It remains to be seen which of these two sets of economic arguments offers more accurate predictions about the future. But neither perspective adequately addresses the non-economic factors that could motivate creditor nations to act to undermine the dollar.

Foreign government agencies-central banks and, more recently, SWFs-have surpassed private purchasers of U.S. assets as the most important sources of financing for America's twin deficits. Today, the central banks of major creditor nations seem to be focused primarily on macroeconomic stabilization and managing the value of their currencies in the near term, and most SWFs seem to be focused on maximizing the long-term value of their assets. But, looking ahead, there is no guarantee that state-controlled entities will not base decisions about asset allocation on strategic calculations as well as economic considerations.

The imperatives of soft balancing will almost certainly influence China's approach to financial and monetary issues. Under the rubric of its "new diplomacy", the current Chinese leadership is committed to avoiding a military confrontation with the United States, as such a confrontation would retard China's continued economic development and growth. But in recent months, Chinese officials have said that Beijing might use China's dollar holdings as a "bargaining chip"-particularly to deter the imposition of U.S. sanctions if the Chinese currency, the renminbi (RMB), does not appreciate as quickly as Washington wants.

Moreover, as China seeks to enhance its regional and international influence, the cultivation of financial and monetary power-inevitably, at America's expense-will be an increasingly important feature of Beijing's policies. In the near term, the Chinese leadership clearly intends to maintain tight control over the pace at which the RMB appreciates. Beijing's stance in this regard is driven to a considerable degree by economic motives-in particular, an interest in keeping the price of Chinese exports relatively low to preserve China's comparative advantage in the global marketplace. But Chinese officials speak privately about their longer-term ambitions to form an Asian economic "zone" organized around China, in which the RMB would emerge as a leading transactional and reserve currency. These ambitions are driven by a mix of economics and strategy, including an interest in reducing America's dominant influence in the Pacific basin.

There is an important monetary component to China's efforts. The RMB is starting to appear in the reserve-asset holdings of some Asian countries; over time, as Beijing allows the RMB to appreciate in value and, ultimately, to "float" relative to other major currencies, the RMB's profile as a reserve currency is likely to rise substantially. Anecdotal evidence suggests that the RMB is already replacing the dollar as the preferred transactional currency in several Asian markets. And there are growing indications that Chinese financial institutions are already beginning to "sell down" the dollar. Again, there are near-term economic motives for this, but, in the longer term, these moves will limit the reduction in the value of Beijing's own reserve assets as the RMB appreciates and pushes the dollar further aside in Asia-critical steps in China's emergence as a regional financial and monetary power.

The imperatives of soft balancing will likewise affect the financial and monetary calculations of major energy producers-not only with regard to the disposition of their reserve assets, but also regarding the dollar's role in international oil trading. Historically, the primary economic justification for trading oil in dollars has been the dollar's position as the world's leading reserve currency. Outside the United States, trading oil in dollars while refined products are sold in national currencies exposes producers, refiners and traders to currency risk. Bearing that risk may have been worthwhile for non-U.S. actors-to accrue the benefits of a more efficient, liquid and transparent market-so long as the dollar was seen as a secure store of value. But, as the dollar's value becomes questionable, energy exporters-particularly those that import more from the eurozone and Asia than from the United States-and non-U.S. energy importers have stronger incentives to trade oil through instruments denominated in other currencies. Although there would be "transition costs" associated with introducing supply and spot purchase contracts denominated in currencies other than the dollar, such a move would shift much of the currency risk associated with international oil trading to the United States.

But, beyond economics, changes in the currency regime for international oil trading would be a significant blow to the dollar's standing-and, thus, to America's strategic position. Already, some major energy producers are exploring ways to use such initiatives as a form of soft balancing against U.S. hegemony. In this regard, Iran's attempts in recent years to shift the currency regime for international oil trading away from exclusive reliance on the dollar clearly reflect Tehran's interest in maximizing the strategic position of the Islamic Republic vis-à-vis the United States. Senior Russian officials say privately that Moscow is exploring the introduction of oil-supply contracts denominated in rubles rather than dollars; while there are plausible economic arguments for such a move-the ruble is effectively pegged to the euro, and Russia buys far more of its imports from the eurozone than from the United States-the Kremlin's interest in finding ways to "push back" against what it views as excessive U.S. unilateralism in international affairs is also a factor.

