In November of 2014, we announced the quiet death of the petrodollar.
The system which underwrote decades of dollar dominance and kept a perpetual bid under USD assets met an untimely demise when the Saudis moved to bankrupt the US shale complex by deliberately suppressing oil prices.
The implications, we said, would be far-reaching.
For years, oil producing nations plowed their USD crude proceeds into USTs and other dollar assets in a virtuous loop both for the currency and for the nation that printed it. The “Great Accumulation” (as Deutsche Bank calls it) of USD FX reserves ended for good in early 2015 but no one noticed until China began to liquidate mountains of US paper in an attempt to manage a runaway devaluation effort.
By the start of September, all anyone wanted to talk about was the depletion of EM FX war chests as the world suddenly came to understand that the selling of FX reserves amounts to QE in reverse and might therefore serve to tighten global monetary conditions, drive up yields on core paper, and sap liquidity as traditional net exporters of capital suddenly stopped buying amid slumping commodity prices and the yuan fiasco. Some wondered if the reserve drawdowns would cause the Fed to delay liftoff as the FOMC would effectively be tightening into a tightening.
Against this backdrop we said that the most important chart in the world may well be one that depicts the combined FX reserves of Saudi Arabia and China.
Now that Saudi Arabia’s oil price gambit has backfired on the way to blowing a hole in the kingdom’s budget that amounted to 16% of GDP last year, the market is speculating that Riyadh’s vast SAMA reserves could disappear altogether - especially considering the added cost of funding the war in Yemen and maintaining the riyal peg.
As it stands, the Saudis have around $630 billion parked at SAMA. That's the third-largest rainy day fund on the planet.
How long the reserves will last given the myriad headwinds facing the kingdom is an open question, but here's a useful graphic from BofAML which endeavors to show how long Riyadh can hold out under various assumptions about oil prices and borrowing:
What’s interesting about Saudi Arabia’s UST reserves is that no one knows how “vast” they actually are.
For one thing, SAMA is a sovereign wealth fund, which means we can’t just look at the headline number and make assumptions about US paper because the fund’s holdings aren’t homogeneous.
But there’s more to the ambiguity than that. “It’s a secret of the vast U.S. Treasury market, a holdover from an age of oil shortages and mighty petrodollars,” Bloomberg writes of Saudi Arabia’s US Treasury holdings. Put simply: there’s no way for the market to assess the impact of the SAMA drawdown because the composition of the portfolio is a state secret of both Saudi Arabia and the US.
“As a matter of policy, the Treasury has never disclosed the holdings of Saudi Arabia, long a key ally in the volatile Middle East, and instead groups it with 14 other mostly OPEC nations including Kuwait, the United Arab Emirates and Nigeria,” Bloomberg goes on to note, adding that the rules are different for almost everyone else. Although Saudi Arabia's "secret" is protected by "an unusual blackout by the U.S. Treasury Department," for more than a hundred other countries, from China to the Vatican, the Treasury provides a detailed breakdown of how much U.S. debt each holds.”
For his part, Edwin Truman (the former Treasury assistant secretary for international affairs during the late 1990s) doesn’t get it. “It’s mind-boggling they haven’t undone it,” he says, incredulous. “The Treasury didn’t want to offend OPEC [but] it’s hard to justify this special treatment at this point.”
So who does know how much US paper the Saudis are sitting on? Well, the Saudis of course, “a handful of Treasury officials,” and some bureaucrats at the Fed, Bloomberg says, noting that “for everyone else, it’s a guessing game.”
Yes, a “guessing game,” and one that may have profound consequences for markets and for geopolitics.
With Iranian supply set to flood an already overflowing oil market, Saudi Arabia’s finances are likely to deteriorate further. Especially if the conflict in Yemen continues to fester and the kingdom refuses to cede the riyal peg. That means that unless the Saudis are prepared to take on more debt (and the kingdom’s debt to GDP is already set to rise to 33% by 2020 from just 2% at the end of 2014), they’re going to be selling something from SAMA and the market has no way of knowing what ahead of time.
Politically all of this comes at an especially critical juncture. The US is pushing to reduce its dependence on foreign (read: Saudi) oil and Washington’s rapprochement with Tehran has ruffled more than a few feathers in Riyadh.
“Events in recent months, from President Barack Obama’s landmark nuclear deal with Iran to Saudi Arabia’s execution of a prominent Shiite cleric who challenged the royal family, underscore just how sensitive U.S.-Saudi relations have become, [but] whatever the political considerations, some analysts speculate Saudi Arabia may actually be trying to hold onto its Treasuries as part of a strategy to bulk up on dollar assets amid the deepening turmoil in global financial markets,” Bloomberg goes on to say. Here’s more:
“You need dollars if you’re an oil producer, you want to make sure you have dollars on your balance sheet,” said Sebastien Galy, Deutsche Bank’s director of foreign-exchange strategy, who suggests SAMA could be raising cash by liquidating riskier investments such as stocks, real estate and private equity. Holding dollars also makes sense as a hedge against the plummeting price of oil, which is priced in the U.S. currency.
Figures from SAMA suggest the kingdom might be reallocating some of its reserves into short-term, liquid assets to help the finance ministry meet budget commitments and defend its 30-year-old currency peg of 3.75 riyals to the dollar.
The central bank has increased foreign currencies and deposits held abroad by 7 percent in the first 11 months of 2015, while at the same time reducing foreign securities, consisting of equities and longer-term debt, by 20 percent.
If the Saudis are avoiding selling US paper for as long as they can, one wonders what it is they're selling instead to boost cash and deposits. As we noted last week, sovereign wealth funds are set to liquidate $75 billion in equities in 2016, an outflow which may or may not be covered by "dumb" money inflows from the retail crowd.
In any event, those hoping for an end to the "legacy" policy of keeping Saudi Arabia's UST holdings shrouded in secrecy shouldn't hold their breath. "They'll want to deal with it sooner or later," the abovementioned Edwin Truman says.
We'll close with a simple question: who would be the new patron saint of the US Treasury Department in the event the Saudis drawdown all of their reserves and decide to diversify away from USD assets once the tide turns for crude, red ink turns to black, and the kingdom once again becomes a net exporter of capital? Put differently, who will monetize the US deficit if relations between Washington and Riyadh hit the skids over Iran? It damn sure won’t be China, where authorities are selling USTs by the hundreds of billions.