THE INTERSECTION of ongoing structural shifts in international energy markets with strategic trends in global financial markets poses the most profound challenge to American hegemony since the end of the Cold War. In 2006, Pierre Noël and I wrote in these pages about an "axis of oil"-a loose and shifting coalition of energy-exporting and -importing states, anchored by Russia and China, that is emerging as a counterweight to the United States (so far, most notably in Central Asia and, increasingly, in Iran).¹ The ability of such a coalition to resist American hegemony is now compounded by the vulnerability of the United States to financial and monetary pressure by its major international creditors-most of which are at least putative members of the axis of oil.

In the past, the United States has exerted financial and monetary pressure on others to leverage their foreign-policy decision-making-on Britain and France during the 1956 Suez crisis, for instance.² But now-as the dollar declines to historic lows relative to other major currencies, against a backdrop of substantial expansion in the U.S. budget and current-account deficits in this millennium-the tables have turned. Half a century after Suez, there is growing potential for a coalition of major energy exporters-disproportionately concentrated in the Middle East and Russia-and major manufacturers like China to coordinate the application of financial and monetary pressure on the United States for strategic purposes.

The Axis of Oil and "Soft Balancing"

THE SUSTAINED rise in energy prices since 2002 is redistributing wealth-and, prospectively, economic power-across the world. The main beneficiaries of this process are major oil exporters and the major industrial exporters-e.g., China, Japan and Germany, the countries with the three largest current-account surpluses in the world-that serve them. The principal "loser" is the United States.

This redistribution of wealth and power has significant implications for the global economy. Today, major energy exporters in the Persian Gulf and Russia are, collectively, at least as important to financing global economic imbalances as China and Japan. China's current-account surplus-already the subject of much concern in the United States-is now dwarfed by the combined current-account surpluses of Russia and the six countries comprising the Gulf Cooperation Council (GCC).³

Moreover, as the redistribution of wealth and power proceeds, economic linkages connecting the principal "winners" in this process-Asian manufacturers and energy exporters in the Persian Gulf and Russia-are deepening and multiplying. If a "world without the West", as Steven Weber and his associates described recently in these pages,⁴ is indeed taking shape, these linkages are its foundation. These linkages are also adding new economic dimensions to the axis of oil.

Despite significant movement toward the creation of a single, integrated market for crude oil and refined products, there remains a profound degree of "regionalization" in oil-supply relationships. Two-thirds of current oil exports from the Persian Gulf-or "west Asia", as the Gulf is frequently described in more eastward Asian locales-are delivered to Asian customers. For Persian Gulf energy producers, the most important "growth" markets for future production lie to the east; Russia and Central Asian producers (Kazakhstan for oil and Turkmenistan for natural gas) also have ambitions to expand exports to Asian markets. For their part, China, Japan and other Asian economies perceive a compelling strategic interest in deepening their energy ties to major oil and gas producers in the Middle East and former Soviet Union.

Now, linkages between Asia and major energy exporters are also taking shape for trade and investment flows. Anchored by China, a rising economic power, and Japan, an established (and recovering) economic powerhouse, Asia has clearly consolidated its position as the "center of gravity" for global manufacturing. To be sure, the United States-which imports roughly 75 percent more than it exports-has been a key "engine" for Asia's economic growth. In recent years, however, new markets-including emerging economies and energy producers-have become increasingly important to Asian manufacturers. This trend has prompted the current emphasis on Asian regionalism in China's economic and foreign policies. It also reinforces China's interest in building strategic trade ties to energy-producing states in the Middle East (such as Saudi Arabia) and Russia; similarly, China wants stronger investment ties to Iran, Central Asian energy producers and Russia.

Looking in the other direction, major hydrocarbon exporters in the Middle East are turning to Asia as a venue for what will surely be increasing volumes of outbound investment. On a per capita basis or in relation to GDP, the current-account surpluses of major Middle Eastern energy producers are larger than those of Asia's manufacturing powerhouses. These surpluses far exceed what their holders can productively use to pay down official debt, stimulate their domestic economies through infrastructure construction, increase consumption and fund economic-diversification initiatives. And energy producers in the Persian Gulf and Russia now hold more dollars as reserve assets than they need for macroeconomic stabilization.

