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“Nations have no permanent friends or allies, they only have permanent interests.”
– Lord Palmerston 
How to Build a Reserve Currency
Here’s a hypothetical question: If you were in charge of a country, how would you incentivize people to use your currency? (Assume you are operating in a fiat system.)
To start, you’d want to have a booming economy.
If your country has companies producing valuable goods and services, you can mandate that people must pay for those goods in your country’s native token (the currency).
You can also require people to pay taxes in your local currency, creating another source of demand and reason that people must own it.
Finally, if the companies in your booming economy become valuable enough, foreign investors will want a piece. You could let the foreigners invest, but only if they do it in your currency.
That’s a good start! But if you have bigger ambitions and want the entire world to use your currency, you have to get more creative about creating sources of demand.
To start — the least creative solution — you could build up a big military and use it to bully people into using your currency. This is not an ideal strategy — most countries won’t like it.
Alternatively, find a commodity that everyone in the world needs (say, oil), cut deals with producers and only accept payment in your local currency.
Here we have a strategy that supports demand and creates liquidity for your currency.
That is (in extremely oversimplified terms) how the petrodollar system works today.
The Petrodollar System Explained
Here is a fascinating article from Bloomberg about how the US secretly struck a deal with Saudi Arabia back in 1974 on the back of the Oil Embargo.
The idea was simple: The US would buy an enormous amount of oil from the Saudis and offer certain security protections.
In return, the Kingdom would price their barrels in dollars and plow excess revenues from exports into the US market.
It was a win-win; Saudi Arabia got to generate yield on their capital that could not be invested productively at home, and the US got an infusion of cash and perpetual demand for their currency.
That is essentially how our system is constructed today. Our currency has transitioned from one backed by gold vis-à-vis the Bretton Woods agreement, to one that is backed by the oil market.
Ten newsletters could be written on this subject alone. Lyn Alden has done a great job of explaining the connection between this system and the hollowing out of the US industrial base. 
The End of Petrodollars
The reason we’re talking about this today is because that system is beginning to fall apart.
Today, the Wall Street Journal ran a story that Saudi Arabia is considering accepting yuan instead of dollars for Chinese oil sales.
“Saudi Arabia is in active talks with Beijing to price some of its oil sales to China in yuan, people familiar with the matter said, a move that would dent the U.S. dollar’s dominance of the global petroleum market and mark another shift by the world’s top crude exporter toward Asia…
It would be a profound shift for Saudi Arabia to price even some of its roughly 6.2 million barrels a day of crude exports in anything other than dollars. The majority of global oil sales — around 80% — are done in dollars, and the Saudis have traded oil exclusively in dollars since 1974, in a deal with the Nixon administration that included security guarantees for the kingdom.”
Even in isolation — and with the caveat that nothing has been agreed on yet — this is big news. But this is not the first sign of cracks forming.
Just last month, it was reported that China and Russia agreed to a 30-year deal to provide gas settled in euros. Before that, even allies were considering mechanisms to price oil outside of dollar settlement.
Now, to be clear, this is not the first time there have been calls for the end of the petrodollar system. Russia has grumbled for years about the dollar reserve system, and major producers like Rosneft have threatened to switch to euros.
But today those cracks are turning into fissures, perhaps due to a rapidly deteriorating geopolitical landscape. Deals are being struck, and strategic partners and even allies of the US are beginning to consider other options.
The enormity of this disruption can’t be understated. Particularly as financial exclusion is rapidly becoming the chief policy instrument of the western world.
Sanctions: The Death Knell of the Petrodollar System
To me, the connection between the acceleration of sanctions and the demise of a dollar based settlement system is clear.
It’s the number one rule of disruption: If a system is abused frequently enough, people will find an alternative.
Countries like China and Russia have long voiced their discontent with today’s dollar based system, but I have to imagine even our allies are raising their eyebrows at the staggering number of sanctions being levied today.
The G-7 has effectively frozen the majority of Russia’s $643 billion in central bank reserves. Eventually, like all geopolitical conflicts, the war in Ukraine will end.
And if you’re reading this thinking “yes, but our allies are in on it too, why would they care?” remember: Countries don’t have friends, they have strategic interests.
The last time there was a major world war, both China and Russia fought with the US. Today, they are our greatest strategic foes.
Long after the effects of this war are forgotten, the whole world will remember one lesson: The assets they keep in the financial system are subject to US interests.
Increasingly aggressive sanctions change the calculus for participants in a petrodollar system. When the risk of keeping your assets in the current systems rises to total forfeiture, there is little countries won’t do to mitigate that risk.
And now that sanctions are rapidly being cheered as a new and evolved form of warfare, the question becomes, “what will we replace them with in a non-dollar system?”
Ultimately, it’s impossible to predict when and how the system will end. But if deals between countries like China, Russia and Saudi Arabia continue to be struck, odds are it will end sooner rather than later. — Mike Ippolito (Byron will be back next week)
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Written by @MikeIppolito_ and @aaronhasapen.
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