What Happens to Petrodollars?

In my previous post I explained how currency exchange works. One of the related comment that is often made is that US would suffer an economic disaster if oil exporting countries start demanding payments in Euro. Some say that was the reason for attack on Iraq. In this post, I'll prove why such an action will not affect US economy. Although, a simple question is, given that most oil exporting countries are US enemies, then why they haven't already done so. Until 2008, even Iran which does not have any diplomatic relations with US was selling its oil in USD. Iran now receives its crude oil payments in Euro and has established an Iranian oil bourse where only products that are derived from oil are traded. At this point no trading is done for crude oil in Iranian bourse so all crude is still traded in dollars.

In my previous post on currency exchange I explained how USD at the end of the day is only used in US. Let's look at what happens to the money that Saudi Arabia receives for selling its oil in Dollar. So what do you think Saudi Arabia does with that money? I think most of you would answer that most of it is deposited in banks or invested. But where would that money be invested? Saudi government can buy US treasury bonds with that money if it wants to invest in US. Another option to invest in US would be to invest in US companies by either direct investment or buying stocks. Either way, the money comes to US and its demand or supply is determined by current market conditions. Another option for Saudi Arabia would be to invest it in some other country. In this case lets assume its some country in Europe. Now Saudi Arabia needs Euro for its investment purpose. In this case Saudi Arabia would first trade its dollars for Euro in foreign exchange market where the exchange rate will be determined by market forces as explained in my previous post. Then, it will use the Euro to invest in Europe. Similar scenario will occur for investment in Japan, Korea, Switzerland or any other country. USD will be traded in foreign exchange market for the currency of the country where money is to be invested. Now some people will say that, we think saudis or other oil producers just keep the money and they don't invest. that bring me to my next point which is why all these oil exporting countries which are US enemies, have been trading oil in USD till today.

Why Iran was trading oil in USD up until 2008? Why Iraq up until 2002 was receiving its oil money in dollars. Why didn't Iraq right after the end of first Gulf war in 1991, started demanding its payments in a different currency, let's say German Mark or Swiss Franc? And if Iran and Iraq were/are afraid of US response then why to this day Russia receives its payments for oil in US dollars? Is it also afraid of US sanctions? I am guessing you'd say no, Russia is not afraid of  US. And truth is that answer is much simple. It's just about good business. As much as Iraq or Iran or Libya (during Gaddafi's rule) hate US, they know what is good for business. If they don't get their payments in USD then what is the alternate? Swiss Franc? Where are they going to invest this money? Switzerland albeit a very well managed country, is not an Economy which can absorb the cash that comes from selling oil. Japan which is a distant third (it used to be second largest economy) is not as big as US and its Economy doesn't need most of the money that comes from selling which means, oil producing countries don't need their money in Yen.

So, oil is traded in USD not because US has some monopoly but because of the size of the US economy, it is just good business to trade oil in USD. Due to the economic sanctions against Iran, it can afford to do business in Euro or Yen but for Russia or Saudi Arabia or even Venezuela it is just not good business. At the end of the day, they need to invest or spend the money earned from oil. Last but not least, US economy is still the largest and strongest Economy. And as for the risks associated with economies, we know what happened to Japanese Economy in 90's and what is euro going through currently. By the way, Euro's demise was already predicted by many Economists years ago. This is what Paul Krugman said in 1998

"Here’s how the story has been told: a year or two or three after the introduction of the Euro, a recession develops in part – but only part – of Europe. This creates a conflict of interest between countries with weak economies and populist governments – read Italy, or Spain, or anyway someone from Europe’s slovenly south – and those with strong economies and a steely-eyed commitment to disciplined economic policy – read Germany. The weak economies want low interest rates, and wouldn’t mind a bit of inflation; but Germany is dead set on maintaining price stability at all cost. Nor can Europe deal with “asymmetric shocks” the way the United States does, by transferring workers from depressed areas to prosperous ones: Europeans are reluctant to move even within their countries, let alone across the many language barriers. The result is a ferocious political argument, and perhaps a financial crisis, as markets start to discount the bonds of weaker European governments."

One currency that I did not touch is Chinese Yuan. Simple reason for that is, that China is the biggest US lender. China itself would be the last country who would want oil to be traded in Yuan. I'll write about Chinese Yuan and what US means when it says that China undervalues its currency and that it hurts US exports (It's actually a good thing for US that China undervalues its currency because it helps US consumer. However it hurts those whose owns businesses that compete with Chinese exports to US).

How Currency Exchange Works

This is one of my favorite topics. Many people have misconceptions about how currency exchange works. So here I'll try to explain how it works and try to make it easy to understand. Later in a second post to follow this one, I'll try to explain about what US government means when they say China is deliberately undervaluing its currency. What are the advantages to China and how it hurts US or other trading partners. However this is a very complicated subject, so some basic understanding of Economics principles is required. I will use "Economics: A Survey" as a reference and some real data that I will use is from this book. If I use an example or text from this book, it will be italicized.

