Implications of the Expiration of the Petrodollar Agreement

The long-standing agreement between Saudi Arabia and the United States created in June 1974 mandated that Saudi oil be sold exclusively in US dollars expired on June 9, 2024 with scant media coverage. The arrangement has played a crucial role in cementing the US dollar's status as the world's reserve currency, and its termination could further threaten the hegemony of the U.S. dollar in global transactions, changes in international finance, foreign exchange rates, and the broader economy.

Demand for the US Dollar - The petrodollar system established through the Saudi-US agreement has been instrumental in ensuring a steady global demand for US dollars. In addition, by requiring oil transactions to be conducted in dollars, countries around the world needed to hold significant dollar reserves to purchase oil, creating sustained demand for US dollars and reinforcing its dominance in international trade and finance. With the expiration of the petrodollar agreement, Saudi Arabia will be free to sell oil in other currencies which over time will lead to a diversification in the currencies used for global oil transactions and may could contribute to diminished demand for US dollars.

Favorable Exchange Rates - In addition, the petrodollar system provides the US dollar benefits in the form of a more favorable exchange rate as a result of the exclusive use of the US dollar for oil. The constant global demand for dollars supports the value of the US dollar, makes imports cheaper and helps contribute to lower inflation. If the demand for dollars subsides, there could be a depreciation in the dollar's value relative to other currencies. While a weaker dollar could help enable US exports to be more competitive by lowering their prices on the international market, potentially boosting American manufacturing and export-driven industries, it would lead to an increase of the cost of imports, higher prices for consumer goods and services in the US, and contribute to current inflationary pressures. Last, if oil prices are no longer pegged to the dollar, significant shifts in currency values could lead to increased volatility in oil prices, further exacerbating inflation.

Demand for US Treasuries - The petrodollar system has also been pivotal in supporting the US Treasuries market. Countries needing dollars for oil transactions have traditionally invested their dollar reserves in US Treasuries, providing the US government with a reliable source of funding. If the global reliance on the dollar wanes, the demand for US Treasuries could decrease resulting in higher interest rates as the US government is forced to offer more attractive yields to entice investors. Higher interest rates would lead to increased borrowing costs across the economy, including higher mortgage rates, increased costs for business loans, and tighter financial conditions that could potentially stifle economic growth and contribute to a more rapid increase the federal debt.

US Government Funding - The US government's budget deficit will continue to necessitated the significant issuance of US Treasury securities with estimates indicating $10 trillion in 2024. These securities have been a cornerstone of the global financial system, providing a safe investment for countries and institutions worldwide. However, a reduction in demand for Treasuries due to decreased dollar holdings could complicate the US government's efforts to finance its deficit. If foreign demand weakens, the Treasury might have to offer higher yields to attract buyers, further exacerbating the federal budget deficit.

Stability in the Financial System - The Federal Reserve's balance sheet has expanded significantly in recent years, particularly through the purchase of Treasury securities to support the economy during periods of financial stress. The expiration of the oil-dollar agreement and its potential impact on Treasury demand could influence the Federal Reserve's actions. If the market for Treasuries becomes less liquid, the Federal Reserve might need to intervene more aggressively by increasing its buyback of Treasury securities in order to stabilize markets resulting in further expansion of the Federal Reserve's balance sheet, complicating future monetary policy maneuvers.

The expiration of the petrodollar agreement between Saudia Arabia and the United States marks a pivotal moment in global economic history as the global financial system adjusts to this new reality. The ultimate impact will depend on how swiftly and effectively the US and other nations adapt to these changes, and on the evolving landscape of international trade and finance.