Petrodollar – eRutledge | Arabian Gulf Economics

First published in:

Rutledge, E. J. (2006, May 28). The dollar declines, while the euro shines. Khaleej Times. https://www.khaleejtimes.com/business/the-dollar-declines-while-the-euro-shines

The dollar is once again losing value, and has depreciated by seven per cent against the euro since the start of the year. How far it will go is anybody’s guess, but the odds are, it will fall further.

Li Yong, China’s Vice-Minister of Finance, has talked of a possible further 25 per cent fall. According to some estimates the amount the United States now owes to the rest of the world now stands at $3 trillion. This, not anything else, is the prime reason for the dollar’s decline.

Although the Federal Reserve does not want to see the dollar collapse, it probably views any dollar devaluation as a convenient way of partially reducing the US’ huge current account deficit. If the dollar declines so will the ‘value’ of the deficit. However, a falling dollar does not bode well for the GCC. It will exacerbate inflation as European and Japanese goods become more expensive and it will also result in a depreciation of the ‘real’ value of the region’s reserve holdings. In addition, because oil and gas are priced and sold in dollars the GCC also stand to loose some revenues in this respect also.

Nevertheless, we have seen only a limited response to these currency conundrums in the form of Kuwait’s decision to allow its currency to appreciate marginally against the dollar. There has been talk from several of the region’s central bankers about a possible realignment in their foreign reserve holdings but as yet no concrete action has been announced. For the time being at least, any speculation that other GCC states were about to follow Kuwait’s lead have been discounted. Both the Saudi Arabian Monetary Authority and the Central Bank of Oman came out and publicly defended the status quo.

Apart for arguments such as ‘providing stability’ and ‘eliminating intra-regional exchange rate risk’ (all 6 GCC states are pegged to the US dollar, albeit Kuwait maintains a more flexible band within which to fluctuate), there is another argument for maintaining the dollar peg. And that is that the collective peg is an interim step towards forming a single GCC currency in 2010. Having a joint peg is a good thing, as it eliminates exchange rate risk within the bloc, but it could just as easily be achieved with a joint peg to the euro or a trade weighted basket of currencies.

Happy creditors no more? For many years Asian central banks, particularly those of China and Japan, have been willing to finance US deficits despite the risks, in order to support their own export-led growth models. However, the scale of financing (subsidising) required to sustain the US’ current account deficit may soon exceed their absorptive capacities. A law of diminishing returns also comes into play; there comes a point when alternative economic growth models look more appealing that accumulating ever greater numbers of underperforming US Treasury Bonds.

The current situation is somewhat perplexing, the country that controls the world’s de facto reserve currency, also happens to be the world’s largest debtor. In any other walk of life, you would be forgiven for being somewhat wary if lending to someone with huge debts. The US like any other debtor may be tempted to use (or not do anything much to prevent) devaluation to reduce external deficit, and this is hardly a desirable trait for a reserve currency.

The dollar has been the dominant reserve currency for at least the past half century and will no doubt continue to be one for some time to come. It can however no longer take this role for granted. One thing is constant in history and that is nothing remains the same forever. Back in the early 1990s after a period where the dollar devalued considerably, many economists at the time speculated about the dollar’s role as the world’s de facto reserve currency. The dollar, nevertheless rebounded, and continued to play its role, in part because there was no viable alternative.

This has changed. Today we have the euro (tomorrow perhaps, even the Yuan). In general for a currency to qualify as a reserve one it needs to meet several criteria including being backed by a large economy, which itself has free flows of capital, open and deep financial markets and low inflation. The euro zone has all of these characteristics and to top it all, it runs a current account surplus.

Those who switch first stand to gain the most: It is now estimated that the US’ deficit consumes no less than two thirds of the worlds total current account surplus. Joseph Stiglitz, a f ormer head of the IMF, recently pointed out that there is obviously something peculiar about a global financial system in which America borrows more than $2 billion each and every day from other countries (in March the US’ Trade Deficit was $62bn) whilst lecturing them on fiscal responsibility.

One could view the current state of affairs as a bit like the classic ‘prisoner’s dilemma’. If any one Asian central bank switched its reserves into euros tomorrow it would undoubtedly benefit vis-à-vis the others, but if they all attempted to switch at the same time they would collectively see the value of their reserves fall considerably, as the resulting run on the dollar would adversely affect all that hold it in reserve.

Reactionary tendencies will probably mean that the GCC dollar peg remains for the time being but there is a strong and growing argument for a move away from too much dependence on the dollar. If Gulf central banks were to buy euros today with some of their dollars reserves, they would get far better exchange rates than if they were to wait for Asian central banks to make the move first.

It is surely worth the while of the GCC’s central bankers to seriously consider alternative options to the current status quo, it would be a shame if the considerable economic achievements of the past few years are washed away by maintaining a rigid dollar peg that may be extremely expensive to maintain and cause unnecessary inflation.- (Emilie Rutledge is an economist with Gulf Research Centre)

First published in:
Al Jazeera

Rutledge, E. J. (2005, November 3). Iran – a threat to the petrodollar? Al Jazeera. https://www.aljazeera.com/news/2005/11/3/iran-a-threat-to-the-petrodollar

Iran’s decision to set up an oil and associated derivatives market next year has generated a great deal of interest.

