Crude prices continue to spiral down and where it will bottom out is anyone’s guess. Integrally involved in this oil crisis is Saudi Arabia and some investors are suggesting that what happens in this country may have enormous consequences for global markets.
The Saudi Arabian riyal is currently pegged to the U.S. dollar, but the nosedive in oil prices has increased speculation in the market that the world's largest oil exporter may allow the 3.75-to-1 peg to drop off in hopes of slowing down revenue.
The crash in oil prices has put considerable pressure on Riyadh which doesn't have the budget or reserves to deal with oil at such a low price. Crude oil dipped below $30 a barrel last Tuesday, the lowest since 2003.
The Saudi Arabian riyal is currently pegged to the U.S. dollar, but the nosedive in oil prices has increased speculation in the market that the world's largest oil exporter may allow the 3.75-to-1 peg to drop off in hopes of slowing down revenue.
Unpeg the Dollar?
Unpegging the dollar is a drastic move and the Saudi government is loath to take it insisting that it won’t happen. Should Saudi Arabia decide in the end to unpeg its currency, it could shake the country's economy, as well as other markets around the world and according some analysts, Saudi Arabia will want to keep the dollar peg in order to avoid market uncertainty and potential inflation.
The same analysts believe that any riyal de-pegging scenario is more likely to occur in a few years’ time rather than in 2016. And even with oil hovering at $30 levels, Saudi officials are still not looking to cut oil production.
What Does it Mean When We Suggest That a Currency is ‘Pegged to the Dollar'?
A dollar peg is when a country keeps its currency's value at the same exchange rate to the U.S. dollar. This allows the country's central bank to control the value of its currency so that it rises and falls as the dollar does. The dollar's value fluctuates because the United States and many other countries have a floating exchange rate, a status that emerged as a result of the 1944 Bretton Woods Agreement when the dollar became the world's official reserve currency.
Today, there are at least 66 countries that either peg their currency to the dollar or use the dollar as their own legal tender. The next runner up, the euro, has 25 countries that peg their currency to it in addition to the 17 eurozone members.
When a dollar is pegged it means it is tied to a fixed exchange rate that the country’s central bank promises to give in return for the U.S. dollar.
In order to maintain this peg, the country must have a large cash reserve of USD and that is why most countries that peg their currencies to the dollar do much exporting with the United States. Their companies receive payments for goods and services of dollars which they can exchange for local currency to pay their workers and domestic suppliers.
Central banks generally purchase U.S. Treasuries with these dollars to and receive some interest on their dollar holdings. When they need cash to pay their companies, they'll sell some Treasuries on the secondary market.
It is the country's finance minister that monitors his country's currency exchange rate relative to the dollar's value and it’s up to him to make any changes in the value of the exchange. If the currency falls below the peg, he may decide to raise its value and lower the dollar's value which he can do by selling some Treasuries and depositing more of them on the secondary market. The cash can then be used to buy up local currency which reduces the cash supply, raises its value and thus restores the peg.
Since the dollar's value changes constantly, it is difficult to keep the exact amount of money available and that is the reason some countries peg their currency's value to a dollar range instead of a specific number.
Because the U.S. dollar is the world's reserve currency, countries are inclined to peg to it which means that most financial transactions and international trade is done in U.S. dollars. Countries that rely heavily on trades with countries such as China, or large oil-exporting countries, peg their currencies to the dollar to maintain competitive pricing. These nations try to keep the value of their currencies lower than the dollar giving them a comparative advantage by making its exports to America cheaper.
Other countries, like the oil-exporting nations in the Gulf Cooperation Council, peg their currency to the dollar because their primary export, oil, is sold in dollars. As a result, they became large owners of petrodollars which are often invested in the United States to earn a greater return.