This article first appeared in Forum, The Edge Malaysia Weekly on January 23, 2023 - January 29, 2023

The end of the petrodollar era may be approaching, and with it the end of an international financial system that has shaped global economics since 1971.

This should not be a matter of alarm because financial systems change historically on a regular basis. In the current phase, the suggestion is that the financial system is transitioning into a multilateral arrangement where the monopoly of the US dollar as an international reserve currency and the power of the US to print so-called fiat money will end.

In this scenario, a new financial era, anchored once again to gold, will reduce the turbulence and instability that the petrodollar created and replace it with a more robust and stable financial system. This will also reduce the risk of financial crises and the huge accumulation of debt, which is undermining the stability of the whole world system, according to some observers.

It will also offer an alternative to new financial systems such as crypto-currencies, which the recent FTX scandal shows are not transparent, very fragile and so are not a viable replacement for conventional financial instruments.

The relevance of this change can be understood in a historical context. After World War II, the Bretton Woods agreement regulated exchange rates by fixing the value of each currency to gold. Over many years, this system ensured the stability that underpinned the post-war reconstruction of global economies and delivered prosperity and growth into the so-called golden age of the 1960s. This was one of the longest and healthiest phases of growth ever seen in the international economy.

In 1971, the Nixon administration ended the convertibility of the US dollar into gold and replaced it with a fiat money system backed by the governments that issued it. This gave the US Federal Reserve an effective monopoly over the currency most widely accepted around the world because the US dollar was the main international reserve currency and was used in the trading of almost all commodities, such as oil and food. This is the system that we still have today.

The value of the dollar was then related to the stability and power of the US, and to solidify the new regime, the then US secretary of state, Henry Kissinger, backed the inconvertible US dollar with a geopolitical strategic agreement with the Arab countries that fixed every transaction in oil to be paid only in dollars.

Any country, including Russia and China, wanting to buy or trade oil would need to buy US dollars to pay for the transaction. This guaranteed the demand for the dollar and the dominance of the American financial system over the international economy.

Moving quickly to recent times, two episodes signal the possible end of this system. The first is that the Fed has printed a huge amount of money, especially after the international crisis of 2008/09, and again during the Covid-19 crisis in the last three years.

This reduces the value of the US dollar and, combined with similar money printing by the four main central banks around the world, has created massive structural imbalances in terms of huge accumulation of both public and corporate debt, especially in China.

Second, the US dollar as fiat money was used systematically in international trade to finance the increasing US deficit in traded goods, especially with emerging countries such as the BRICS (Brazil, Russia, India, China and South Africa). The huge trade surpluses of these countries were accumulated in the form of dollar-denominated assets, including US bonds, which are losing value, and this has reached a tipping-point as a percentage of their total foreign reserves.

The consequence for the BRICS over the last decade or so is the need to diversify their assets out of the US dollar and into other asset types. Increasing their reserves of gold has been the main alternative to protect asset values.

Events of recent months — including the Russia-Ukraine war and sanctions, especially on oil and gas, by Europe and the US — have added to this problem in ways that directly affect Russia, China and India, which collectively account for almost half of the world population and more than one-quarter of global gross domestic product (GDP).

In this new scenario, the strategic choices of the BRICS include direct trade in their own currencies, bypassing the US dollar. Sanctions on Russian oil and gas, for example, have simply shifted sales from Europe to Asia and consolidated trade and investment links.

The BRICS club’s strategic scope has also enlarged considerably over recent months to include Arab countries that were originally the pillar of the petrodollar, and new countries such as Turkey and Egypt are also reinforcing the club, giving more economic and political weight to the new set of possible agreements.

Taken together, something like 70% of the global population and almost 50% of the world GDP could shift towards this new financial system, which many argue is multilateral, more robust and stable and fairer for all the countries involved.

The possible break-up of the US dollar monopoly is a by-product of changing strategic alliances in a time of war and political uncertainty that we see in the news every day that fuels the idea of a historical shift not unlike those we have seen in the past.

In the long term, the benefits of a shift to a new system seem to outweigh the costs for many countries but in the short term, there are significant costs due to the crises we are experiencing.

In particular, financial markets such as Wall Street are supported by the dollar-centric financial system and any “disintermediation” will add risk to an already weak stock market. The looming international recession is likely to cause a downward revision in expected earnings on Wall Street, which is already factoring in a more adverse economic scenario in 2023. Interest rate hikes in all Western countries also raise the likelihood of a loan and housing crisis. 

The deteriorating global geopolitical situation adds to the risk of a crisis in the financial and banking system, which can cause a recession in the real economy and it is now time that the international community works effectively and quickly to find a Plan B.

For Malaysia and other dynamic, young and developing countries, a more multilateral, open, robust and competitive financial system offers long-term opportunities. One effect of a more open financial system would be a relative strengthening of the countries today in the “periphery” with an important redistribution of resources and wealth worldwide. This would reinforce the role of many small but vital and dynamic countries like Malaysia.

From a strategic perspective, the Malaysian government should look closely at this problem and take a leading role in coordinating a joint response among the Asean-10 countries. The events that may be unfolding open many opportunities that are important to leverage.

Professor Paolo Casadio is an economist at HELP University and Professor Geoffrey Williams is an economist and provost for research and innovation at Malaysia University of Science and Technology

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