Are We Seeing the Collapse of the Petrodollar System?
What are Petrodollars?
Petrodollars are the U.S. dollars earned from the sale of oil, or simply put, the oil revenues denominated in U.S. dollars (Chen, 2022).
Petrodollars are the primary source of revenue for many OPEC members and other oil exporters. The Petrodollar came to prominence during the oil crisis of the 1970s and regained attention in the early part of the 2000s. The petrodollar system creates surpluses, which lead to large U.S. dollar reserves for oil exporters, which need to be recycled, meaning they can be channelled into domestic consumption and investment, used to lend to other countries, or be invested back in the United States.
History of the Petrodollar System:
The petrodollar emerged as a concept in the 1970s, as burgeoning U.S. imports, of increasingly costly crude oil, increased the dollar holdings of foreign producers. The origins of the petrodollar system go as far back as the Bretton Woods Agreement, which saw the replacement of the gold standard with the U.S. dollar as the reserve currency. Under the agreement, the U.S. dollar was pegged to gold, while other global currencies were pegged to the U.S. dollar. But because of massive stagflation, President Nixon announced in 1971 that the greenback would no longer be exchanged for gold to boost economic growth for the U.S.
That led to the creation of the petrodollar system, where the U.S. and Saudi Arabia agreed to set oil prices in U.S. dollars. That meant any other country that purchased oil from the Saudi government would have to exchange its currency for U.S. dollars before completing the sale. In 1974 the basic framework agreed upon was strikingly simple, the U.S. would “buy oil from Saudi Arabia and provide the kingdom military aid and equipment. In return, the Saudis would plough billions of their petrodollar revenue back into (American) Treasuries” as stipulated in a Bloomberg article (Wong,2016). That led the remaining OPEC countries to follow suit and price their oil in U.S. currency. This is evidenced as in 1974, 20% of global oil was still being transacted in the British pound, but that number fell to only 6% by 1976. Whilst in 1975, Saudi imports of U.S. military equipment had risen from $300 million to more than $5 billion.
Advantages and Disadvantages of the Petrodollar
The petrodollar greatly helped to elevate the U.S. dollar's standing in the financial markets, as the price of the most important commodity in the world, oil, was linked to the dollar. This has partly aided the dollar in being the world's most dominant currency, which allows the dollar to continuously finance its account deficit by issuing dollar-denominated assets at very low rates. This has also allowed the U.S. to wield significant control economically over the globe. Furthermore, for the US it means an inflow of foreign capital through petrodollar recycling.
Petrodollar recycling means that oil-producing countries end up with surpluses of US currency that need to be “recycled” back into the economy. Petrodollar recycling can involve channelling these dollars back into their own domestic economies or investing them in the US economy as stipulated by Tony Robbins.
On the downside, however, the U.S. is the world's reserve currency. Meaning it has to run account deficits to fulfil reserve requirements in a global economy that is continuously expanding. If these deficits were stopped then the lack of liquidity would lead to an economic decline. Despite this, if these deficits continue, then other countries will lose faith in the dollar, possibly leading it to lose its status as the world's reserve currency. This is known as the Triffin Dilemma.
The petrodollar system also created significant stress on Russia (formerly USSR), which was now faced with an increasingly dollarized world market, where the U.S. could print money to buy oil, but it had to dig oil out of the ground. Only heightening tension between the two hegemons.
Emerging markets, such as Mexico, created swathes of dollar-denominated debt that these countries found difficult to repay, in a system that caught them in a web that prioritised dollar accumulation over domestic investment.
Countries' need for US dollars exposes them to US sanctions, this is seen by many, as threatening. This is because of the political clout and authority it equips the US with, meaning anyone who thinks or behaves in a way that the US deems as wrong can be subject to expulsion from SWIFT, just ask Venezuela, Iran or Russia. Hence why, Luke Gromen calls the petrodollar system a “company town,” (Gromen, 2020) one in which the US asserts its dominance through coercion and violence.
Lastly, one of the most significant consequences of the petrodollar system is the steady growth of the oil and fossil fuels industries at the expense of nuclear power and regional energy independence.
The Collapse of the Petrodollar System?
The Journal of International Economics in a 2020 study, discussed four potential future monetary outcomes for the world: continued dollar hegemony, competing monetary blocs and an international monetary federation (where at the top of the international hierarchy stands an organisation like the IMF and their special drawing right, SDR).
With the decline in the purchasing power of the US dollar, some nations have developed a new narrative surrounding the benefits of the petrodollar system. Countries like China, Iran, Russia, Saudi Arabia, and India have considered shifting the base value of their exports to their own currency rather than the U.S. dollar. This would be a move towards the monetary outcome of competing for monetary blocs.
Strikingly, the recent geopolitical events in Ukraine have evidenced an increasingly likely end to the US monopoly in global affairs. As a consequence of the development of a more assertive Eurasian hegemony between Russia and China. Is the end of Fukuyama’s ‘End of History’ (1989) (an assertion by Fukuyama of the universalisation of western liberal democracy) insight? In 2015, 90% of Russo-China bilateral transactions were conducted in dollars (D'Antona Jr, 2020). By Q1 2020, 46% of their bilateral transactions were conducted in dollars.
