Why OPEC prefers dollars to euros

The Times of India, May 11, 2003

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.