Lead Story: China acts to make petro-yuan a reality

This article first appeared in Capital, The Edge Malaysia Weekly, on April 23, 2018 - April 29, 2018.
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IN the early 1970s, the US administration led by President Richard Nixon came to a synergistic agreement with Saudi Arabia that would dictate the way the world transacts in oil. The US would provide technology to the Arab Kingdom and the Saudis would price their oil sales in the greenback, with any excess profit to be invested in US Treasuries.

Hence, the petro-dollar was born and it has enjoyed global supremacy for the past four decades. However, much has been said about the inception of the “petro-yuan”. Simply put, it refers to a situation in which China is able to purchase oil in its currency, the renminbi (RMB).

These transactions are backed by gold, that is, the seller would be able to convert RMB into gold should there be a deterioration in the currency. The US dollar’s deteriorating performance has also ignited much discussion on a possible future with petro-yuan.

That conversation has taken centre stage now as China — the world’s largest net importer of crude oil — last month launched its first-ever RMB-denominated oil contracts on the Shanghai International Energy Exchange (INE) in a move largely viewed as a catalyst for the petro-yuan agenda.

Seven grades of oil, including Basrah Light Oil, Dubai Crude, Oman Crude and Shengli Oil, are understood to be traded on the platform.

The move rivals global oil trading benchmarks such as Brent Crude Futures, which are traded on the London-based Intercontinental Exchange, and West Texas Intermediate, which is traded on the New York Mercantile Exchange.

According to INE’s website, 42,236 lots equivalent to 21.1 million barrels of oil were transacted on March 26 — the first day of trading — at an average price of RMB433.8 (US$69) per barrel. News reports placed commodity giants Glencore Plc and Trafigura Pte Ltd as among the early purchasers.

Last Tuesday, 55,164 lots equivalent to 27.5 million barrels of oil were transacted at RMB425.1 per barrel.

China is the dominant customer, particularly for major oil exporters such as Russia, Venezuela, Iraq, Iran and Saudi Arabia, according to an UBS Asset Management note on petro-yuan issued last month.

“If, or rather, when China’s total oil import bill gets priced in RMB, that’s going to create large piles of RMB reserves in oil-exporting countries that will either be spent on Chinese exports, or recycled into China’s financial markets, giving China much more heft in the global economy.

“This will have two principal effects: increased demand for RMB assets and a switch out of the US dollar for trading purposes, which will likely undermine the US’ dominant role in the global economy and create a sea change in global asset allocation to China’s financial markets.

“And that’s why the launch of oil trading contracts in RMB really matters,” UBS says.

Under the leadership of President Xi Jinping, China has been pushing for the internationalisation of the RMB. In November 2015, the International Monetary Fund (IMF) added the RMB into its basket of currencies that make up the Special Drawing Rights (SDR) — an international reserve asset created by the IMF in 1969 to supplement its member countries’ official reserves.

The IMF’s move recognised the RMB as a currency that is freely useable and enhances its attractiveness as an international reserve asset. As at the fourth quarter of 2017 (4Q2017), the RMB made up 1.23% of the world’s allocated reserves, compared with 1.07% in 4Q2016.

China’s Belt and Road Initiative (BRI), which encompasses more than 60 countries, is also seen as a move to gain wider acceptance for the RMB.

Sunway University Business School Professor of Economics Dr Yeah Kim Leng says, “It is likely that Malaysia and other countries in this region will consider denominating oil and other trade with China in RMB, especially if the currency is stable and China’s financial markets continue to be liberalised.”

As for the oil market, UBS opines that in order for RMB oil trading to shift the structure of the global oil market, two things need to happen. “Firstly, China will have to remove, or substantially reduce, capital controls for RMB-priced oil trading to take off and allow global commodity trading houses access to the INE. We think this is already in process, although happening gradually, based on recent policies to make the RMB more market-determined and ease rules on foreign banks’ RMB businesses,” it says.

“China’s other landmark changes, like giving institutional investors direct access to the Chinese bond market, expanding access via the Bond Connect programme in 2017, and launching the Shanghai and Shenzhen Stock Connect links with Hong Kong, show the government is intent on the necessary reforms to open the economy to international investors.

“Secondly, China’s oil trading partners, like Saudi Arabia, Russia, and Iran, will have to agree to accept RMB for their oil exports to China. This is also taking shape because Russia already accepts RMB for oil exports, as does Iran, and we expect Saudi Arabia to soon begin invoicing China in RMB,” the firm says.

 

The experts weigh in

Shan Saeed

IQI Global chief economist

There is a love triangle between oil, gold and renminbi (RMB). China has been conducting most of its oil transactions with Russia in RMB, and these transactions are backed by gold. In this way, it secures the transaction as Russia can convert RMB into gold should the currency depreciate.

Venezuela and even Saudi Arabia, to some extent, also conduct their oil transactions with China in RMB. With the Belt and Road Initiative (BRI)impacting more than 67 countries, including Malaysia, it is just a matter of time before the BRI countries follow suit as RMB is becoming the currency for emerging markets.

