Passing the ‘Buck’

Back in June 2003, with its oil exports to Europe already euro-denominated, Dr Mohammed Jaffar Mojarrad, then Vice-Governor of the Central Bank of Iran (CBI), announced that Iran would be prepared to offer member countries of the Asian Clearing Union (ACU) a two-month settlement period for oil transactions. But there was one caveat: though trades would continue to be invoiced in dollars, Iran would require payment in euros.

Although motivated in part by political tensions, Iran recognised that its earlier switch to euros for trades with Europe – which accounts for around 40% of its imports – had provided a degree of insulation from the damaging economic effects of the weakening dollar. The move to adopt the euro as the unit of payment for oil trades with ACU members was simply a pragmatic extension of this policy, particularly given that its oil export destinations by rank were Asia (~60%), Europe (~30%) and Africa (~10%).

“The dollar as a benchmark currency has been weakening quite a lot and it creates distortions in oil markets” – Rafael Ramirez, Venezuela’s Energy Minister

Today, only 15% of Iran’s oil revenue is dollar-denominated. And, whilst Iran acted unilaterally in moving to abandon the dollar it looks as though long-standing calls from some other OPEC members to discuss the need to establish a basket of currencies for oil pricing are finally being heeded. According to an October 27th Reuters report, “the cartel is slated to hold a summit of the heads of state of OPEC nations in November and a meeting of ministerial delegates in December.”

Having stemmed the influx of dollars, Iran spent much of 2007 steadily diversifying its external reserves away from dollar-denominated assets. On October 23rd, Tahmasb Maaheri, the new Governor of Iran’s Central Bank, announced that this process was almost complete. And it is not alone. Recent US Treasury Department Statistics suggest that several countries in the Middle East, particularly OPEC member countries, have been doing likewise.

The problem for the US is not so much that OPEC member countries own a great deal of US debt, but because such diversification might precipitate an accelerated weakening of the dollar, prompting countries with large dollar reserves and dollar debt instruments, such as China, to do likewise. This could have dire consequences for the US economy.

To appreciate some of the factors at play, it is first important to understand how the dollar became the global reserve currency, and also how US economic and foreign policy is geared around keeping it that way.

In July 1944, delegates at the United Nations Monetary and Financial Conference signed the Bretton Woods Agreement – a fully negotiated monetary order intended to govern commercial and financial relations among independent nation-states. As Daniel Singer explains…

…a multilateral, international institution [was set up] to deal with the financial problems of the world. At its heart was the International Monetary Fund (IMF), which was to authorize the very exceptional adjustments in the fixed rates of exchange, but also to act as a supplier of liquidity. (Gradually it became a lender of last resort.) It was to fulfill this function thanks to a fund filled by members’ contributions according to a complex mechanism of quotas, determined by the given country’s economic strength, which also signaled the amount of money that country could borrow.

However, Singer goes on to argue that, in practice, ‘the arrangement [was] an instrument of American domination’, explaining that ‘the new monetary arrangement was in fact a gold-dollar exchange standard, since all currencies were linked to the dollar valued at $35 per ounce of gold’. Furthermore, because the American quota in the IMF was by far the biggest, no decisions could be taken without Washington’s consent. Thus the US exerted its predominance and an economically decimated post-war Europe had little option but to acquiesce.

Initially, the Bretton Woods system worked well. Dollars flowed into the world economy through the institutions established under the agreement, as well as through US aid programmes such as the Truman Doctrine and the Marshall Plan. This in turn created vibrant overseas markets for US corporations to exploit. Before long, over half of the world’s international money transactions were dollar denominated, establishing it as the de facto global reserve currency.

However, by the late 1960’s, the system was in danger of collapse. The emergence of Germany and Japan as economic rivals, coupled with the enormous costs associated with the Vietnam War, led the US into a period of relative economic decline.

Dollar-holding countries, fearing dollar depreciation, began exchanging their currency reserves for gold. In August 1971, with gold supplies dwindling, President Richard Nixon abandoned the gold-dollar exchange standard, allowing market forces to determine the dollar’s floating value. Without firm backing, the currency became volatile, forcing the US to explore new ways of re-establishing dollar hegemony.

