ANZ Finance blog | SWIFT-cheese & Petrodollars

SWIFT-cheese & Petrodollars

Published 1 April 2022

By Dr Peter J Phillips, Associate Professor (Finance & Banking) University of Southern Queensland

SWIFT-cheese & Petrodollars -- McGraw Hill ANZ Finance Blog

Late last year, we mentioned the connection between finance and national security. We talked mostly about SWIFT. The West’s financial system has long been a key strategic advantage that it can use to place pressure on its rivals. It was not surprising to see, therefore, that one of the first responses to the war in Ukraine was to restrict Russian banks’ access to SWIFT. Critics quickly noted, however, that access had not been completely closed. Why not? Because Western countries, some more than others, still need to transfer funds to Russia to pay for the significant amount of oil and gas that Russia supplies them. In fact, since the war began, Europe has paid Russia $19 billion (US dollars) for oil and gas. That’s $600 million a day during the first month of the war. And that’s only Europe. There’s roughly that much again coming from other customers, including the United States (though they have pledged to stop). More than $1 billion a day. That sounds like SWIFT-cheese.

Lost in the fog of war has been an even bigger picture that only some commentators have glimpsed. To glimpse it too, we need to consider the connection between the US dollar and the international oil market.

"Petrodollars have been a key supporting plank in the US dollar’s global hegemony as the world’s reserve currency since the 1970s."

The price of oil is denominated in US dollars. And the buying and selling of oil around the world is, for the most part, settled in US dollars. The US dollar as a unit of account in the oil market gives rise to the name “petrodollars”. Petrodollars have been a key supporting plank in the US dollar’s global hegemony as the world’s reserve currency since the 1970s. The world’s reserve currency is the one people prefer to hold when things get rocky. For five decades, this has represented one of the United States’ most important competitive advantages.

Imagine that in your town everyone uses IOUs when they buy and sell. Each family writes up their own, but people end up holding IOUs from different families. Their relative value (i.e., how many goods and services they exchange for) depends on how much a family produces and the relative demand for a family’s output. This is the real economy underpinning the purely monetary (IOU) one.

Now imagine two things: (1) your IOUs are your town’s reserve IOUs; and (2) the most important thing in town, food, is denominated in your IOUs. What advantage does this give you over everyone else? First, you can simply write up IOUs and exchange them for food. You don’t have to exchange them first, so you don’t have to worry about an exchange rate. Second, it doesn’t matter as much for you as it does for others what you produce in terms of real goods. People want your IOUs anyway (at least up to a distant limit). The result is that you can afford all sorts of things for your family. In fact, your family will have one of the highest living standards in town. But only if people still want your IOUs. If they stop wanting them, you are in a bit of trouble.

"What if the US dollar loses its place as the world’s reserve currency? And what have petrodollars got to do with it? And what has a war in Ukraine got to do with petrodollars?"

This leads us to some big questions. What if the US dollar loses its place as the world’s reserve currency? And what have petrodollars got to do with it? And what has a war in Ukraine got to do with petrodollars? These are not easy questions to answer, especially when you get into second-round effects. One thing, though, is very clear. If the price of oil was denominated in some other currency and oil exporting nations only accepted that currency, the United States would have to begin exchanging US dollars for that currency before using that currency to buy oil. The difference sounds slight, but it is profound. It’s the difference between you being able to write out IOUs for food and you having, like everyone else, to exchange your IOUs for whatever IOU the food sellers accept. You have lost a big part of your advantage, especially if the main reason people accepted your IOUs was not because of what you really produce but simply because of their position as the reserve IOU in town.

In late March 2022, Russia announced that it would only accept payment in Roubles for its oil and gas. It would not accept US dollars or Euros. Iran already only accepts Euros and Venezuela is trying to develop a cryptocurrency for its oil exports. The Russian decision probably has multiple motives. For one, sanctions imposed on Russia during the war in Ukraine make it difficult for other countries to obtain Roubles without breaking sanctions. It could be a move designed to place pressure on the alliance of “sanctioneers”. If Roubles could be obtained, the value of the Rouble would obviously increase. And Russia would still get Euros or US dollars in the end because it is the Bank of Russia (the Russian central bank) that would supply the Roubles that would be purchased by Russia’s oil and gas customers. But it could also be viewed as another small step towards reducing US dollar hegemony. This is especially important when one considers that China is actively negotiating with Saudi Arabia to denominate the oil price in Yuan and China already opened a futures market in 2018 where oil futures could be traded in the Chinese currency.

While the focus has been on oil supply and its price, the currency in which it is denominated has big implications for the global order and the struggle for supremacy in that narrow but critically important field of human activity is well and truly underway.

Discussion Question

What is a second-round effect of denominating the price of oil in US dollars? Or no longer denominating it in US dollars? [hint: research “petrodollar recycling”].

Further Reading

Foreign currency and exchange rates are discussed in Chapters 15 and 16 of the text.