The end of the Petrodollar?

An occasional series on stuff not a lot of people know a lot about.

Bambaji, my wife, saw a headline asking, “The Saudis are selling oil to the Chinese in renminbi. Is this the end of the petrodollar?” What’s a petrodollar said she?

We need to go back to the 1970s when the then fledgling OPEC decided to raise the price of oil from $3 to $9, a somewhat more significant increase than we've seen recently in the price of oil, certainly in percentage terms. This left the Saudis with a lot of surplus dollars and the question of what to do with them. The answer came in that they would recycle these dollars into US Treasury bonds to help the US government fund their deficit spending. USTs were safe, secure and paid a decent rate of interest. Back then at least anyway.

The quid pro quo was that the Americans would supply Saudis with arms to deal with what was then a very aggressive Israel. This worked very well for the next 40 years. And then we had the Russian invasion of Ukraine. And one of the first things that the West did was to deny the Russians access to their currency reserves. In fact, they were confiscated. These were dollar reserves that the Russians held in western banks.

This gave other dollar holding countries pause for thought. If they can do that to Russia, then presumably they can do that to any nation that upsets the US or the EU.

The Chinese and the Russians had smelled this particular rat coming a lot earlier and have been selling down US Treasuries (the Russians pretty much eliminating them and the Chinese not adding to their pile) and converting surplus dollars to gold instead. The Saudis still have a lot of US Treasuries, but they are now thinking, well, we don't want to add to that pile, so we'll do deals for our oil in in other currencies. Hence the deal with the Chinese for them to buy oil in renminbi. Now what are the Saudis to do with the renminbi? Well, they can keep it on their balance sheet as it were, or like the Russians and Chinese they can use it to buy gold.

So, is this really the end of the petrodollar? The dollar still accounts for the majority of world trade something like 86% of which is carried out in dollars but there is definitely a move afoot, particularly amongst the Asian and obviously the Russian and Chinese economies to start dealing in currencies other than dollars. Notably India, not a small economy now that they now have a population larger than China, and under Modi, their influence is beginning to grow. It hasn't been fully felt yet as the transfer from dollar trading into rupees and renminbi trading has only just got started.

On the other side of the coin there is still a huge amount of dollar denominated debt, especially in emerging economies, and there is a huge demand for dollars to service and ultimately repay this mountainous liability., which is driving up the dollar and making the uphill struggle ever steeper. What they are not doing with their dollars is buying US Treasuries on the scale they did in the past when interest rates were much lower.

This of course, gives the US Treasury a headache because, at a time when the Federal Reserve are actually selling Treasuries back into the market, which they bought as part of their quantitative easing programme to provide liquidity and generally help the economy survive through the pandemic, they are spending more and more money on entitlements and benefits which require additional Treasury issuance.

So, there is a problem in that the diminishing significance of the petrodollar is going to have a negative effect on the US Treasury market. And we've seen that already in terms of interest rates rising. If there aren't sufficient buyers for US Treasury debt, and there certainly aren't as anything like as many foreigners buying as they used to be, then the price of the new Treasuries that they will be issuing has to go up. Things may change temporarily when the recession that seems to be baked into the proverbial cake arrives, but probably not until mid-2023. We may then actually start to see UST yields fall but certainly for the immediate future with the Fed continuing to raise the Fed funds rate (50bps or 75bps makes no difference to the direction of travel) UST yields look like staying high.

At the last Federal Reserve press conference, Powell was very, very keen to make the point that they are in this for the long haul i.e., they are not going to give up on inflation. They are going to keep the pressure on interest rates and even if they stop raising rates, they're likely to hold them at a high level for quite some time, and that level may in fact, exceed 5%, which is still quite a way above where we are at the moment. Bullard (President of the Federal Reserve Bank of St. Louis) has suggested it may reach 7%! The only thing likely to stop them in their tracks is something out of left field that unhinges the Treasury market and then we are back to QE and risk on. Oh…and higher inflation…

In conclusion, the petrodollar may be on its way out, but there's still a lot of trade globally done in USD so the end game for the dollar is still a long way off. But the writing is on the wall…