The Dollar Is Still Essential

In 1974, during a crucial period of shuttle diplomacy, Secretary of State Henry Kissinger orchestrated an agreement of cooperation with Saudi Arabia. This landmark accord, negotiated in the aftermath of the Yom Kippur War, where the U.S. backed Israel and faced a crippling oil embargo by Arab nations, was a pivotal moment in global geopolitics.

The agreement, which recently expired and has been the subject of much chatter and hand-wringing, was never a secret and was extensively covered by mainstream media at the time. But the real story isn’t about the agreement; concern for the dollar arises from the agreement’s recently expired 50-year secret “side deal.”  

Comprising just six pages, the original agreement created two joint commissions between the countries — one addressing Saudi Arabia’s military needs and the other focused on economic cooperation. Records of an Oval Office meeting between Richard Nixon and Prince Fahd on the day of the signing show both parties agreed on the need for a robust Saudi military to protect itself and all of the Gulf states. 

After that, the military commission’s future work was detailed but relatively straightforward.  It focused on establishing what type and how much armament would be sold to the Kingdom for defensive purposes.

The Economic Commission’s meetings were straightforward as well but much more secretive.  Negotiated by U.S. Treasury Secretary William Simon, the details of economic cooperation remained in darkness until a Bloomberg 2016 Freedom of Information Act request brought them into the light.  Now, eight years later, that fifty-year side deal has recently expired, prompting predictions of economic doom by some and of total irrelevance by others.  Both reactions are extreme, but there is some truth in each. (READ MORE from Kevin Cochran: Inflation’s Puppeteer: The Government)

At the time, Simon, the former head of the Treasury Department’s trading desk at Salomon Brothers, was faced with two tasks: insulating the U.S. from another oil embargo and finding an outlet for financing the growing national debt.  The agreement brokered with Saudi Arabia achieved both outcomes by requiring the Kingdom to sell oil to the United States denominated in dollars and then to invest the proceeds of those sales by buying Treasury bonds. 

While not binding on other OPEC countries, they mostly all fell in line with Saudi Arabia, priced oil trades in dollars, and purchased U.S. Treasuries.  The Euro wouldn’t exist for another twenty-five years, and the British pound sterling was the only other currency marginally used for trades. There was no reasonable alternative.

Because of the Saudis’ leadership role and OPEC’s dominance in world oil markets, other countries outside the Middle East correspondingly followed suit by trading oil in dollars. This standardization also provided economic benefits to countries beyond the commodity itself by pricing petroleum transportation and its insurance in dollars. The more significant effect, however, was that it cemented the U.S. dollar as the world’s reserve currency. Global energy was denominated in dollars, and the profits from its trade were invested in U.S. Treasuries.  

With the agreement’s expiration, many now fear a collapse or a highly weakened dollar as a consequence.  Doomsayers foresee a move by OPEC away from dollar-based oil trade settlements and into other currencies, most notably the Chinese Yuan.  If that were to happen on a large scale, global demand for U.S. currency would drop, weakening it and strengthening the Yuan.  The effects on Americans would be more expensive imports and increased interest rates needed to attract Treasury investors.  But is this relegation of the greenback to second-world status likely? 

Looking behind the sensational hyperbole, there is some solid contrary evidence to the premise that the dollar will be abandoned. Because the agreement was only binding on U.S./Saudi trades, a not insignificant amount of oil has always moved outside the dollar’s purview.  JP Morgan estimates that as much as 20 percent of all petroleum sales are settled in other currencies.  

The UAE recently took payment for a trade denominated in Indian rupees, while French oil giant Total Energies has made deals valued in Yuan for liquified natural gas (LNG).  And, because of U.S. economic sanctions, Russia and Iran have not unexpectedly moved to pricing oil trades in the Chinese currency.  Trading without dollars has always existed, and while it has marginally increased in recent years, the shift is not because of the 1974 agreement’s expiration.

However, the dollar’s use for trading oil shouldn’t be the focus — its standing as a reserve currency is much more important.  It isn’t the currency you spend that matters; it’s the currency you hold.  All the big kids in the Middle East — OPEC’s major players — peg their currencies to the U.S. Dollar.  This includes not only Saudi Arabia and the UAE but also Jordan, Bahrain, Qatar, and Oman as well.  Abandoning the dollar as their reserve currency would decimate their economies. It’s not going to happen.

China, while not pegging the Yuan to the dollar, also has a hand in the game of maintaining the strength of the U.S. currency. The United States is China’s largest single trading partner — it needs a strong dollar to buy its exports.  Likewise, China is the second largest foreign holder of U.S. Treasuries (behind Japan), and a devalued greenback means significant losses for those reserves.  Indeed, trading oil with the Yuan transactionally makes life a bit easier for the Middle Kingdom, but it still needs to hold piles of dollars to maintain its export volume. That won’t change.

While the Biden administration hasn’t been overly friendly with the Saudi Kingdom, there is a decent chance that a new agreement on oil trading and treasury investment could be reached.  Saudi Arabia, notwithstanding its currency’s peg to the dollar, also holds a significant investment in Treasuries like China. 

The exact amount isn’t known as the secret 50-year deal obfuscates its holdings by lumping them into the reporting category of “other countries.” Still, it is estimated to be well in excess of $100 billion.  Regardless of the status of diplomatic relations, economic ones typically drive solutions. (READ MORE: An Economist Looks at the Immigration Crisis)

Yes, a few more independent oil trades may take place valued in Yuan, or even the Euro, but nothing significant enough to merit fear of the dollar’s collapse.  And, Russia and Iran may become used to using the Yuan and not abandon it even if the economic sanctions are removed. However, there is too much inertia behind maintaining the status quo for most oil trades. There’s a reason it’s called the Petro Dollar.

Kevin Cochrane is an economist, former senior banking executive, and regularly published national columnist.  He is currently a visiting professor at the University of the West Indies in Barbados and has taught university economics for the past two decades in the United States.

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