The answer came in the form of ‘petrodollar recycling’, an arrangement brokered by US Secretary of State Henry Kissinger, whereby oil-producing countries agreed to price their oil exports exclusively in US dollars.

The effect of this ‘recycling’ was elegantly summed up by Henry Liu in his April 2002 article for the Online Asia Times.

World trade is now a game in which the US produces dollars and the rest of the world produces things that dollars can buy. The world’s interlinked economies no longer trade to capture a comparative advantage; they compete in exports to capture needed dollars to service dollar-denominated foreign debts and to accumulate dollar reserves to sustain the exchange value of their domestic currencies.

As a consequence of petrodollar recycling, both foreign-owned US debt and dollar reserves have soared astronomically.

Table showing dollar-denominated foreign debt ownership by country: June 2006 (source: US Treasury Department)

Current ‘live’ US Debt Clock.

“China has accumulated a large sum of US dollars. Such a big sum, of which a considerable portion is in US treasury bonds, contributes a great deal to maintaining the position of the dollar as a reserve currency” – Xia Bin, finance chief at the Chinese Development Research Centre

Until now, China’s grossly imbalanced economic relationship with the US has been largely symbiotic; the US has had the benefit of a steady stream of cheap funding for its deficit, whilst China has been able to maintain a high rate of export-led economic growth.

But this sustained high rate of growth has led to domestic inflationary pressure. This is because Chinese citizens are not permitted to hold foreign currency. Instead, exporters hand over any foreign currency they receive to the government in exchange for Chinese yuan. The government then retires dollars from circulation in order to keep the yuan weak relative to the dollar, which in turn fuels further export growth.

China’s rate of export growth for the first three quarters of 2007 was over 27%. Its foreign reserves are growing at the rate of $1 billion per day and have now reached a staggering total of $1.5 trillion.

China’s policymakers recognise things must charge, however they are undecided about the best course of action. The weak yuan, whilst essential for China’s export policy, has not only driven domestic inflation up, it has also widened the trade gap between it and its partners, encouraging some to threaten possible protectionist measures to force a yaun revaluation.

In response, Xia Bin, finance chief at the Development Research Centre, hinted that the Chinese government might be prepared to use – i.e. to dispose of – its foreign reserves as a ‘bargaining chip’, in talks with the US. Pointing out that several countries had already started to look at diversifying away from the dollar, he added:

China is unlikely to follow suit as long as the yuan’s exchange rate is stable against the dollar. The Chinese central bank will be forced to sell dollars once the yuan appreciated dramatically, which might lead to a mass depreciation of the dollar.

“Spring 2007 indeed appears as the tipping point of the global systemic crisis: the US economy went into recession, US interest rates were restored, the bond market is in crisis, the subprime crisis begins to hit large US financial institutions such as Bear Stearns, Goldman Sachs and Freddie Mac, the US housing crisis is speeding up…” – Laboratoire europeen d’Anticipation Politique, June 16th 2007

In a February 2007 letter to Henry Paulson, Secretary of the United States Department of the Treasury, and Ben S. Bernanke, Chairman of the Federal Reserve Board, US Presidential nominee Hilary Clinton expressed her concerns about the extent to which countries like China had ‘been buying [US] debt and in essence becoming [America’s] banker.’

I have long argued that a great source of vulnerability is the fact that other countries, including China, own so much of our debt. Today, foreign nations according to the most recent Treasury statistics hold over $2.2 trillion or 44% of all publicly held United States (U.S.) debt with Japan and China alone holding nearly $1 trillion. In essence, 16% of our entire economy is being loaned to us by the Central Banks of other nations. Having so much debt owned by other countries can be economically unsound.

…if China or Japan made a decision to decrease their massive holdings of U.S. dollars, there could be a currency crisis and the U.S. would have to raise interest rates and invite conditions for a recession.

