What Happens Overseas Doesn't Necessarily Stay Overseas

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By Jeffrey P. Snider

In another case of government meeting reality, Saudi Arabia sacked its long-serving Finance Minister at the end of October. In a move reminiscent of the recent shakeup in Beijing's Finance Ministry, with longstanding technocrat Lou Jiwei being ousted, Saudi Arabia has had to face up to more than just oil prices. Ibrahim al-Assaf had been in that position since 1996, guiding the previous Saudi King successfully through several crises. But as Lou in China, 2016 proved to be too much.

The Saudi government in the middle of 2015, the start of "global turmoil," faced a potentially disruptive choice - they could scale back government spending as revenues declined, or they could borrow to fill in part of the gap. They chose the latter option, with al-Assaf instrumental in convincing the rest of the Saudi authorities to go along with the plan. The result was an ongoing banking crisis.

It was amplified by the inception of a bond auction in the local currency, riyals, that, along with lower government deposit balances as deficits caused more riyals to go out than come in, stripping Saudi banks of almost all excess liquidity. The result was a sharp rise in SAIBOR, the interbank rate, which jumped from less than 80 bps in August 2015 when all this began, to more than 2.36% as of late last month.

To combat the liquidity crisis, that also threatened the currency peg, the Saudi Arabia Monetary Authority (SAMA), the kingdom's central bank, initiated term repos in riyals before appealing to the global bond market in October with the largest international EM bond sale in history ($17.5 billion). Still, it wasn't enough to bring down SAIBOR rates until this month when the government first hinted at suspending their local currency borrowing (by not submitting offers) and then confirming the move not just for November but also December and perhaps beyond into 2017. It was during this time that al-Assaf was removed.

Again, like Lou in China, we see financial and economic conditions leading to more shakeups in key political positions in vulnerable locations. What was supposed to be a "transitory" problem in 2015 has become in 2016 more about survival; desperation in finance that translates to economy in increasingly harmful ways.

The massive bond sale is one big clue to all this. If you review the recent history of large "dollar" flotations like Saudi Arabia's, you can't help but notice what they all share in common: Argentina, April 2016, $16.5 billion; Qatar, May 2016, $9.0 billion; Qatar, November 2009, $7.0 billion; Russia, March 2012, $7.0 billion; Russia, September 2013, $7.0 billion. All the big bond sales come during "dollar" troubles, which is to say that each of these countries at those times are being forced to work around by appealing directly to bond markets rather than banks.

In the case of Saudi Arabia's monster $17.5 billion last month, that, too, was as much about "dollars" as oil or deficits. The country has a massive foreign currency need that is a result of enormous remittances at home from its large foreign worker pool. Though Saudi Arabia reports still about $600 billion in "reserves," largely UST assets, it isn't as simple as all that, especially as it relates to Saudi banks. What are potential reserves on account for SAMA don't do local banks any favors.

The $17.5 billion bond sale in dollars, by contrast, is very likely to end up in the hands of Saudi banks, giving them a much-needed supply of "dollars" they can't seem to source elsewhere. The new Finance Minister, Mohammed Al Jadaan, has indicated that there may be another huge international bond sale next year, too.

Saudi Arabia shows, all over again, that having a huge pile of reserves is no insurance against an intractable, harmful "dollar" problem. To maintain the currency peg, SAMA would have to let internal interest rates rise to clearly disruptive levels, making an already tenuous economic situation worse. The other option is to provide "dollars" in whatever way it can, but either way it ends up stripping its banks of liquidity and currency.

As we have seen with China, Brazil, and elsewhere, $600 billion sounds like it would be more than sufficient to fund any "dollar" shortfall, but in reality, we don't really know what is on the "other" side of those assets (including FX).

Part of the problem is how this all plays out in FX markets themselves; in Saudi Arabia, it has been increasing trouble in forward markets. Again reminiscent of China and its offshore RMB function (CNH), SAMA and the Saudi Finance Ministry have been forced to wage an increasing battle against "speculators" who aren't really that. Higher forward exchange prices (which seems like betting on riyal devaluation) is just the same higher price Saudi counterparties are being forced to pay in order to source "dollars" from wherever they can - they can't get them from Saudi banks, or couldn't until the bond sale proceeds are deposited.

SAMA had previously attempted to ban Saudi banks from writing forwards after a surge in corporate customers, importantly, appealing to that option at the end of last year. The main argument for the restriction was that SAMA was worried about the "appropriateness" of "non-linear product dealings with clients." That first ban was issued on January 18 this year, and then reinstituted (or reaffirmed) again in May. As Bloomberg reported in early June:

PointState Capital's Zach Schreiber, who made $1 billion betting against oil two years ago, is wagering that weaker long-term crude prices and rising costs will cause the country to abandon the peg, he said last month. Bill Ackman, the billionaire founder of Pershing Square, wrote in his annual letter to investors in January that Saudi Arabia, along with China, was "inadvisably" spending billions of dollars to protect its currency.

I don't think that last sentence is quite right. Like China, Saudi Arabia isn't "spending billions of dollars to protect its currency," it is instead desperately trying to fund/fill a "dollar" gap that just won't go away.

The events of the past few months in the Saudi Kingdom, as those in China, further highlight these further distinctions. The eurodollar system was never a single place, a monolithic market for global dollars. It was always separated by very real bottlenecks and technical yet real distinctions, one reason why I like to refer to a possible Asian "dollar" that doesn't always go along with the rest. At the very least, the eurodollar system was always fragmented between onshore (US/NYC) and offshore (London, Tokyo, Hong Kong, Zurich, etc.).

As the media should have learned by the events of early 2015, the rest of the world can be enthralled by a "dollar" shortage which doesn't seem to the US perspective as either happening or even possible. I wrote last June, quite presciently, that:

This is not to say that we are on the road to repeating 2008, only that the conditions in liquidity, half of what took us down then, may be already as bad. If there were some less benign ignition now, a spark of selling that was the other half of the panic run, what support would there be for orderly pricing?

The answer to that, given already by October 15, December 1 and January 15, isn't very encouraging. To a great extent, Americans are both sheltered and wholly unaware, but the rest of the world is very much alerted to the continued downside of the eurodollar standard. Stocks may be at or near record highs (though broader stock indices, such as the NYSE composite, have gone nowhere since the "dollar" started to rise), but Brazil is in a state of total economic and financial chaos while China flirts with what was never thought possible…There was a "dollar" system somewhat in place, largely before the middle of 2013, which supported all those but no longer does. [emphasis added]

Just two months later, Americans were shocked from their "full employment" Janet Yellen fantasy by just that sort of overseas "spark" that had before seemed, and had been repeatedly declared, irrelevant to the domestic case. What should have been learned at least in August 2015 is that the "dollar" shortage that seems to be "their" problem overseas is not likely to stay "their" problem alone.