Dollar gets respite as Saudi Arabia keeps dollar peg, for now

By Ambrose Evans-Pritchard
The Telegraph, London
Wednesday, September 26, 2007

http://www.telegraph.co.uk/money/main.jhtml?xml=/money/2007/09/26/bcnsau...

The dollar has at last begun to stabilize after a week of preciptious falls on news Saudi Arabia intends to stick to its closely-watched exchange-rate peg, despite its refusal to cut interest rates in lockstep with US Federal Reserve.

The greenback gained slightly to $1.4124 against the euro. Traders even brushed off a 4.9 percent plunge in US orders for heavy goods and machinery in August, which came hard on the heels of a 4.5 percent drop in the Case-Schiler index of house prices in the 10 biggest US cities.

Fears that Saudi Arabia and other super-rich sheikhdoms across the Gulf region might be preparing to cut their umbilical cord to the dollar has unsettled the currency markets, raising fears of a Mid-East exodus from US assets.

The region's oil producers together have some $3,500bn under management by investment trusts and central banks.

Four Gulf states have so far chosen to keep rates steady after the Federal Reserve's half point cut last week. They all fear that soaring oil prices and a local construction boom could set off an inflationary spiral.

Oman became the latest country this week to break with US monetary policy. "Our economy is different than it is in the United States. They have their own reasons for reducing interest rates that do not necessarily match our requirements," said the central bank governor, Hamood Sangour Al Zadjali.

Matt Vogel, head of Mid-East research at Barclays Capital, said it is far from clear whether the Riyadh can hold the peg if the gap between Saudi and US interest rates keep widening.

"Pressure to revalue the riyal or at least do something about the exchange rate is not going away. The interest rate differential is now 70 basis points between Saudi Arabia and the US, and it's drawing in speculative investors. There is now a riyal carry trade," he said.

"Saudi Arabia has a huge balance of payments surplus and an inflation problem, which are both telling you that the currency should appreciate. Housing costs are going up and now they face the additional threat of rising global food prices," he said.

Mr Vogel said any decision by the Saudis and other Gulf states to switch to a basket of currencies would send a powerful signal to the markets about the investment strategy for the region's investment funds, putting fresh pressure on the dollar.

Gabriel Stein, an economist at Lombard Street Research, said there was a risk that Asian states with dollar pegs would follow suit if the Gulf banks began ditch the system, as Kuwait has already done.

"So far the only people who have really abandoned the dollar are the Russians. That is not too serious but if the Mid-East goes too, then it becomes a mug's game for anybody who stays. China has the same problems of inflation and overheating as Saudi Arabia," he said

"The effect is largely psychological. The Gulf States already invest their wealth where they get the best returns so I don't think this in itself would have that much impact on the dollar exchange rate," he said.

The Saudi monetary authority said it would take steps to counter speculative inflows. Traders said the statement appeared to be a lukewarm endorsement of the peg, raising as many questions as it answered.

Even so, the dollar seems to being enjoying something of a respite after the battering it has taken since the Fed rate cut, which has been widely viewed as a sign that Washington is slackening in the fight against inflation.

The soaring euro has in any case reached the pain-threshold for much of Europe manufacturing industry, with even German companies now beginning to complain vocally.

Guy Quaden, a governor of the European Central Bank, has warned against "brutal" moves in the exchange rate. The use of this ECB code word suggests that the bank may be launching a camapign of verbal intervention to dissuade currency speculators from pushing the euro any higher.

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