by Valentina Kiefer and Alexios Seibt
In recent months, the oil price has plummeted dramatically, from a relatively stable USD 110 per barrel in mid-2014, to below USD 30 per barrel in January 2016. This has had a significant impact upon the exchange rates of many oil-exporting nations. Canadian, Russian and Norwegian currencies, in particular, have been strongly affected.
One reason for the strong effect of falling oil prices on exchange rates lies in the fact that the value of oil-exporting countries’ currencies is either strongly connected to the price of oil or strongly linked to the US dollar — the main currency used to price oil. In both cases, revenues generated through oil exports play an important role in a country’s ability to buy foreign exchange currencies for trading and currency-safeguarding purposes. Consequently, falling oil prices can lead to a depreciation of a currency’s exchange rate against the US dollar.
The graph below illustrates a correlation between the price of one barrel of Brent crude oil and the exchange rates of five oil-exporting countries vis-à-vis the US dollar. The effect can be expected to be most significant in countries with freely floating exchange rates, such as Canada and Norway. Floating exchange rates are determined by supply and demand. The external value of the currency is therefore particularly relevant as it has a direct impact on the prices and volume of exported and imported goods of the respective economy. Canada, for example, has a very open and trade-dependent economy. According to the Bank of Canada, Canada’s target for inflation aims to preserve the domestic value of the Canadian dollar. Consequently, no target for its external value has been set.
The fact that Russia nevertheless has suffered from a stronger impact upon its exchange rate than Norway or Canada remains unexplained. Despite declaring a transition away from a soft euro/dollar peg in 2014 toward a floating exchange rate, the Central Bank of Russia’s chairwoman Elvira Nabiullina announced that they would “intervene in the currency market at whichever moment and amount needed to decrease the speculative demand.” Therefore, foreign exchange intervention still remains at the Central Bank’s disposal.
Thus, one may perhaps have expected the Ruble’s value to have been somewhat insulated from the plummeting oil price. There are, however, other criteria which can impact the magnitude of a commodity price fluctuation upon a currency’s value. The percentage of oil exports held in a country’s export portfolio is a major criterion when it comes to determining the extent to which a drop in price will impact exchange rates. In the case of Russia, more than 70% of all exports are directly linked to the energy sector. The energy sector therefore accounts for more than 50% of the nation’s budgetary intake. In Canada, on the other hand, oil accounts for only 25% of exports and comprises a mere 3% of the country’s GDP. The bigger the industry’s role, the stronger the effect.
Norway is also highly dependent upon the export of oil, which represents around two-thirds of total exports. But Norway has managed to accumulate enormous reserves during oil-price peaks, which may explain why it has not been so hard hit. These are funds that can be utilized to stabilize the krone. This is true for Russia as well, yet the Russian government has been forced to contend with additional economic hurdles following recent economic sanctions. It has therefore used excess finances to address budgetary issues. Since late 2015, however, there have been signs that Russia is beginning to tackle this with some success.
The fiscal consequences for those countries with fixed exchange rates are often more problematic. The situation in Venezuela is particularly troubling. In early 2013, the government devalued the Bolivar Fuerte by 32%, according to Bloomberg Business, even before oil prices began to fall dramatically, in an attempt to take some pressure off of the economy. Falling oil prices have completely undermined these efforts, and a further devaluation is now absolutely necessary. In order to regain a sound economic footing, the country would need an oil price of around USD 120 per barrel, far above current prices.
In Saudi Arabia, the Saudi riyal has maintained its fixed rate in the face of falling prices. As a result, the government is now quickly burning through its reserves and acquired a budget deficit of a staggering USD 100 billion in 2015 alone. Just before the dawn of the New Year, a massive austerity program was unveiled. According to the Financial Times, the Ministry of Finance “confirmed wide-ranging economic reforms, including plans to “privatize a range of sectors and economic activities.” The local population will be the hardest hit by “an increase in gasoline prices … and a modest change in water costs for all.”
These are but a few examples of how fixed exchange rates, implemented with a view to creating stable economic environments, can prove unsustainable and deleterious in the face of exogenous shocks. Although floating exchange rates do not provide the predictability and security of a fixed rate, they can often prove themselves to be the most sustainable in the face of extended economic crisis.