July 2008

Investors should be concerned about rising inflation — not in the United States, says Paul Kasriel, Northern Trust’s director of economic research, but in Saudi Arabia.

Increasing inflation in Saudi Arabia and other Gulf states, whose currency is pegged to the U.S. dollar, could eventually drive down the dollar’s value.

“The biggest threat to the dollar’s value is the management of currencies by countries whose currency is pegged to the dollar, like Saudi Arabia and, to a lesser extent, China,” Kasriel says.

Dollar no longer king
For many years, most of the world’s currency reserves were held in dollars, in part, because the dollar was the most stable currency available. Today, however, many countries are rethinking their exclusive relationship with the dollar.

In May 2007, Kuwait decided to de-peg its currency from the dollar, joining an increasing number of foreign central banks that have begun to take a more active role in managing their currency. Diversification is becoming increasingly common today as banks invest reserves in the euro or a basket of currencies instead.

This trend toward diversification and the end of the dollar’s global supremacy is a vicious circle: The trend was caused, in part, by increasing weakness in the dollar and, it also has contributed to the dollar’s current depreciation.

This vicious circle can cause problems for countries maintaining close ties to the dollar. The relationship between the Saudi riyal and the dollar, for instance, is very tight. When the dollar is under pressure, the Saudi monetary agency has to act to maintain that relationship by buying dollars with Saudi currency.

This intervention has caused an explosion of growth in riyals, which has driven up the prices of imported goods. Consumer prices in Saudi Arabia in April rose 10.5 percent from a year earlier.

“This inflation is becoming increasing untenable,” Kasriel explains. “If the inflation reaches a point where the Saudis decide to de-peg their currency, it will cause a sharp decline in the U.S. dollar.”

Breaking up is hard to do
Despite inflationary pressures at home, Saudi Arabian Finance Minister Ibrahim Al-Assaf said that the kingdom has no immediate plans to de-peg its currency from the dollar. For now, that means the riyal and the dollar will continue to move hand-in-hand.

“As Neil Sedaka said, ‘Breaking up is hard to do,’” Kasriel says. “For the sake of the economic welfare of the United States, let’s hope this applies to foreign currencies and their peg to the dollar.”