arabia having to devalue its currency has been reduced. If oil prices can recover more quickly in 2017 and Saudi Arabia successfully lists Saudi Aramco's shares, the threat will subside even further. In all likelihood, in a few more years, Saudi Arabia's plan to unpeg it's currency from the U.S. dollar could even be complete.
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Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.