The demise of dollar in a world financial system is a popular prediction among some financial commentators. often predicting the most gloomy consequences of a decline of an era of dollar for the USA and world economy. However while the dollar continues to be the main reserve currency in the world, making considerable part of the international currency reserves. What still holds the American currency afloat in the ocean of the international finance? After the end of "the gold standard" in 1971 oil became a power source and reliability of dollar.
To strengthen dollar positions as world reserve currency cooperation with oil most large exporters helped with the Persian Gulf and the OPEC countries which finally settled in 1975. Since then the oil market underwent serious structural changes. Economic growth in developing countries made them one of the largest consumers of oil. China became the largest consumer of energy resources in the world, having outstripped the USA. Also for the last years Russia became the major player in the market, having won first place on oil production and natural gas. Thus both consumers and producers of hydrocarbons continue to use dollar in settlements.
However, this situation is gradually changing. For example, China is actively transferring settlements with some trading partners to national currencies. The historical gas contract with Russia worth $400 billion can be viewed as a showcase example. It is still unknown in which currency the contract will be settled, but the probability that it will paid for country in rubles and yuan is pretty high. The volume of trade between these countries comes close to $100 billion, and leaders of China and Russia are seriously considering the possibility of removing the dollar from trade.
Tensions between the West and Russia as a consequence of the Ukrainian crisis and confrontation between China and its neighbours, who are supported by the US, over the disputed islands in the South China Sea, will accelerate the process of removing the dollar from trade between the largest developing countries.
The history of petrodollar standard originates in 1971. The Nixon
administration unilaterally terminated dollar’s convertibility to gold,
bringing the post-WW2 Bretton Woods system to an end. Within this arrangement
the dollar’s stability was guaranteed by gold and could be at any time converted
After dollar became a free-floating fiat currency there was fear of keeping a high demand on dollar from other countries. Also there was a question of a national debt of the US which was considered as a reliable asset within Bretton Woods system as the dollar was guaranteed gold. When this standard was terminated the debt of the USA stopped being an attractive asset.
In the early 1970s the dollar was depreciating and reached the minimum of 85.0 points. Then the period of stable growth of the dollar followed, which is explained by two reasons. Firstly, high interest rates in the US during the times of Paul Volcker as a head of the Fed. Secondly, the strategic partnership between the US and Saudi Arabia made sure that there was a stable demand for the dollar.
Nixon administration found a way out in signing an agreement with Saudi Arabia. The then Secretary of State Henry Kissinger agreed with the Saudis that they will buy arms from the US as well as guarantees of safety, including from Israel, in exchange for transferring the trade of the Saudi oil to dollars. By 1975 other oil producers from the OPEC countries followed the example of Saudis.
This was a huge success of American diplomacy, which allowed replacing the Bretton Woods system with the petrodollar standard. Artificially overestimated demand for dollars not only stayed the same, but started growing thanks to an increasing demand for oil.
How the petrodollar standard works
The existence of petrodollar system is undoubtedly one of the pillars in economic might of the US as it creates external demand for dollars, allowing its economy to accumulate debt without threatening solvency. In addition to it growth of money supply does not lead to higher inflation. The system is arranged in such a way that if the Japanese resident buys crude oil from Saudi Arabia he has to pay in dollars despite the fact that the US was not involved in this transaction in any way. Positions of the dollar as the world reserve currency are so firm that contracts of the Russian gas giant Gazprom with Europe are settled in dollars. Even trade between the European Union and China until recently was also settled in dollars.
If some energy importing country has no reserves
of dollars it has to find a way to receive them to buy energy resources. The
easiest way of receiving dollars is through the international foreign exchange
markets. However, it is not the most cost efficient way. Therefore many
countries opt out to expanding their exports potential with the US and as a
result increase the dollar reserves.
Oil consumers have to stock up with dollars in order to purchase oil, and the dollar profit of the oil exporting countries ends up in a national debt of the US.
As the result, existence of system of petrodollars gives to the USA at least three advantages:
- Increases the external
demand for dollars
- Increases the external demand for the American
debt instruments and other financial assets
- Possibility to buy oil for dollars for which the
US is a single currency-issuer
The inflated demand for the US national debt allows it to keep low
interest rates, which is crucial for consumer spending. The oversupply of
dollars in an international financial system as well as artificially low
interest rates in the US creates structural imbalances in world economy.
The demise of the petrodollar standard?
Albeit dollar status as world reserve currency gives US a number of
advantages it does not suit all the participants of international relations and
the question is, whether it is possible to change the current situation. First
of all it concerns China. Deterioration of the relations between the West and
Russia that will accelerate movement of the economic center of the world to the
east can lead to the decline of US dollar in international trade. The more
pressure the West puts on Russia through sanctions, the closer cooperation
between Asian countries and Russia will become.
According to some sources, there has been an active discussion in the Russian government and business community about the possibility of transition from dollars to euros, rubles and yuan in trade operations. Keeping in mind that Russia is the world's largest exporter of natural gas and second largest oil exporter, this would considerably reduce the role of the US currency in the global energy markets.
At the same time China possesses $4 trillion of reserves, which makes up for a third of world’s total currency reserves. In spite of the fact that the structure of reserves in China is a state secret and the People’s Bank of China (PBC) actively diversifies the composition of reserves, it is possible to say with confidence that the lion's share of currency reserves of China are dollars.
