In spite of several international financial crises, the dollar has remained the international reserve currency because of the size of the US economy and the volume of American trade, while vulnerabilities of the dollar and the euro as a viable alternative have been widely discussed.

The decision of the Gulf countries to continue their peg to the dollar despite its falling value and rising inflation in the Gulf economies calls for a further enquiry into this dogged loyalty to the greenback. International monetary system is inevitably linked to commodity markets, of which oil is the most important globally trading item..

Several factors can be attributed to the relative weakening of the dollar since the World War II. United States is the largest debtor nation in the world because of its rising trade and budget deficits. These deficits are being financed through government borrowings which are being provided by countries like China, the Far East and the Gulf nations flushed with dollars from booming export-led growth and petro-dollars, and the domestic US debt. The following figure shows US current account balance as a percentage of nominal GDP.

Second, the global economy is experiencing shifting bases of economic power due to rising productivity in Japan, the formation of a single euro block and sustainable high growth in emerging countries like China and India. The ability of the US to maintain its economic supremacy has come under speculation. If the forecast data given by IMF is projected up to 2013, we see a converging trend. The share of large emerging economies like India, China and Brazil is increasing where as that of the developed world is decreasing rapidly.

Inevitably, questions have also been raised about the US foreign policies regarding the Middle East, leading to unrest and dissent in the world community at large. Iran and Venezuela’s proposals for removing the dollar denomination of oil have received support of the Muslim world.

Euro has emerged as a stable currency and is becoming stronger against the dollar. “The Euro Area has, in terms of membership, 43 per cent of the share of the G7 (economies), 20 per cent of the G20, 40 per cent of the OECD and eight per cent of the WTO. It holds 24 per cent of IMF quotas and is the provider of a large number of UN contributions.” Smaghi (2003)

However, certain considerations prevent euro from replacing the dollar as reserve currency: First, the Euro Zone is not a homogenous currency region as is the US. Second, euro is not integrated in many fiscal aspects. Countries like France and Germany have violated the deficit targets of EU in order to bring their economies out of a slump. Third, their foreign policies differ and even contradict one another and finally, ECB is not functioning as planned as there are certain flaws in the system highlighted by Grauwe (2006).

Oil is the most important international traded commodity. With the membership of the EU rising, the oil consumption is bound to increase to a level more than that of US, the largest sovereign user of oil. Due to rising currency risk and the EU’s bargaining power, the EU might put pressure on Opec and non-Opec oil producers to trade oil in euros which due to trade compatibility will also reduce currency risk for these oil producing countries. This might persuade non-Opec producers to start denominating their oil in euros. Hence, if not solely, euro-based but a dual currency pricing of oil is a possibility (Sharma et al., 2004).

Other countries have to earn the dollar by selling their goods to other countries and US and if they fall short of earning enough dollars to purchase oil, they have to borrow from supranational financial institutions. These loans must be paid back in dollars with interest creating further demand for the dollar generating outside US. Compared to this, all the US has to do is to print dollar bills to pay for their oil (Sharma et al., 2004).

If the major dollar holding are converted into euro, there is bound to fall, and so will the wealth of many countries holding them.

Most of the dollars and sovereign funds of Asian countries and oil producers alike are invested in US securities and a sliding dollar will erode the value of their savings. To protect their prior savings, these countries can neither remove the dollar denomination of oil nor can they convert their reserves to another reserve currency such as euro.

With the euro zone, China, India and Japan constituting larger proportion of world’s output, the dollar’s position as an international currency should and will change inevitably; but to bring about this key change in the least injurious way to the world economy, especially to the developing world, is a question requiring further study.