More recently, in June, Laboratoire europeen d’Anticipation Politique published an even bleaker assessment in an almost apocalyptic paper entitled ‘Global systemic crisis / Summer 2007: Fed looses control on US interest rates and crisis reaches China and EU’. It really ought to be read in full but, failing that, here is one of the key paragraphs.

The rest of world now determines US rates. Simultaneously systemic uncertainty is back on financial markets. Investors suddenly realise that in the medium- and long-term, they no longer have any guarantee on global system’s trends (while only a few months ago, they were convinced that the current system was sustainable). This situation highlights the fact that it is outside the US that the country’s future economically and financially speaking is being played, as illustrated on three occasions in the last six months by the impact on US markets of Chinese decisions (dollar and stocks). This is a totally new situation for the US ever since the end of WWI which clearly suggests that the world order created after 1945 has come to an end.

And if China’s influence on the US economy policy alone wasn’t worrying enough, it also poses an ever-increasing threat to US energy needs – a threat exacerbated by China’s relative geographic proximity to the vitally important Gulf and Caspian regions, not to mention its strong ties to Iran.

As Senator Joe Liebernam pointed out back in December 2005…

Today… one of the biggest sources of potential friction between the U.S. and the PRC [People’s Republic of China] – that is our global competition for oil. The U.S. and China are now the world’s number one and two consumers of oil respectively, with China’s need growing as rapidly as its economy is.

Over the past decade, China’s population has increased by over 82,000,000 (6.7%), whilst its oil consumption has risen by nearly 3,600,000 barrels per day (105.8%). During the same period, US population has grown by around 28,000,000 (10.3%), yet its oil consumption has increased by just over 2,900,000 barrels per day (16.5%). The upshot is that China’s oil consumption per head has risen by 93% compared to just 5.6% in the US.

According to Lieberman, not only are these trends set to continue, but in a world with increasingly limited resources (see Peak Oil and the Shanghai Cooperation Organisation) the implications are very clear.

In the next 20 years estimates show that the Chinese demand for oil will double [to around 14,000,000 barrels per day] as their economy grows. Estimates also are that they will need to obtain two thirds of that from outside of the PRC [People’s Republic of China] itself.

What I want to say today is it is time the U.S. and China not only recognize the similarity of our oil dependency status, and the direction that competition may take us, but begin to talk more directly about this growing global competition for oil so that we can each develop national policies and cooperative international policies – even joint research and development projects – to cut our dependency on oil before the competition becomes truly hostile.

Some commentators have recently suggested that preparations for a Sino-American conflict are being made under the guise of the war on terror. In an article published in the Sydney Morning Herald on November 4th, for example, Hugh White, Professor of Strategic Studies at the Australian National University, claimed that ‘big-ticket’ weapons sales were being publicly portrayed as a response to the threat posed by global terrorism when, in reality, they were ‘designed to contain China’.

Another contributor to the article, Professor Kevin Clements, director of the Australian Centre for Peace and Conflict Studies at the University of Queensland, said ‘the war on terrorism was a front to keep up arms spending to maintain the US’s ability to fight a [sic] wars on three fronts – Asia, the Middle East and Europe.’

Clements’ and White’s views seem to reflect those expressed by the Project for the New American Century in a publication entitled ‘Rebuilding America’s Defenses’ (emphasis added).

Today [the US military’s] task is to secure and expand the “zones of democratic peace;” to deter the rise of a new great-power competitor; defend key regions of Europe, East Asia and the Middle East; and to preserve American preeminence through the coming transformation of war made possible by new technologies. From 1945 to 1990, U.S. forces prepared themselves for a single, global war that might be fought across many theaters; in the new century, the prospect is for a variety of theater wars around the world, against separate and distinct adversaries pursuing separate and distinct goals.

The similarity between Clements’/White’s and PNAC’s positions is striking, particularly when you consider that the former were speaking in 2007 and the latter way back in 2000.

It’s almost as though PNAC was expecting a war on terror, brought about, perhaps, by ‘some catastrophic and catalyzing event – like a new Pearl Harbor’.

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