The central banks of various countries are denominating their reserves in RMB and more sophisticated investors are taking long positions in the currency, especially in Asean. Many corporations in the region are considering issuing their debt in RMB-based denomination going forward.

I believe it would take the BRI countries another two to three years to adopt the petro-yuan. Subsequently, in probably five years, the petro-yuan will be a new global reality. It will emerge prominently in the energy market.

Acceptability of the usage of RMB is the biggest concern as the US dollar has been the global reserve currency for more than four decades. However, more and more countries are moving away from the US dollar hegemony. The US may try to retaliate with more sanctions and tariffs, but I think China will be in the driving seat should that happen — its reserves alone stood at US$3.14 trillion as at March. China is taking centre stage in the global financial markets.

Kuala Lumpur-based Shan Saeed first wrote about the petro-yuan in November 2014 and is probably among the initial few to comment on it

 

Dr Yeah Kim Leng

Professor of Economics, Sunway University Business School

There won’t be much impact initially as the use of RMB in international trade is still very small. However, a rising trend is visible and more so now with the petro-yuan widely accepted by the Middle-Eastern and Russian oil exporters. It is likely that Malaysia and other countries in this region will consider denominating oil and other trade with China in RMB, especially if the currency is stable and China’s financial markets continue to be liberalised.

There will be stronger demand for Chinese assets as oil exporters seek to invest their RMB holdings. Since the petro-yuan is backed by gold, there is greater market confidence and acceptance besides providing another support for gold prices. The US dollar will be increasingly under threat and its decline will be accelerated by US President Donald Trump’s insular and anti-trade policies. If the Chinese economy maintains its steady growth momentum, it is just a question of when, not whether, RMB will replace the dollar as the international currency. A more stable international financial and trading system may arise in a multi-polar world that will see the rising use of RMB and less dependence on the US dollar in international trade.

It is hard to predict when the petro-yuan will become a widely accepted international benchmark but if the Chinese economy and its trade links with the rest of the world continue to expand as projected, that could happen in a decade or two. The pace might quicken in tandem with the growth of the global fintech (financial technology) industry.

 

Dr Mamdouh G Salameh

International oil economist and Visiting Professor of Energy Economics at ESCP Europe Business School, London

It will not be easy to unseat the petro-dollar without the participation of major oil producers. Saudi Arabia and Russia, for example, account for 26% of global oil production and 25% of oil exports.

Russia is already on board, along with Iran and Venezuela, to accept the petro-yuan for crude oil. China is now trying to persuade Saudi Arabia to do the same. If it succeeds, other oil exporters could follow suit. Still, Saudi Arabia would find itself between a rock and a hard place: lose China’s oil market or invite the ire of the US.

On balance, I think Saudi Arabia will compromise by accepting the petro-yuan for oil exported to China and Asia-Pacific while continuing to accept the petro-dollar for exports to the EU and the US. Such a compromise will still tip the balance in favour of the petro-yuan as 75% of Saudi’s oil exports go to China and Asia-Pacific.

The petro-dollar is backed by Treasuries so it can help fuel US deficit spending. Take that away and the US economy will be in trouble, leading to a loss of value in the dollar against other currencies. Contrast this with the petro-yuan convertible to gold.

 

Carl Weinberg

Chief economist and managing director, High Frequency Economics Ltd, New York

If the Saudis, the world’s biggest oil exporters, join the Russians in accepting RMB, then the two biggest exporters and the biggest importer of crude oil will have to switch out of US dollars. All other oil producers will have to follow to avoid losing market share. China will favour RMB pricers over refusers, just as it has already shifted oil imports away from Saudi Arabia to Russia to reward Moscow for its decision to accept RMB.

 

Marshall Gittler

Chief investment strategist and head of education, ACLS Global Ltd

If other countries do agree to take RMB for their oil, it will increase the amount of RMB in circulation outside China. That will help promote the internationalisation of the currency. But I think it will be a long, long time before RMB becomes commonly used as an international settlement currency among third countries, for example, a French company paying for Russian oil in RMB.

There are three problems here. First, it just is not that easy to get enough RMB. Banks do not have access to enough Chinese currency to make RMB-denominated bank loans. That is because China is a trade surplus country, meaning it is constantly importing foreign currency, not exporting its own currency. By contrast, the US has run a current account deficit for the last 30 years or so. The world is awash in US dollars. There is no advantage to using RMB instead of the US dollar.

Second, US interest rates are lower than RMB interest rates, so even if there were enough RMB available, it would still make more sense for buyers to borrow in US dollars.

Third, there is a big advantage to everyone using the same system. It increases transparency, just like most of the world uses PCs (personal computers), not Apple, and everyone uses Excel. This is called “return to scale”. It would make the system more complicated for everyone to have two different currencies in use for pricing commodities.

 

 

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