The Fuse

China’s Currency on Track to Challenge the U.S. Dollar in Oil Markets

by Matt Piotrowski | October 15, 2015

China’s forthcoming launch of a crude futures contract to be traded with the yuan is another major step to cement itself as a global economic powerhouse and challenge the U.S. currency’s dominance in oil markets.

The U.S. dollar has been the de-facto international reserve currency for seven decades, but its supremacy is being challenged rapidly. China’s forthcoming launch of a crude futures contract to be traded with the yuan is another major step to cement itself as a global economic powerhouse and challenge the U.S. currency’s dominance in oil markets. While China has a long road to travel if it wishes to unseat the dollar, the Asian juggernaut has taken a number of steps to boost its currency’s standing in the global marketplace, but the move to establish a crude futures exchange is among the most significant.

There is general agreement among economists that, although it may take decades, China’s yuan will eventually rival the U.S. dollar, whether as a secondary reserve currency or at the very top. In fact, a cycling of reserve currency status is the historical norm: Since the 1400s, six different currencies have held the designation as their parent country has ceded status as a global hegemonic power. Beijing’s political will to internationalize its currency will be a key factor in this likely shift.

Furthermore, China’s economy has the strength to present a credible challenge to the dollarized oil market. China’s economic rise has been fast and should continue to move in the same direction, if not at the same pace. Despite visible setbacks such as this summer’s stock market plunge and the subsequent devaluation of the yuan to give a short-term stimulus to the economy, these moves shouldn’t be seen as a negative reflection of its longer-term financial clout.

20120103_JPM_reserve

Oil deals already done in yuan

As major producers compete for market share from Chinese buyers, they have been willing to do deals in yuan.

There has already been movement in displacing the dollar in oil deals, a trend that has not received much attention in mainstream U.S. outlets. China overtook the U.S. this year as the top importer of crude oil, and as major producers compete for market share from Chinese buyers, they have been willing to do deals in yuan. Both Russia and Iran are accepting the yuan, as are Angola, Venezuela and Sudan. Others are likely to follow. The growing use of the yuan in oil trading represents the decline of the petrodollar—dollars earned by producers through the sale of petroleum—and also signify China’s growing importance in the world economy. These shifts will have major implications for the geopolitical backdrop, while also providing a boost to the new crude futures exchange.

Earlier this year, the Chinese government set up guidelines for independent refineries, which are called teapots, to start importing crude. Giving the green light for these imports was a move designed to bolster the number of buyers in the country, as it becomes the world’s top importer, and deepen liquidity ahead of the launch of the futures exchange.

Some Asian countries already accept the yuan in trade, but more importantly, a bond market to allow foreigners to include yuan in their portfolios has kicked off.

Outside of oil trading, China is making other moves to compete with the greenback. Beijing’s long-term strategy is clearly to boost its competitiveness and attract foreigners to buy and hold the yuan. So far, it has taken a number of key strides in this area. Some Asian countries already accept the yuan in trade, but more importantly, a bond market to allow foreigners to include yuan in their portfolios has kicked off. China has boosted its initiatives to bring in more foreign borrowers to issue bonds in yuan onshore, which are called Panda bonds, in an attempt to open its domestic capital markets. In a reflection of investors’ appetite for access to China, Hong Kong and Shanghai Banking Corporation (HSBC), the first foreign bank to do so, plans to sell up to 1 billion yuan ($156.73 million) of these Panda bonds.

The International Monetary Fund (IMF), meanwhile, is looking at whether to include the yuan in the Special Drawing Rights (SDR), IMF’s basket of reserve currencies. If included, the decision would be a symbolic victory for China: The yuan would take a major step in its role as an international currency alongside the euro, the yen and the Swiss franc. It would also attract more investors. With a more liquid market of yuan assets, Beijing can accelerate transforming Shanghai into a major international financial center by next decade. The Shanghai Futures Exchange (SFE), owner of the new crude futures exchange Shanghai International Energy Exchange (INE), is one example of this trend.

Implications of the dollar’s decline

dollar

With some 64 percent of currently reserves in global central banks held in dollars, Beijing has a long way to go to achieve its vision. Furthermore, some 60 percent of the world’s economic output is either in the dollar or “dollar zone”—currencies pegged to the greenback. But what does the dollar’s supremacy mean for everyday Americans? The relative stability of the dollar is what drives the global appetite for dollar-denominated assets, since the Fed has reluctantly rescued the offshore dollar in the past. The U.S. uses this financial clout as a political tool regularly, and domestically, the dollar’s significance enables inexpensive lending for Americans, allowing the government and U.S. companies to borrow easily.

Financial crisis a turning point

One reason China is so determined is because of its desire for superpower status, but another factor is its frustration during the 2008 financial crisis.

One reason China is so determined is because of its desire for superpower status. But another factor is its frustration during the 2008 financial crisis, which exemplified how vulnerable the rest of the world is to the U.S. economy and its currency. Although the recession began in the U.S., it negatively impacted China, which is on pace to be near the U.S. in total GDP by 2030. To be sure, China talked of moving away from the dollar and boosting the status of its own currency before the financial crisis, but its motivation accelerated post-2008.

chinaecon

In the aftermath of the financial meltdown, Chinese officials believed the U.S. manipulated the global financial system and passed its economic pain on to the rest of the world with the depreciation of the dollar with three rounds of quantitative easing, and allowing the national debt to balloon. Moreover, it showed the danger of holding reserves of the U.S. dollar.

The recession of 2008 also hurt China’s export economy with demand for its goods and products taking hits in the U.S. and Europe. The export-led economy that sustained growth for so long in China is not viable in the longer term. By moving toward a consumer-based economy, the yuan has a better chance of becoming a major reserve currency, as Beijing would not have to worry about the yuan appreciating. Moreover, the structural change in the economy sets in motion more liberal market reforms, increased capital inflows, and a flexible exchange rate, all of which are needed for a major reserve currency.