How Petrodollars Affect the U.S. Dollar

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After the illness of the Bretton Woods golden modular successful the aboriginal 1970s, the United States struck a woody with Saudi Arabia to standardize lipid prices successful dollar terms. Through this deal, the petrodollar system was born, on with a displacement distant from pegged exchanged rates and gold-backed currencies to non-backed, floating complaint regimes. 

The petrodollar strategy elevated the U.S. dollar to the world's reserve currency and, done this status, the United States enjoys persistent trade deficits and is a planetary economical hegemony. The petrodollar strategy besides provides U.S. fiscal markets with a root of liquidity and overseas superior inflows through petrodollar "recycling." However, a afloat mentation of the effects of petrodollars connected the U.S. dollar requires a little synopsis of the past of the petrodollar.

History of the Petrodollar

Faced with mounting inflation, indebtedness from the Vietnam War, extravagant home spending habits, and a persistent equilibrium of payments deficit, the Nixon medication decided successful Aug. 1971 to abruptly (and shockingly) extremity the convertibility of U.S. dollars into gold. In the aftermath of this “Nixon Shock,” the satellite saw the extremity of the golden epoch and a escaped autumn of the U.S. dollar amidst soaring inflation.

Key Takeaways

  • Petrodollars are dollars paid to oil-producing countries for oil.
  • The emergence of the petrodollar dates backmost to the aboriginal 1970s erstwhile the U.S. reached an statement with Saudi Arabia to standardize the merchantability of lipid based connected the U.S. dollar.
  • Petrodollar recycling creates request for U.S. assets erstwhile dollars received for lipid income are utilized to bargain investments successful the United States.
  • Recycling of petrodollars is beneficial to the greenback due to the fact that it promotes non-inflationary growth.
  • A determination distant from petrodollars could perchance summation borrowing costs for governments, companies, and consumers if sources of wealth go scarce.

Through bilateral agreements with Saudi Arabia beginning successful 1974, the U.S. managed to power members of the Organization of the Petroleum Exporting Countries (OPEC) to standardize the merchantability of lipid successful dollars. In instrumentality for invoicing lipid successful dollar denominations, Saudi Arabia and different Arab states secured U.S. power successful the Israeli-Palestinian conflict along with U.S. subject assistance during an progressively worrisome governmental climate, which saw the Soviet penetration of Afghanistan, the autumn of the Iranian Shah, and the Iran-Iraq War. Out of this mutually beneficial agreement, the petrodollar strategy was born. 

Benefits of the Petrodollar System

Since the astir sought-after commodity successful the world—oil—is priced successful U.S. dollars, the petrodollar helped elevated the greenback arsenic the world's ascendant currency. With its precocious status, the U.S. dollar enjoys what immoderate person asserted to beryllium the privilege of perpetually financing its current relationship deficit by issuing dollar-denominated assets astatine precise debased rates of interest as good as becoming a planetary economical hegemony.

For instance, countries similar China, who clasp immense quantities of U.S. debt, person voiced their concerns successful the past astir the imaginable dilutive effects to their plus holdings should the dollar depreciate.

However, the privileges associated with being capable to tally persistent existent relationship deficits travel astatine a price. As the reserve currency, the United States is obligated to tally these deficits to fulfill reserve requirements successful an ever-expanding planetary economy. If the United States were to halt moving these deficits, the resulting shortage of liquidity could pull the satellite into an economical slump. However, if the persistent deficits continue indefinitely, eventually, foreign countries volition statesman to uncertainty the worth of the dollar, and the greenback whitethorn suffer its relation arsenic the reserve currency. This is known arsenic the Triffin Dilemma

Petrodollar Recycling

The petrodollar strategy besides creates surpluses of U.S. dollar reserves for oil-producing countries, which request to beryllium "recycled." These surplus dollars are spent connected home consumption, lent overseas to conscionable the equilibrium of payments of processing nations, or invested successful U.S. dollar-denominated assets. This past point is the astir beneficial for the U.S. dollar because petrodollars marque their mode backmost to the United States. These recycled dollars are utilized to acquisition U.S. securities (such arsenic Treasury bills), which creates liquidity successful the fiscal markets, keeps involvement rates low, and promotes non-inflationary growth. Moreover, the OPEC states can avoid currency risks of conversion and put successful unafraid U.S investments.

Recently determination person been concerns of a displacement distant from petrodollars to different currencies. In fact, Venezuela said successful 2018 that it would statesman selling its lipid successful the yuan, euro, and different currencies. Then, successful 2019, Saudi Arabia threatened to wantonness petrodollars if the U.S. moved guardant with a bill—called NOPEC—that would let the U.S. Justice Department to prosecute antitrust enactment against OPEC for manipulating lipid prices. In short, the changing scenery of the planetary vigor marketplace could effect successful a de-facto extremity to the U.S.-Saudi petrodollar agreement. 

$711 Billion

The planetary nett lipid export gross from OPEC members successful 2018, according to the U.S. Energy Information Association.

Meanwhile, the U.S. is becoming a large exporter of vigor for the archetypal clip since the 1960s. This, on with a beardown home vigor assemblage that focuses connected exports, could assistance a smooth transition distant from the petrodollar arsenic vigor exports regenerate the capital inflows from Saudi purchases of U.S. assets and uphold planetary request for the U.S. dollar. An added vantage for the United States is that it volition guarantee home vigor security, which was the main crushed for the petrodollar statement successful the archetypal place. 

Nevertheless, portion it volition not hap overnight, a drying up of recycled petrodollars could drain immoderate liquidity from American capital markets, which volition summation the borrowing costs (due to higher interest rates) for governments, companies, and consumers arsenic sources of wealth go scarce. 

The Bottom Line

After the 1970s, the satellite switched from a golden modular and petrodollars emerged. These extra-circulated dollars helped elevate the U.S. dollar to the satellite reserve currency. The petrodollar strategy besides facilitates petrodollar recycling, which creates liquidity and request for assets successful the fiscal markets. However, the rhythm could scope an extremity if different countries wantonness petrodollars and statesman accepting different currencies for lipid sales.

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