Saudi Arabia’s foreign reserves exceeded $500bn for the first time in July
The dollar is undergoing a period of sustained weakness, base rates are flatlining and the US has lost its AAA credit rating from ratings agency Standard & Poor’s (S&P’s). Despite this, Saudi Arabia’s economic policy remains anchored on the dollar with its currency pegged to the greenback and the country’s foreign holdings held in US.
With economic crisis management the order of the day, the Saudi authorities have little appetite to change a strategy that has ensured stability over the decades. Depegging is firmly off the agenda for Riyadh.
The dollar peg, in place since 1986, ensures that interest rate risk premiums over the dollar are kept low giving investors the confidence to commit long-term funds to the kingdom.
But the central bank’s Saudi Arabia Monetary Agency (Sama) strategy of holding most of its net foreign assets, which now exceed $500bn, in US government bonds has come under the scrutiny in the wake of the ratings downgrade in early August.
Sama has publicly referred to three criteria it uses to manage its portfolio of reserves: safety; liquidity; and long-term returns. The downgrade has clearly challenged the first of these.
The creditworthiness of the US sovereign as a borrower has been called into question, with the lowering of its credit rating to AA+ suggesting an increased likelihood the borrower will default. The downgrade was sparked by the political impasse in Washington over extending the ceiling on the amount of debt the US could issue.
The US has some serious structural problems, but the dollar is still the reserve currency of the world
James Reeve, Samba Financial Group
The decision coincided with the revelation that Saudi Arabia’s foreign reserves had exceeded $500bn for the first time in July. The Washington-headquartered IMF estimates that the kingdom’s reserves rose 7.1 per cent on the previous month to $517bn, thanks to rising oil prices and output.
Sama does not provide a breakdown of its foreign holdings, but estimates say the amount held in US fixed-income securities exceeds 80 per cent. The Saudi central bank clearly considers the US alone to have sufficient liquidity to act as a true safe haven.
There is little obvious near-term benefit from undermining the credibility of an established system that still closely mirrors the structure and needs of the Saudi economy.
“The US has some serious structural problems, but the dollar is still the reserve currency of the world,” says James Reeve, assistant general manager and senior economist at the local Samba Financial Group.
Given the close financial relationship between Washington and Riyadh, any shift in the Saudi government’s holdings of the former’s debt could only be precipitated by a major crisis in the US. Although S&P’s downgrade is a source of anxiety, it is not a trigger for an imminent refashioning of the kingdom’s external asset placement strategy.
With investors spooked by the sovereign debt crises in Europe and the US, demand for US securities has actually increased in the wake of S&P’s downgrade, with a flight to quality accelerating moves into US Treasuries. The kingdom – for the moment at least – remains a committed buyer of US Treasury bills.
Alternatives to US debt do not easily recommend themselves. The deepest bond market after the US is Japan, but Japanese fixed-income yields are lower still than the US and Japan’s fiscal health remains in parlous condition.
Meanwhile, the dollar still retains its AAA rating from both Fitch and Moody’s. “The euro looks a lot worse and China’s renminbi is not freely convertible. Small holdings of the renminbi are sensible, but it is a long way from being world’s reserve currency at the moment,” says Reeve.
Change is unlikely as long as most foreign exchange inflows into the kingdom are dominated in dollars, says Jarmo Kotilaine, chief economist at the local National Commercial Bank. “There are obvious limitations in how you can spend those dollars and that typically leaves you with US Treasuries or something akin to them. In the context of the policy commitment to the dollar peg, it’s a case of better the devil you know.”
Any change in the way Saudi Arabia maintains its foreign assets would represent a shift in strategy and ideally would not be made under the pressure of volatility in the foreign exchange markets.
But it is an issue that is nonetheless receiving attention from far-sighted Saudi economic strategists. Said al-Shaikh, a senior Saudi economist and member of the Majlis al-Shura (the consultative assembly), argues that the question of moving out of treasuries needs to be addressed over the long term.
