Opt Out

Achilles' heel, a metaphor for a fatal weakness in spite of overall strength.President Richard Nixon was a mastermind. He surrounded himself with people who, for both excellent and dreadful functions, were extraordinarily bright and perspicacious. In terms of management of the economy he dared to do what people thought would inevitably contribute to a decline in the USA – he audaciously removed the country from a gold standard (further background on the decision can be found in this article).  Notably, it was the next step that was perhaps his administration’s greatest stroke of genius. But first, let us recollect the accomplishments of step one.

With an abandonment of the USA’s fourth effort at maintaining a gold standard, the result was predictable. The nation would conserve its remaining gold and the dollar would decline in value – either in terms of other currencies that were backed by more than a promise, or through internally generated inflation resulting from money creation not backed by gold. While the dollar suffered from both effects, it was the inflation that exceeded a cumulative 50% from 1977 through 1981 that did the most damage. With these sorts of predictable and eventual difficulties, the decline would have to be arrested at some point. After all, a declining currency makes it less likely to attract foreign direct investment in new infrastructure, makes it more expensive to acquire raw materials, and generally destabilizes the financial system – amongst many other maladies. These negative attributes are currently ignored as folks trumpet the dim prospect that a declining currency will lead to an increase in exports. The truth is that a stable currency is what should be pined after. But, I digress.

So how can a country arrest the decline of its currency in a somewhat orderly and reliable manner? Enter step two. In concert with removing the dollar from the gold standard, President Nixon also negotiated with King Faisal of Saudi Arabia and other leaders in the region to exchange the pricing of their oil production in USA dollars in return for military protection of the newly formed – and some claimed barely legitimate – governments. In 1973 an officially reported agreement with Saudi Arabia was reached. More regional countries followed suit in the next few years. This agreement effectively guaranteed not just constant, but growing demand for dollars. Importantly the agreements also called for surplus revenues to be invested in USA Treasury securities – thus guaranteeing demand for USA debt. So the valuation of dollars in gold ended but was replaced, and effectively supported, by the demand for oil (and gas) priced in dollars. This is referred to as the ‘Petrodollar’ arrangement. Obviously, by connecting the value of the dollar to oil in this way also subjects the USA to the decisions and fortitude of those supplying oil.

All was well with this Petrodollar arrangement until the year 2000. The French and several other European Union members convinced Iraq to begin transacting oil sales in Euros. Between this time and just before the 2003 USA led invasion of Iraq, the countries of Indonesia, Iran, and Russia – to name a few – also voiced their interest in departing from dollar based oil sales. However, this talk ceased once Iraq was invaded. Interestingly, following a muted attempt by former leader Gaddafi’s Libya to depart from the petrodollar in 2010 (his idea was to use gold), late last summer other suppliers began to renew and vocalize their desire to depart from dollar based sales. This time the movement was initiated by Iran and Russia on the supply side. While this is an important development there appears to be something overlooked by global strategists; what about those that are actually purchasing the oil? What if a formally small segment of demand has effectively grown to become a majority of demand – and these end users no longer a desire to transact in dollars?

The assumption that controlling oil suppliers will ensure longevity of the 'Petrodollar' is wrong.

The chart above shows that Emerging and Developing Economies probably will account for the majority of economic production – and thus demand for oil – sometime this year. Further, the IMF estimates that by 2015 the Asia & Pacific region alone may account for more economic production than the USA and Europe combined. These trends are buttressed by the Nielsen Global Consumer Confidence, Concerns, and Spending Intentions Survey where they found that confidence in future economic conditions were dominated by the Asia and Pacific region. Out of 56 countries surveyed, just 11* saw their populations indicate positive expectations – six of these are Asia & Pacific components. Even if the IMF estimates as well as indications of economic confidence are waylaid a bit by unforeseen events, the trend is clear. Global GDP production is increasingly emanating from those who are not beholden militarily and economically to the USA. So it is not the suppliers that are the key to maintaining the Petrodollar, it is increasingly the folks who actually use the oil. If a buyers strike were to emerge then the Petrodollar’s days would likely become numbered. This is the USA’s Achilles heel.

While we have pontificated about large economies such as China developing trade while bypassing the dollar (click here for references midway in the article) we also note that many other cracks have appeared in the Petrodollar arrangement over the past six months.

China (the world’s 3rd largest economy**): Direct trade with Iran will be settled in Rial and Yuan, or barter. This effectively means that China may be the largest benefactor of the recent sanctions and efforts to shut Iran out of westernized oil, westernized tanker shipping, and westernized banking markets. The Chinese already consume 20% of Iran’s oil and natural gas exports (this is more influential than the USA’s consumption of roughly 12% of Saudi Arabia’s oil output). It likely will be uncomplicated to incorporate the newly available Iranian supply into the relentless Chinese demand. They will also continue to seek expanded supply from the Middle East. The Chinese have just announced multiple arrangements with Qatar and the UAE to establish new alliances and infrastructure build outs that will produce liquids bound for China. Most importantly China has announced an arrangement relating to settling payments for the infrastructure investment as well as the resulting liquids in Riyal (Qatar), Dirham (UAE), and Yuan. This echoes announcements that the world heard from the Nixon administration during the 1970s at the dawn of the Petrodollar.

Japan (the world’s 4th largest economy**): Direct trade with China will be settled in Yen and Yuan.

India (the world’s 5th largest economy**): Direct trade between India and Japan will be facilitated by currency swap arrangements. This is one step away from direct settlement in Rupees and Yen. India has also asserted that they do not desire to participate in the various economic sanctions against Iran. This is no wonder when one realizes that India consumes about 15% of Iranian production. Perhaps they too, like China, will be a welcoming buyer of the oil and gas that will be freed up by western sanctions.

Russia (the world’s 7th largest economy**): Direct trade with China, including oil and gas, will be settled in Rubles and Yuan.

The Middle East: In recent meetings hosted by the UAE, senior Chinese officials indicated and publically voiced a desire to create an international body that is mandated to determine the price of oil. The structure would regulate policies governing the entire supply chain involving the supplier countries, transit countries, and as this article unveils, the increasingly important and influential end consumers. Because this was widely reported in the region and echoed in a lengthy interview with His Highness Shaikh Mohammad Bin Rashid Al Maktoum, Vice-President and Prime Minister of the UAE and Ruler of Dubai, it indicates a willingness of Arabian Gulf countries represented by the Gulf Cooperation Council (Bahrain, Kuwait, Oman, Qatar, Saudi Arabia and the UAE) to move away from the Petrodollar.

So, while the Nixon Administration brilliantly formed the petrodollar based on alliances with the suppliers of oil, it appears that the true Achilles’ heel of the USA dollar is that of those on the demand side of oil. Recent events seem to add fuel to these observations and may become the critical ingredient in terms of countries opting out of utilizing the USA dollar.

* The complete list of eleven countries confident in their economic future are Brazil, China, Hong Kong, Indonesia, Malaysia, Philippines, Thailand, India, Saudi Arabia, U.A.E, and Norway.

** This ranking of countries in terms of economic output assumes that the Euro Area economies are cumulatively the largest, the USA 2nd, China 3rd, Japan 4th, India 5th, Brazil 6th, and Russia 7th.