Countries with currencies pegged to the dollar are coming under increasing attacks by traders who bet that it has become too expensive for policymakers to continue defending exchange rates amid a soaring greenback and a collapse in commodities prices.
It may be the speculators who end up losing.
It’s a tempting trade. Already, Kazakhstan, Azerbaijan and Argentina have been forced to devalue, and derivatives tied to the Saudi Arabia riyal and Hong Kong dollar suggest traders expect it won’t be long before the same happens to those currencies. Options prices put the odds of the Hong Kong dollar weakening beyond the weaker end of its current trading range this year at 36%, Bloomberg data show.
What traders may be underestimating are the hefty reserves available to policymakers and their willingness to defend the pegs, which have anchored their economies for decades and helped them survive financial crises in 1997 and 2008, according to analysts at Deutsche Bank and Union Bancaire Privee Ubp.
Together, Saudi Arabia and Hong Kong hold $1tn in foreign reserves, or enough to cover their imports and spending for years. Devaluations would only serve to destabilise their economies and could undermine Hong Kong’s status as Asia’s financial centre, the analysts say. Hong Kong Monetary Authority chief executive Norman Chanon on Monday reiterated his commitment to keeping the exchange rate’s existing link to the US dollar.
Countries are unlikely to de-peg “without exhausting their ammunition,” said Koon Chow, a currency strategist at Union Bancaire Privee in London. “They can take the pain in defence.”
Oil exporters in the Gulf region are under unprecedented stress. A 69% drop in crude prices over the past two years has dwindled their US currency revenues. Hong Kong’s 32- year-old dollar peg was threatened last week after a slide in the Chinese yuan sparked speculation that the authorities may revise the system to tighten its link to the mainland.
Twelve-month forwards for the Saudi Arabian riyal, which investors use to bet on or hedge the currency, tumbled to an all-time low of 3.87 per dollar this month. That was about 2% weaker than the country’s 3.75-per-dollar peg, suggesting traders are betting on the end of the 30-year peg, according to data compiled by Bloomberg. Hong Kong’s dollar posted its biggest two-day drop since 1992 last week to HK$7.795 versus the greenback in New York. A measure of volatility surged to the highest since 2003 amid speculation that the Chinese city will revise its linked exchange-rate system, which limits fluctuations in the currency to a range of HK$7.75-HK$7.85. The currency was recently at HK$7.7971.
Policy makers are rushing to damp such expectations. Saudi Arabia pledged last week to stick with the peg and said “misperception” is driving forwards contracts higher. HKMA’s Chan said there is no intention or need to reform the exchange rate and he expects the Hong Kong dollar to drop to the weak end of its trading range.
While Saudi Arabia, the world’s largest oil exporter, has burnt through 15% of its foreign reserves since August to defend the riyal, the stockpile, at $636bn, is still the third largest in the world after China and Japan. Instead of devaluing the currency, the kingdom is cutting spending and subsidies to cope with the decline of oil revenue and may tap debt markets this year to fund a deficit.
“Stay away from the Saudi riyal peg trade,” Deutsche Bank analysts including Daniel Brehon wrote on January 12. Devaluation wouldn’t restore the kingdom’s competitiveness as oil dominates exports and will make imports of labour and materials more expensive, according to their report.
Hong Kong holds a record $359bn in foreign reserves and can tap into China’s $3.3tn coffer. Its currency board arrangement, which requires every Hong Kong dollar in circulation to be backed by an equivalent amount of the US currency, means the money supply would shrink in case of capital outflows, pushing interest rates higher and making the local currency more attractive.
Hong Kong companies, in the past, were also able to slash costs and wages, to maintain their competitiveness without having the city resort to a devaluation.
“We expect speculation on the Hong Kong dollar peg to dissipate,” as seen in “episodes of similar speculations in the past,” analysts at Australia & New Zealand Banking Group Ltd wrote in a report on January 15.
That hasn’t deterred speculators. With relatively low costs, a bet on the de-peg can be rewarded handsomely.
Buying put options against the Saudi riyal could double the investment if the currency weakens by about 8% in a year, according to data compiled by Bloomberg.
Even without de-pegging, short selling via forwards and options can be profitable, as long as the pressure remains, which will push the prices of derivatives higher.
Policy makers in Saudi Arabia and Hong Kong showed their commitment under even more distressed times. Saudi Arabia’s peg remained intact with foreign reserves less than $13bn and oil prices below $11 a barrel in 1998. Hong Kong’s link survived a change of sovereignty in 1997, a 1998 attack by speculators during Asia’s financial crisis and almost three months of pro- democracy protests in late 2014.
“Hong Kong has been tested,” said Stephen Jen, co-founder of SLJ Macro Partners in London and a former economist at the International Monetary Fund. “They’ve seen much worse before. The peg is not going to go away.”
Saudi central bank warns against riyal speculation
The Saudi Arabian central bank has warned commercial banks against betting on depreciation of the riyal as tumbling oil prices put pressure on the Saudi currency, several bankers operating in the market said.
The action by the Saudi Arabian Monetary Agency (SAMA) suggests authorities want to prevent investors’ unease over the impact of cheap oil on the Saudi economy from triggering capital flight or destabilising local markets.
The riyal, pegged in the spot market at 3.75 to the US dollar since 1986, hit a record low against the dollar in the one-year forwards market last week as some banks and funds hedged against the risk that low oil prices might eventually prompt Riyadh to scrap the peg.
In order to pay the government’s bills as its oil revenues shrink, SAMA has been drawing down its overseas assets at an annual rate of more than $100bn, although it still has enough to support the riyal for several years.
The bankers, declining to be named because of commercial sensitivities, said SAMA had contacted them privately and urged them not to conduct derivatives trades that would pressure the riyal.
“SAMA has ordered banks to stop giving structures for FX swaps. I mean banks can quote for straight forwards and FX swaps, but can’t price for swap options,” said one banker.
The bankers said SAMA’s action was so far succeeding in supporting the riyal. One-year dollar/riyal forwards had dropped back to 690 points on Wednesday from a record 1,020 points last week, even though Brent crude has hit fresh 12-year lows below $30 a barrel.
A spokesman for SAMA could not be reached for comment.
Saudi Arabia faced two previous bouts of speculation against its currency after 1986, according to a 2013 paper by former SAMA vice-governor Abdulrahman al-Hamidy and Ahmed Banafe, published on the Bank for International Settlements website.
In both cases, cheap oil fuelled concern about budget and external deficits. Both times, SAMA quashed speculation fairly easily by gathering information about speculative positions through its contacts with local banks, then pushing the riyal back up in the forwards market with steps such as placing deposits with domestic banks, the paper found. “In episodes of speculation against the riyal...SAMA’s tactics were effective, and they are still available for use,” Hamidy and Banafe wrote in their paper.
Bankers noted that after falling slightly below 3.7500 to the dollar in the spot market earlier this month, the riyal had in recent days rebounded very close to that level, suggesting SAMA was providing an ample supply of dollars to the market.
Current forward market prices only imply riyal depreciation of about 1.8% in the next 12 months, and many Gulf bankers think Riyadh remains very unlikely to depreciate its currency.
That is because any benefit to state finances from higher oil revenue, after converting dollars to riyals, would be more than outweighed by a surge in import costs - uncomfortable for the government - and a market panic.
But even as pressure on the riyal in the forwards market has eased in the last few days, the interest rate swaps market, also used to bet on depreciation, shows traders remain nervous.
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