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GEMs: Saudi Arabia - SAMA draws a line in the sand.

GEMs has reported that SAMA has instructed local banks to halt trading currency options on SAR forwards.

"This suggests that SAMA continues to be committed to the USD peg, while using administrative measures to limit speculation and local banks' exposure to speculative positioning against SAR. While SAR forward points may move higher, they are at risk of further intervention or prudential measures, and are already at historically elevated levels which reflected in the past a much weaker Fx reserve position. We still expect the USD peg to likely hold over the medium-term.

"SAMA has issued a directive on 18 January instructing local banks and Saudi branches of international banks to halt the sale of currency options contracts on SAR forwards, according to news reports. Our understanding is that there are currently no restrictions on activity in SAR Fx forwards. Following recent verbal intervention by SAMA Governor Al-Mubarak reiterating the official commitment to the USD peg, this administrative measure likely suggests continuing discomfort by the levels of speculative activity.

"This speculative activity and drain on system liquidity could exacerbate interest rate rises and hold cost implications for business activity. Also, speculative activity in the Fx forward market as offshore accounts buy USD forward against SAR could impact Fx reserves. This is because local banks, which can treat these derivative positions as offbalance sheet items, in turn can aim to cover their short forward USD positions by buying USD from SAMA.

"We cannot exclude further intervention either directly, indirectly or through prudential measures. We think that the targeting of currency options contracts trading reflects the likely speculative, as opposed to hedging, nature of the flows under a pegged Fx regime. With the liquidity in the currency options market being squeezed, the market may move to become purely offshore, or activity may turn instead to the Fx forward market, we think. Domestic banks may nevertheless be reluctant to face offshore institutions given the tone of SAMA's directives or may be unable to do so in size given international banks' credit limits.

"Unlike the currency options/volatility market, the Fx forward market is also used for genuine corporate hedging and banking sector access to foreign liquidity (while currently earning a positive carry). So it would be more difficult to halt activity in the Fx forward market, in our view. Otherwise, domestic banks would need to turn to the wholesale market to access foreign liquidity at a cost instead.

"Unless there is a major unwinding of speculative flows, the impact of potentially restricting local banking sector supply in the Fx forward market could move activity offshore instead, and push points further higher, in our view. The gross actual settlement of forward transactions could make it more costly for counterparties speculating against SAR as they would need to make SAR payments to take delivery of forward USD purchases and access to SAR supply would be compromised.

"We do not expect RRR changes or future symmetric increases in the policy rate corridor (ie, both repo and reverse repo rate hikes, in line with future Fed hikes, as opposed to just increasing the reverse repo rate, as currently being done) to strengthen the interest rate support for the USD peg. Authorities remain watchful of the deteriorated domestic liquidity trends and are considering external debt issuance to mitigate it. Furthermore, these measures are likely to slow down private sector credit growth. They are unlikely to discourage speculation on their own in the absence of broader macro-economic policies, given the asymmetric risk-reward payoff profile of SAR speculative trades, in our view.

"While SAMA is likely to continue to passively respond to market speculation, this first instance of prudential administrative measure being implemented suggests direct intervention could be pursued going forward, in our view. Passive intervention reflects SAMA continuing to provide required spot USD to domestic banks to meet the private sector's commercial and financial demand, as part of its commitment to the USD peg. Fx forward intervention could be further backed by money market intervention in the form of liquidity injection and deposit placements to maximize impact and lower points.

"In late 1993 and 3Q98, the trigger for direct SAMA intervention was forward points moving to the c800 level in the 1-year tenor. Intervention was relatively modest and totaled $655 million in 1993 and $820 million in 1998. However, the situation was somewhat different, in our view, because there was a fully-fledged speculative attack on SAR on both occasions. Fx reserves were $7 billion (five per cent of GDP) and $14 billion (9.7 per cent of GDP) at the time, respectively. Dollarization was increasing; in 1998, it increased by 4ppt to 24.2 per cent in the private sector. Note that 1-year forward points touched the 600 level in 2002 but SAMA did not intervene back then; it had Fx reserves of $45 billion (24 per cent of GDP). Dollarization in the private sector was more muted with just a 1.5ppt increase. In comparison, private sector dollarization is well behaved currently, with dollarization down by 1ppt year-to-date to 6.8 per cent in November.

"SAMA's prudential measure is also likely aimed to effectively limit local banks' exposure to speculative positioning against SAR. Exposure of domestic banks to forward Fx contracts and currency options is treated as an off-balance commitment. As of 9m15, the notional amount of forward Fx contracts and currency options outstanding at local banks stood at $97 billion and $116 billion respectively, representing a large 36 per cent of total assets and 367 per cent of net foreign assets. Arbitrarily assuming that 50 per cent of the notional amount is in SAR Fx derivative products would suggest very crudely c$100 billion in SAR Fx derivative positioning, which exceeds the banking sector on-balance sheet net foreign asset position of $54 billion as of November."

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Publication:CPI Financial
Date:Jan 25, 2016
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