The Saudi riyal fell sharply against the US dollar in the forward foreign exchange market early on Monday after relations between Saudi Arabia and Iran deteriorated, raising concern that dollar funding for the kingdom could become more expensive.

Saudi Arabia cut diplomatic ties with Iran on Sunday in response to the storming of its embassy in Tehran. The diplomatic row between the two major oil producers escalated following Riyadh's execution of a prominent Shi'ite cleric on Saturday.

One-year dollar/Saudi riyal forwards jumped to 680 points, near a 16-year high, from a close of 425 points on Thursday.

The riyal has little scope to move in the spot foreign exchange market because of its peg of 3.75 to the dollar, so banks use the forwards market to hedge against risks.

In the last few months, the riyal dropped in the forwards market to its lowest level since 1999 because of fears that huge Saudi budget deficits due to low oil prices might eventually force Riyadh to abandon the currency peg.

An austerity budget for 2016 which Riyadh announced last week appeared to partly ease such fears, but geopolitical tensions may now increase them.

Iran and Saudi Arabia have had tense relations for many years without direct, major conflict, and the breaking of diplomatic ties will not necessarily have a direct impact on their economies, which have minimal trade and investment ties.

But geopolitics could make foreign banks and investors more wary of funding Saudi Arabia, at a time when Riyadh is considering borrowing abroad to ease the pressure of funding its fiscal deficit on the domestic banking system.

"One-year forwards will likely touch 800 points levels this week, depending on the level of escalation of the events between Saudi and Iran," a senior bank trader from the region said, declining to be named because of political sensitivities. - Reuters