Following the downfall of the gold standard (Bretton Woods) during the early 1970s, a deal was entered into by the United States of America and Saudi Arabia for the purpose of standardizing oil prices in terms of U.S. dollars. This deal gave birth to the petrodollar system and a paradigm shift from gold-backed currencies and pegged exchange rates to non-backed and floating rate regimes.
The petrodollar system was instrumental in elevating the U.S. dollar as the reserve currency of the world. As a result of this, the United States of America enjoys trade deficits on a continuous basis and global economic supremacy. The system also ensures the financial markets in the United States with liquidity and inflow of foreign capital through petrodollar recycling. However, when discussing the impact of petrodollars on the greenback calls for a clear understanding of the petrodollar’s history.
Petrodollar – History In Brief
When the United States was faced with the accrual of debt because of the Vietnam War, mounting inflation, excessive domestic spending habits, and a persisting balance of payment deficit, the Nixon administration suddenly decided to terminate the U.S. dollar’s convertibility into gold. Following this shocking decision, the gold-era came to an end and the U.S. started falling freely amidst zooming inflation. This prompted the U.S. to enter into several carefully drafted bilateral deals with the Kingdom of Saudi Arabia starting from 1974 for promoting commercial and political relationships, marketing of goods and services imported from the U.S., and recycling of Saudi petrodollars.
The economic cooperation and petrodollar recycling framework helped the United States influence Saudi Arabia in persuading other OPEC (Organization of the Petroleum Exporting Countries) members also to sell oil in exchange for the U.S. dollar. Saudi Arabia along with the other Arab nations secured America’s influence and military assistance in return for raising invoices in dollar denomination for oil to deal with the Palestinian-Israeli conflict during a period of extreme political turmoil with the Soviet Union invading Afghanistan, the Iranian Shah falling, and a war erupting between Iran and Iraq. It is this mutually beneficial agreement that led to the development of the petrodollar system.
Petrodollar System – What Are the Benefits
The most sought-after commodity by people around the world is oil. As this commodity was denominated in U.S. dollars, the greenback rose to the status of a global currency. In fact, the triennial survey carried out by the International Settlements Bank showed that 88 percent of the foreign exchange transactions that were initiated in the month of April 2016 involved the U.S. dollar on one side. This status enables the greenback to enjoy the privilege of continuously financing the country’s current account deficit through the issue of dollar-denominated assets at extremely low rates of interest.
However, countries holding a vast amount of U.S. debt such as China have been very vocal in the past about their concerns related to the dilutive effects caused to the assets they hold in event of the depreciation of the U.S. dollar. However, the privilege of persistently running current account deficits comes at a cost to the United States. America is obligated to running the current account deficits and fulfilling the reserve requirements in a global economy that is ever expanding. If the United States of America stops running the deficits, the resulting liquidity crunch could cause the whole world to experience economic contraction. On the other hand, if the deficits continue to persist indefinitely, other countries will start doubting the U.S. dollar’s valuation. This could lead to the greenback losing its importance as the reserve currency.
Petrodollar Recycling
The petrodollar system could also lead to the creation of surplus U.S. dollar reserves with the oil-producing countries. It is of utmost importance that these reserves are recycled. These surplus reserves of U.S. dollars available with these countries will be diverted to support domestic consumption, advancing loans to the developing nations to meet the balance of payments obligations of oil-producing nations, or invested in assets that are denominated in U.S. dollars. Investing in assets denominated in U.S. dollars benefits the United States a great deal. This is because it helps the petrodollars to get back to America. The recycled dollars can then be used for buying U.S. securities, for example, Treasury bills, and this contributes to improving the liquidity in the financial markets, keeping the interest rates at lower levels, and promoting non-inflationary growth. This, in turn, helps the OPEC countries in avoiding conversion risks and investing in secure U.S. assets.
In recent times, some concern was raised because of the talk about shifting petrodollars to currencies like the Chinese Yuan. The worry is justified and there are some merits to the concern. This is because the landscape of the energy market is changing globally and is pointing towards a de-facto end to the agreement between the United States and the Kingdom of Saudi Arabia. According to experts, the United States is turning into one of the major exporters of energy for the very first time ever since the 1960s. This change in the energy market landscape clubbed with the strength of the U.S. energy sector is expected to lead to a smooth transition from the petrodollars. This is because energy exports would divert Saudi capital inflows from treasury purchases and contribute to an increase in global demand for the U.S. dollars, which is rooted in energy requirements. Another advantage that the United States would enjoy is increased domestic energy security. This is the main reason why the United States signed a petrodollar agreement with Saudi in 1973.
However, this transition is not expected to happen overnight as a reduction in recycled petrodollars could drastically impact the liquidity of the capital markets in the United States. This, in turn, would increase the borrowing costs of companies, consumers, and governments because of a scarcity of money.
Final Thoughts
The world changed over from the gold standards because of the emergence of the after the 1970s. The circulation of the petrodollars helped elevate the status of the greenback as the reserve currency. The petrodollar system which facilitates petrodollar recycling has increased the liquidity in the financial markets.