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Trading oil in euros – does it matter?

With speculation mounting over the possibility of a US- or Israeli-led military attack of Iran sometime later this year, it has been suggested that real motivation for US antipathy towards the Iranian government has little to do with concerns that Tehran is developing nuclear weapons. Some commentators have instead suggested that Iran’s real Iranian threat to the US and its economy is that, in defiance of the US administration, it is attempting to establish an oil ‘bourse’ (exchange) in March of this year which would enable oil to be traded in euros. This would move oil sales away from their usual denomination in dollars and would, it is argued, undermine the American currency with grave consequences for the US economy. (1,2) This internet-based debate is reminiscent of what occurred before the invasion of Iraq when several observers, myself included, hypothesised that Saddam Hussein’s decision to sell Iraqi oil in euros was perhaps one of the reasons the US wanted ‘regime change’. (3,4) The US decision after the invasion to return Iraqi oil sales to dollar denomination and to convert back into dollars all Iraqi foreign currency reserves, which had been in euros prior to the war, was certainly entirely consistent with this theory. (5)

However, others have claimed that the idea that the currency in which oil is sold matters at all is based on a poor understanding of economics. If oil sales were switched away from the dollar, they claim, it would make no difference to the US economy, and therefore this cannot have anything to do with the reasons the US went to war in Iraq and is now adopting a threatening stance towards Iran. I will try and address their main argument, as I feel the economic reasons why the denomination of oil sales are is an important issue have not always been clearly explained, including by myself.

Those arguing that the denomination of sales is crucial to dollar strength have tended to say that countries are forced to save dollars so that they have dollars to buy oil. Their critics, however, reply that you do not have to save in dollars to buy oil since you can save in whichever currency you want and then buy dollars on the foreign exchange market whenever you want to buy oil. What matters, say the critics, is in which currency people ultimately save rather than in which currency they trade. (6,7) It is people saving in dollars, or in US financial assets, which results in high levels of investment in the US and ultimately permits the US to run a huge trade deficit.

The latter argument is largely correct, but it leaves out the crucial fact that the reason countries choose to save in dollars, to a far greater extent than in any other currency, is nonetheless related to the fact that oil is sold in dollars. Yes, what is important is in which currency countries save, but this is to a significant extent determined by which currency they trade in.

In order to understand why, we need to ask ourselves, why do central banks keep foreign exchange reserves at all? Also, what considerations determine which currency they choose to keep as reserves? The answer to the first part of this question is that the main reason central banks keep foreign currency reserves is so that, if necessary, they can intervene in the markets to support the exchange rates of their own currency. If, say, their currency is being attacked by speculators who are selling it on the foreign exchange markets, the central bank can use its foreign currency to buy up its own currency, thus supporting its value. You cannot, of course, buy up your own currency unless you have previously accumulated savings of foreign currency. So when central banks keep foreign currency reserves, their prime concern is not so much to invest this money in order to secure the maximum possible return, but instead to protect their own currency so that it is a stable currency. The more reserve currency a country has, the less likely that speculators are going to attack that currency. Nobody would dream of launching a speculative attack against the yen or the yuan because their reserves are so massive, but the currencies of many poor countries are far more likely to suddenly devalue since their central banks have only small foreign currency reserves and can do little to protect their currency if the markets decide to sell it. In this context, it is worth also remembering how George Soros became famous by launching a speculative attack against the pound. The Bank of England ultimately was unable to defend the currency as its foreign exchange reserves were being run down, a clear illustration of how the strength of a currency is related to the ability of the central bank to defend it. (8)

So protecting your own currency is the main reason for keeping foreign exchange reserves, but in which currency should you keep them? Well the answer to this question depends nearly entirely on the answer to the question 'against which currency would a sudden and unwanted devaluation of your own currency be most damaging?' If the answer to the second question is 'by far the most damaging unwanted currency devaluation would be a fall of my currency versus the dollar', then it makes sense to keep the vast majority of your currency reserves in dollars: doing so will enable you to buy your own currency with dollars, thus supporting its dollar exchange rate. If you are most worried about your currency devaluing against the dollar, it makes no economic sense to keep most of your reserves in euros or yen.

For all of the rich countries in the world, a sudden devaluation against the dollar has the potential to be far more damaging than a sudden devaluation against the euro, the yen, the yuan, the rubble, etc. This is because most of the goods and services traded internationally are priced and paid for in dollars and, virtually all commodity trade, including the trade of oil which is by far the most important good traded internationally, is denominated in dollars. If your currency falls suddenly against the dollar, then the price of oil will suddenly increase for you, whereas if your currency falls against the yen, but not against the dollar, the price of some Japanese imports will go up, and these imports are probably not essential to the running of your economy anyway. Furthermore, many Japanese imports are also priced and paid for in dollars, so even these are more likely to go up in price for you if your currency devalues against the dollar rather than the yen. Since virtually all of the really important imports are priced and paid for in dollars, it makes complete economic sense for rich central banks to keep most of their reserves in dollars. If the denomination of these important imports, in particular oil, were to move away from the dollar, then rich countries would move their reserves into other currencies and consequently the dollar would lose a lot of its importance.

