The dollar serves as the world’s reserve currency, with over 57% of global foreign exchange reserves held by central banks and approximately 90% of global foreign exchange transactions taking place in US dollars. History bears witness to the fact that whoever challenged the dollar in the past, be it Saddam Hussein, Muammar Gaddafi, or more recently Nicolas Maduro, has had to pay a heavy price. Given that the petrodollar system is the backbone of US economic dominance, which has been surprisingly challenged by Iran during this war, an Iranian ground invasion plan is inevitable sooner or later. This attack can be avoided only if Iran makes a ‘compromise’.

Therefore, this fear of losing dollar dominance is perhaps preventing the US from exiting this war quickly. Since an early US exit without any solution would give Iran an edge over the US in setting global oil prices, this war is probably not going to end any time soon. The paradox of this war is that neither can Iran be easily defeated, as it has decentralized its central command across 31 provinces, nor will the US exit this war quickly without reaching its objectives. So it is quite clear that the war will last a long time. Both Iran and the US have recently proposed a ceasefire; The conditions demanded by both the parties are not acceptable to anyone. While Iran wants a permanent and permanent solution from this agreement to prevent any future actions by the US, the US side indirectly wants regime change and complete control over Iran as well as the Strait of Hormuz. Given the lack of trust, neither side is likely to accept the terms of the ceasefire, as both sides continue to mobilize their troops internally to prepare for the next phase of this war. While the US plans to order an additional 10,000 paratroopers for ground operations in Iran, Iran’s crumbling regime is also looking to add more than a million fighters to the Iranian military.

The Federal Reserve recently issued a statement from the Federal Open Market Committee saying that it will maintain the interest rate between 3.5% and 3.75%, while there is speculation that the Federal Reserve will increase this rate in the coming months, aiming to attract global investors to invest in the US bond market.

It can be argued that the dominance of the dollar, the petrodollar mechanics, and the depth and liquidity of the US financial markets are all interconnected. Oil is considered one of the most important commodities required to run every country. Meaning, the world needs oil to run, which is actually and usually traded in dollars (petrodollars). For that matter, every country deposits dollars in the form of foreign currency, which is again directly linked to the country’s overall depth and financial liquidity, through which the dynamics of money supply (the main purpose of an economy) is regulated. Thus the dominance of the dollar in practice depends heavily on petrodollar mechanics, and similarly, for the US, the importance of the Strait of Hormuz came into prominence. Since the Iran war is more of a geo-economic and less of a geopolitical war, the importance of the Strait of Hormuz for the US has increased further when Iran has hinted at replacing the petrodollar with the petroyuan and announced that it will allow passage through the Strait of Hormuz only to those countries that conduct only yuan-denominated transactions. The announcement came as a complete surprise to the US, which challenged the decades-old petrodollar system in the international crude market. Since the petrodollar system is the foundation of the US economy, this decision by Iran has shaken it from within, which is well reflected in the Federal Reserve’s recent decision not to cut interest rates so as to attract a large number of investors to US bonds and securities. These moves are apparently aimed at absorbing shocks from supply chain disruptions, primarily to prevent panic selling of US bonds and securities. If not handled with sensitivity, it could lead to dumping of US securities, resulting in damage to the US economy.

Although the world is facing skyrocketing crude oil prices, supply chain disruptions and negative sentiments towards the dollar, the US central bank is reportedly still seeing relatively high inflows of funds into the US bond market following the FOMC statement. As the gold market appears to be entering a bearish trend, falling gold prices suggest that investors are possibly shifting their money from gold to US bonds as a safe haven and better returns. Although raising interest rates is not sustainable in the long run for the US economy, given the US’s huge national debt of over $39 trillion, the Federal Reserve has no other option but to raise or maintain interest rates to address the problems arising from West Asia. Nonetheless, in addition to the $2 trillion budget deficit, an additional $9 trillion of US debt is due to mature in 2026, requiring massive refinancing by the end of this year. Therefore, failure to comply with timely interest payment terms will reduce investor confidence in US bonds, which could pave the way for financial ruin, as had already happened in 1971–1973 (collapse of the Bretton Woods system). Trump appears to have realized that he may have made a mistake by attacking Iran; However, an early exit from this war is likely to damage not only the US economy but also America’s global image as a hegemonic power.

Given that some central banks around the world have significantly reduced their US security holdings, if Iran, with the help of China, Russia and other important players, succeeds in replacing the petrodollar with the petroyuan, a domino effect could be seen in the selling of US Treasuries globally, leading to the collapse of the dollar as the main global financial system. However, this is not so easy to do. Historically speaking, the US economy overtook Britain’s in 1916; It took more than 28 years for the dollar to become a global reserve currency in 1944, given that the world went through many ups and downs (the First and Second World Wars and the Great Depression) during this period. Therefore, it would not be wrong to say that the world’s reserve currency does not change overnight. However, in the long term this is very possible. The Trump administration’s recent policy of imposing tariffs and the ongoing crisis in West Asia may soon lead to a move towards the yuan in place of the dollar. Iran, by allowing only countries transacting in yuan to pass through the Strait of Hormuz, is possibly trying to break the Gulf petrodollar agreement and move towards allowing crude oil trading in Chinese yuan. If this happens successfully, countries holding US bonds and securities may dump dollars and switch to other options available.

Because bond yields and bond prices are inversely related, dumping of US bonds and securities can cause interest rates on US bonds to become significantly higher. Therefore, for the US it can be said that the recent attack on Iran is more suitable for phrases like ‘digging your own grave’. However, it is also widely said that when America sneezes, the world catches a cold. This saying is not just an exaggeration. It should not be forgotten that today, more than 57% of global foreign exchange reserves and about 90% of all global foreign exchange transactions are conducted in US dollars. Now, the question arises: To what extent is the world prepared to treat the common cold, which has the highest chance of becoming a chronic, incurable disease?

In this context, it is not unreasonable to assume that the world is not far from another global financial crisis. Now, another question arises: Can the US really afford to pull out of the Iran war in the meantime? The answer is no. Although President Trump constantly reiterates that he will end the war soon, America’s geo-economic compulsion will not allow it to exit this war early without achieving its objectives. The recent speculation of the US planning a ground invasion into Iran is not just a prediction, but sooner or later it is inevitable. In fact, from the American economic perspective, it may have become necessary for America, knowingly or unknowingly, to save its economy from collapse. Since the world’s economies are well integrated with the US economy, its potential collapse could lead to a global financial crisis.

(Views expressed are personal)

This article is written by Sanjay Turi and Praveen Sothwal, Doctoral Candidate, Center for West Asian Studies (CWAS), School of International Studies (SIS), Jawaharlal Nehru University, New Delhi.