So, what to do with these excess funds? Increasingly, major energy exporters-and China as well-are looking to convert their dollars not only into other currencies but also into other types of international assets-equities, bonds, private-equity holdings and strategic stakes in investment projects across a range of economic sectors. This has led to an explosion of so-called "sovereign wealth funds" (SWFs) and similar types of state-owned investment channels in recent years. The most important ongoing trend in SWFs' investment flows is diversification away from the United States and toward Asia, which will bolster the consolidation of economic ties joining Asian manufacturers with energy exporters in the Persian Gulf and former Soviet Union.

These developments are playing out against mounting concern over what many states in Asia, the Middle East and the former Soviet Union see as the unilateral and ideological manner in which the United States has exercised strategic leadership in the post-Cold War period. To an impressive degree, these states are using the techniques of globalization-cultivating trade, telecommunications and investment links disproportionately with one another-to create a "world without the West." But, in various combinations, these states are also exploring what Robert Pape and other international relations scholars have called "soft balancing": The collaborative development of non-military means to restrain the United States from asserting influence in ways that other important regional and international players see as antithetical to their interests-the United States as dysfunctional hegemon.

The exercise of financial and monetary leverage over the United States by a coalition of creditor nations-including China and major energy exporters, the core of the axis of oil-would constitute a deep intensification of soft balancing. Since the end of World War II, the dollar's status as the world's premier currency has benefited America economically while also bolstering Washington's international leadership. However, the dollar's standing as the leading international transactional and reserve currency is increasingly fragile-creating a profound strategic vulnerability for the United States.

Dropping the Dollar

THE DOLLAR has enjoyed a long run as "the world's money." Following the collapse of the Bretton Woods system in the early 1970s-when the world moved to a monetary regime based on floating exchange rates for most major currencies-the dollar consolidated its position as the world's leading transactional currency, including for international oil trading. It also became the world's dominant reserve asset, effectively replacing gold as the ultimate international store of value and best instrument for settling deficits in countries' external accounts.

The dollar's unique standing has, among other things, enabled the United States to cover its current-account deficits and pay for growing and increasingly expensive oil imports by issuing debt instruments denominated in its own currency. Essentially, foreigners have underwritten America's credit card purchases with no credit limit, and the U.S. Treasury and Federal Reserve have been able to manipulate the interest rate on Washington's "account" to U.S. advantage.

But with the dramatic expansion of global economic imbalances, will countries with enormous current-account surpluses and burgeoning foreign-reserve assets continue financing America's "twin deficits" (current account and federal budget), providing critical support for the dollar's value and international standing? Or will there be, at some point, a slowdown in foreign financing of America's deficits, prompting flight from the dollar on a scale that would do long-term damage to its value and, effectively, displace the greenback as the world's top currency?

Dollar "optimists"⁵ argue that the comparative attractiveness of the United States as a venue for foreign investment and the relatively small percentage of global savings needed to finance America's current-account deficit mean that foreigners will continue to buy dollar-denominated debt instruments. Additionally, optimists argue that because manufacturing giants such as China and major energy exporters hold a high percentage of their reserve assets in dollars, they cannot move too far away from the dollar without seriously undermining the value of those assets. Dollar "pessimists"⁶, on the other hand, argue that the ratio of debt to GDP in the United States will, at some point, reach a level making continued financing of that debt economically unattractive to foreigners. At that point, declining demand for U.S. assets will prompt a fall in their prices-including the value of the dollar itself.

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.

Displacement of the dollar as the world's leading transactional and reserve currency would hurt the United States economically, by reducing seigniorage benefits accruing to the U.S. Treasury from foreigners holding dollars-in effect, an interest-free loan for the U.S. government. More importantly, it would raise the costs of financing America's twin deficits. By extension, these economic losses-whether actually imposed or only threatened by a critical mass of America's creditors-could constrain U.S. "freedom of action" internationally, in a manner reminiscent of America's exercise of leverage over British decision-making during the 1956 Suez crisis.

Trends in global financial markets in coming years will almost certainly further weaken America's financial and monetary position. Unless current trends in global energy markets are purely cyclical-and, therefore, the price of oil drops substantially in the near-to-medium term-energy market developments will exacerbate this vulnerability. Preventing creditor nations from exploiting that vulnerability is one of the most important challenges facing the United States during the next decade.

Unfortunately, this challenge is almost completely overlooked in current debates about the direction of U.S. foreign policy-still often defined by some conservatives' continued attachment to America's unilateral prerogatives or by the shared belief of some neoconservatives and liberal internationalists that a "Concert of Democracies" can replace the UN Security Council as the legitimator of U.S. military initiatives. These notions overlook a critical reality: A "community" of largely non-democratic manufacturing powers and energy exporters is already laying the groundwork for real strategic collaboration, aimed at limiting America's ability to carry out precisely such hegemonic agendas.

