Critical Thinking_Fiscal and Monetary Policies under the Fixed Exchange Rate in Saudi Arabia

Critical Thinking: Fiscal and Monetary Policies under the Fixed Exchange Rate in Saudi Arabia

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Critical Thinking: Fiscal and Monetary Policies under the Fixed Exchange Rate in Saudi Arabia

Introduction

Saudi Arabia uses a fixed exchange rate regime with the Saudi riyal being pegged on the dollar. Since June 1976, the spot exchange rate of the dollar against the riyal has been fixed at 3.7500. Oil exports are the major source of foreign exchange earnings of Saudi Arabia. The foreign exchange earnings are deposited with the Saudi Arabian Monetary Agency (SAMA), which subsequently credits the Saudi government’s account with the equivalent amount of money in riyals. This implies that SAMA is solely responsible for meeting the foreign exchange needs of both the public and private sector through the sale of riyals to domestic banks.

How fiscal and monetary policy under fixed exchange rate in Saudi Arabia help the country increase the standard of living

Normally, having a fixed exchange rate policy subjects a country to a monetary policy trilemma. This refers to the tradeoff that exists between stability of the exchange rate, monetary independence, and openness of capital markets (Carbaugh, 2019). Having a fixed exchange rate regime is only sustainable if it is accompanied with the capital controls or the use of passive monetary policy. However, globalization makes it difficult and undesirable for a country to engage in capital control. Having a fixed currency peg also leads to limited monetary independence (Carbaugh, 2010). Nevertheless, the use of a fixed exchange rate policy helps in stabilizing inflation expectation. In addition, it helps maintaining the balance sheet risks and transaction costs at a low level. As such, fixed exchange rate leads to nominal stability SAMA, the monetary authority of the country, which promotes long-term economic growth.

Comparing the previous exchange rate policy of Saudi Arabia would highlight the benefits of the fixed exchange rate on the Saudi Arabia economy. Before 1986, Saudi Arabia did not use a fixed exchange rate policy. As such, between 1973 and 1980, the value of the riyal against the dollar increased from 3.56 riyal at the end of 1973 to 3.33 riyal by the end of 1980. The increase was caused by the weakening of the dollar. This period was also accompanied by high levels of inflation in the non-oil private sector. Between 1981 and 1986, the value of the riyal against the U.S. dollar depreciated. The value of the dollar increased from SAR 3.33 to SAR 3.75 by mid-1986. The increase in the value of the dollar against the riyal was caused by the reduction in oil export revenues due to the reduction in the prices in the global market and cutbacks in oil production. In 1981, oil export revenues were SAR 375.3 billion. However, by 1986, they had reduced to SAR 66.7%, which represented 82.2% decrease (Alkhareif, Barnett, & Qualls, 2017).

Pegging the riyal to the dollar helped in stabilizing Saudi Arabia’s economy. Since the introduction of a fixed exchange rate policy, there have been two major conflicts, the 1990-1991 and 2003-2004 Gulf Wars, and two main declines in the price of oil in the global market, 1993-2000 and 2014 to present. The declines in the price of oil were separated by a major boom in the price of oil. Despite these changes, the riyal has only been under pressure on only two occasions during this period, between late 1993 and early 1994 and between the late 1998 and early 1999. In each of the instances when the riyal faced pressure, the value of the riyal against the dollar increased marginally from 3.750 to 3.754 at its lowest point (Alkhareif, Barnett, & Qualls, 2017). The efforts of SAMA helped in stabilizing the value of the riyal against the dollar.

The use of a fixed exchange rate has improved the economic performance of Saudi Arabia. From 1986 to 2015, the annual inflation rate in the non-oil sector ranged from -3.6% to 6.8%. As such, the sector has an inflation rate that was significantly less volatile than between 1973 and 1986 when Saudi Arabia did not use a fixed exchange policy regime (Alkhareif, Barnett, & Qualls, 2017). Negative inflation during the fixed exchange rate regime has mainly been caused by decline in the export prices of petrochemical products whose prices are linked to the oil prices. Less volatility has led to a smoother economic growth of the private sector. This has helped in improving the standard of living of Saudis. The growth of the private sector has created wealth and millions of jobs. It has improved the share of the private sector in the GDP of the country.

