Gold had a great week this past week hitting its all-time high of $1062.70 in nominal U.S. dollars. While there are many factors to such a rise in prices, an article by Robert Fisk on October 6 in The Independent, a U.K. newspaper, helped spur some of the action.
The article, entitled "The Demise of the Dollar", has set off something of a firestorm in the financial and political blogosphere. The article suggests that a secret agreement has been reached between key nations to end the pricing of oil in U.S. dollars which would subsequently end its dominance as the world's reserve currency. Is this a true signal of the dollar's collapse? Is hyperinflation around the corner? Or is this just overblown rhetoric and meaningless scaremongering? In order to answer these questions, we have to get a basic understanding of the world's currency markets.
All modern major currencies are fiat currencies and no longer exist on a commodity standard such as gold. Since the currencies cannot be converted into a commodity which has inherent value, the value of the currency is determined by the dynamics of supply and demand. These dynamics play out in the foreign exchange markets (forex) which set the prevailing rates of exchange between international currencies. The forex market accounts for between $3-4 trillion (yes, with a "t") of trading per day! It is the largest of the financial markets - bigger than stocks, bonds, commodities, or any other such market. Currencies are traded twenty-four hours a day for five days of the week. Banks and other financial institutions, multinational corporations, hedge funds and central banks are the biggest players; although, individual investors and many others also play the market.
To understand the value of a currency, one must break down the factors which contribute to the supply and demand for that currency. A currency is demanded when it is required for payment of goods and services or desired as a store of value. In the domestic economy, the fiat currency has its value since the government establishes it as required for payment of taxes. This gives the currency much of its inherent value. Consider a multinational corporation. It must pay its employees in a variety of currencies and may incur other expenses in multiple currencies as well. Similarly, revenues are collected in various currencies as customers generally pay in their local currency. Such corporations establish bank accounts in multiple currencies and execute currency exchange transactions to manage the differences in how their revenues and expenses are denominated. They also trade currencies to mange risks associated with changes in exchange rates.
Banks will also engage in currency trades for similar reasons as the multinational corporations. Banks also engage in transactions with central banks which adds an additional element to the supply and demand dynamics. Central banks issue currency and maintain reserves held against the issuance. Many central banks hold reserves of foreign currencies as assets which "back" the issuance of new currency which is considered a liability. This is a process which deserves its own article, but, needless to say, the actions of central banks and their relationships with commercial banks have an impact on the demand for various currencies.
These are some of the most important factors which impact the demand for a particular currency in the forex market. The supply of a currency is also variable. It would seem that the total circulation of the currency as issued by the central bank would be the most important factor in the supply of a currency. This is not entirely true for a few reasons. First, money supply measures do not fully capture credit money (money "created" by banks) and the potential expansion thereof. Second, and related to the first, leverage is widely used in the forex market. In other words, traders will take on debt to enter the forex market. Third, the supply of a currency in the forex market is dependent on the desire of the trader to not hold on to that particular currency. The currency of a completely insulated national economy with no international trade would have very little (if any) supply in the forex market regardless of the total supply of such a currency.
With this background, we can turn to the oil market. Since the 1970s oil has been (for the most part) priced and sold in U.S. dollars. Oil producing countries seeking to sell oil around the world have demanded U.S. dollars as payment for oil. This, along with other factors, has helped establish the U.S. dollar as the primary reserve currency of the world. Everyone needs oil. Thus, everyone needs dollars. This implicitly creates a demand for U.S. dollars as those who buy oil need to exchange their currency to complete their transactions. This also places dollars in the hands of oil producing countries who can either hold them (as reserves), invest them (by purchasing dollar-denominated assets such as U.S. treasuries or stocks), or exchange them for other currencies.
The term used to describe the dollars earned by these oil producing countries is a petrodollar. When these nations invest their petrodollars in other assets, it is referred to as petrodollar recycling. This recycling process leads to investment. The investment is arguably very favorable to the United States. Since countries such as Saudi Arabia, Kuwait, and Qatar amass large amounts of petrodollars, it enables easy recycling towards U.S. stocks and bonds. If oil were priced in euros or some other currency (or possibly even a new currency), these nations would now hold something other than dollars.
A key question is how such a change would change the behavior of the oil rich nations. If they earned an increasing amount of petroeuros (for the sake of argument), they could either hold them as reserves or recycle them. Holding them as reserves would link the value of their currency more closely to the euro. Recycling would imply either increased investment in euro-denominated assets or utilizing the forex market to sway euros for, say, dollars. It seems clear that if the oil producing nations prefer to hold and/or invest dollars, they would prefer to demand dollars for oil rather than accepting euros only to swap them later for dollars.
According to the Fisk article, China, Russia, Japan and France are involved in the discussions with the oil producing Arab nations to end the petrodollar hegemony. If this is the case, then it implies that these nations would prefer to avoid having to hold as many dollars as they do today. These countries acquire their dollars today via trading relationships, existing currency reserves, and the forex market. Their desire to move away from dollars would indicate an expected decrease in trade with the U.S., a desire to maintain or reduce their dollar reserves, and/or seeking to avoid the forex market. The last one is an unlikely reason since this would imply an expected increase in the value of the dollar.
However, the status of the U.S. dollar as the world's primary reserve currency is due to more than dollar-denominated oil. The U.S. is by far the largest consumer economy and importer of international goods and services. Other economies depend on a health U.S. consumer and, as a result, need the U.S. dollar. The U.S. has also been the leader in technology and other economic expansion which attracts foreign investment; this too creates demand for the dollar. Finally, political stability and military dominance solidifies the dollar as a safe investment. All these factors, in addition to the petrodollar hegemony, ensure U.S. dominance.
Will these things come to an end? Not anytime soon... but, the tide may be well be shifting. An end to the petrodollar hegemony may be an important step towards the end of the U.S. dollar hegemony and, ultimately, the end of U.S. political and military dominance.
For additional reading, see here and here.
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