“Sama is keeping its reserves in fixed income securities, largely at the short end of the curve in the US. That has been fine and rather safe, but the problem over the long term is one of valuation,” says Al-Shaikh. As the value of the greenback declines, the value of Saudi assets held in dollars will also depreciate.
Herein lies the issue, says Al-Shaikh. Sama has enough funds to defend the riyal with about $200bn of its holdings covering the currency. The remaining $300bn or so of its holdings kept in fixed-income securities could be gradually diversified, either into other currencies, or even real assets, he says.
Future excess revenues could be invested in ways that mimic the Gulf sovereign wealth funds (SWFs), such as Abu Dhabi Investment Authority, Qatar Investment Authority or Kuwait Investment Authority.
The template offered by these SWFs is distinct from Sama’s mandate. Although it is commonly considered an SWF, Sama does not invest in the types of assets typically targeted by the latter funds. which mainly take positions in blue chip investment opportunities in strategically prized markets.
Asset management concerns
The concern is that Sama’s focus on US Treasuries means it is not getting the best possible return on its assets. Debate is focusing on whether Saudi Arabia needs to improve the efficiency with which it manages its oil wealth and energy reserves. Increasing attention is being paid to the unsustainability of some of the trends in energy consumption and the use of oil reserves.
“The complexities of the issue are starting to be appreciated more than they used to be and it is quite possible that at some point a more strategic approach will materialise and perhaps a sovereign wealth fund or a more centralised or regulated approach to running some of the current government funds will also materialise as part of that process,” says Kotilaine.
Whether through a formal SWF or not, placing currency reserves and future excess revenues in a fund invested across different currencies, asset classes and countries, is one means of diversifying risk. Al-Shaikh says this move would protect the valuation of Saudi Arabia’s assets if the dollar were to weaken further.
The Saudi authorities had given thought to the need for an SWF in the heady pre-crisis days. Back in 2008, Saudi officials announced plans to establish two new sovereign wealth funds. The Hassana Investment Company, linked to state-owned General Organisation of Social Insurance, was to have a mandate to invest pension fund assets in global stock markets. The Sanabil al-Saudia, set up with capitalisation of $5.3bn, had a remit to act as the portfolio manager of the Public Investment Fund, again investing in a range of asset classes.
However, little has transpired over the past couple of years and it is unclear whether there is any serious government push to have these two proto-SWFs up and running.
With Saudi economic policy absorbed by crisis management, the day-to-day has taken priority over strategic thinking. There are doubts as to whether there is serious appetite for a Saudi SWF akin to Qatar’s or Kuwait’s. For one thing, it would be dwarfed by the other Gulf states. Even with all of Sama’s reserves, it would still be smaller than the other funds.
Some analysts question how compelling the case for a SWF is. “The UAE got burnt on many of its trophy assets – think Vegas – and Qatar’s accumulation just seems vainglorious rather than sensible. I think the Saudis can reasonably claim that in this age of uncertainty safe liquid assets, such as US bonds, make sense,” says Reeve.
But if Saudi Arabia is to make a better fist of managing its existing portfolio of assets, then a gradual diversification into alternative currencies could prove invaluable.
“A shift into Swiss francs, yen, sterling or renminbi might be possible through swap arrangements with China’s central bank. This is something the Chinese central bank has been granting to various trade partners and Saudi Arabia is an important partner,” says Reeve.
The Chinese are working on commercialising the renminbi, but this is a slow and cautious process.
To really start revising some of the old assumptions, the Saudi authorities need to do more to develop financial markets and deepen commercial relations with other emerging economies. A lot of work still needs to be done for the new global currency order to emerge.
As long as crisis management is the key driver behind economy policy, Sama is unlikely to be convinced of the merits of a shift out of treasuries – even if those bonds are no longer the AAA-grade quality that the central bank would ideally like.
When calmer markets return, policy makers in Riyadh may give fresh attention to the country’s massive exposure to US government debt. They will also need to see if other currencies and debt markets suggest themselves as suitable homes for the kingdom’s massive earnings.