Persistently low oil prices have dealt a huge blow to countries whose economies are dependent on producing and exporting oil. But there is an important knock-on effect from the economic downturn for oil producers: As a nation’s economy deteriorates, so does its currency.
Currencies from commodity exporters have had a rough year and a half, depreciating in corresponding fashion with the decline in oil prices. Brazil’s real and the South African rand are down by more than half since mid-2014, while Mexico’s peso hit record lows this year.
The latest decision from OPEC to leave production levels steady has brought about more losses in oil markets, putting deeper pressure on emerging market currencies.
The latest decision from OPEC on December 4 to leave production levels steady and to shed its production target has brought about more losses in oil markets, putting deeper pressure on emerging market currencies. Colombia’s peso fell to a record low against the dollar on December 9, for instance.
With little prospect of a rebound in oil prices anytime soon, currencies from commodity exporters will likely come under more significant stress in the near term. This trend could create the conditions for more depreciations, devaluations, depletion of foreign exchange reserves, and fluctuations in interest rates, all of which create a high level of uncertainty heading into 2016.
The good and the bad
A poor economic performance from lower commodity prices puts downward pressure on currencies in commodity-exporting countries. A weaker currency, in turn, has an array of effects on a nation’s economy. But not all are bad. For example, exports become more competitive, as foreign buyers can scoop up relatively cheaper products.
Currency declines act as a sort of “automatic stabilizer” to a wilting economy, but there are risks.
In a similar vein, a weakening currency can actually help oil producers as they often sell oil in dollars, while their costs, including labor and materials, are in the local currency. The Canadian dollar, for example, traded at parity with the U.S. dollar between 2010 and 2013, but it began depreciating in the middle of 2014, just as oil prices peaked and entered an extended period of decline. Today, one U.S. dollar is worth around CAD$1.35, the weakest exchange rate for Canada’s currency in 11 years. So while Canadian oil sands producers are hurting from low oil prices, they are cushioned by a depreciating currency—they sell oil in dollars and use their weaker domestic currency to pay their bills. In this sense, currency declines act as a sort of “automatic stabilizer” to a wilting economy.
However, there are numerous downsides to a fall in one’s currency. Imports become more expensive and inflation can rise. These trends put central bankers in a bind. On the one hand, they want to cut interest rates or keep them low in an effort to stimulate the flagging economy, but doing so could exacerbate inflation and weaken the currency further. On the flip side, raising interest rates could stop the currency from depreciating, but it could also crush the economy and deplete foreign exchange reserves. For countries facing an acute monetary crisis, such a measure sometimes becomes unavoidable.
The ruble crisis
Take Russia, for example. Plunging crude oil prices have devastated the Russian economy. The International Monetary Fund (IMF) predicts that the Russian economy will contract by 3.8 percent in 2015. Oil accounts for half of government revenues and over two-thirds of Russia’s exports. The U.S. and the EU slapped sanctions on Russia in 2014 following the violence in Ukraine, but it wasn’t until crude prices collapsed in the second half of the year that Russia’s economy felt pain. The ruble suffered a rapid loss in value, culminating in a brief currency crisis late last year following OPEC’s now infamous November 2014 decision not to alter production despite falling prices.
The Russian central bank responded in dramatic fashion, raising interest rates to 17 percent in order to halt the currency’s decline. The move choked the economy, but succeeded in its goal—the ruble regained ground in the following months. The central bank eventually eased off, lowering interest rates in successive moves as the currency stabilized.
When oil prices went through a second downturn in late August 2015, the ruble slid again. The same thing is happening now—under renewed pressure following the latest result from Vienna in which OPEC failed to take efforts to stabilize prices, the ruble is again closing in on record lows, losing about 7 percent of its value over the past month. The Bank of Russia is back in the same conundrum of whether to raise interest rates.
The dilemma of fixed exchange rates
While many nations see their currencies depreciate as their economies flounder, those with fixed exchange rates by definition do not experience such sharp depreciation. But that doesn’t mean they aren’t affected.
While many nations see their currencies depreciate as their economies flounder, those with fixed exchange rates by definition do not experience such sharp depreciation. But that does not mean they are unaffected.
Saudi Arabia offers an instructive case. Low oil prices have led to a ballooning fiscal deficit, which the IMF estimates could reach 20 percent of GDP this year. To address the problem, Saudi Arabia has options, but it also has competing objectives. On the oil market side, it could cut production to boost prices, but it has not shown a willingness to go this route yet.
OPEC’s most important oil producer also maintains a fixed exchange rate of 3.75 riyals to the dollar, a level that has not changed years. It wants to keep this intact, but this has brought about several problems, which include the aforementioned deficit and the depletion of foreign exchange reserves. To address the deficit, it could undertake austerity measures, but with an eye on social stability, the government does not want to cut too deeply.
Saudi Arabia has a massive war chest of cash reserves, but Riyadh is burning through them quickly as it defends its exchange rate. The IMF says that Saudi Arabia likely had about $654 billion as of September 2015, sharply down from a peak of $737 billion a year earlier. It could survive several years of low oil prices by drawing down on these reserves, but the government surely does not want to squander its reserve base entirely.
With adjusting oil production levels off the table and fiscal austerity not a solution to declining foreign exchange, Riyadh is faced with two options: staying the course and hoping for a rebound in oil prices, or a currency devaluation. A devaluation could boost exports and cut down on the fiscal deficit, but that could create the impression that the government is losing control of the economy. For the Saudi government, political stability is paramount. Against this backdrop, a stay-the-course strategy is likely for now.
An untenable situation
There are several other countries in a similar predicament as Saudi Arabia, except without the colossal foreign exchange reserves.
The Nigerian central bank has come under pressure to devalue its fixed exchange rate. Nigeria did so at the end of 2014 as oil prices declined, but the West African producer has thus far tried to defend its new fixed rate through capital controls. Although the intervention has been successful at maintaining the fixed exchange rate, it has led to a shortage of dollars, which has dragged down the economy. The IMF is pressing Nigeria to devalue its fixed exchange rate.
Venezuela is arguably in the worst situation, with depleting cash reserves, an economy in freefall, and shortages of basic consumer goods. Venezuela ostensibly maintains a fixed exchange rate, but in reality, the black market exchange rate for the bolivar is vastly weaker. The currency has already depreciated significantly, and the government has few short-term options. This situation could lead to a continuing deterioration of the economy, perhaps ending in a debt default.
Low prices to continue to hammer currencies
For most producers, 2015 is a year to forget. With so much oil still flowing around the world, 2016 may not be better.
OPEC ruled out a cut in its production target for the foreseeable future, likely keeping oil prices to sub-$50 per barrel territory for the foreseeable future. This environment will continue to hammer countries that depend on oil exports. Oil-producing countries with flexible exchange rates will continue to experience downward pressure on their currencies, while those with fixed-exchange rates may try to withstand the turmoil, but could ultimately be forced to abandon their pegs.
Compounding the uncertainty for oil-producing currencies is the widely expected move by the U.S. Federal Reserve to raise interest rates in mid-December. A small rate hike will strengthen the dollar, to the detriment of emerging market currencies. What’s more, a rate increase could also slightly push down oil prices.
The move won’t be a catastrophe, but it could further undercut the currencies of oil exporters. For most, 2015 is a year to forget. With so much oil still flowing around the world, 2016 may not be better.