PACING PETRODOLLAR-S
EDU DDA JUNE 1, 2024
Summary: The dollar continues to be dominant in the most critical aspect of the modern reserve currency dynamic: FX. Despite the loss of some “petrodollars” there never was a threat from the “petrodollar” because the latter never existed. Economics has left the public with a host of misconceptions since Economists have failed to accurately account or even depict how money functions let alone reserve currency money
Sometimes a single letter can change everything. Consider the case of the so-called “petrodollar.” For many, this has come to be the essential case in foreign exchange and thus critical to the ongoing survival of the US dollar as the world’s reserve currency. Should Saudi Arabia and the United Arab Emirates further team up with Russia and China, the thinking goes, the petrodollar would wither and die.
That’s not an accurate representation of where things stand now, nor does that statement reflect what might happen as those countries conduct more bilateral exchanges than they already have been. Instead, petrodollars would increasingly disappear yet leaving the eurodollar system undisturbed. Including the “s” at the end of the term reduces its meaning back to its proper assignment.
There is not now, nor has there ever been, a petrodollar system. One has been conjured in broad imagination quite understandably from a limited view into the eurodollar’s world (there’s another “s” in its correct place). This, too, is yet another defect of Economics, having left the functions of the entire global reserve currency architecture completely out of all of its textbooks and mainstream discourse.
Worse, the Federal Reserve has been stood in its place if only as an avatar.
This was not always the case. Before the Volcker era conjured up a monetary myth (that interest rate policy is a substitute for real money policies and knowledge), eurodollar functions were more widely known. It is debatable from our later perspective just how widely, though the volume of interest and scholarship in the topic was substantial up until around the middle eighties.
A byproduct of the legit booming global economy of that era was that people came to assume these matters were unimportant especially as the Great Inflation began to fade away. While it was raging, however, there were concerted efforts on a number of fronts to understand, detail, even quantify its scope and reach. Many had come to appreciate the gravity.
In 1975, for instance, in the shadow of the first oil crisis of the decade, President Ford’s economic report to Congress contained a supplemental section on the beneficial connection between the eurodollar system and one of the somewhat positive outcomes (if you could call it that) of the oil embargo. The skyrocketing price of oil had radically altered the financial standing of a great many countries.
Before 1974 (the embargo was instituted late in ’73), oil exporters were more likely to have been poor and cash-starved due to the relatively low and stagnant price of crude along with lack of diversity in economic capacities (oil or nothing). To participate on global markets, they were net dollar borrowers obtaining funds from the eurodollar system which had been in place and serving reserve currency roles since the late fifties (and arguably further back in time to the late forties, under what was called then the “Continental dollar” for how it was mainly European, later shortened to eurodollar for obvious reasons).
In other words, the eurodollar system redistributed currency (primarily but not exclusively in dollar denomination) from those who had it to those who needed it – the most essential aspect of any reserve design. Its most desirable aspect was its ability to adapt to circumstances, as would be the case for the oil crisis.
When oil prices soared due to the embargo, the situation flipped all the way around but not for the eurodollar. What shifted was those who were borrowing and who would be lending. The previous cash-poor oil exporters suddenly became cash rich. Meanwhile, countries that previously had currency surpluses found themselves with deficits having to pay more to obtain that form of energy.
As the President’s report noted:
The discussion of the international financial aspects of the "energy crisis" brought into public focus the Eurodollar market as an important channel for moving funds from the oil-exporting countries to borrowers. The recycling of "petro-dollars" has been merely one of many functions performed by the Eurodollar market over the years of its existence.
Those petrodollars became a subset of the eurodollar only because of who was lending those “dollars.” Had there been no embargo, the system would have gone on as before. The petrodollars label was applied as a special case only to denote the change in direction for redistribution of currency, not the currency or the system itself.
That point was even made clear in the same report:
The Eurodollar market, as such, has no specific location. Its physical dimension is a network of international telecommunications media which link financial centers around the world and through which Eurodollar transactions are conducted. Eurodollars are dollar-denominated claims on commerical [sic] banks located outside the United States, largely but not exclusively in Europe. They are dollar funds placed with foreign banks by either U.S. or foreign residents, and maintained on the books of these banks as dollar-denominated liabilities to the depositors.
This work was put together by economists, too, meaning at one time nearly a half century ago even those working within the political realm understood real monetary mechanics in a way none of their successors have been able. And that is why the myth of the petrodollar has lived on though petrodollar never actually existed in the first place, just petrodollars.
The economists even manage to appropriately compare the eurodollar to a telecommunications network. That’s not to say there weren’t errors in the report, mistaken interpretations and assumptions about key aspects. Those were understandable given the state of knowledge, but that’s also a main point here – the state of knowledge was never sufficient back then yet many experts and scholars clearly possessed more than a rudimentary awareness of the eurodollar’s existence and its key features.