Notably, Russia’s central bank also revealed that it had slashed its dollar holdings by $101 billion, with the yuan increasing its share of Russia’s foreign exchange reserves jump from 5% to 15%. This de-dollarization has resulted in a de-facto alliance. Evidenced in June 2019 by Xi and Putin’s decision to conduct all transactions between the nations in their native currencies. Moreover, as China seeks to purchase its oil in yuan rather than dollars, it is rumoured that they may have found another seller in Saudi Arabia. This is on the backdrop of an increasingly frayed Saudi-US relationship. The reality of Saudi Arabia’s oil for yuan bid may not fructify in the near future, as Saudi Arabia pegs its riyal to the dollar, meaning any blow felt by Saudi’s move towards the yuan will inadvertently hurt its own currency. However, the talks between the two nations, highlight growing momentum for de-dollarization.
The de-dollarization is truly in full swing as western sanctions on Moscow spur trade deals that exclude the use of the dollar. In March, several Chinese firms used yuan to purchase Russian coal, which will begin arriving this month. Furthermore, Russian oil purchased in yuan will arrive at Chinese refineries in May. Aleksandar Tomic (2022) has stipulated that “countries’ need for dollars exposes them to the US financial sector… and gives the US political leverage.” Consequently, other nations see this as a warning to reduce their reliance on the dollar. Evidence of this is most glaring with India’s exploration of reinstating the cold-war era rupee-rouble ledger. Despite India’s interest in this, one of the biggest stumbling blocks to the implementation of the rupee-rouble ledger would be how to decide upon a rate of exchange against the Russian rouble that has been so volatile since the beginning of the war. It is not viable to peg the rouble and the rupee, even against a third currency. Secondly, despite India remaining neutral, the extent to which India will be willing to engage with Russia before the US objects remain to be seen.
I would like to posit another potential monetary outcome. Despite the evidence of the development of a competing monetary bloc. The fall of the petrodollar system may not be attributed to China’s Yuan or Russia’s Rouble, or any other currencies issued by nation-states. Rather, Bitcoin’s rise may end the dollar dominance as we know it. Satoshi Nakamoto, Bitcoin’s inventor, defined the cryptocurrency as a “peer-to-peer version of electronic cash” that allows “online payments to be sent directly from one party to another without going through a financial institution.” The economic independence promised by Bitcoin makes it attractive as a store of value, this is helped by the growing inflationary pressures on fiat currencies that are not proving to be transitory. As bitcoin’s value goes up against fiat currencies, more and more corporations and individuals will begin to accumulate, evidenced by companies such as Tesla who are accumulating Bitcoin (holding now over 43,000 bitcoin), potentially leading to the eventual adoption by nations and governments.
However, one of the main constraints of Bitcoin as a reserve currency, is that countries will be unable to finance their wars and welfare states unlike with the inflationary monetary tools fiat currencies provide. In addition, there are those who say that governments may also be unwilling to relinquish the power and dominance that fiat currencies provide them. Under the Bitcoin standard, everyone would play by the same rules. No government or alliance of governments can manipulate the monetary policy. However, game theory suggests bitcoin adoption may happen. As the world hegemons will seek to assume leadership roles in this new industry, which is the fastest-growing technology the world has seen, as macroeconomist Raoul Pal stipulates that the industry is growing at 137% a year, whilst the Internet was at 76% at this same stage. The result of this will mean the world's biggest players will fear smaller powers assuming powers and dominance of such a disruptive currency, that also cannot be banned. Leading to a proliferation in the adoption of bitcoin.
Increasingly bullish sentiment for bitcoin as a reserve currency is best characterised by Credit Suisse (the Swiss global investment bank) who recently released a report predicting a radical change to the world’s monetary system. Given the soaring inflation in the west and Russo-Ukraine geopolitical tension, a “new monetary order” could emerge, in which Bitcoin could be a beneficiary.
There are several trends to consider when debating the future of the petrodollar system. Firstly, concerns about global warming and a move toward more sustainable energy are reducing the demand for oil. Secondly, the US’ continuation of running deficits is only leading to a loss of faith in the system, and this is coupled with the increasingly likely end to the unipolar system, with the World’s multipolar drift now becoming inevitable. With these factors in mind, a new monetary system that moves away from the petrodollar and all of its costly externalities could be around the corner.
However, moving away from the dollar has very high barriers to exit. The world relies on the U.S. dollar and U.S. treasuries, giving America unparalleled and outsized economic dominance. Nearly 90% of international currency transactions are in dollars, 60% of foreign exchange reserves, even though the U.S. only accounts for around 20% of global GDP. As result, sanctions as harsh as banning Russia from the swift system have been a catalyst in the acceleration of de-globalisation. Yet, the biggest takeaway should be that the U.S.’s hegemony and ability to stop other nations from pricing oil in their own currencies have eroded, and threats to the petrodollar system are rising.