This is primarily because of Iran’s reported intention to invoice energy contracts in euros rather than dollars.

The contention that this could unseat the dollar’s dominance as the de facto currency for oil transactions may be overstated, but this has not stopped many commentators from linking America’s current political disquiet with Iran to the proposed Iranian Oil Bourse (IOB).

The proposal to set up the IOB was first put forward in Iran’s Third Development Plan (2000-2005). Mohammad Javad Assemipour, who heads the project, has said that the exchange will strive to make Iran the main hub for oil deals in the region and that it should be operational by March 2006.

Geographically Iran is ideally located as it is in close proximity to major oil importers such as China, Europe and India.

It is unlikely, in the short term at least, that large numbers of energy traders will decamp and set up shop in Iran; a country which happens to be categorised as a member of the “axis of evil” by the president of the world’s largest oil-importing country; the United States.

But over time, Iran could take some business away from the two incumbent energy exchanges, the International Petroleum Exchange and the New York Mercantile Exchange who both invoice sales solely in dollars.

Economic motives

If successful, the IOB will provide Iran with concrete economic benefits especially if it invoices at least some of its energy contracts in euros.

Iran has around 126 billion barrels of proven oil reserves about 10% of the world’s total, and has the world’s second largest proven natural gas reserves.

From an economic perspective, invoicing oil in euros would be logical for Iran as trade with the euro zone countries accounts for 45% of its total trade. More than a third of Iran’s oil exports are destined for Europe, while oil exports to the United States are non existent.

The IOB could create a new euro denominated crude oil marker, which in turn would enable GCC nations to sell some of their oil for euros. The bourse should lead to greater levels of foreign direct investment in Iran’s hydrocarbon sector and if it facilitates futures trading it will give regional investors an alternative to investing in their somewhat overvalued stock markets.

Euro zone countries alone account for almost a third of Iran’s imports and currently Iran must exchange dollars earned from hydrocarbon exports into euros which involves exchange rate risk and transaction costs.

The decline in the dollar against the euro since 2002 – some 26% to date – has substantially reduced Iran’s purchasing power against its main importing partner.

If the decline continues, more states will increase the percentage of euros vis-à-vis the dollar they hold in reserve and in turn this will increase calls both in Iran and the GCC to invoice at least some of their oil exports in euros.

A move away from the dollar and a strengthening of the euro would further benefit Iran as according to a member of Iran’s Parliament Development Commission, Mohammad Abasspour, more than half of the country’s assets in the Forex Reserve Fund are now euros.

It is primarily the US which stands to lose out from any move away from the petrodollar status quo, it is the world’s largest importer of oil and a move away from invoicing oil in dollars to euros will undoubtedly have a negative effect on its economy.

Fewer nations would be willing to hold the dollar in reserve which would cause a significant devaluation and result in the loss seigniorage revenues. In addition, US energy-related companies stand to lose out as they will be unable to participate in the bourse due to the longstanding American trade embargo on Iran.

Political considerations

In the 1970s, not long after the collapse of the gold standard, the US agreed with Saudi Arabia that Opec oil should be traded in dollars in effect replacing the gold standard with the oil standard.

Since then, consecutive US governments have been able to print dollar bills and treasury bonds in order to paper over huge current account and budgetary deficits, last year’s US current account deficit was $646 billion.

Needless to say, the current petrodollar system greatly benefits the US; it enables it to effectively control the world oil market as the dollar has become the fiat currency for international trade.

In terms of its own oil imports, the US can print dollar bills without exporting commodities or manufactured goods as these can be paid for by issuing yet more dollars and T-bills.

George Perkovich, of the Washington based Carnegie Endowment for International Peace, has argued that Iran’s decision to consider invoicing oil sales in euros is “part of a very intelligent strategy to go on the offense in every way possible and mobilise other actors against the US.”

This viewpoint however, ignores Iran’s economic motives, just because the decision, if eventually taken, displeases the US does not mean that the rationale is purely political.

In light of such sentiments and the US’s current insistence that Iran be referred to the UN Security Council Iran must consider and weigh carefully the economic benefits against the potential political costs.

Although a matter of conjecture, some observers consider Iran’s threat to the petrodollar system so great that it could provoke a US military attack on Iran, most likely under the cover of a preemptive attack on its nuclear facilities, much like the cover of WMD America used against Iraq.

In November 2000, Iraq began selling its oil in euros, its Oil For Food account at the UN was also transferred into euros and later it converted its $10 billion UN held reserve fund into euros.

At the time of the switch many analysts were surprised and saw it as nothing more than a political statement, which in essence it may have been, but the euro has gained roughly 17% over the dollar between then and the 2003 US invasion of Iraq. Perhaps unsurprisingly, since the US led occupation of Iraq its oil sales are once again being invoiced in dollars.

The best policy choice for Iran would be to proceed with the IOB as planned as the economic advantages of such a bourse are clear, but in order to mitigate against the potentially greater political “threat” should provide customers with flexibility.

It would make it much harder for America to object to the new bourse, overtly or covertly, if Iran allows customers to decide for themselves which currency to use when purchasing oil, such an approach would facilitate for euro purchases without explicitly ruling out the dollar.

[As Aljazeera then put it: “Emilie Rutledge is a British economist who is currently based at the Gulf Research Center in Dubai”].