Minimizing the strategic risks associated with America's financial and monetary vulnerability is going to require hard foreign-policy choices. First, the United States must recognize that, fundamentally, this vulnerability is rooted in perceptions that American strategic initiatives and positions are increasingly threatening to the interests of key creditor nations. These initiatives and positions include the Iraq War, feckless stewardship of the Arab-Israeli peace process, refusal to pursue serious diplomacy with Iran, support for "color" revolutions in former Soviet states and lackluster vision in managing China's rise.

Second, the United States should make the cultivation of mutually beneficial strategic partnerships with major energy producers, such as Russia and Saudi Arabia, a much higher foreign-policy priority. As Dimitri Simes has argued, successive U.S. administrations have crafted policy toward Russia on the basis of an increasingly unrealistic assumption that Moscow has no choice but to tolerate whatever America wants to do.⁷ Similarly, U.S. policymakers continue to operate as if Saudi Arabia somehow needs America more than America needs Saudi Arabia.

The United States can no longer afford to maintain these illusions. The next U.S. administration will need to establish broad-based strategic understandings with Russia, Saudi Arabia and other important energy exporters to raise confidence in the benefits of America's continued international leadership. With regard to Russia, the United States should make clear that, while the Kremlin will not have a veto over U.S. policy in Central and Eastern Europe, Washington recognizes that Moscow has important interests in the post-Soviet space. With regard to Saudi Arabia, the United States should work to restore Saudi leaders' perceptions that American hegemony in the Middle East is strongly positive for the kingdom's interests; this will require serious dialogue with Saudi leaders about how U.S. policy can accommodate Saudi interests and initiatives on Arab-Israeli peacemaking and regional security.

Finally, the United States needs a long-term strategy for accommodating China's economic and political rise that assures Beijing of America's respect for legitimate Chinese interests while also protecting America's most important interests in Asia. This will require a much more robust American effort to shape the evolution of existing multilateral institutions in Asia-and to create new ones, especially for energy and security issues.

The rise and evolution of the axis of oil is a watershed development in the history of American primacy. This development is rooted in structural shifts in the global energy balance and global financial flows; the next U.S. administration will not be able to escape the strategic consequences of these shifts by fatuous invocations of "energy independence" or "putting our economic house in order." The continuation of America's international primacy now truly depends on Washington's ability to take account of the perceptions and interests of others in its foreign-policy decision-making.

The author is grateful to Hillary Mann Leverett, Pierre Noël and Øystein Noreng for their indispensable contributions to his analysis and understanding of the issues treated in this article, and to Sameer Lalwani for outstanding research assistance.

Flynt Leverett is a senior fellow and the director of The New America Foundation's Geopolitics of Energy Initiative.

¹Flynt Leverett and Pierre Noël, "The New Axis of Oil", The National Interest, No. 84 (Summer 2006).

²In 1956, the Eisenhower Administration-opposed to the Anglo-French campaign to seize the Suez Canal in cooperation with Israel-orchestrated a run on sterling that compelled the Eden government to secure financing from the International Monetary Fund to defend the pound's value. Washington then refused to back the loan unless Britain withdrew its forces from Suez; in short order, decisions were taken in London and Paris for British and French troops to leave Egypt.

³The GCC includes three of the so-called "OPEC Five" states-Saudi Arabia, Kuwait and the United Arab Emirates-as well as Qatar, the world's leading producer and exporter of liquefied natural gas. (Bahrain and Oman are also members.)

⁴Naazneen Barma, Ely Ratner and Steven Weber, "A World Without the West", The National Interest, No. 90 (Jul./Aug. 2007).

⁵Dollar "optimists" include prominent academic economists and policy experts such as Richard Cooper, Ronald McKinnon and current Federal Reserve Chairman Ben Bernanke.

⁶Dollar "pessimists" include a number of prominent academic economists, policy experts at the Peterson Institute for International Economics, Morgan Stanley's Stephen Roach, former Treasury Secretary Lawrence Summers and former Federal Reserve Chairman Alan Greenspan.

⁷Dimitri K. Simes, "Losing Russia: The Costs of Renewed Confrontation", Foreign Affairs, Vol. 86, No. 6 (November/December 2007).