Goals of Saudi Arabia’s monetary and fiscal policies and how they are achieved

Saudi Arabia’s monetary policy is implemented by Saudi Arabia monetary Agency (SAMA), a government agency. Policy rate targeting is the monetary policy of Saudi Arabia. The country uses this monetary policy since it is a resource-based economy that receives foreign exchange from the sale of oil in dollars. The stability of the riyal against the U.S. dollar encourages investments in the country, which facilitates the diversification of the economy. Since the oil and petrochemical products are the major exports, changes in the USD/SAR rate do not have a significant impact in the terms of trade of Saudi Arabia.

Saudi Arabia runs a fiscal surplus if oil exports are strong, which makes the economy have an external surplus. On the other hand, the weakening of oil exports necessitates the government to use its foreign exchange assets and boost the economy through deficit spending. SAMA strives to ensure there is long-term stability instead of implementing short-term solutions. Saudi Arabia tackles the supply side inflation through by addressing bottlenecks and using subsidies. It rarely uses interest rates to tackle inflation since consumers are not heavily borrowed with the country having a modest bank credit to GDP. In addition, Saudi Arabia does not inflation targeting since it uses a fixed exchange rate regime.

Saudi Arabia’s fiscal policy is influenced by government spending since the government spending drives most economic activities in the country. Just like any other government, budgeting and projecting spending and revenue are the major governance issues in Saudi Arabia. The government uses the fiscal policy to accelerate the growth of the private sector and reduce the country’s reliance on oil in line with the Vision 2030 plan and the National Transformation Program. Increase in the prices of oil provides the country with higher revenues which helps in easing the fiscal pressure of the country. Saudi Arabia also uses deficit spending to promote the growth of the private sector (Young, 2017).

Challenges of that Saudi Arabia Faces in the journey to achieve the goals of the monetary and fiscal policy

All oil revenues in Saudi Arabia are received by the government. In addition, the government spending is the major factor that helps in influencing the economic activity in the country. Volatility in the price of oil poses a major challenge to the government. The government also faces three competing considerations due to its dependence on oil revenues. The first challenge is containing inflation. Containing inflation would necessitate the government to have fiscal restraint. However, this would have a negative impact on the performance of the economy since government spending is the major factor that influences economic activity in the country.

The second challenge that Saudi Arabia faces is ensuring that it distributes oil revenues through investments in sectors associated with value addition. The government should ensure that oil revenues are invested in sectors that lead to job creation and are socially valuable. However, it is difficult for the government to determine the right sectors where they can invest the oil revenues.

Another challenge facing the Saudi Arabia government is ensuring it preserves intergeneration equity through the accumulation of foreign assets while increasing economic diversification through investments in physical and social infrastructure. Saudi Arabia government prioritizes health, education, and infrastructure spending. Ensuring there is intergenerational equity and long-term fiscal sustainability requires the government to have fiscal restraint. However, diversification of the economy requires the government to use an expansionary fiscal policy that involves increased government spending in sectors that play a strategic role in the future economic prosperity of the country (Pugel, 2016).

Using a fixed exchange rate regime where the riyal is pegged to the dollar implies that the monetary developments in the dollar influence the interest rate policy of Saudi Arabia. This implies that an increase in the interest rates of the dollar would affect the economic performance of Saudi Arabia.

Instruments that the Saudi Arabia Government uses to overcome the challenges

Saudi Arabia uses several instruments to tackle the challenges mentioned above. Policy interest rate corridor is one of the instruments. It helps in tracking U.S. federal funds rate. The policy interest rate corridor comprises of the repo rate (upper bound) and the reverse repo rate (lower bound). The use of the policy rate corridor reduces the impact of deferral funds rate on the interest rate of the riyal. In so doing, it helps in insulating the economy of Saudi Arabia from negative internal interference from the dollar.

SAMA also uses the statutory reserve requirements as one of the monetary policy instruments. The statutory reserve requirement is one of the most influential instruments that help in controlling the supply of loanable funds from banks. Banks in Saudi Arabia are required to maintain cash reserves that correspond to 7% of the demand deposits and 4% of time and savings deposits. In addition, banks are required to maintain 20% of their deposits in highly liquid assets to enable them have funds to deal with any eventualities.

