• Excessive speculation, arbitrage drives SAMA intervention In a move aimed at quashing excessive speculation in the forwards market, Saudi Arabian Monetary Agency (SAMA) ordered banks to stop selling forward currency option products. While the plain vanilla forwards and swaps market will continue, banks have been prohibited to sell options on forwards and swaps. The move is aimed at reducing speculative activity in the forwards market, and provide stability to the forward currency rate. We understand that local and international banks had been selling option products on the currency amid high demand. With only option price as the underlying cost, traders had been increasingly putting in money to play on the break in the peg. The increased activity also led to the development of two parallel markets – onshore and offshore – with a c100-150bps differential on the quoted rates between the two. This also increased arbitrage activity between the onshore and offshore markets.
• Impact on banks – Limits room for margin enhancement, fee income Since the end of 2014, increased volatility on the currency amid the oil price slump had driven demand to hedge against currency risks. While part of this was genuinely backed by commercial interests, it was being driven up by speculative interest in the SAR-USD trade. This had been a source of decent fee and investment income for the banks over the past 12-18 months. Some banks were also using currency options for yield enhancement. The recent directive closes the revenue opportunity for local banks, in our view. For offshore banks, it makes the currency option product more expensive. In the absence of a local bank as a counter party, offshore banks would need to source SAR liquidity or use an alternate currency (QAR/AED) to write options on currency forwards.
• Peg policy is safe for now; Non-reserves financing sources can help We reiterate our view that the risk of a change in the peg policy is remote since the benefits of maintaining the peg outweigh those of a devaluation, as maintaining the peg boosts confidence and policy credibility, particularly at a time when the country is trying to encourage FDI and FPI. Moreover, KSA has ample reserves to protect the peg. Having said that, we believe that it is essential that the government reduces the drain on reserves by seeking other BoP financing sources. This can come from: i) sovereign bond issues; ii) reviving project financing; iii) changes to stock market regulations to attract foreign funds; iv) reducing domestic demand through fiscal consolidation; v) IPOs; and vi) maximising oil export revenues through subsidy reform and use of alternative energy sources. The latter will take some time to materialise, but some of the options listed above - such as the first three - can be done in the short term.

Murad Ansari
Simon Kitchen
Mohamed Al Hajj