Reserve currencies are held by governments and institutions outside the country of issue and are used to finance international economic transactions, including trade and the payment of debts.
Reserve currency status is not just an international status symbol. It brings international seigniorage, benefits for ‘home’ financial institutions, relaxation of the ‘external constraint’ on macroeconomic policy, a greater role for the issuer in international institutions, and the wider geopolitical consequences of exercising currency hegemony. However, this all changed in 1971 when President Richard Nixon took the dollar off the gold standard that has been agreed to at the Bretton Woods Conference in 1944. Thus, the dollar has been an irredeemable currency, no longer defined or measured in terms of gold. This removed the restraints on printing new dollars. The dollar has become the world’s dominant currency and the core reserve asset of central banks all over the world. It has replaced gold as an international currency. Central banks around the world have built up large reserves of dollars. Those dollars flow back into the US banking system in the form of investments in US dollar-denominated assets. The dollar hegemony is key to the future of American global dominance, in many respects as significant if not more so than the overwhelming military strength. And the petrodollar has been at the heart of the dollar hegemony since the early 1970s.
Almost two-thirds of the world’s currency reserves are kept in dollars because oil importers pay in dollars and oil exporters keep their reserves in the currency they are paid in. The entire global oil trade is conducted in dollars. This means that everyone needs to keep dollars. This effectively provides the American economy with an interest-free loan, as these dollars can be invested back into the U.S.A. with zero currency risk. This money is not inactive; it is invested in dollar securities like US Treasury notes, stocks, mutual funds, and bonds. The US dollar’s current strength is supported by OPEC’s requirement that all OPEC oil sales be denominated in dollars. This was secured by an agreement between the US administration and Saudi Arabia, the largest OPEC oil producer. This had been determined in June 1974 by Secretary of State Henry Kissinger, establishing the US-Saudi Arabian Joint Commission on Economic Cooperation.
In 1975 OPEC officially agreed to sell its oil only in dollars. America today practically borrows from the entire world without keeping reserves of any other currency. Because the dollar is the de facto global reserve currency, the US currency accounts for approximately two-thirds of all official exchange reserves. America does not have to compete with other currencies in interest rates; even at low-interest rates, capital flies to the dollar. The more dollars there are circulating outside the US, the more the rest of the world has had to provide the US with goods and services in exchange for these dollars
The fact that the world uses the currency in this way means that the US is importing vast quantities of goods and services virtually for free. The US has a luxury of having its debts denominated in its own currency. This is the position the US has enjoyed for 30 years. It means that the US has been afforded a huge subsidy from everyone else in the world. The United States economy is, therefore, intimately tied to the dollar’s role as reserve currency. The dominant position of the US dollar in world markets is not only a matter of pure economics but also “deeply rooted in the geopolitical role of the United States.” Until the advent of the Euro in late 1999 there was no potential challenge to this dollar hegemony in world trade.
The coming of the Euro has threatened the dominant role of the US dollar as reserve currency. Some European leaders have even said that the Euro’s main aim is to put Europe on an equal monetary footing with the United States – ending the dollar’s ‘hegemony,’ in the word of former President Jacques Chirac of France. In just a few years, the Euro has emerged as a real alternative to challenge the dollar. It has established itself as the second-most important currency in the world’s financial markets. Just before the introduction of the Euro, the outstanding amount of bonds and notes denominated in the legacy currencies of the Euro accounted for barely 28% of world issues, compared to 45% for dollar-denominated bonds and notes. By mid-2007, the gap became much smaller: the share of issues in dollars had fallen to 32%, while the Euro’s share had increased to 51%. And even more, spectacular development took place on the money market. At the end of 1998, money market instruments denominated in the Euro’s predecessor currencies accounted for just over 17% of world issues, compared to 58% for dollar-denominated instruments.
By mid-2007, the share of issues in dollars had fallen to 19%, while the share of Euro issues had climbed to almost 61%. The Euro today accounts for over one-quarter of the global market. Iraq was the first OPEC country, in November 2000, to convert its reserves from dollars to Euros. This was the first time an OPEC country dared violate the dollar price rule. Iraq also converted $10 billion of its currency reserves to Euros. Since then the value of the Euro has increased, and the dollar has begun to decline. Libya has been urging for some time that oil be priced in Euros rather than dollars. Iran, Venezuela, and other countries have begun to denominate their petroleum trade in Euros. In 2002 the majority of reserve funds in Iran’s central bank had been shifted to Euros. Some in Saudi Arabia have called for switching to the Euro as “a more effective punishment [than an oil embargo] for the United States, Israel’s principal source of financial and political support”. Russian President Vladimir Putin has threatened to price its oil in Euros as well.
Since the oil trade is a central factor underpinning the dollar’s hegemony, all these are potentially very significant threats to the strength of US economy in particular and the US global hegemony in general. With a significant part of the petroleum trade using the Euro instead of dollars; many countries would have to keep a part of their reserves in Euros. The dollar would then have to compete with the Euro for global capital. Not only would Europe not need dollars anymore, but Japan (which imports more than 80% of its oil from the Middle East) would have to convert most of its dollar assets to Euros.
The US, too, being the world’s largest oil importer would have to get hold of Euro reserves. This would be disastrous for the American attempts at monetary management. Not only they would lose a large part of their annual subsidy of effectively free goods and services, but the switch to Euro reserves from dollar reserves would bring down the value of the US currency. Even a modest shift out of dollars, or a change in the flow, would create significant changes. If the Euro becomes a bigger reserve currency [i.e. if the US were to share its reserve currency status with the Euro] it is also likely to mean that either the US buys more Euros or the Europeans reduce their dollar holdings and buy Euros. That is why there is a clear and definite oil (and petrodollar) connection in the recent military conflict in Iraq. This financial dimension is a power game of the highest geopolitical significance.
The future of the dollar/Euro competition to be the global reserve currency is far from a minor issue of interest only to banks or currency traders. A hidden war between the dollar and the new Euro currency for global hegemony corresponds to two different perceptions of the global order: Pax Americana, or the American Century model of global hegemony on one hand; and to balance the overwhelming dominance of the U.S. in world affairs on the other. Consequently, the war in Iraq is a war whose purpose is much bigger than fortunes of Halliburton or Exxon: it’s a long term and a strategic objective being fought to maintain America’s position on top of the world.
Dr. Aref Assaf is president of the American Arab Forum, a think-tank specializing in Arab and Muslim American affairs, www.aafusa.org.