SAMA bills are also major monetary instruments used in Saudi Arabia. They are issued by SAMA to both banks and non-banks to facilitate the removal of excess liquidity. The maturity period of SAMA bills range from 1 week to 52 weeks. There is limit on the summer bills that can be issued to banks in a week. Banks can be issued with a maximum of SAR 9 billion in summer bills per week. Conversely, non-banks do not have a limitation on the SAMA bills that they can be issued with. The weekly limit of SAMA bills issued to banks is revised regularly. The interest rate of SAMA bills is 80% of the reported interest rate in the inter-bank market. In so doing, it promotes additional transactions in the inter-bank market.

Saudi Arabia’s fiscal policy instruments help in controlling macroeconomic activity in the country. However, the fiscal policy instruments mainly involve government spending instead of taxes (Ramady, 2010). The government uses fiscal deficit to finance spending in various infrastructural projects that would facilitate the diversification of the economy to reduce overreliance on oil. In 2020, the fiscal deficit of Saudi Arabia is expected to increase to SAR 187 billion or 6.5% of the GDP of the country. The increase in the fiscal deficit is due a reduction in oil export revenues due to lower oil prices and output. In addition, increase in government expenditure to stimulate growth is stimulate growth is expected to contribute towards the widening of the fiscal deficit (Rashad, 2019).

The Saudi Arabia government can also use taxation to tackle the challenges posed by the fiscal policy. Currently, Saudi Arabia charges resident non-Saudis and non-GCC individuals a flat rate tax of 20% of the tax-adjusted income. The country also levies a “sin tax” on cigarettes and tobacco products, energy drinks, and sugary drinks. Cigarettes and tobacco products and energy drinks are subjected to a 100% tax whereas fizzy drinks and sugary drinks are subjected to a 50% tax. The aim of the tax is discourage the use of products that are regarded as being harmful to public health. These taxes can provide additional revenues to the government, which can enable it to implement its fiscal policies effectively. Additional taxes such as undeveloped land tax would provide the government of Saudi Arabia with addition sources of revenue to reduce the fiscal deficit and spend in more infrastructural projects that would help in stimulating the economy.

Conclusion

Oil export revenues are the major source of foreign exchange in Saudi Arabia. Since Saudi Arabia is a resource-based economy, it is vital for the country to implement policies that would ensure the resource benefits its citizens. Use of the fixed exchange rate regime helps in stabilizing the economy of Saudi Arabia. Stability helps in attracting foreign investment in the private sector, which facilitates the growth of the sector. This would help in the diversification of the economy to reduce overreliance on oil. However, Saudi Arabia also faces several challenges due to its fiscal and monetary policies. The uncertain nature of oil revenues on which the country’s budget depends on poses a major challenge. As the leading producer of oil in the world, oil revenues in Saudi Arabia also depend on the country’s efforts to stabilize the oil market. Saudi Arabia has adopted a policy that involves the swapping the oil revenues with an economic base that would facilitate the growth of the private sector. This has increased the dominance of the fiscal policy in Saudi Arabia as government spending drives most economic activity in the country with monetary policy of the country mainly focusing on the exchange rate stability.

References

Alkhareif, R. M., Barnett, W. A., & Qualls, J. H. (2017). Has the Dollar Peg Served the Saudi Economy Well?. International Finance and Banking, 4(1), 145-162. Doi: 10.5296/ifb.v4i1.11189

Carbaugh, R. J. (2010). International Economics, 13th Edition. Boston, MA: Cengage Learning.

Carbaugh, R. J. (2019). International Economics, 19th Edition. Boston, MA: Cengage Learning.

Pugel, T. A. (2016). Interntional Economics, 16th Edition. New York, NY: McGraw-Hill Education.

Ramady, M. A. (2010). The Saudi Arabian economy: Policies, achievements, and challenges. New York, NY: Springer Science & Business Media.

Rashad, M. (2019, October 31). Saudi expects wider 2020 budget deficit of $50 billion – finance minister. Reuters. Retrieved from: https://www.reuters.com/article/us-saudi-economy-budget/saudi-expects-wider-2020-budget-deficit-of-50-billion-finance-minister-idUSKBN1XA2EOYoung, K. E. (2017, January 11). Reformers are Holding Ground: Saudi Arabia’s New Fiscal Policy. The Arab Gulf States Institute in Washington. Retrieved from: https://agsiw.org/reformers-holding-ground-saudi-arabias-new-fiscal-policy/