The term ‘Petrodollar’ was coined to denote the United States dollar received by a producer in exchange for selling oil. The United States today is recognised as one of the most economically and politically influential superpowers in the world – but it is rarely discussed how a nation with a population less than a quarter the size of China’s has been able to exert such hegemony over the world in modern times. The key factor in America’s global dominance is the convertibility of currencies into the dollar in foreign exchange markets – a system that has been dependent on the global demand for petrodollars.
The events of World War II led to the prominence of the dollar as the world’s reserve currency; an era which dollar-trading sceptics and emerging economies believe should soon come to an end.
The Bretton Woods Conference (1944)
In the final days of World War II, all 44 allied nations met in Bretton Woods, New Hampshire, United States to develop a new system for monetary order in the post-war world.
The conference eventually led to the establishment of the International Bank for Reconstruction and Development (now the World Bank) and the International Monetary Fund (IMF); but equally as key for the eventual emergence of the Petrodollar, was the development of a new fixed exchange rate system.
The dollar was the only currency strong enough to meet rising demand for international currency transactions, so members agreed to convert their currency into US dollars, which in turn was backed by gold at a convertible rate of $35 per ounce.
The US currency has now become the only currency that could be converted into gold; which created an artificial global demand for USD, effectively making it the global standard currency. European nations that had amassed large amounts of debt during World War II transferred large amounts of gold into the US, leading to an appreciation in the value of the dollar.
Failure of the Bretton Woods system (1960-1971)
One of the key proponents of the fixed exchange rate system is that it can put constraints on how much a country could borrow, as this amount had to be convertible into gold. However, countries were entitled to take US dollars and insist of the delivery of gold.
During the late 1960s and early 1970s, the US faced enhanced social reform (“Great Society” programs), rising oil prices and continued escalation of the Vietnam War (with a suspected price tag of over $200 billion on the war alone). Consequently, the US was required to sell more Treasury Bills and print more cash to enhance the amount of currency in circulation. This led to increased speculation about whether the US had enough gold to back the global supply of dollars.
France became concerned about their USD currency reserves, and threatened to execute their right to insist on gold delivery. This presented threat to the US, as a clear inability to cover their dollars would lead to a run on the gold reserves, leading to a reduction in US currency in circulation. As 1971 progressed, so did the demand for US gold – at this point, gold represented a much safer monetary holding than the US currency.
“The Nixon Shock” (1971)
On August 15th 1971, President Richard Nixon decided to detach the US dollar from the gold and essentially “close the gold window” so that foreign governments could no longer exchange their dollars for gold. This ended the international gold standard, and meant that the US dollar was declared a purely fiat currency (currency declared by government to be legal currency – not backed by any physical commodity).
The US dollar was now considered a floating currency, affected by the forces of market supply and demand; so all other currencies previously attached to the dollar naturally faced floating exchange rates too. This left the US Federal Reserve free to print money at will with no need to hold gold reserves to back the currency.
This, and the series of events which followed, later became known as “The Nixon Shock,” as the US faced the question of whether they could maintain the same level of global demand for dollars as in the post-Bretton Woods years.
Emergence of the Petrodollar (1971-1975)
In order to preserve an increasing demand for the dollar, and thus maintain a dominant global position, the US needed a plan. In order for this plan to succeed, it would require that the artificial dollar demand that had been lost in the wake of the Bretton Woods collapse to be replaced through some other mechanism.
In the early 1970s, the US Secretary of State, Henry Kissinger, made an agreement with the Saudi royal family. The US agreed to provide Saudi Arabia with military defence and weapons to protect themselves from Israel, as well as protection for Saudi oil fields, subject to two conditions:
- Saudi Arabia must be willing to price all of their oil sales in USD only
- Saudi Arabia would be open to investing surplus oil proceeds in US debt securities
By 1975, all oil-producing nations in OPEC had agreed to price their oil in USD and hold surplus oil in US debt securities subject to similar military aid and reinforcement.
The petrodollar system immediately gave new benefits to the US. The global demand for US$ and debt securities increased, the US remained self-sufficient and capable of purchasing oil with the currency it prints at will, while the Federal Reserve could maintain low, stable interest rates.
The future of the Petrodollar
In modern day, virtually all oil transactions are priced in dollars, which has allowed for sustained artificial demand; and the dollar is the currency denomination of over half of all international debt securities due to its continued stability. Additionally, over 60% of reserves of all foreign central banks and governments are in dollars; as an increasing number of developing countries become subjected to dollarization.
However, a number of countries have attempted to switch to another system to lessen their dependence on the dollar – including Iraq who began to sell oil in euros (November 2000) and Iran in Kish Island (February 2008).
This leads to the question:
What would happen if the Petrodollar system collapsed?
Part 2 of the Petrodollar series will be published tomorrow.