Petrodollar Revisited

Adit Jain

Contrary to previous expectations of a quick resolution, the war in Ukraine has dragged on. Going forward, there are really two possibilities. First, an agreement is reached between President Vladimir Putin and his Ukrainian counterpart, which accepts the limits of Nato as being the boundaries of Ukraine. Second, the war leads to further chaos, dragging European Union member states into the conflict, risking a global surge. Regardless of how this saga ends, one thing is certain – it will change the liberal world order. The decades ahead will be highly polarised with tensions between the alliance of western democracies on the one hand and the authoritarian regimes of Russia and China on the other. Other countries may be forced to make difficult choices. What form the new order will take, is difficult to predict but it will, most likely, affect strategic alliances, global trade and investment and perhaps even financial markets.

One outcome in the longer term would be an impact on the dollar. Since the 1970s, the United States dollar has been the dominant global currency and the principal medium of exchange between nation states. This is largely on account of a surge in global demand for the greenback, caused by the introduction of the petrodollar. Now, over 70% of dollars in circulation remain outside the United States. It all began when oil was priced in dollars by Saudi Arabia, on the persistence of the Nixon administration in exchange for security guarantees, and followed quickly by other petroleum producing states.

Since the 1970s, the US dollar has been the principal medium of exchange between nation states. This is largely on account of the demand for the greenback caused by the introduction of the 'petrodollar'.

The global demand for dollars has ensured its overriding position and enabled America to finance its deficits cheaply. Most oil producing countries run large trade surpluses, investing their savings in US Treasury. Consequently, American administrations and households have been able to borrow cheaply. But this is not a one-way street. In exchange, the United States has, over the last several decades, provided security guarantees to other nation states and maintained a liberal world order that allowed free-trade, investment and consequently prosperity to spread across the world.

Over the years, analysts have argued that other currencies would begin to pose a challenge to the dollar’s dominance. Initially the euro was considered a strong possibility but that never really materialised. Recently, cryptocurrencies have attracted investor interest and, some would argue, may eventually pose a threat. However, many of them come with inherent problems and are not likely to replace the dollar in a hurry, or ever. The most important reason for this is that there are simply not enough of the alternatives in wide circulation, to provide a seamless medium of exchange for trade and investment. But now things appear to be changing with the Chinese yuan emerging as a candidate.

For instance, whilst Saudi Arabia previously dealt exclusively in dollars for its oil, it has more recently been in talks to trade in yuan. This will be a difficult step to take. Gulf monarchies are used to getting subsides and payments in dollars and splurge on assets overseas. The issue is – will the yuan be seen as a safe currency for them to still be able to do so?

China is trying very hard to maintain stability in its yuan but it is far from a reserve currency, let alone a transparent one. If Saudi Arabia were to go through with its decision, it would constitute a significant step away from historical allegiances. But, the wheels of change are in motion and Covid and Ukraine have just brought that timeline closer to provide an alternative to the petrodollar.

In the longer term, as more countries begin to accept an alternative mechanism to price oil and other traded goods, it will get harder for the dollar to maintain its dominance.

Following Russia's invasion of Ukraine and the imposition of sanctions, Russian banks have been pushed out of the Swift system making it impossible for them to buy and sell dollars in exchange for their commodities. Russia could theoretically barter its oil with China through a rouble-yuan mechanism, avoiding the dollar as the medium of exchange. In any case, China, which considers itself an economic and military super-power, is preparing its own version of Swift although it has failed to take-off as yet. For now, China appears to be treading cautiously as it values stability above everything else. A switch away from the dollar would be perceived as an open challenge to the supremacy of the United States and its currency, risking the imposition of sanctions. But in the longer term, as more countries begin to accept an alternative mechanism to price oil and other traded goods, it will get harder for the dollar to maintain its dominance.

The pace of change, in the final count, depends on the determination of three countries – China, Russia and Saudi Arabia. Russia, burdened with sanctions, is practically at war with America. It is pushed against a wall and left with, what it considers, few good options. The Saudis feel mis-treated by the Biden Administration, which has been unwilling to support their war in Yemen and has reduced the diplomatic importance of Riyadh. Finally, China believes its time has come to remerge, after two centuries of being in the shadows, as the dominant global power and occupy its rightful stature as the Middle-Kingdom – a place defined as being between the Heavens and earth. Whilst it is unlikely that all three will come together in a hurry to create an alternative mechanism that replaces the petrodollar, it is for the first time in decades that serious thought is being applied to this matter.

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Adit Jain, Editor