The dollar’s global reign: The Iran war has strengthened the greenback but the story is far from over

Given the competing narratives on the war’s trajectory, it is difficult to fathom how the scales will eventually tilt. One may guess that America’s ‘Ashvamedha run’ has not gone by plan; The Economist’s latest cover story is titled ‘Advantage Iran’. However, if one undertakes a dispassionate analysis of the direction of currency and bullion markets, a different story emerges.

The strengthening dollar not only reaffirms its status as a safe-haven currency during turmoil, but suggests its privileges as a reserve currency are not weakening. Both of these would not have been possible if America’s military and strategic dominance had materially reduced. But there are tactical reasons as well for the dollar’s strength.

Safe haven or one-eyed ruler among the blind? The currencies of almost all G-20 countries (the largest 20 global economies) have weakened against the dollar in March. The currencies of India, Mexico and South Korea weakened by more than 4%, while those of Australia, Eurozone, the UK, Japan and South Africa fell between 2% and 3.5%. The least weakening was observed in the currencies of Saudi Arabia and China, as both are more or less pegged to the dollar (even if the former technically runs a hard peg and the latter a managed float).

With around 95% of the world’s crude oil and natural gas priced in dollars, higher hydrocarbon prices increase global demand for the US currency. This was the direct reason for the dollar’s strength. The associated effects of it include a rise in inflation across most countries.

Local factors had a role too. Fiscal deterioration in emerging economies such as India and South Africa further weighed their currencies down. While the energy price shock will seep into the US economy too, the US is a large oil producer, so its economic activity will be less impaired than of countries that import most of their crude oil—which, apart from the price increase, will also be hit by a physical oil scarcity.

Interestingly, the Swiss and Swedish currencies have dropped 3% plus, perhaps explained by a loss in safe-haven appeal. For the time being, the dollar’s top status is being upheld by the world.

Ground realities and narratives: Iran’s crude oil deliveries to China have long been priced in the yuan. So, Iranian oil going via Hormuz to China will not hurt the petro-dollar’s dominance.

The US is the third-largest exporter of crude oil (with a 10% share) and the largest exporter of liquefied natural gas (16% share) to the world. Since the war started, US oil firms have made an estimated incremental $5 billion in revenue. The price of Brent crude oil has risen from around $70 per barrel to about $115 during March.

Of course, the war could not have been motivated by such gains. Even if we ignore the cost of inflation on the US economy and weigh direct costs against benefits, the math would not favour war. In the first week, the US government spent $11 billion on hostilities. A month’s war bill is estimated at $35-$40 billion.

Now consider an extreme scenario. A back-of-the-envelope calculation suggests that for America’s monthly war expenses to be covered by an oil windfall, Brent would need to touch $170-$180 per barrel. A $15-20 spike in oil translates roughly to $5 billion extra monthly revenue for US oil firms.

Iran would do well to take this into consideration. The longer its Hormuz blockade lasts, the higher the global price of crude oil, and that means a bonanza for US firms that Washington could tax to fund its war.

For most oil importers, the doomsday scenario is one of oil hitting $135-$140 per barrel. But even under this, the dollar may remain strong while those of other economies weaken. It’s about time that the world brought all warring parties to the table for talks on ending hostilities.

Hope for the best and prepare for extremes: Uncertainty over the dollar’s dominance has reduced. Thus, gold, which is a hedge against uncertainty, has stopped rising. Gold, being a yield-less asset (as it generates no cashflow), is now getting hurt by worries of heightened inflation. In the short- to medium-term, given the current scope of the war, the dollar is likely to remain strong and gold weak.

A quick end to the war, even with an ambiguous winner, is possibly the best outcome. A protracted war may hurt America’s geopolitical standing. While its military dominance will remain, its capacity to enforce its will may be questioned, weakening its stature and with it possibly the dollar.

If crude oil prices continue to move up, the world may have to intervene—without boots on the ground or gunboats. In the event of an extreme-oil-price scenario, extreme reactions could include Europe or Japan, say, opting to pay for non-US oil in non-US currency. America needs to run more game-theory scenario simulations than Iran and Israel.

The author is a risk management and AI consultant, and a member of the visiting faculty, IIM Ahmedabad and IIM Calcutta.