On one hand, such dependence on the dollar is a problem as these dollar reserves come back to the USA in the form of Treasuries bought by PBC. On the other hand, for China to hold so many dollars is favourable regarding the purchase of imported oil. It must be noted that China consumes 10% of crude oil exports and increasing its share in the market. Besides China there is one more potentially large consumer of energy resources – India. These countries in alliance with a large exporter of oil, for example Russia, can rebuild the current functioning of the world energy market and US dollar’s role in it.
According to IMF COFER data, the dollar accounted for 32% of the international foreign exchange reserves in 2013, down from 55% in 1999. The share of the European currency stayed at the same levels. Such a sharp change is explained by growth of foreign exchange reserves in countries which do not provide data to the IMF about the structure of their reserves. These countries include China and Taiwan, which accumulated reserves of $4 trillion and $420 billion respectively. If we were to exclude these countries, the picture will be following: the share of the dollar fell from 71% in 1999 to 53% in 2013, and the share of euro grew from 17.9% in 1999 to 32.4% in 2013.
The data from HSBC research team states that since the beginning of 2014 the world companies sharply increased the use of yuan in trade settlements. According to HSBC data, now 22% of the world companies use yuan to settle with their counterparties, and 60% from them intend to increase volumes of such transactions in 2015. The doubling of the companies, which opt to settle in yuan, is recorded in the US. Last year there were 9% of such enterprises, and this number has gone up to 18% this year.
PBC is actively developing cooperation with other large central banks in trading swaps. At the moment such agreements are signed the Swiss National Bank, the European Central Bank and the Bank of England. Further development of yuan as a reserve currency must be accompanied with financial reforms: liberalization of an exchange rate and expand the types of available operations. Unless China carries out a broader reform of the financial sector and does not liberalize the capital markets for purchase Chinese assets by foreign investors, the role of the Chinese currency as potential world reserve currency will be limited.
China’s trade exceeded $4 trillion last year and it overtook the US as a biggest trading economy. It is forecasted that in 2015 30% of the Chinese trade will bypass the dollar.
Lately the tendency to dropping the dollar was highlighted in trade between the largest developing countries and corporations. The second largest bank of Russia, VTB, has signed an agreement with PBC about settlements in local currencies. Gazprom Neft, the oil company, according to some information, has agreed with the majority of its clients about transferring settlements to euros, and with Belarus to rubles. MegaFon, a telecommunication company, has exchanged 40% of its cash to Hong Kong dollar. Norilsk Nickel, a basic materials giant, is also moving to HKD.
BRICS as the new pole of economic power
Since 2001 it has been obvious that BRICS countries will be the next center of economic power. Today BRICS account for 26.7% of land, 42% of world population, 28.3% of world GDP, 22% of oil production, 40% of agricultural production and more than 50% of official foreign exchange reserves. The extent of economic cooperation between BRICS countries is rather low, but recent agreements at the summit in Brazil allows us to seriously reconsider BRICS’ role as the largest economic bloc and the powerful geopolitical player.
At the summit in Fortaleza, Brazil, the New Development Bank was set up with the capital of $50 billion and a fund with available currency reserves of $100 billion. The reserve fund will be a safety mechanism for developing countries during dramatic currency fluctuations and protect them from speculating attacks.
Currency reserve fund can become an important milestone in diversifying balance sheets from dollars and dollar assets. Developing countries have to accumulate huge currency reserves for protection against the volatile capital markets. Private investors and financial institutions search for reliable and liquid assets, and such assets usually are the government bonds. The problem is that the supply of these assets in going down. In the eurozone only Germany satisfies the low risk profile. Japan and Switzerland have capital inflow limits so that the yen and franc do not appreciate. Thus, the US is the main supplier of reliable and liquid assets in the form of the Treasuries.
The share of the BRICS in world exports has doubled from 8% in 2001 to 16% in 2011. With growth of trade between the BRICS the need to use the dollar will come to an end and the role of the dollar in a world financial system will be dramatically reduced. In our opinion, membership in the BRICS will not be limited to Brazil, Russia, India, China and South Africa, and will extend to the so-called MIST group – Mexico, Indonesia, Turkey and South Korea – and other developing countries. The countries of BRICS can become the locomotive in anti-dollar campaign, attracting new countries which are interested in disposal of the dollar dominance.
The standard of living in the US is dependant among other things on the dollar’s use in international trade. If Russia and China will start trading with each other without using the dollar and they will be followed by other countries it can be a huge blow to the petrodollar standard and global dependence on dollar assets. Possible refusal of Saudi Arabia poses an even greater threat for the petrodollar standard. Then the whole system will crash as two of the largest oil exporters – Saudi Arabia and Russia – will remove the dollar from oil trading. The world financial system will undergo the most serious structural adjustment since the WW2 with uncertain consequences.
This transformation to use several reserve currencies and the decrease in a role of dollar will not happen tomorrow. This process will definitely take time and can last from several years to decades. We do not urge anyone to dump dollars, which was strengthening in recent months, or the US Treasuries, which also show signs of growth. What we want to state is that the dollar system is not considered a holy grail of world’s finances anymore. The process has been launched and it can hardly be stopped.