Saudi Arabia and Oil economy

Introduction

Pegging is a process of baking a currency of a country with some resources. As of a few decades ago, currencies are backed by gold as standards for their values. But as of globalization and the US became the centre of trade for most of the countries. It is taken as an instrument for trade within the countries. As the dollar gained importance, countries started to shift their resources from gold to dollar as international market is becoming more and more dollar-based. If a country tried to trade in the gold standard, it has to convert it in dollar first and then to be accepted by other countries. In the past, as a barter system found to be collapsing, fiat currencies are introduced, and gold is taken as standard. But as time passed and the US gained popularity in the international market (mostly after the end of second world war), causing most of the countries to trade in dollars rather than gold. As of today, there is not a single country with gold backing its currency (Henderson, 2020). Saudi Arabia has an oil-based economy after being discovered with oil resources back to 1933. Saudi Arabian rial is also pegged to dollars and could fluctuate in the result of international market condition. There are two types of the exchange rate. One is a fixed rate that means the rate of currency will remain the same as the other currency and will not change on a daily basis regardless of the demand and supply in the market. The other type is a floating exchange rate that means the rate of a currency change with respect to demand and supply of that currency in the market. This can help countries to provide flexibility with respect to their market demand. The Saudi government is using a floating exchange rate that means the value of rial can change against the value of a dollar.

As the oil economy, international oil prices can affect the price of SAR.

Scenario when oil price decrease

Oil demand is complex in the international market and changes drastically, and as a major oil-exporting country, Saudi Arabia’s economy gets affected by it.

Economy

The oil price is one of the key players in the market, and change in pricing can affect the country’s economic condition. Ito (2010) found that the 1% decrease in oil price can affect the Russian economy by decreasing it by 0.46%. That shows that the Russian economy is highly dependent on the oil price. Similar results have been found by Berument, Ceylan and Dogan (2010) in their research. They found that oil prices can have an effect on the economies of countries that have oil-based economies in middle eastern regions such as Kuwait, Iraq, UAE and Syria. Saudi Arabia is also a net oil-exporting country, and its economy is most dependent on oil exports as there is no knowledge or any other main industry in the country.

Exchange rate

Saudi Arabian Rial is pegged to the US dollar, and it can be problematic in causing a disturbance in the economy. So in order to keep the stability in rial price, Saudi government use floating exchange rate rather than a fixed one. The best example of this is presented by Chile, that saved it from economic crises. According to Aleisa and Dibooĝlu (2002) exchange rate of Saudi Rial is more dependent on oil demand shocks rather than oil price shocks. That means if the oil demand in international market changes, Saudi Arabia will find a change in its real value.

Inflation

As the price of oil decreased back in 2018, the inflation in the country rise to 2.48%. It is because the government is having a problem with expensing its projects. As income generated from oil-based products had decreased when the Obama regime removed sanctions from Iran in case of the nuclear deal. This results in a decrease in international income of the kingdom from oil supply; thus, the government has been imposing new methods of generating revenues. This cause rise in overall inflation in the kingdom. As oil prices decreased, the government had to find other ways to finance its activities. To do so, the government implied new taxes and fines (Alharbi, 2020). This created unrest in people of the kingdom, and people have to spend more than before.

Interest rate

The risk premium is one of the essential variables in the interest rate of a country; it is a factor that what is chances of losing the investment in a project. Pierrru and Matar (2014) found that the risk premium is highly dependent on oil price in the international market. The low oil price can bring the change up to 5% in the oil-producing country, thus increasing the interest rate in a country. Saudi Arabia has faced a crucial time after Iran entered in the international oil market in 2014. This caused an increase in the supply of crude oil in the international market as Iran is a low rate oil-producing country. This cause decrease in international oil prices and thus pushing the long-term economy of Saudi Arabia down.

Trades issues

As the country faced critical economic condition, the government has to go to the IMF for the loan to make its international payments. Saudi Arabia is allying to some most important nations such as India, US and China. With Iran entering the market as a new supplier caused international prices to go down. This generated a gap between international nations with Saudi Arabia, and the policies of trades changed internationally. This cause new tariffs imposed on Saudi product in the international market. Saudi Arabia is also considered as a home for Muslim countries and as the government has to impose new fees to the religious people. This created a trade dispute between Muslim countries such as Turkey and Malaysia; thus, the country has faced new trade barriers with these countries. 

