There were speculations that Saudi Arabia ended the Petrodollar Agreement it had with the US; while this has not been confirmed by official sources, this article provides some forward guidance on the likely impact of terminating the agreement.
A trip down the memory lane – The year was 1974; the Saudi’s were basking in the euphoria of their oil wealth. They had just found a resource that could control the world order in the next ten decades or more. The US was embroiled in cold war with the Soviet Union; both bloc desperate for economic, political and military dominance. The US government, seeing the potential in crude oil and the leadership of Saudi Arabia in that space, decided to send delegation to Riyadh to design an agreement, which will subsequently be called the Petrodollar Agreement. The detail of the agreement is that Saudi Arabia will be allowed to sell as much oil as it wants to the US, enabling the former to systematically manage its oil inventories. In return, Saudi Arabia will invest the proceeds from oil sale in the US in US treasuries, which will support deficit financing in the US. While it is widely believed that China is perhaps US biggest creditor, it is very likely the China shares that space with Saudi Arabia. Besides US, other countries like the United Kingdom and France had lobbied for similar arrangement with Saudi Arabia in the 1970s. Implicitly, the Petrodollar agreement meant that Saudi’s crude oil will be sold in USD and since Saudi controls OPEC, it was quite easy to influence all OPEC members to sell their crude in USD. Furthermore, another condition of the Petrodollar agreement is that the US will allow Saudi Arabia to bypass the conventional bidding process for treasuries. Instead, the US Treasury was allowed to directly take bid orders discreetly from Saudi Arabia and fill those bids. Saudi Arabia also requested that the US keeps the overall size of their treasury holdings anonymous. Simply put, the Petrodollar agreement was a clandestine ‘affair’ between the US and Saudi that supported US deficit financing and dominance of the Dollar.
There are potential reasons why Saudi Arabia would consider pulling the plug on the Petrodollar Agreement. Top of the list would be geopolitical tension. Saudi Arabia is a strong ally of the US, but it is opposed to US alliance with Israel. Saudi Arabia wants to rule the Middle East and the US has always lent their support. A good example was US role during the tension between Saudi Arabia and Iran. There is no blazing tension between Saudi Arabia and the US, but if there was something brewing, it would precipitate the termination of the agreement. Another reason would be Saudi’s plan to diversify their reserve currency. This is because most economies do not want to be subservient to the Dollar. In the event of a conflict with the US, there are several monetary sanctions the US can impose which could significantly stall economic activities. This is the current situation in Russia; however, Russia has gotten by due to its strategic alliance with China and the different channels to trade in currencies besides the Dollar. It is also likely that other countries are lobbying for similar arrangement and Saudi is weighing the pros and cons of the switch. Broadly speaking, the plug on the Petrodollar Agreement will likely be pulled due to geopolitical tensions or a need to reduce dependence on the Dollar
What would be the implications for the US? The US will push hard for the Agreement not to be cancelled and one of the reasons is because historically the Petrodollar Agreement has funded US fiscal deficit. When the US Treasury Department goes to the market to borrow, they rely heavily on big bids, which, as described earlier, come from heavyweights like Saudi Arabia. Although the size of Saudi’s bid is not public information, it is no news that the Saudi’s are heavy spenders. Therefore, the US Treasury will have to rely on other big bidders to close the gap. The US government may be trapped into two options – reduce spending or scout for new oil-rich countries to close their fiscal deficit. A termination of the Petrodollar Agreement could reduce the pace of dollarization globally, but the impact may not be significant. I am of the view that replacing the US Dollar as the world’s leading trading currency will be difficult because a leading global currencies should have a stable value over time; not be subjected to exchange rate fixing; have sufficient liquidity; tied to strong manufacturing and export; and should be generally acceptable. I do not think any other global currency checks all these boxes yet. So, while an annulment of the Petrodollar Agreement would allow oil to be priced in other currencies, the Dollar may still be involved in some cross currencies exchange. Another extreme possibility would be that the Treasury will have to offer their securities at higher yields to fill in the gaps from the repudiation of the Petrodollar Agreement. Higher yields mean higher debt service payment for the US government. Barring an official announcement of the annulment, the Petrodollar Agreement continues to hold and remains a valid complementary relationship between Saudi Arabia and the US.
Written by Michael Ogunremi
Credit – Bloomberg
Feature Image Credit – Unsplash