Since the ratification of the Bretton Woods Accord, in early 1944, the United States Dollar (USD) has become the world’s predominant reserve currency. It is accumulated and held in enormous amounts by Central banks across the world, and has been adopted as the universal pricing mechanism for several commodities. Oil, one of the most essential commodities, has been a strong driver of economic growth and prosperity. Oil-rich regions are often found entangled in issues concerning geopolitics, military conflict and commerce. What bridges the gap between two powerful entities, namely dollar and oil, is the Petrodollar.
Tracing the Origin of Petrodollars
Petrodollars are US dollars paid to oil-exporting countries in exchange for oil. In other words, they refer to oil revenues denominated in US dollars or ‘greenbacks’. The concept of petrodollars is prevalent in OPEC member countries, other oil-producing nations of the Middle East, Norway, Russia etc.
Since petrodollars are denominated in the U.S.’ currency, their real purchasing power relies on the core inflation rate in the States as well as the value of the US dollar. This implies that economic factors affect the value of petrodollars in a way similar to the US dollars. When the greenback falls, so do the petrodollars, thereby leading to a reduction in oil revenues.
The origins of the petrodollar system trace back to the Bretton Woods Agreement of 1944, which replaced the gold standard with the U.S. dollar as the global reserve currency. Under the conditions of this agreement, the U.S. dollar was pegged to gold, while other global currencies were pegged to the U.S. dollar. The dollar was secured to gold at a price of $35 for an ounce. However, faced with inflationary pressures, high unemployment and a potential gold run, President Nixon decided to exit the gold standard system in favour of a fiat-based monetary system, in 1971. He announced that the greenback would no longer be exchanged for gold, to boost economic growth for the U.S. Subsequently, the value of the dollar plummeted, in the wake of the ‘Nixon Shock’, hurting the oil-exporting nations whose contracts were priced in the currency.
The Oil Crisis of 1973-74
1973 witnessed the buildup of the global oil crisis. When the United States provided military aid to Israel following the Yom Kippur war, the members of OPEC increased crude oil prices by almost 70 percent and imposed an embargo on exports to the U.S. and other Israeli allies. As petroleum prices quadrupled, the world decided to streamline the structure of oil pricing. Consequently, in 1974, the United States and Saudi Arabia entered into an agreement, which laid the groundwork for the petrodollar system.
Beginning with the bilateral talks with Saudi Arabia, the United States managed to convince the former as well as other OPEC members to standardize oil prices in US dollars, the latest by 1975. Under this agreement, any country who wishes to purchase crude oil from the signatories of the agreement would be required to first exchange their domestic currency with US dollars. In reciprocity for invoicing oil in dollar denominations, Saudi Arabia and other Arab states secured U.S. influence in the Israeli-Palestinian conflict along with U.S. military assistance during an increasingly worrisome political climate, of the Soviet invasion of Afghanistan, and the Iran-Iraq War. Out of this mutually beneficial agreement, the petrodollar system was born.
Petrodollar Recycling
The petrodollar system creates a phenomenon known as ‘petrodollar surpluses’, which is defined as the US dollars earned from the sale of oil which exceeds the domestic development needs of the exporter. These excess reserves have to be ‘recycled’, and are hence spent on domestic consumption, lent abroad to meet the balance of payments deficit faced by developing nations, or invested in US dollar-denominated assets. The last recycling channel mutually benefits both parties since it channelizes the dollar back into the U.S. economy. These recycled dollars are invested in securities such as government treasury bills and bonds leading to triple benefits: higher liquidity in the financial market, lower interest rates and growth with little or negligible inflation. In addition, the OPEC countries can hedge the financial risks accompanying volatile currency conversion rates and insecure investments.
The Dollar Discord
A widely debated issue, the system of petrodollars has found both supporters and critics. While the former believes that the mechanism has brought greater stability to world trade and has restructured the oil pricing system for better, the detractors feel that it is inherently risky for the oil exporters. This is primarily because the real value of oil revenues is dependent on the value of US dollars. Any form of dollar devaluation will cause the stakeholders to lose market share. Over time, this risk has been reduced as many exporting countries have pegged the domestic currency to USD conversion rate. Countries such as Russia, China, and India are considering shifting the base value of their oil exports in their domestic currency instead of the US dollar. As the world’s largest oil importer, the People's Republic of China announced that it will soon move the crude oil prices to Yuan, in 2017.
What lies ahead?
The future holds the viability of petrodollars in a grey area. As alternative oil valuation methodologies have begun to hold ground, including the ‘Petroyuan’ and Iran’s oil contracts in Euros, a paradigm shift in the monetary system is inevitable. However, owing to the fact that the volume of petrodollars in circulation is immense, the substitute potential mechanisms will take time to grow. In an effort to counter US hegemony and the associated market risks, novel tools will be planned and implemented. The question of ‘when’ however remains.
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