12 January 2016 FX Blueprint: Forever Young Theme #13: Can SARdines - Stay away from SAR peg trade ▪ Saudi Arabia still has time to defend the dollar peg but they must act more decisively on fiscal matters. Wait for better levels before buying 12m USDSAR. • Reserves are nearly equal to GDP and twice the M1 130 money supply. Debt was far higher and reserves far lower during successful defenses in 1998-2003. 120 Both falling oil prices and a rising dollar suppress 110 Saudi inflation but outright deflation is unlikely 100 ▪ Monetary policy credibility far outweighs any minimal economic gains from releasing the peg 90 ▪ Other Gulf currencies (Oman), are more vulnerable 80 Still time to spare in Saudi Arabia In recent days those sleepy Gulf dollar pegs have suddenly awoken. The dollar's relentless rise has made the Saudi Arabian riyal expensive too and SAR 12m forward points have jumped to record levels (Figure 1). It turns out those large FX reserve buffers were handy after all. EM exchange rate policy is being challenged in Asia and the Middle East, with the likes of China and Saudi Arabia seeing reserves depleted at rates above 1% per month. Fortunately for the USDSAR peg, Saudi reserves still total $635 billion, or approximately 95% of GOP. Record outflows may continue for several years, fueled not just by the trade deficit but also by capital outflows, and we project them to be $510bn by end-17. Even still they will be far larger as a share of the economy than China (30%) and equal to Switzerland. The IMF estimates a 5-year fiscal buffer even at the 2015 $100 oil budget breakeven price (Figure 2). The reverse repo rate is only 50bp and the economy is not very sensitive to rate increases given low diversification. Moreover the Saudis have several as-yet untapped sources of dollar financing. One is to simply issue USD debt as in the 1990s - private external debt totals $68bn, a mere I0% of GDP (by contrast, South African