After the collapse of the Bretton Woods gold standard in the early 1970s, the U.S. struck a deal with Saudi Arabia to standardize oil prices in dollar terms. Through this deal, the petrodollar system was born, along with a paradigm shift away from pegged exchanged rates and gold-backed currencies to non-backed, floating rate regimes.
The petrodollar system elevated the U.S. dollar to the world's reserve currency and through this status, the U.S. is able to enjoy persistent trade deficits, and become a global economic hegemony. The petrodollar system also provides the United States’ financial markets with a source of liquidity and foreign capital inflows through petrodollar "recycling." However, before the effects of the petrodollars on the U.S. dollar can be examined, a brief history lesson is in order. (For more, see: Global Trade And The Currency Market and US-Saudi Relations: A Complex Scenario.)
History of the Petrodollar
Faced with mounting inflation, debt from the Vietnam War, profligate domestic spending habits and a persistent balance of payments deficit , the Nixon administration decided to suddenly (and shockingly) end the convertibility of U.S. dollar into gold. In the wake of this “Nixon Shock,” the world saw the end of the gold era and a free fall of the U.S. dollar amidst soaring inflation. According to, Dr. Bessma Moomani in the article, " GCC Oil Exporters and the Future of the Dollar," through a series of carefully crafted bilateral agreements with Saudi Arabia beginning in 1974, the U.S. was able to promote bilateral political and commercial relations, market imported U.S. goods and services, and help recycle Saudi petrodollars (more on this later).
Through this framework of economic cooperation, and more importantly, petrodollar recycling, the U.S. managed to influence Saudi Arabia to persuade the other members of Organization of the Petroleum Exporting Countries (OPEC) to standardize the sale of oil in dollars. In return for invoicing oil in dollar denominations, Saudi Arabia and other Arab states were able to secure U.S. influence in the Israeli-Palestinian conflict, along with U.S. military assistance amidst an increasingly worrisome political climate that saw the Soviet Invasion of Afghanistan, the fall of the Iranian Shah and the Iran-Iraq War. Out of this mutually beneficial agreement, the petrodollar system was born.
Benefits of the Petrodollar System
Since the most sought after commodity in the world--oil--is priced in U.S. dollars, the petrodollar helped elevated the greenback as the world's dominant currency. In fact, according to the Bank for International Settlements (BIS) triennial survey, 87 percent of all foreign exchanges deals initiated in April 2013, involved the USD on one side. With this status, the U.S. dollar was able to enjoy, what some have asserted to be an "exorbitant privilege" of perpetually financing its current account deficit by issuing dollar denominated assets at very low rates of interest, as well as, becoming a global economic hegemony.
For instance, countries like China, who hold vast quantities of U.S. debt have voiced their concerns in the past about the possible dilutive effects to their asset holdings should the dollar depreciate. However, the privileges associated with being able to run persistent current account deficits come at a price. As the reserve currency, the U.S. is obligated to run these deficits to fulfill reserve requirements in an ever in an ever-expanding global economy. If the United States were to stop running these deficits, the resulting shortage of liquidity can pull the world into an economic contraction. However, if the persistent deficits continued ad infinitum, eventually foreign countries will begin to doubt the valuation of the dollar and the greenback may lose its role as the reserve currency; this is known as the Triffin Dilemma. (For more, see: How The Triffin Dilemma Affects Currencies.)
The petrodollar system also creates surpluses of U.S. dollar reserves for the oil producing countries, which need to be "recycled." These surplus dollars are spent on domestic consumption, lent abroad to meet the balance of payments of developing nations, or invested in U.S. dollar denominated assets. This last point, is the most beneficial for the U.S. dollar; as the petrodollars make their way back to the U.S., these recycled dollars are used to purchase U.S. securities (such as Treasury bills), which creates liquidity in the financial markets, keeps interest rates low and promotes non-inflationary growth. Moreover, the OPEC states are able to avoid currency risks of conversion and invest in secure American investments.
Below is a chart showing the flow of Gulf Cooperation Council (GCC) surplus capital:
Bloomberg, BOA Merrill Lynch by way of Financial Times" />
(For more, see: A Primer On Reserve Currencies.)
Recently there have been concerns of a shift away from petrodollars to other currencies, such as the Chinese yuan. These worries are not entirely without merit, as according to the Moscow Times, Gazprom Neft, Russia's third largest oil producer, has reiterated its commitment to sell crude in non dollar denominated terms. Furthermore, according to BNP Paribas, falling oil prices have decreased capital inflows from recycled petrodollars into the United States economy, as show in the chart below from BNP Paribas research.
While, it will not happen overnight, a drying up of recycled petrodollars would drain the liquidity of American capital markets, which will increase the borrowing costs for governments, companies and consumers as sources of money become scarce.
The Bottom Line
After the 1970s, the world switched from a gold standard and gave birth to the rise of petrodollars. These extra-circulated dollars have helped elevate the U.S. dollar to the world reserve currency. The petrodollar system also facilitates petrodollar recycling, which creates liquidity and demand for assets in the financial markets.