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).