Low Oil Prices Threaten Global Currency Rates

Low oil prices put pressure on the budgets of major oil producing countries in 2015, but the next domino to fall could be their currencies.

Petro-economies with flexible exchange rates have already seen double-digit declines in the value of their currencies over the past year, in percentage terms. But with crude now at 11-year lows, pressure is also mounting on a range of currency pegs. The futures contract for the value of the Saudi riyal, which has been pegged to the dollar for three decades, hit a 16-year low. While Saudi Arabia has no plans to ditch its currency peg, at least officially, the markets are starting to bet that the country won’t be able to maintain the peg due to budgetary pressures and dwindling foreign exchange reserves.

Low oil prices have blown a massive hole in the Saudi budget. For now, Saudi Arabia has chosen a path of austerity in order to try to address the problem. It revealed a budget that calls for reforming fuel subsidies, raising taxes, and lower spending. But for a government that is keen to maintain social stability, slashing public expenditures is not really something it can lean on too much.

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With its oil market strategy a priority at the moment, ruling out an effort to significantly increase oil prices through production cuts, the only other option to fix its budget deficit is to abandon its currency peg. The Saudi riyal has been pegged at 3.75 to 1 U.S. dollar, but the futures market sees one-year contracts at 3.82, a 16-year high. Commerzbank AG says the peg is no longer sustainable. “Markets clearly no longer believe that the USD-SAR peg is durable,” Peter Kinsella, an analyst at Commerzbank, concluded. “If they did, then forwards would not diverge from spot prices to any large extent.”

But a currency devaluation carries its own risks. Imports become more expensive. Inflation becomes more of a worry. Dollar-denominated debt becomes vastly more expensive to deal with. “Speculation over a devaluation of the Saudi riyal has mounted in the past few days but we think such a move is likely to be used as a last resort,” Jason Tuvey, Middle East economist at Capital Economics, told The Wall Street Journal. “In light of the potential political ramifications, this is something that the authorities will be extremely keen to avoid.”

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Meanwhile, Saudi Arabia is now engaging in a diplomatic spat with Iran. While it is likely to remain a war of words, it remains a crucial conflict for domestic political reasons. It is hard to imagine the Saudi government undertaking a currency devaluation while dealing with such a delicate situation.

But Saudi Arabia is only one, albeit one of the most prominent, countries facing currency pressure. Nigeria is another oil-producer that could be forced to devalue its currency. For now, Nigerian President Muhammadu Buhari opposes such a move, but he has softened his language on the issue as of late.

Christine Lagarde, Managing Director of the IMF, recently said that Nigeria should look at “added flexibility in the monetary policy” in order “to support the poor people of Nigeria,” especially if oil stays lower for longer. “Clearly, the authorities should not deplete the reserves of the country simply because of rules that could be exceedingly rigid,” Lagarde said. “I’m not suggesting that rigidity be entirely removed, but some degree of flexibility will be helpful.” Lagarde’s use of “flexibility” is jargon for loosening the fixed exchange rate, which would lead to a currency devaluation.

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Adding to the problem of declining currencies from commodity producers if the fact that emerging markets have lost their luster as the most attractive investment vehicles for global capital. China’s slowing economy is adding to concerns that the world’s growth engine is starting to slip away. As such, China’s yuan has hit a five-year low as its economy continues to slow. The Brazilian real and the Turkish lira fell another 2 percent at the start of 2016 on fears of emerging market turmoil. Canada, another major oil producer, has seen its currency dip to a 12-year low.

The U.S. dollar has strengthened both because of a pullback in monetary policy from the U.S. Federal Reserve and also because the dollar acts as a safe haven during times of instability. With Brent falling below $35 for the first time in 11 years in intraday trading on January 6, global finance will continue to flee petro currencies in the early part of 2016.

This article originally appeared on Oilprice.com