An event that can be considered historic is happening quietly amidst the guilty silence of the media. After half a century, Crown Prince Mohammed bin Salman’s Saudi Arabia has not renewed the agreement on the so-called petrodollars. It was officially signed in 1974 and expired on June 9th, but the kingdom did not want to follow up on it. The long-term implications for the supremacy of the dollar American are likely to be overwhelming.
Dollar guaranteed by the ’74 agreement
Before understanding why, let’s see what the agreement included.
We have to go back to 1971, when Richard Nixon’s administration declared that it could no longer guarantee the convertibility of the dollar into gold. The agreements of Bretton Woods of 1944 suddenly became waste paper. Western currencies entered a phase of instability. The very supremacy of the greenback was in danger of disappearing. To avoid the worst scenario, the then National Security Advisor Henry Kissinger convinced the president to fly to Riyadh to stipulate a historic agreement with King Faisal: the United States would guarantee military security to the kingdom, while the latter would not only sell the oil needed to satisfy American demand, but would undertake to accept only dollars as a means of payment from all customers.
Win-win operation
The exchange was “win-win” for the parties. The Saudis were able to focus on their own economic development without worrying too much personally about instability in the Middle East. Americans continued to benefit from the dollar as world reserve currency. In fact, that agreement forced the entire planet to hold dollars to buy oil and other raw materials. The demand for dollars remained high and this brings undoubted advantages to this day: US debt securities always find another demand on the markets, with the consequence that governments, companies and banks in the United States can borrow at low cost and at the same time have a strong change.
What happens if the agreement is not renewed? Let’s keep in mind that tensions between Riyadh and Washington have been going on for some years. The prince detests Joe Biden for his past hostile statements on human rights against the kingdom. On a geopolitical level, there is the belief that Asia will be the main long-term outlet market for oil, while the West is a mature market and, above all, intent on loosening its dependence on fossil fuels with energy transition.
Consequences of failure to renew the agreement
Failure to renew will not have immediate consequences. The dollar remains a currency without alternatives for various reasons. None enjoy the same liquidity, as well as the degree of security guaranteed by the legal and financial system of the United States. It is unthinkable that there are people or entities in the world eager to replace the greenback with the yuan or even the euro. For years, however, China has been leading the front of countries hostile to the dollar with the intention of dethroning its primacy, at least in the Asian regional context. The huge purchases of gold by its central bank go in this direction, imitated by the other banks, to the complete detriment of the purchases of Treasuries.
In the long term, the consequences could become disruptive if Saudi Arabia actually regulates trade in other currencies with non-American customers. An agreement has already been signed with China to make payments in their respective currencies. Given that exports to the United States are now low, there is a serious risk for Washington to see one escape from the dollar. And this would happen precisely in a delicate phase for its fiscal situation. Federal debt is growing at a rapid pace, reaching 125% of GDP at the end of 2023.
The cost of issuing Treasuries would rise even faster and the entire interest rate structure would rise.
Risks to the US system from the dollar no longer being a global currency
Suddenly it would become more expensive for the American system to borrow, that is, to invest and purchase durable goods in installments. As if that weren’t enough, the dollar would lose value against other currencies. L’inflation it would also rise due to the higher cost of imported goods. And the Federal Reserve would be forced to keep rates higher than it does today, having to deal with a greater gearbox instability. The United States would become a normal nation, that is, subject to the laws of the economy like the rest of the planet. And it would be painful for a system accustomed to believing for decades that it can spread and spend without negative consequences, managing to attract capital from abroad and having stable prices and low rates at home. Some in Washington are giving little weight to what (did not) happen in Riyadh.
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