It’s hard to figure out the state of the dollar these days.
On one hand it is strengthening so quickly that it threatens to hurt exports, and there is even talk of a bubble.
The market is so hungry for the safety and liquidity of Treasuries that interest rates are being crushed to almost nothing.
Ironically, this is also the problem.Interest rates are so low that foreign investors in oil exporting countries are no longer recycling their profits into dollars. Hence, the petrodollar machine has largely stopped.
First of all, what is the petrodollar?
The essence of the deal was that the U.S. would agree to military sales and defense of Saudi Arabia in return for all oil trade being denominated in U.S. dollars.
As a result of this agreement, the dollar then became the only medium in which energy exchange could be transacted. This underpinned its reserve currency status through the need for foreign governments to hold dollars; recirculated the dollar costs of oil back into the U.S. financial system and — crucially — made the dollar effectively convertible into barrels of oil. The dollar was moved from a gold standard onto a crude oil standard.
One of the main things undermining the petrodollar is perpetually low interest rates by the Federal Reserve, used to prop up the financial and housing markets.
But what may ultimately be seen to have proved fateful to the petrodollar system has been the policy of zero interest rate policy and “quantitative easing” pursued so unrestrainedly since 2008. Effectively, energy producers saw that the U.S. economy had now become so dependent on low interest rates that it could never again manage to keep oil prices steady relative to U.S. treasuries without blowing up the global financial system.
There are two other underlying reasons for the halt in the petrodollar machine.
One is the drop in oil prices has caused there to be fewer profits from oil exporting to recycle. But then the petrodollar machine stopped before the oil price dropped.
The other reason has been a series of calculated moves by political rivals, and this is more serious and will have a lasting impact.
For example, Iran has ditched the dollar in all of its foreign trade.
Iran will now be using its own currency and foreign currencies with all of its trade. It’s interesting that Iran made this move while at the same time being our de facto ally in the Iraq.
Russia has gone a step further and created a reserve fund.
In late December, the Kremlin ordered five large state-owned exporters – including oil and gas giants Rosneft and Gazprom – to sell their foreign currency reserves….
More recently, the Kremlin announced it will open its $88 billion sovereign wealth fund and flip it for rubles.
The plan will see Russia convert as much as $8 billion to rubles (~500 billion) over a two-month span and place them in deposits for banks Russia still holds about $400 Billion in hard currency in its currency reserves, and it is trying to give its currency credibility by boosting its gold reserves.
If these and other countries succeed in trading in other currencies, this would effectively negate American-imposed economic sanctions. And since Washington has forgotten how to do diplomacy, that would only leave our military might when it comes to the international stage. And that hasn’t been working so well in recent decades.
Russia was aggressive in making currency swap agreements even before the sanctions.
Russia has signed two “holy grail” gas contracts with China and is in negotiations to offer the latter sophisticated weaponry. It is also in the process of finalizing significant trade deals with India and Iran. All of this will be to the benefit of Iran, too: the Russians recently announced a deal to build several new nuclear power plants there.
The drying up of petrodollars will also have a significant effect on the global financial markets. This is a big reason why the Federal Reserve has been talking about raising short-term interest rates.
This year, however, the oil producers will effectively import capital amounting to $7.6 billion. By comparison, they exported $60 billion in 2013 and $248 billion in 2012, according to the following graphic based on BNP Paribas calculations:
‘At its peak, about $500 billion a year was being recycled back into financial markets. This will be the first year in a long time that energy exporters will be sucking capital out,’ said David Spegel, global head of emerging market sovereign and corporate Research at BNP.
While these are interesting moves, they are not surprising because these are countries that we have economic sanctions against.
What makes it more interesting is to watching what other countries are doing. Even the Gulf Nations are talking about the need to rethink their dollar policy.
However, the big player here is China. In recent years they have made currency swap deals worth some 3 trillion yuan with 28 countries. The most recent was with Switzerland this week. The Chinese Yuan is now the world’s fifth-most used currency.
China is slowly and carefully positioning itself for a post-dollar hegemony world.
Paul Krugman calls the reserve currency status of the dollar a “much over-rated phenomenon”, which means he needs to ask any nation that must borrow in another nation’s currency what it means. Especially when there is an economic crisis and its currency suddenly drops.
Basically it means that sovereignty can fly out the window at any moment.
Or to put it another way. It is the status of the dollar, above all, that’s allowed Washington to get its way, putting the financial squeeze on recalcitrant countries via the IMF while funding foreign wars.
To understand politics and power it pays to follow the money. And for the past 70 years, the dollar has ruled the roost.
However, those days may be coming to an end.
Seven decades on from Bretton Woods, the governments of Brazil, Russia, India and China led a conference in the Brazilian city of Fortaleza to mark the establishment of a new development bank that, whatever diplomatic niceties are put on it, is intent on competing with the IMF and World Bank.
The IMF has been unfairly balanced towards the west. Belgium has more votes than Brazil, Canada more than China. Washington’s refusal to reform the IMF has forced the hand of the BRIC nations.
Slowly, gradually, the world is moving away from the dollar.
The dollar’s reserve currency status won’t end right away, but it will end.
The US currency accounted for just 33pc of all foreign exchange holdings in 2013, on IMF numbers, down from 55pc in 2001.
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