One of the many conspiracy theories about the Iraq war is that the US could not tolerate Saddam Hussein’s decision to designate his oil sales in euros, not dollars. To prevent other OPEC countries from also selling oil in euros, say the conspiracy theorists, the US invaded Iraq and ensured the hegemony of the dollar.
Rubbish. The US does not ask countries to trade in dollars. And for over a decade, it has let the dollar float up and down at will. The dollar has fallen over 15 per cent against the euro in the last year, but Washington does not care. There is no conspiracy here to keep the dollar supreme.
When then do most corporations and countries conduct trade in dollars unasked? To mitigate risks arising from currency fluctuations. Safety lies in conducting all international transactions in one currency rather than many. If you trade in dollars, borrow in euros, and keep foreign exchange reserves in yen, you run several risks. If the yen falls against the dollar, your forex reserves will decline even as your imports rise. If the euro rises against the dollar and yen, your debts will increase even as your exports and foreign exchange reserves fall.
Countries and companies are both risk averse. Avoiding currency risk means keeping most foreign transactions in one currency. And the safest currency is the dollar.
Why the dollar rather than the euro or yen? History provides the answer. In the heyday of British colonialism, the pound sterling was dominant. But World War II shattered all economies other than the US. At the end of that war, the only convertible currency in the world was the dollar. Ever since, global confidence has remained highest in the dollar.
Economic resurgence in Europe and Japan after the 1950s gradually increased confidence in their currencies. Indeed, the yen doubled against the dollar in the 1980s. Yet to bankers with a long view, the US dollar always looked the safest haven, and they flocked to it in crises. Good US economic performance in the 1990s heightened that confidence. Besides, the US markets for bonds and equities are by far the biggest and inspire the most confidence. By contrast, the Japanese and German capital markets are thin and risky.
All countries keep foreign exchange reserves as a safety cushion. Since the dollar represents safety, most global reserves of countries are held in dollars.
Forex reserves help finance imports. If your reserves are in dollars, you should import in dollars too, to reduce currency risk. So, dollar dominance in reserves translates into dollar dominance for designating imports.
But once you designate imports in dollars, you should designate exports in dollars too. If a company imports raw material in dollars and exports in euros, a rise of the dollar could lead to losses.
In sum, rational folk prefer to conduct most international transactions in a single currency as a form of self-insurance. This explains why OPEC (or for that matter India) trades mainly in dollars. The US is the biggest consumer of oil. OPEC countries keep their reserves in dollars. Many of their imports are dollar-designated. It is rational for them to sell oil in the same currency in which they buy goods and hold reserves.
Saddam Hussein designated his oil exports in euros as a political gimmick, lacking economic significance. It was like Nepal’s gimmick of creating a time zone 15 minutes different from Indian Standard Time. No other country in the world has such a tiny difference in time. But Nepal wanted to show its independence from Indian dominance, just as Saddam wanted to from US dominance.
No other OPEC country prices oil in euros, because of the currency risk. But for arguments sake, suppose they do. Will the US suffer? Not really. More countries will want to hold reserves in euros to reduce their currency risk, and rising demand could push up the euro against the dollar. That will make Europe more attractive for foreign investors. But European exporters will complain that a strong euro has made them uncompetitive, hitting production and employment. American exporters meanwhile will be delighted that a weaker dollar has made them more competitive. So a strong dollar or a strong euro is a mixed blessing for the countries concerned. It helps attract foreign investment but also damages exports, production and employment. That is why the US and Europe leave it to markets to decide the exchange rate.
The fact that most world trade is designated in dollars does not make the US strong. Rather, the strength of the US economy leads people to designate trade in dollars. The very humdrum aim is to reduce risks of currency fluctuations. No conspiracy theory is needed to explain this.
Wrong: “Safety lies in conducting all international transactions in one currency rather than many.” How does this work with customers/vendors who insist on being invoiced in their own currency? For example, I charge my foreign clients in rupees, dollars, or euros, based on my own buying/selling requirements as well as those of the other participants in the market. When I buy from a European seller, I have to pay in euros, when I buy from a Singaporean company, I pay in Sing dollars. OPEC member countries like to be paid in US dollars because they wish to buy US bonds, which have to be paid for in US dollars.
Interesting. Well while I would agree that there probably wasn’t a conspiracy to invade Iraq for this reason (although you never know), I do wonder about the dollar’s future as the reserve currency and I don’t think its a good assumption that this is set in stone for ever. It is true that large foreign transactions tend to be in dollars, but given the level of US borrowing, and the somewhat stable alternatives of the Euro and the IMF SDRs I wonder if there is a threat to this continuation. I am sure some of the US government’s recent actions (e.g. debt ceiling questions) hasn’t helped confidence. Some large countries such as China and Germany have agreements to trade between each other in their own currencies now. It might take some kind of tipping point like OPEC raising the specter of trading with the European countries, at least, in Euros to send this over the edge. If this happens then I would hate to have money tied up in dollars – which his a shame for me as I do live in the US now!
Care to comment. Thanks for the article.