To make currency exchange simple, I'll use an example of currency exchange between two countries. Let's say US and Japan. The reason I chose Japan is because both US and Japan are strong economies and both have a lower inflation rate. It will make things simple to understand. Although in recent years Japan has experienced a deflationary cycle but I think its still a good example. Inflation rates for different countries. Let's jump in.

Money is just a commodity like all other commodities that are traded. So the price of one currency in terms of another currency in foreign exchange market is determined by its supply and demand. There are three major components of supply of USD in foreign exchange market.

1. Individuals and companies seeking to buy foreign merchandise (US imports).
2. US citizens and institutions buying foreign financial assets, for example US investment banks buying German bunds or US companies setting up factories or acquiring companies in a foreign country.
3. Foreign owners of US based factors of production seeking to convert their dollar factor into foreign currency.


Similarly demand for dollar has three major components

1. Individual and companies based in foreign countries seeking to buy US merchandise (US exports).
2. Citizens of foreign countries and foreign institutions buying US assets, for example US treasury bonds or foreigners investment in US companies (either through stock market or foreign direct investment)
3. US owners of foreign based factors of production seeking to convert their foreign currency into USD. For example if Apple decides to bring its $85B cash to US it would need to convert money held in foreign currency into USD.

Basically the above mentioned factors decide the price of USD in foreign exchange market. Let's first analyze the affect of inflation on the value of currency in foreign exchange market. Assume two country economy with Japan and US. At 2% inflation rate in the US, all US goods will increase by two percent. So a $100 item would cost $102. Japanese demand for US goods will decrease due to higher prices ($2 more). This means Japanese demand for USD will decrease. Similarly assuming no price changes (inflation) in Japan it will now be cheaper for US citizens to buy Japanese goods. This happens because prior to inflation when US citizens were buying US goods they were giving up $100 worth of Japanese goods. But now they will be giving up $102 worth of Japanese goods (remember no inflation/price changes in Japan). So it makes Japanese goods cheaper. As US citizens seek to buy more Japanese goods, this will increase the supply of USD in foreign exchange market. This will depreciate the value of USD in foreign exchange market. Following tables shows how important the effect of inflation is in the foreign exchange market [source: Economics: A Survey]. Inflation alone accounts for most of the changes in the value of the currency.

Now, let's look at the affect of government borrowing on currency value. Let's say that US government decided to cut taxes but not its budget. Now it has to finance this budget by borrowing more. This will increase interest rates. Higher interest rates will attract foreign investors to invest in US. US citizens who were going to invest in foreign countries are now going to invest in US as they are also attracted by higher return. As foreigners try to invest in US, they will increase the demand for USD and US citizens investing more in US rather than a foreign country will reduce the supply of dollars. Both of these actions will result in dollar getting appreciated in foreign exchange market.

Now here is the fun part. An appreciation in USD means that relative price of US goods has increased for foreigners. Let's say if a Japanese was paying 100 Yen to buy a $1 in US goods, then he might now have to pay 105 Yens to buy $1 in US goods. This will result in a decrease in US exports. Also for US buyers imports will become cheaper.

What this means is that, starting with a balanced budget and trade balance, when government decides to increase borrowing to fund its budget deficit, it increases interest rates, which result in inflow of capital into the country, reduces the outflow of capital, but at the same time increases imports and reduces exports thereby increasing the trade deficit.

I can write pages and pages about this, but in a nut shell, the price of a currency in terms of another currency is determined by three main factors described above. To see whether a currency has appreciated against or depreciated one should look against a basket of currencies to see the real change. For example, to see if USD has really depreciated in foreign exchange market, one should compare USD against not only Yen, but also against Euro, Pound Sterling, Australian Dollar, Canadian Dollar and currencies from similar stronger economies.

In the next post I'll explain what happens to USD that are used for oil trading in international markets and what will happen if countries decide to use a different currency for trading oil. I'll also write about how Chinese government controls the value of Yuan and US government's charge that it manipulates its currency to help its exports (I have already explained above how depreciated currency helps exports).

The Monkey Economy

Every fan of Economics must watch this video. Fascinating.

November's Job Report

Market last week soared based on some positive development in Europe and partly due to the unemployment numbers from November. Unemployment sharply dropped to 8.6%. If you read the unemployment report, you'll find that Non farm payroll increased by 120,000 in November. Out of this 120,000,  50,000 were employed by retail sector. Following is from the BLS, unemployment report.

"Employment in retail trade rose by 50,000 in November, with much of the increase occurring in clothing and clothing accessories stores (+27,000) and in electronics and appliance stores (+5,000). Since reaching an employment trough in December 2009, retailers have added an average of 14,000 jobs per month."


You don't need to be a Nobel winning Economist to realize that most people employed in November are due to the holiday season. I'd like to see the January employment situation before I get excited about the unemployment drop.