Even amid the torrent of disquieting news from the Middle East in recent weeks, an Iranian suggestion that it might start offering safe passage to oil tankers that paid in Chinese yuan, instead of the U.S. dollar, raised eyebrows.
Sourced to an anonymous Iranian official, the threat sparked a spate of warnings that Tehran might use its control of the Strait of Hormuz not to just threaten the world’s access to petroleum, but also upend the dollar-based international monetary system. By striking a blow against the petrodollar, Iran could initiate the unraveling of the dollar’s dominance, itself a linchpin of U.S. power—or so the argument goes. Those citing such ominous scenarios envisioned other possible dangers, including the debilitation of America’s security guarantees to Saudi Arabia and other Gulf oil exporters.
“The conflict could be remembered as a key catalyst for erosion in petrodollar dominance, and the beginnings of the petroyuan,” with potentially “significant downstream effects to…the dollar’s role as the world’s reserve currency,” Deutsche Bank analysts warned in a report last week.
The war’s consequences will doubtless be serious—but not for the dollar. The U.S. currency’s success rests on robust foundations, and Iran’s petroyuan gambit looks to be just the latest of many episodes in which alarmism over the dollar’s primacy has proven misplaced. Even if the petrodollar system weakens, it would matter little: As massive as world oil markets are, the reasons for dollar dominance lie elsewhere.
The greenback’s status stems from two features that no other currency can match. First is the depth, breadth, and liquidity of U.S. financial markets, in particular the market for Treasury bills and bonds, which can be bought and sold in enormous volumes without causing significant movements in price. This attribute is crucial in a financial crunch, when firms are scrambling to ensure that they can obtain the cash needed to meet obligations coming due.
The second feature is America’s open capital account—that is, the freedom to move money across U.S. borders virtually unimpeded. Many countries have open capital accounts but, importantly, China doesn’t. And no country, even open ones, has the U.S. market’s depth and breadth.
Having defied obituary writers on numerous occasions, the dollar continues to play a role in international transactions far out of proportion to the U.S. economy’s size. It accounts for well over half of foreign currency reserves held by central banks, and a similar share of export invoices for cross-border trade, as well as international bank loans and bond issuance. Network effects entrench its status; everybody has an incentive to use the dollar because so many others do.
Nowhere is the extent of the dollar’s entrenchment more evident than in the working of the little-known but gigantic market for foreign exchange swaps. In this market, global firms—multinational corporations, banks, insurance companies, securities dealers, and pension funds—shield themselves against currency fluctuations. According to the Bank for International Settlements (BIS), the amount of outstanding swaps currently stands above $100 trillion, with some 90% involving the dollar. (Far lower percentages involve the euro, Japanese yen, and other currencies.) This reflects the myriad ways in which the greenback is used for lending, borrowing, and investing.
So why are so many people obsessed with the petrodollar? It mostly comes down to a narrative that is only loosely grounded in facts. As the story goes, in the mid-1970s, the U.S. struck a bargain with Saudi Arabia, offering military aid and protection to the ruling House of Saud, in exchange for a Saudi promise to only accept dollars for oil and invest the proceeds in U.S. Treasuries. That set a precedent for other oil exporters to follow.
Those on the ground at the time remember things differently. One of the few foreigners allowed to live in the desert kingdom then was David Mulford, a young investment banker hired in 1975 by the Saudi Arabian Monetary Agency (SAMA), the nation’s central bank, as an adviser. In his 2014 memoir, he recalled how a team of six professionals struggled in SAMA’s dilapidated headquarters to manage “a portfolio growing at $5 and later $10 billion every thirty days,” relying on a single, sluggish telex machine for communicating with the outside world.
It turns out that oil was already predominantly priced in dollars and, as Mulford explained, Saudi Arabia had little choice but to plow its revenue into dollar-denominated assets. According to Mulford, who later became a U.S. Treasury undersecretary and ambassador to India, “In most markets outside the U.S. in those days a currency trade of just $10 million was enough to move markets, so there were practical limitations on the amount of currency diversification that we could achieve.” Furthermore, “purchases of German [bonds], or Japanese yen bonds, or Dutch guilder bonds, or Swiss franc notes were just not possible in the sizes common in the U.S. market.”
In other words, it was the American market’s unique depth, breadth, and liquidity—and not some secret deal—that led the Saudis to choose the dollar.
Petrodollars were a major reason why the greenback internationalized in the 1970s and the decades thereafter, as much of the income received by oil exporters was deposited in dollar accounts at banks around the world, primarily in Europe. But they are a much less significant factor in the global dollar market today.
While 44% of earnings from oil sales were deposited in offshore dollar bank accounts during the 1970s, that figure shrank to 27% by the early 2000s, noted Jess Hoversen, chief economist at Column, a San Francisco financial services firm, citing research from the IMF. The percentage is now in single digits, she estimates, as oil exporters’ earnings today are directed toward domestic development and sovereign wealth funds, which in turn are invested heavily in international stock markets and startups.
But the dollar market has surged even as the petrodollar took a step back. Hoversen pointed out that the offshore dollar credit market stood at $2.5 trillion in 2000, and hit $14.2 trillion by last year. “This tells us that the dollar is very structurally resilient,” she writes.
The debate about dollar dominance will continue to rage, as the Trump administration shakes investor confidence with actions like attacking the independence of the Federal Reserve. But barring much more serious self-inflicted wounds, the dollar will keep its place at the top of the currency league table for the foreseeable future—even if Iran demands oil payments in yuan.
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