The Slow Death of the Petrodollar

An action always has consequences – and the stranger the action the greater the chance of the consequences being unintended.

The ultimate death of the Dollar as the international reserve currency was sealed when the first Russian shell landed in Ukraine almost a year ago. This is a slow-speed revolution, but a revolution it is. Since at least 2014 there has been serious talk of the demise of the petrodollar and its replacement by the petroyuan, but the war in Ukraine has given fresh impetus to the Dollar’s declining status and the rise of China’s currency. The Dollar/Yuan tussle – President Xi Jinping would never emulate the crassness of President Putin and openly declare a war on the West – will be the defining event for fiat money over the next few years, perhaps even more significant than the evolution of Central Bank Digital Currencies (CBDCs).

Weaponising the Dollar via the lengthy list of sanctions imposed on Russia means that countries not directly involved in the conflict have become warier about Dollar-based trade and holding Dollar reserves. That’s not just China; it’s also Saudi Arabia, the country with the second-biggest oil reserves and an increasingly shaky ally of the US. Joe Biden during his campaign to win the Presidency pledged to treat Saudi Arabia as a “pariah” thanks to state involvement with the murder of Jamal Khashoggi and an intelligence report that seemed to implicate the state of Saudi Arabia in the 9/11 attack on the World Trade Centre. Nevertheless he visited Saudi Arabia in July 2022, shook hands with ‘MBS’ (Mohammed bin Salman, the de facto leader of Saudi Arabia), but failed to achieve his aim of getting a boost in Saudi oil production.

The Saudi-US relationship for the past four decades has been rooted in the petrodollar. There’s nothing mysterious about the term petrodollar; it’s simply the term for what has become the global practice of paying for oil in US Dollars. As the US started to worry about its diminishing oil production capacity, President F.D. Roosevelt met the then Saudi king, Abdul Aziz, in 1943, and declared that Saudi oil was vital to US security. In exchange, the US agreed to build military bases and supply the Saudi army with training and equipment.

In 1974, following an oil embargo by the Arab state members of OPEC (the Organisation of Petroleum Exporting Countries) the petrodollar system was consolidated by a deal between the US and Saudi Arabia which formally agreed to price and trade oil in US Dollars, and to recycle the Dollars by buying US government debt – Treasury bonds.

This symbiotic relationship is now on its last legs – the Dollar’s dominance of the global oil trade is dying, and in turn the status of the Dollar as the international reserve currency is increasingly in doubt. This will have as serious repercussions for the world’s future stability as Russia’s invasion of Ukraine. Could petroyuans replace petrodollars?

Recycling drying up

Pricing crude oil in Dollars meant that many oil producers started to earn more money from crude oil exports than they could efficiently invest in their own economies. The Dollar became the currency of international trade and finance; petrodollars were recycled into many different investments, including US Treasury bonds, as well as European trophy investments such as soccer clubs, glitzy London property, art works and so on. By 1977 Saudi Arabia had accumulated around 20% of all US Treasuries held abroad, and the US was importing a third of its oil demand. High energy prices in 2022 (a by-product of Russia’s invasion) meant that OPEC countries last year probably earned in excess of $900 billion, almost twice the annual average since 2000. While some of these unexpected profits followed the traditional path and were recycled into US assets (Saudi Arabia’s sovereign wealth fund, the Public Investment Fund or PIF, picked up shares in Alphabet, Zoom and Microsoft among others) the need to protect themselves against Washington’s ire (and possible sanctions one day) means that their energy profits are increasingly finding homes other than US government debt.

China’s ambition

President Xi increased the pressure on the petrodollar late last year, when he addressed a meeting of Arab Gulf state leaders – significantly hosted by Crown Prince Mohammed bin Salman of Saudi Arabia in Saudi Arabia – and told them China would “make full use of the Shanghai Petroleum and National Gas Exchange as a platform to carry out Yuan settlement of oil and gas trade”. Yet the Chinese request to pay for its energy imports from Arab states in its own currency appears to have been given the thumbs-down, for now at least.

President Xi’s baptism of the petroyuan, which some scholars have called “the most significant challenge yet to the indefinite prolongation of dollar dominance in international oil and gas transactions – and thus, by extension, to the dollar’s global primacy” was thus only partially successful. Yet, as one commentator has pointed out, although China doesn’t have the same level of global trust, rule of law or reserve currency liquidity of the US, “the Chinese have offered up something of a financial safety-net by making the renminbi [yuan] convertible to gold on the Shanghai and Hong Kong gold exchanges… If the petroyuan takes off, it would feed the fire of de-dollarisation”. A gold-backed petroyuan would allow China simultaneously to retain control of its capital account and boost the currency’s internationalisation, as well as enabling China to bypass the Dollar-dominated SWIFT (Society for Worldwide Interbank Financial Telecommunication) global payments system, which (as shown by Russia’s ejection from SWIFT) is unreliable if a country invokes Washington’s anger. China has its own version of SWIFT, the CIPS (Cross-Border Interbank Payment System) and Russia has joined it to trade its crude oil.

Hedging bets

Before last year’s Winter Olympics, Russia and China declared a “no limits” friendship. While China has been careful to keep its distance from Russia’s war on Ukraine, the two share the ambition of humbling the Dollar. Russia’s energy giant signed an agreement with China late last year to settle payments for its gas exports in Yuan and Roubles instead of US Dollars. China wants the same kind of commitment from Saudi Arabia but is as yet frustrated by Saudi Arabia’s reluctance to ditch its relations with the US.

Twenty years ago the share of international reserve assets taken by the Dollar was 71%; today it’s 59%. By contrast, around a third of central banks said in mid-2021 they planned to increase their allocations to China’s Yuan over the following 12-24 months; 70% said they intended to do so over the “long term”. Saudi Arabia is flirting with the petroyuan but is reluctant to overtly abandon the US and the petrodollar; for now it is hedging its bets in the greatest gamble of the 21st century.