Scenario when the oil price increase

Inflation

It is not necessary that only lowering in international oil prices can damage the ratio of disposable income in an oil-exporting country. The increase in international oil prices can also damage the economy of Saudi Arabia. As an oil-producing country, Saudi Arabia depends highly on other countries for consumable products. When international oil prices rise, the cost of production for those goods goes up, causing an increase in the prices of those products. As an importer, Saudi Arabia has to buy those products at a higher cost, thus pushing the inflation up (Foudeh, 2017). It has been found that Saudi Arabia can increase world inflation through oil pricing, but the result will increase in the prices of imported goods, causing inflation in the country (Aleisa & Dibooĝlu, 2002).

Economic Condition

Saudi Arabia is a country who enjoys most of the benefit from an increase in oil prices. As of the oil boom when prices are skyrocketing, the kingdom enjoyed one of the best economies in the world. It is because the per barrel revenue of Saudi Arabia can go really up by the increase in oil price, thus having more money for investment. The government of Saudi Arabia has its income generated than seventy percent from oil products as the oil prices go up, the income of government increase. Saudi Arabia is a country with one of the lowest extraction costs. It can be in breakeven even at 50 Dollar per barrel. Thus higher prices can help the country to generate a higher margin.

Exchange Rate

As Saudi Arabia is one of the biggest importers of consumable goods from the US and China, the increase in international oil prices can cause the products produced in both countries to increase. This will result in expensive imports from the world within the country. This can cause more foreign currency to be traded out of the country, causing a change in the exchange rate of the country. As prices of oil increases, it can create more damage to the economy by pulling the overall import rate up. After a specific point, rial will not be able to demand shock anymore, thus representing the effect on the exchange rate of SAR and USD. This will cause rial to devalue in the long term with respect to American Dollar.

Interest rate

A positive effect cannot be seen in case of an increase in oil prices. Interest rate also counts from the supply and demand of money in the open market from the general public to the businesses. As inflation rises because of expensive imports, people will have to spend more on their consumptions than before leaving them with less income to be saved. This can create a shortage at the supply side in the money market. To cover up this gap, lending institutes will offer more to the general public, thus increasing the overall interest rate of the market up. The higher rate of interest will be offered to businesses causing them to charge more in order to pay their expenses off, causing a loop of inflation.

Summary

As increasing and decreasing oil prices have their perks for Saudi Arabia, it is wise for the government to create a method of supplying oil in the international market that can keep the oil prices stable for the long run. This will provide the country benefit of stable economic growth and controlled inflation and interest rates. The government should cope with OPEC in order to maintain stability in the oil market.

 

References

Aleisa, E. A., & Dibooĝlu, S. (2002). Sources of real exchange rate movements in Saudi Arabia. Journal of Economics and Finance, 26(1), 101-110.

Alharbi, A. (2020). Economic effects of low oil prices in Saudi Arabia. International Journal of Information Technology, 1-6.

Berument, H., Ceylan, N., & Dogan, N. (2010). The impact of oil price shocks on the economic growth of selected MENA1 countries. The Energy Journal, 31(1).

Foudeh, M. (2017). The long run effects of oil prices on economic growth: The case of Saudi Arabia. International Journal of Energy Economics and Policy,, 7(6), 171-192.

Henderson, A. (2020, March 4). BACK TO THE GOLD STANDARD: WILL THERE BE A GOLD BACKED CURRENCY? Retrieved from Nomad Capitalist: https://nomadcapitalist.com/2018/08/30/gold-backed-currency/

Ito, K. (2010). The impact of oil price volatility on macroeconomic activity in Russia. Economic Analysis Working Papers.

Pierru, A., & Matar, W. (2014). The impact of oil price volatility on welfare in the Kingdom of Saudi Arabia: implications for public investment decision-making. . The Energy Journal, 35(2).