Petrodollar

Petrodollar Meaning

The meaning of petrodollar is that it is the dollar spent to purchase oil from OPEC countries. It is not any special kind of currency, it is United States Dollars which is fixed as a paying currency for the purchase of Oil from OPEC countries

  • Earlier US Dollars were backed with Gold. So it means that if someone gives back US Dollars to the Central Bank then it will have to give back gold, worth of that dollar. The United Kingdom in the middle of the 19th century started taking Gold from the US Government in exchange for their US currency reserve. This inculcated fear in the mind of the US Government as they thought that their Gold Reserve may deplete.
  • So in 1971, they stopped backing Dollar with Gold. So now to stop other countries from losing faith in US Dollar as it was no more backed with gold, they entered into a contract with Saudi Arabia that they should only sell oil in exchange for US Dollars. Slowly other OPEC countries started following the same and oil was only traded in US Dollars. This led US dollars to become a global currency as oil is the most important commodity in the world.

Petro Dollar

How Does Petrodollar Work?

OPEC countries have set the US Dollar as the base currency for their oil trade. So any country that wants to buy oil from OPEC countries will have to pay in US dollars. Say, India wants to import oil from Saudi Arabia. Saudi Arabia will not accept payment in INR, so India will have to convert INR into the US Dollars and then pay for the oil.

Example of Petrodollars

If Australia wants to sign a deal with any OPEC country to import oil, then it should buy US dollar currency futures in order to save itself in case the US dollar rises. So Australia will have to make payments in USD, for which it will have to convert the Australian dollar to the US dollar.

If Dollar appreciates, then the cost of import will also appreciate. So each country buys USD futures to safeguard from currency fluctuation which in turn increases the value of USD even further.

Purpose of Petrodollars

The petrodollar has helped the United States to make its currency USD as the Global currency.

  • USD demand will not fall as any country that wants to buy oil will have to convert their domestic currency into USD and then do the trade.
  • OPEC countries have agreed for the petrodollar because they feel that the US Dollar is a stable currency and it will help them to preserve their wealth.
  • If US Dollar currency depreciates then oil revenue also decreases, so for this reason many OPEC countries have pegged their domestic currency with the US Dollar. It means if the dollar depreciates, then prices of their domestic goods will also fall and their purchasing power will not fall.

Advantages

The petrodollar has helped USD to become the world’s reserve currency.

For years dollar is being used as a base currency for petroleum trade.  This has helped Dollar to strengthen its position in the world market. The petrodollar has helped the US to maintain the stability of its currency.

Disadvantage

The petrodollar has increased demand for US Dollars in the world market. When the demand for domestic currency increases in the foreign market, the currency tends to appreciate it. When a currency appreciates, the domestic goods become costly to the outer world, so export falls and it results in the current account deficit.

If the current account deficit is not leveled by capital account surplus, then slowly the reserve gets used up which will affect the economy.

Petrodollars Recycling

As OPEC countries are accepting payments in US Dollar, so the reserve of US Dollars in OPEC countries is increasing heavily. If the Dollar doesn’t come back to the US then there will be liquidity issue and interest rates may rise. OPEC countries know that their primary income is from oil. So their income is concentrated on a single source.

To avoid this situation, OPEC countries are investing US Dollars back in the United States in Bonds, treasury bills, and other securities.  So Dollar is getting recycled. This petrodollar recycling is helping OPEC countries to diversify their source of income.

The recycling of petrodollar back to the US is helping the United States to regain liquidity.

Petrodollar Collapse

Many countries are signing new deals with OPEC countries in their own currency. China is the largest importer of Oil and it signed a deal with Saudi Arabia in Yuan. So, if slowly all countries start to sign new deals in their domestic currency, then USD will no longer be the world’s Reserve currency and its demand will fall and currency will depreciate.

Depreciation of the USD will have a serious effect on the world economy as many HNI’s wealth will deplete to a great extent. Slowly the petrodollar is collapsing and it will have a serious effect in the US economy.

Conclusion

The petrodollar has helped USD to be the world’s reserve currency for many years. Slowly it is changing and we are also shifting away from non-renewable energy to renewable energy. In future Oil will no longer be the most consumed commodity. Once petrodollar collapses, it will be really difficult for the United States to maintain its economy as a supreme one.

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