Petrodollar refers to the US dollar, which is the fixed payment currency for the purchase of oil from most oil-exporting countries. For example, a nation can buy oil from Saudi Arabia only in dollars. Therefore, it would have to convert its currency into the US dollar to materialize the purchase.
Having USD as the standard unit of exchange allows stability and uniformity in the system. In addition, using petrodollar recycling, OPEC (Organization of the Petroleum Exporting Countries) members utilize their oil export surplus for domestic economic growth.
- Petrodollar refers to the US dollar, the base currency to export oil in the OECD members and many other oil exporting countries. The system came into being in the 1970s as a result of the Saudi-US agreement.
- Any country looking to import oil from OPEC countries needs to convert its currency into the US dollar to pay for the oil.
- Petrodollar recycling is the method of reinvesting the US dollars received as the payment of oil exports into the US economy. Exporters recycle the petrodollar by investing in US bonds and securities, allowing liquidity in the US. It also helps oil exporters with domestic economic development and foreign investments.
- By pegging their export denomination to the dollar, oil exporters face the heat from fluctuations in the dollar values. If the US dollar depreciates, it reduces their revenue.
The Petrodollar Explained
OPEC countries use the US Dollar as the base currency for oil trade as part of the petrodollar system. Any country that wants to buy oil from them will have to pay in US dollars and no other currency. For example, if Australia is buying oil, it will convert its currency to USD to make payments. It should also buy US dollar currency futures to save itself if the USD rises.
The purpose of the petrodollar can be traced back to its history. In 1944, the gold standard returned to stabilize the economies post wars. It led nations to peg their currency to the US dollar, fixed to gold at $35 an ounce. Countries could redeem dollars for gold. Resultantly, the US’s current account deficit rose, and so did the fear of their gold reserve depleting.
The year 1971 ended the dollar’s gold convertibility. Following political dilemmas, skyrocketing crude oil prices, and no gold backing, the petrodollar agreement emerged as a solution in 1973. Initially, Saudi Arabia agreed to sell oil oily in exchange for the US Dollar. The confidence in USD as an overall stable currency nudged other OPEC members to follow suit. While it gave security to the currencies, the USD became the global currency.
Petrodollar recycling and other advantages
Let us take you through some advantages that have made this system survive for so long.
- It allowed uniformity and stability in the exchange process. Many OPEC countries agreed to the petrodollar system because they considered the US dollar as a stable currency. It convinced them that their wealth would remain preserved against currency and market fluctuations.
- As for the US, it was believed that the dollar’s demand would stay integral due to its central place in oil agreements as oil is amongst the world’s most traded commodities. Even today, the USD is the global reserve currency.
- Moreover, when OPEC countries accept payments in US dollars, it heavily increases the reserve of USDs in these countries. Over the years, many of these countries had amassed heavy export surplus in dollars. If the dollar hadn’t gone back to the US somehow, it would have caused liquidityLiquidityLiquidity shows the ease of converting the assets or the securities of the company into the cash. Liquidity is the ability of the firm to pay off the current liabilities with the current assets it possesses. issues in the state. To avert this, OPEC countries invest their dollar reserve in US bonds, treasury billsTreasury BillsTreasury Bills or a T-Bill controls temporary liquidity fluctuations. The Central Bank is responsible for issuing the same on behalf of the government. It is given at its redemption price and a discounted rate and is repaid when it reaches maturity., and other securities using international channels. The process results in dollars getting recycled, which is referred to as petrodollar recycling.
- Recycled petrodollars contribute a great deal to the US securities investments. In 2007, around 12 oil exporting nations in the Middle East and Africa held 3.2% of outstanding U.S. Treasuries. This excluded the Federal department’s own holdings. The countries’ collective stash was over $500 billion in 2016.
- Apart from allowing liquidity in the US, recycled petrodollars help restrict oil exporters’ reliability on crude oil as their prime source of revenue. They utilize their dollar reserves for domestic consumption.
- Oil exporters also use their reserves for foreign investments to diversify their revenuesRevenuesRevenue is the amount of money that a business can earn in its normal course of business by selling its goods and services. In the case of the federal government, it refers to the total amount of income generated from taxes, which remains unfiltered from any deductions.. The IMF had estimated that in 2007, UAE’s sovereign wealth funds were between $250-$875 billion.
Will Petrodollar Limitations Fuel its Collapse?
Critiques have argued that petrodollar limitations may threaten its dominance and pave the way for its collapse someday. Some crucial limitations are as follows.
- The petrodollar has increased the demand for US dollars in the world market. When the demand for a domestic currency increases in the foreign market, its value appreciates. This makes the country’s domestic goods costly, resulting in falling exports and a high current account deficit.
- Moreover, many oil exporters are running a current account deficit, making them invest less in US bonds and more domestically. It furthers challenges the inflow of money to the US. If the current account deficit is not leveled up by surplus, then the reserve gets used up, which will affect the economy.
- Also, many oil exporters have pegged their domestic currency to the US dollar as when the USD depreciates, it reduced their revenue. With fewer earningsEarningsEarnings are usually defined as the net income of the company obtained after reducing the cost of sales, operating expenses, interest, and taxes from all the sales revenue for a specific time period. In the case of an individual, it comprises wages or salaries or other payments., their domestic consumption becomes expensive. By pegging their currency to the USD, their domestic costs also fall with the USD depreciation.
- Another issue with petrodollars is the trade barriers. American banks are involved in US dollar transactions, which puts the transacting entities to US jurisdictions. Some experts suggest that many countries feel uneasy with the idea as it allows US jurisdiction when the trade has nothing to do with the country. Sometimes it puts a country under a political dilemma when it trades with an oil exporter under US sanctions. It fears straining its relationship with the US.
- As such, a few countries have tried to find alternative arrangements for oil exports. There have been reports that China is planning to import oil in its own currency of yuan or petro-yuan and not the US dollar. In 2017, China overtook the US as the largest importer of oil. If China shifts to non-dollar oil imports, it could threaten the dominance of the US dollar.
- Lastly, excessive oil consumption pollutes the environment. It also indicates a reliance on a non-renewable resource. There has been a push towards finding renewable resources and sustainable consumption to arrest climate change. If oil consumption falls, petrodollar reserves will fall, and the US may risk losing oil exporters’ massive investments.
However, the US dollar is still at the center of most oil trades, experts say. Alternative mechanisms may take several years to threaten USD’s dominance as the country continues to be amongst an ever-growing economy. Its position could be challenged if the oil trade comes to an end. Although, many think that it isn’t happening anytime soon.
A few countries have opted out of the petrodollar system and have looked at alternate currencies. However, most players still export petroleum products in the US dollar, keeping it at the center of many crucial trade deals.
Petrodollar refers to the US dollar which is the fixed payment currency for the purchase of oil from the exporting countries.
Nations, as part of the petrodollar agreement, export oil only in US dollars. If the system collapses, they may panic against the fall of years of stability. Alternative mechanisms like petro-yuan may gain immensely by taking the place of the USD.
The USD may depreciate with the country facing heavy liquidity woes, a fall in securities investments, current account deficit, and high-interest rates.
This has been a guide to what is Petrodollar and its meaning. Here we discuss its working, recycling, and collapse of the petrodollar along with examples. You can learn more from the following articles –