The Kingdom of Saudi Arabia is significantly reliant on oil, as income from oil exports accounts for over 90% of the revenue and forms almost 50% of its GDP. The country boasts the second-largest reserves worldwide. Undoubtedly, government investments/expenditures are supported by income from oil exports. Oil is regarded as a volatile market that has ripple effects on the macroeconomic field; thus, its analysis by economists and business is mainly based on the upswings or downswings it has on currencies globally (Aloui, Hkiri, Hammoudeh, & Shahbaz, 2018). The Saudi Arabia Riyal (SAR) is hooked to the U.S. dollar (USD) because the receipts and payments from its foreign exchange are principally in USD. Another reason for connection to the USD is that the stable SAR/USD exchange rate is appealing to investors, hence it boosts investments in the kingdom. Since June 1986, the SAR has been at a fixed rate to the USD at SAR 3.7500 per USD. The following paper seeks to critically analyze two different scenarios of dramatic increase and decrease of oil prices concerning the currency perspective in Saudi Arabia.Let our writers help you! They will create your custom paper for $12.01 $10.21/page 322 academic experts online
Any oil-exporting country experiences the following conditions in a fall or an increase in oil prices globally. Mosteanu (2017) postulates that an increase in the oil price results in an upsurge in inflation, government spending, and revenue. Negative real interest rates are a result of the augmented inflation. Simultaneously, fiscal and monetary policies in Saudi Arabia turn expansionary. On the other hand, if the price of oil plummets, there is a reduction in income, decreased spending, deflation, and an increase in interest rates (Carbaugh, 2019).
Declining World Oil Price
Temporary falls have followed the oil price collapse in global inflation. Although deflation is usually pronounced in states with higher GDP, the effect across nations has varied significantly. This is reflected specifically in the vitality of oil in consumer baskets, developments in the exchange rate, monetary policy’s stance, the scope of fuel subsidies, and other price regulations (Mosteanu, 2017). In theory, Vohra (2017) suggests that oil exporters’ currencies should depreciate in times of negative oil price shocks. The kingdom’s SAR will depreciate even though counter-balancing forces can come into place. Monetary authorities may dislike significant swings in the nominal exchange rate, countering the pressures through the growth or decrease of reserves in foreign exchange. The universal risk-sharing channel could provide stability through currency exposure. Given that Saudi Arabia has accrued many foreign exchange reserves and has a propensity to be “net long” in external currency, a decline in the price of oil and the eventual depreciation will result in a positive valuation effect (Bagchi, Dandapat, & Chatterjee, 2016). This is a net gain for the kingdom in relation to domestic GDP, thus playing a stabilizing role.
A dramatic reduction in the price of oil automatically leads to sharp drops in Saudi Arabia’s GDP as its currency is pegged to USD. The kingdom is likely to experience budget deficits since low oil prices cannot explain the social spending provided to their citizenry and the cost of subsidies (Costigan, Cottle, & Keys, 2017). For example, in 2009, when the price of oil critically declined, the kingdom dedicated $373 billion for economic advancement projects to protect its economy from uncertainties in the oil market globally. Oil prices impact social spending by affecting inflation and activity through pushing the aggregate demand and supply (Aloui et al., 2018). For supply, a dramatic fall in the oil price leads to a reduction in the cost of production in all industries. Consequentially, the reduced production cost across a variety of energy-intensive goods may trickle down to consumers and hence, inadvertently lessen inflation (Carbaugh, 2019). This also translates into higher investment. On the other hand, for demand, by dropping energy bills, a fall in the prices of oil increases real income of consumers, which leads to a rise in consumption.
Increasing World Oil Price
According to Costigan et al. (2017), an increase in the price of oil favors higher consumption and investment rates in the oil-exporting country, which in this case is Saudi Arabia. It should result in the substantial expansion of the Saudi Arabia’s economy; hence, the real appreciation of the SAR. In the case of a permanent shock, Saudi Arabia may consider offsetting the inherently expansionary effects of an increase in prices of oil with a comparatively constricted monetary policy. The International Monetary Fund (IMF) outlines that a complete upsurge in the real price of oil typically leads to half the real appreciation of the currencies of states exporting oil (Aloui et al., 2018). This adjustment may emanate from changes in the exchange rate. However, in the case of a fixed exchange rate being intertwined with the USD like in the kingdom, the alteration in the real exchange rate essentially will manifest through changes in local prices. An increase in oil price automatically leads to a momentary rise in inflation. Even if the USD holds steady in relation to other currencies, there would exist a need for a change in domestic prices. However, if the USD drops comparatively to other currencies, dragging down the nominal exchange rate of the kingdom, the surge in inflation required to create the anticipated real appreciation increases. Both the escalation in the oil price and the depreciating USD exerts pressure on domestic prices.
There are two outcomes to consider when maintaining the nominal exchange rate and permitting all the real adjustment to arise from changes in the price level (Bagchi et al., 2016). The first consequence involves the process of inflationary and deflationary change, which is sluggish. Many of the augmented local commodity prices that are linked to an increase in prices of oil will manifest after the oil price has gained a stable ground. Moreover, once instigated, inflationary adjustment can advance its impetus, as economic agents look forward to increasing price levels and call for higher nominal wages. The second cost is on the inflationary and deflationary adjustment process, which may result in significant shifts in the real interest rate. In the late twentieth century, economies exporting oil (those pegged to the dollar) had their real interest rates far higher as compared to that of the United States (Mosteanu, 2017). An example is during the year 1999, when the kingdom had an inflation rate of -1.3 percent contrary to that of the U.S which had over 2 percent of the rate. At a period when the economy was contracting, Saudi Arabia had real interest rates of approximately 7 percent. An exchange rate that is pegged backs a very procyclical macroeconomic policy. A heightened oil price results in rising inflation, government revenue, and spending. Negative real interest rates are a consequence of high inflation.Order now, and your customized paper without ANY plagiarism will be ready in merely 3 hours!
Pegging to the dollar primarily has made it difficult for oil-exporting nations like Saudi Arabia to adjust to dramatic changes in the price of oil. Dollar pegs will not halt oil-exporting economies’ currencies, in particular SAR, from ultimately appreciating in real terms. The countries exporting oil with no establishments to conduct an independent monetary policy should consider pegging to a basket that comprises the oil price. As was discussed in relation to Saudi Arabia, exchange rates should be flexible to lessen the need for local prices in oil-exporting nations to grow and drop along with the oil price. It will eventually create extra room for monetary policy committees to echo domestic situations.
Aloui, C., Hkiri, B., Hammoudeh, S., & Shahbaz, M. (2018). A multiple and partial wavelet analysis of the oil price, inflation, exchange rate, and economic growth nexus in Saudi Arabia. Emerging Markets Finance and Trade, 54(4), 935-956.
Bagchi, B., Dandapat, D., & Chatterjee, S. (2016). Dynamic linkages and volatility spillover: Effects of oil prices on exchange rates, and stock markets of emerging economies. West Yorkshire, England: Emerald Group Publishing Limited.
Carbaugh, J. (2019). International economics (17th ed.). Boston, MA: Cengage Learning.
Costigan, T., Cottle, D., & Keys, A. (2017). The US dollar as the global reserve currency: Implications for U.S. hegemony. World Review of Political Economy, 8(1), 104-122.
Mosteanu, N. R. (2017). Currency pegged to a foreign currency-GCC and Europe models. The Business & Management Review, 9(1), 52.We'll complete your 1st custom-written order tailored to your instructions with 15% OFF!
Vohra, R. (2017). The impact of oil prices on GCC economies. International Journal of Business and Social Science, 8(2), 7-14.