Rather than progress to fill in those gaps, from that time forward mainstream thinking has very clearly regressed and to highly detrimental effects (Global non-Financial Crisis being the most obvious example). Everyone can see there are critical international components to “the dollar” but all we are given for money is the Fed, so people have made up a petrodollar as a consequence when in terms of the reserve currency it was a trivial shift.
Though numerous threats to “dollar dominance” have been proposed especially in recent years, at least that part makes sense given the state of the eurodollar, the loss of the petrodollar was never actually one. The more oil the Saudis sell to the Chinese using yuan merely lessens the dollar balances China will have to source from the eurodollar market leaving Saudi Arabia with fewer in its own accounts.
Setting aside reserve currency reality, many critics who cite the petrodollar claim this is still a substantial setback. If fewer people are using the dollar in trade, eventually the dollar should wither leaving the door open for competing arrangements (that they happily and conveniently sell you, be it gold, Bitcoin or whatever else).
But that’s not what the data shows. On the contrary, by all accounts the eurodollar continues to be more than dominant. In many ways, its role has increased not diminished even as bilateral trade has become more frequent and not just in relation to China or, say, Russia. The loss of some petrodollars hasn’t made much or any difference at all (again, this should not be surprising).
Reserve currency business in this stage of the eurodollar’s existence is almost entirely FX. Foreign currency swaps and FX have become the central point of all global commercial and financial flows. This, too, makes sense because in an environment where broken-down money dealers are therefore highly balance sheet constrained, any derivative contract is going to be many times more balance sheet efficient.
The thing is, while accounting conventions basically overlook these derivatives (why they are so efficient) the derivatives function as close, near-perfect substitutes. An FX swap can and probably should be considered as a synthetic repo. The properties are highly similar as are motivations driving these transactions, as well as the results. A key difference is the collateral; in cash repo the borrower typically uses a financial asset such as a Treasury instrument whereas in FX it is some kind of foreign currency.
FX has exploded over the last decade due to the balance sheet constrained environment. Business still needs to get done and the eurodollar (not petrodollar) system is evolving as best as it can given these limitations. This, by the way, is one of the features which made the eurodollar dominant in the first place, the capability to adjust as the dynamic world we inhabit changes constantly.
Flexibility is absolutely critical to a reserve currency and no other alternative can come close to matching it. What’s sorely lacking from the eurodollar since 2007 is liquidity. You can clearly see this even for the trajectory of FX; put it on a log scale and the trend change is obvious which also coincides with the Silent Depression and all the monetary characteristics associated with it.
As a result, FX volumes have surged just not nearly enough (especially at important times, our eurodollar cycles). Using the BIS data on gross notionals, total FX reached $118 trillion as of the latest update for the second half of 2023. Of that, the US$ was involved in 87%; meaning, out of almost all FX transactions, nearly every one uses the US$ on the other side. And that share has been relatively constant throughout the entire series.
As a true reserve, the eurodollar very often translates between two different non-dollar currencies. As the BIS put it in its last report on the subject:
Dollar dominance is striking in this FX market segment, greater than in any other aspect of dollar use. As a vehicle currency, the US dollar is on one side of 88% of outstanding positions – or $85 trillion (Graph 1.A). An investor or bank wanting to do an FX swap from, say, Swiss francs into Polish zloty would swap francs for dollars and then dollars for zloty.
In other words, the eurodollar is a true global medium and it hasn’t changed one bit despite all the challenges since 2007. If you want to see what a dying reserve currency looks like from the FX perspective, look instead at the yen. At one time, the yen was on its way to becoming a quasi-reserve but nowadays it is atrophying as the economy continues to stagnate and there really is no other use for yen as a true medium.
The Canadian dollar, on the other hand, has seen as a surge in use which is disproportionate to its economic and financial status. This is likely Chinese in origin, using the Canadian dollar as a way to access the eurodollar system still intermediating through it despite the fewer petrodollars they are paying.
But therein also lies our problem. The eurodollar system has the capabilities but no longer the capacity. For a competing monetary system to replace it requires that monetary system to, at bare minimum, be realistically able to replicate its functions. Even in this malfunctioning state, the eurodollar is orders of magnitude more useful than anything else starting with China’s yuan.
So, as Saudi Arabia or some countries in Africa (often not by choice) end up getting paid in CNY, there is simply little for them to do with those balances apart from buy only from China or, as Beijing would like, invest in China itself (something no one really wants to do these days). You sure aren’t going to be able to intermediate from francs through CNY into zloty.
Bilateral trade and currency swap arrangements are a useful though only ever small-scale adaptation. There may be fewer petrodollars these days, but the eurodollar doesn’t seem to be missing them. And that is the problem.