For poor countries, there is another reason for wishing to trade and save in dollars. They often have international debts, and these debts are usually denominated in dollars (in the case of IMF debts this is always the case). This means that if their currency devalues against the dollar, their debts go up. As a result, poor countries often denominate their exports in dollars, so that they can acquire dollars, without exchange risk. These are used to repay debts, conduct trade (including, in particular, buying oil which most of them do not have), and protect their own currencies. Since the exports of poor countries are often essential to the running of the world economy (they often export commodities), their decision to export in dollars has knock-on effects on rich countries who then have a further reason for saving in dollars.

So can we conclude that an Iranian oil bourse trading oil in euros is the real reason for the current crisis? Perhaps this is prematurely jumping to conclusions. The claim that the Iranian bourse will definitely trade in euros appears to me to be based primarily on speculation at this stage. I have yet to see a clear statement on this from the Iranian government. There are certainly good reasons for suspecting that it might be in euros, since Iranian government sources have previously spoken favourably about trading for oil in euros (9,10) and according to a statement attributed to the Vice-Governor of the Iranian central bank, Iran began selling oil in euros to Europe in 2003. (11)

However, in January of 2004, Bijan Namdar Zangeneh, who was then Oil Minister, played down the possibility of Iran switching to euro payments, (12) and as recently as last September, the head of Iran’s stock exchange dismissed claims that the new oil bourse would be using the euro as the transaction currency. (13) We also know that Iran has previously been involved in discussions with other primarily Muslim countries, like Malaysia, which aimed at introducing an entirely new currency, the ‘Islamic Gold Dinar’, which would be used in international trade, and in particular the oil trade. (14) In the euro’s favour, on the other hand, is the fact that little has been heard of the Islamic Gold Dinar in the past year, and just last month the Chairman of the Majilis Energy Commission (the Majilis is the Iranian parliament) was quoted as saying that ‘preparatory measures have been taken to sell oil in euros instead of dollar’ and that initially Iran should ‘sell its oil in both dollar and euro, and then gradually move toward euro’. (15) However, until we hear from official Iranian sources that the trading will be in euros, it is probably unwise to draw too many firm conclusions.

The possibility that the Iranian oil bourse might not use euros would not necessarily diminish its significance and there could still be good reason for believing that US/UK governments and financial interests would still be strongly opposed to it as it would challenge their control of oil trading, but that is another question.

REFERENCES

1. William Clark, ‘The Real Reasons Why Iran is the Next Target: The Emerging Euro-denominated International Oil Marker’, October 2004, www.energybulletin.net/2913.html
2. Krassimir Petrov, ‘The Proposed Iranian Oil Bourse’, January 2006, www.energybulletin.net/12125.html
3. William Clark, 'The Real Reasons for the Upcoming War With Iraq: A Macroeconomic and Geostrategic Analysis of the Unspoken Truth', January 2003, www.ratical.org/ratville/CAH/RRiraqWar.html
4. Cóilín Nunan, 'Oil, currency and the war on Iraq', January 2003, www.feasta.org/documents/papers/oil1.htm
5. Cóilín Nunan, ‘Petrodollar or petroeuro? A new source of global conflict’, November 2004, www.feasta.org/documents/review2/nunan.htm
6. James D. Hamilton , ‘Strange ideas about the Iranian oil bourse’, January 2006, www.econbrowser.com/archives/2006/01/strange_ideas_a.html
7. Chris Cook, ‘What the Iran 'nuclear issue' is really about’, January 2006, www.atimes.com/atimes/Middle_East/HA21Ak01.html
8. William Keegan, ‘Black Wednesday gets a whitewash’, February 2005, The Observer, politics.guardian.co.uk/conservatives/comment/0,9236,1411995,00.html
9. C. Shivkumar, 'Iran offers oil to Asian union on easier terms', June 16 2003, www.blonnet.com/2003/06/17/stories/2003061702380500.htm
10. Anon., 'Iran may switch to euro for crude sale payments', Alexander Oil and Gas, (September 5, 2002), www.gasandoil.com/goc/news/ntm23638.htm
11. Juan Caros Escaron, ‘El ‘petroeuro’ rompe el cascarón’, November 2000, El Mundo
12. Hashem Kalantari, ‘Iran Oil Min: No Plan To Switch Oil Pricing From Dollar’, IranExpert, www.iranexpert.com/2004/oilmin11january.htm
13. Anon., ‘Oil bourse not to use euros in Iran: TSM chief’, Iranmania,
www.iranmania.com/News/ArticleView/Default.asp?NewsCode=35269&NewsKind=Current%20Affairs
14. Faisal Islam, ‘Return to an old standard?’, February 2003, The Observer, observer.guardian.co.uk/business/story/0,,891682,00.html
15. Anon., ‘Preparatory measures taken to sell oil in euros’, December 2005, Mehrnews.com, www.mehrnews.com/en/NewsDetail.aspx?NewsID=260851

Editorial Notes: Cóilín Nunan studied mathematics at the universities of Brussels, Cambridge and Oxford. He now lives in Scotland and works for the Soil Association, the UK organic farming charity. His work focuses on the use and abuse of antibiotics in intensive farming and he has co-authored several reports examining the many ways in which this can impact upon human health. He is a Trustee of Feasta (The Foundation for the Economics of Sustainability) and editor of its website.

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