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Investing Answers Building and Protecting Your Wealth through Education Publisher of The Next Banks That Could Fail

Petrodollars

What it is:

Petrodollars are cash -- usually U.S. currency -- derived from the sale of oil and deposited by oil exporters into Western (usually American) banks.

How it works (Example):

Let's assume that country XYZ sold US$40 billion of oil in 2008. The money that country XYZ deposits into an American bank is called petrodollars. Country XYZ does this in order to earn the highest return possible on the money and perhaps later use it to fund infrastructure projects, combat budget imbalances, or other governmental initiatives.

A December 2006 study published by the Federal Reserve Bank of New York found that oil exporters use about half of their petrodollars to import goods and services (particularly from Europe and China), while they invest the other half in foreign assets (particularly in the United States). This is important because when oil prices are up, imports to the oil exporting countries go up, which stimulates the economies of the countries the oil exporters are buying from. Likewise, when oil prices are up, the oil exporters make more foreign investments, which tend to drive up prices of securities in the markets in which they invest. However, the reverse is also true. When oil prices are down, fewer petrodollars flow to foreign countries.

Why it Matters:

Petrodollars are a good example of how one country's economic prospects affect other countries. For instance, countries that rely on petrodollars for economic stability can experience windfall gains when the price of oil increases. Likewise, they are hard hit by decreases in oil prices, which often causes foreign investors to flee the market and can ultimately prompt these countries to diversify.

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