Monday, 27 March 2017

Chronicles of an Omani devaluation unforetold

What does a devaluation in 1986 tell us about the likelihood of another devaluation today?

Of all countries in the Gulf, Oman carries the highest risk of devaluing its currency. Last year, it ran a large current account deficit (roughly trade deficit plus remittances) of around 21% of GDP, a large budget deficit worth 12% of GDP, and it has the lowest reserves among its neighbours. History shows that devaluation is not impossible: Oman devalued its currency by 10% in 1986 when oil prices collapsed. Why did Oman devalue its currency then? And what does that tells us about the likelihood of devaluation today?

The fundamental reason behind the 1986 devaluation was that Oman’s foreign currency reserves were not sufficient. At the very least, a country should be able to back every unit of currency in circulation with US dollars to maintain the peg, similar to the gold standard. In 1985, just before the devaluation, Oman had $441 million dollars of reserves. And although there is no official money supply data going back to the 1980s, I estimate currency in circulation to have been also around $400 million in 1985. With the decline in oil prices in 1986, Oman had to use its reserves to finance its deficit, which meant that it was no longer able to provide dollar coverage for its currency in circulation and was therefore forced to devalue.

Does Oman have sufficient means today to avoid a similar devaluation?

·      Oman’s reserves today are enough to last the country for two years. Oman has $38 billion of reserves, which is more than enough to back the $13 billion of Omani Rial currency and deposits. Moreover, the remainder $25 billion of reserves could be used to finance two years of external deficits (trade plus remittances), estimated to have reached $13 billion in 2016.

·   Oman could also safely borrow from international markets to finance the deficit for an additional year given its low public debt ratio. Oman could still borrow around $13 billion while keeping its public debt ratio relatively moderate at 30-40% of GDP. The additional borrowing could finance its needs for one more year.

·    The recovery in oil prices and support from other Gulf countries could double the survival time of Oman. The recovery in oil prices, which have bottomed out in 2016, will shrink Oman’s deficits and financing needs. This means that the same amount of reserves and debt would last the country longer. More importantly, other Gulf countries are likely to step in to support Oman when needed to avoid the risk of contagion on their own currencies. Indeed, recent reports suggest that Oman was in talks with Kuwait, Qatar and Saudi Arabia to receive a multi-billion dollar deposit. And although Omani authorities subsequently denied the report, other Gulf authorities have not. Interestingly, Oman joined the Islamic Military Alliance, led by Saudi Arabia, around the same time of the alleged talks.

Reserves, the ability to raise debt, the expected recovery in oil prices and support from the rest of the Gulf mean Oman could maintain the value of its currency for the next 5-6 years. There might be issues such as questions about the illiquidity of reserves, the impact of a potential credit rating downgrade on Oman’s ability to raise debt or concerns about political transition (although these have abated lately). But all in all, a devaluation in Oman is unlikely in the medium term.

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