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Will China Destroy the Petrodollar?

by Paul-Martin Foss

The government of Saudi Arabia recently signaled its openness to fund its operations with Chinese yuan, raising funds by borrowing in China. If Saudi Arabia goes further by accepting the yuan as payment for oil exports, it would upend the dollar’s status as the world’s reserve currency. The petrodollar system, in which Middle Eastern oil exporters only accept dollars as payment for oil, in exchange for military assistance from the United States, has defended the dollar’s position as the world’s reserve currency.

China’s increasing industrialization has led to an increased demand for raw materials, including oil and minerals, to support increased production. Chinese agreements with Saudi Arabia have strengthened the relationship between the two countries and could serve to pull Saudi Arabia further from its once-close relationship with the United States. If the yuan were to play a greater role in Saudi Arabia, and especially if Saudi Arabia begins to accept yuan for oil payments, the yuan’s status as a world currency would grow exponentially.

That would weaken demand for the dollar, depress sales of Treasury debt, and lead to higher interest rates on government borrowing. The US government has relied on foreign demand for US Treasury debt to fund its deficit spending over the past several decades, and a shift in oil markets from the dollar to the yuan would put that to an end.

While the petrodollar system’s existence isn’t something with which most Americans are familiar, the threat of its erosion or destruction is probably keeping policymakers in Washington up late at night. The US government’s spending is built on a house of cards, propped up by the Federal Reserve’s loose monetary policy and the willingness of foreign creditors to turn in their dollars in exchange for Treasury debt. If the petrodollar were to collapse then that house of cards comes tumbling down.

The real signal that the end is near is if the Saudi government eliminates its currency peg with the US dollar. The Saudis don’t want their currency to go down with the dollar, so an elimination of that peg would indicate that the petrodollar system is on its way to oblivion.

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