Given the general tendency for crude oil prices to rise and become more volatile in recent years, it can be argued that crude oil trading may, in the long term, be a significant liability for the stability of the currency in which the trade is conducted. With crude prices hovering around $100 a barrel, oil importers accumulated huge bills they could not pay and oil exporters accumulated large amounts of US dollars - more than they knew how to use.

These dollars were known as ‘Petrodollars.’ The vast majority of the world’s countries are oil importers and, since oil is such a crucial commodity, the need to pay for it in dollars encourages these countries to keep the majority of their foreign currency reserves in dollars not only to be able to buy oil directly but also to protect the value of their own currencies from falling against the dollar.

Because a sudden devaluation of country’s currency against the dollar would lead to a jump in oil prices and a possible economic crisis. Oil being denominated in dollar, determines the economic and the currency position of both the net exporters and the net importers of oil. The importers generally keep the reserves in dollar terms to cope with the import bills for oil. Any rise in the crude prices raises the demand of the dollars and the dollar seems to strengthen. But this is possible only upto certain extent.

Intricate relationship

Beyond a certain level if the crude rises there is a fear of recession in the importing economies leading to a fall in the demand for the dollars. This has to be favourable for the US currency considering that the slowdown in other economies should appreciate its currency. However since US is the major oil importer the fear of a possible recession in US has weakened the dollar.

Similarly when there is a fall in the crude prices beyond a certain level there would be sudden selling of dollar as higher dollar reserves are not required for crude buying. This results in weakening of US dollar creating an worry among the exporters of crude since the greenback is losing its value. Thus they are again provoked to rise the prices by manipulating the inventory level of crude.

As the dollar is losing its strength   crude traders have taken it positively. This shows the vulnerability in the concept of Petrodollar. High crude prices are welcome by the oil exporting countries but beyond a certain level they create a fear of recession, as any fall in the value of the greenback will cause a fall in their oil revenues. This is one of the reasons why the financially stronger members in OPEC  want the crude prices to come down from the $100 level. The largest oil producer Saudi Arabia believes a moderation in oil price is desirable for the long term benefit of OPEC countries.

Many believe that volatility in oil prices could be tackled only by the way of recycling of the Petrodollars. Oil producers play a significant role in financing the current account deficit gap of US. High oil prices have contributed to enormous financial outflows from the oil exporting countries to the US.

Give and take

The way in which oil exporters deploy their revenues has important implications for oil importing countries. Higher oil prices reduce purchasing power in oil-importing countries and thus are a drag on their growth. But when oil exporters use the revenues from oil sales to increase their purchases of goods from oil-importing countries, these negative effects on growth are reduced. Increased purchases of foreign assets by oil exporters can also help sustain growth in oil importing countries.

If oil prices remain high, oil-exporting countries can increase spending. Ideally such spending would be concentrated in investments in order to strengthen the economy and raise standards of living. High oil prices have contributed to enormous financial outflows from oil producing countries in search of higher returns. New investment alternatives are developing in the Middle East as stock exchanges and real estate markets become increasingly active.

There are various issues and challenges in Petrodollar recycling. A significant part of the oil windfall has been recycled through Middle Eastern stock markets. Local governments have used the markets as a mechanism for redistributing oil revenues to their populations. A large number of public-sector companies have been listed on the stock market in offerings restricted to nationals at “Under-valued” prices.

In the Gulf countries, the recycling of Petrodollars has sustained a kind of exuberance on local financial markets. Households borrowing money to invest in local markets further exacerbated this situation. The new infrastructure needed to meet the needs of growing populations constitutes a second challenge. Gulf countries have plans to spend a massive amount on infrastructure over the next five years. However, it is not certain that all countries will choose relevant development strategies and invest in areas of activity where they enjoy comparative advantages.

Inflation pangs

For example, the six Gulf countries have all decided to invest in the development of financial districts but only one or two of them will succeed in becoming regional financial centres. A third challenge involves not succumbing to the temptation to maintain the status, which is often difficult for countries that suddenly became rich. 
Depending on oil export revenues for 95 per cent of national income is a highly risky proposition. Reforms come at a high social cost and these countries may be inclined to buy social peace by redistributing income. Inflation is the final challenge they face. Substantial capital inflows linked to the oil-engendered trade surpluses have resulted in very substantial increases in foreign exchanges reserves in Middle Eastern and North African countries.

With fixed exchange-rate systems and the absence of so-called sterilisation policies the domestic liquidity tends to increase and support inflation. Moreover, in countries whose currencies are tied to the dollar, the dollar’s decline has generated imported inflation.

Source: Khandwala Securities