Even amid disturbing news from the Middle East in recent weeks, the Iranian proposal that it may begin offering safe harbor for oil tankers paid in Chinese yuan, instead of the US dollar, has raised eyebrows.
Delivered by an anonymous Iranian official, the threat has sparked a flurry of warnings that Tehran could use its control of the Strait of Hormuz not only to threaten the world’s access to oil, but also to develop an international financial system based on the dollar. By attacking the petrodollar, Iran could begin the unraveling of the dominance of the dollar, itself the linchpin of US power—or so the argument goes. Those who cite such dire scenarios envision other potential risks, including a deterioration of American security guarantees to Saudi Arabia and other Gulf oil exporters.
“The conflict may be remembered as the main cause of the erosion of the dominance of the fuel, and the beginning of the petroyuan,” which could have “significant consequences below … the role of the dollar as a reserve currency in the world,” warned Deutsche Bank analysts in a report last week.
The consequences of war will undoubtedly be dire—but not in dollar terms. The success of the US currency depends on strong fundamentals, and Iran’s petroyuan gamble appears to be just the latest episode of many in which panic about the rise of the dollar has proved misplaced. Even if the petrodollar system weakens, it doesn’t matter much: Although the world’s oil markets are large, the reasons for the dollar’s dominance lie elsewhere.
The greenback’s status stems from two factors that no other currency can match. First is the depth, breadth, and liquidity of the US financial markets, especially the market for Treasury bills and bonds, which can be bought and sold in large amounts without creating significant price movements. This aspect is important in the financial crisis, where firms try to make sure that they can get the necessary funds to meet the upcoming obligations.
The second feature is America’s open currency account—that is, the freedom to transfer money across US borders without restrictions. Many countries have open capital accounts but, importantly, China does not. And no country, even an open one, has the depth and breadth of the US market.
Defying the obituaries on many occasions, the dollar continues to play a role in international trade that is far out of proportion to the size of the US economy. It accounts for more than half of foreign currency held by central banks, and the same share of foreign trade export invoices, as well as international bank loans and bond issuance. The effects of the network anchor its status; everyone has an incentive to spend a dollar because so many others do.
Nowhere is the dollar’s inflow more apparent than in the performance of the little-known but vast foreign exchange market. In this market, global firms—multinational corporations, banks, insurance companies, securities dealers, and pension funds—protect themselves from financial volatility. According to the Bank for International Settlements (BIS), the value of the current outstanding exchange is more than 100 trillion, and the other 90 percent includes the dollar. (The lowest percentages involve the euro, the Japanese yen, and other currencies.) This shows the thousand ways the greenback is used for borrowing, lending, and investing.
So why are so many people obsessed with the petrodollar? Especially when it comes to a story that has a solid foundation in facts. As the story goes, in the mid-1970s, the US negotiated with Saudi Arabia, providing military aid and protection to the ruling House of Saud, in exchange for a Saudi promise to accept only oil dollars and invest the proceeds in the US Treasury. That set an example for other oil traders to follow.
Those who were on the ground at that time remember things differently. One of the few foreigners allowed to live in the desert kingdom at the time was David Mulford, a young investment banker hired in 1975 by the Saudi Arabian Monetary Agency (SAMA), the nation’s central bank, as a consultant. In his 2014 memoir, he recalled how a team of six professionals struggled at SAMA’s crumbling headquarters to manage a “portfolio growing by $5 and later $10 billion every thirty days,” relying on a single, sluggish telephone to communicate with the outside world.
It turned out that oil was already overpriced in dollars and, as Mulford explained, Saudi Arabia had no choice but to plow its currency into dollar assets. According to Mulford, who later became US Treasury undersecretary and ambassador to India, “In most markets outside the US in those days a $10 million trade was enough to move the markets, so there were practical limits to the amount of exchange we could accomplish.” In addition, “German acquisitions [bonds]or Japanese yen bonds, or Dutch guilder bonds, or Swiss franc notes were not available in sizes common to the US market.”
In other words, it was the unique depth, breadth, and liquidity of the American market—not secret deals—that led the Saudis to choose the dollar.
Petrodollars were a major factor in the internationalization of the greenback in the 1970s and decades after, as much of the money earned by oil traders was deposited into dollar-denominated bank accounts around the world, especially in Europe. But it is not a very important factor in the world dollar market today.
While 44% of oil revenue was deposited into offshore dollar bank accounts in the 1970s, that number dropped to 27% in the early 2000s, noted Jess Hoversen, chief economist at Column, a San Francisco financial services firm, citing IMF research. The percentage is now in the single digits, he estimates, as oil traders’ earnings today are directed to domestic development and to private wealth funds, which are largely invested in international stock markets and startups.
But the dollar market rallied as the petrodollar retreated. Hoversen pointed out that the overseas dollar debt market stood at $2.5 trillion in 2000, and reached $14.2 trillion last year. “This tells us that the dollar is able to withstand the structure,” he wrote.
The debate over the dominance of the dollar will continue to rage, as the Trump administration shakes investor confidence with actions such as attacking the independence of the Federal Reserve. But without much harm to itself, the dollar will maintain its place at the top of the currency league table for the foreseeable future—even if Iran wants to be paid for oil in yuan.
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