So far, the United States has benefited from the actions of traditional allies in stemming the tide. One reason that European financial centers have not launched euro-based instruments for oil trading-including not only supply contracts but also instruments for forward and futures trading, options and derivatives-is concern by European governments that such a step would be perceived as hostile to U.S. interests.

Similarly, Saudi Arabia's continuing commitment to the dollar-both as the currency for international oil trading and as the "peg" currency for the riyal-reflects what Saudi officials explicitly describe as a "strategic" decision by the kingdom. In early 2005, as the dollar continued an already year-long decline toward what were then historic lows against the euro, a senior official of a small Gulf Arab state with close security ties to the United States said privately that, if the dollar's value declined another 10-15 percent against the euro, his country would support a shift in the currency regime for international oil trading "on economic grounds alone." Soon political developments in Europe-in particular, rejection of the European constitution by Dutch and French voters-caused the euro's value to fall, relieving economic pressure on Middle Eastern energy producers to consider shifting away from the dollar. But during 2004 and early 2005, Saudi Arabia's strategic loyalty to the dollar was an important safeguard for America's financial and monetary interests.

More recently, however, as the monetary-policy imperatives of the United States and Gulf Arab states with their currencies pegged to the dollar have diverged, economic pressure has mounted on these states to drop their dollar pegs. Kuwait took this step in May 2007, and expectations rose in regional and international financial markets that other GCC states might do the same. Once again, Saudi leadership and continuing commitment to the dollar-reflected in a November 2007 decision by the Saudi central bank to cut interest rates in tandem with the Federal Reserve (even though rising inflation in the kingdom meant that raising interest rates was a more appropriate Saudi policy response)-delayed any wholesale movement by GCC states away from their dollar pegs. That same month, at an extraordinary OPEC summit in Riyadh, Saudi Arabia fended off pressure from Iran and Venezuela to move away from pricing oil exclusively in dollars; in a closed session, a microphone accidentally left on picked up Saudi Foreign Minister Prince Saud al-Faisal warning that the dollar would "collapse" if currency issues were even mentioned in the summit's final declaration.

But how long will Saudi Arabia be willing to defend the dollar? Since the September 11, 2001 terrorist attacks-and, more intensively, since the U.S. invasion of Iraq in 2003-the Saudi leadership has been reevaluating the kingdom's long-standing strategic partnership with the United States. Although there is a range of views among influential members of the royal family regarding the future direction of Saudi policy toward the United States, on balance the leadership believes that Riyadh must "hedge" against a precipitous deterioration in relations with Washington. The kingdom is thus diversifying its economic partners and cultivating what Saudi officials openly describe as a "strategic" relationship with China. The evolution of Sino-Saudi relations-and, more broadly, the consolidation of an axis of oil encompassing Asian manufacturing powers and major energy exporters in the Middle East and former Soviet Union-is emerging as a critical factor that will shape the management of global economic imbalances in coming years.

Strategic Risks and Policy Responses

THE EXPANSION of economic linkages between Asian manufacturers and energy exporters in the Middle East and Russia is adding important monetary and financial dimensions to the axis of oil, strengthening its capacity to act as a counterweight to the United States. Depending on how America behaves internationally in the near-to-medium term, a coalition of creditor nations-encompassing major manufacturing powers and major energy exporters-could decide to take action to undermine the dollar's international status. Such action could take a variety of forms: restricting the flow of financing for the U.S. current-account deficit, further diversification away from the dollar as a reserve asset or broadening the currency regime for international oil trading to include currencies other than the dollar.