In the course of our research we have studied how the One Belt One Road Initiative (OBOR) is part of an effort by Beijing to “internationalize” the yuan. By setting up new dispute mechanisms and by providing nearly $1 trillion in loans and currency swaps to 65 countries, China is making a full court press to see the RMB actively used in trade settlement throughout Eurasia and Africa.
An additional facet of this push is the yuan-denominated crude oil futures exchange that opens in Shanghai later this month.
Though China recently surpassed the US in oil imports (and more broadly Asia has surpassed both America and Europe in crude consumption), the Pacific region lacks a benchmark of any great recognition. Many analysts believe the Shanghai’s crude futures will emerge as the dominant price benchmark in the region, becoming part of the 24-hour global trading system, alongside the Brent and WTI futures.
Trading in these crude oil futures contracts will start at 9 a.m. on March 26 at the Shanghai International Energy Exchange, or INE, according to a recent press release the organization.
The trading margins for the futures have been set at 7% of the contract value, with the trading limits on the first trading day set at 10% of the benchmark prices. (The INE will release the benchmark prices on March 25, one trading day before the launch of the futures).
Will there be hiccups — liquidity issues, contract settlements concerns, etc — at the start of this new exchange? Of course. China actually tried and failed with a futures market back in 1993; it was simply overcome by the unanticipated volatility. But much has changed since then.
Though the yuan remains a minor currency in worldwide trade settlement, China recently surpassed the US in oil imports and GDP on a PPP basis. Its financial institutions are far more robust.
Ultimately this futures exchange is designed to give China much greater pricing power over the oil it consumes, and in the long term it will likely succeed. One question that remains for the American investor is whether this new Sino-centric oil benchmark (and thus a new era of multi-currency pricing for oil) will have ramifications for both the demand for dollars and US interest rates.
“Petrodollar recycling” has existed as a major aspect of the international financial markets since Nixon’s famous pact with the Saudis in July 1974 to have them only sell oil in US dollars. International trade settlement was critical for dollar demand after his administration closed the “Gold Window” and essentially defaulted on the long wavering Bretton Wood’s promise to exchange one ounce of gold for $35.
Since that time any oil importing country worldwide needed dollars to make its transactions. The vast volumes of petrodollars earned from oil producers were cycled back into US treasury securities and invested through the major US and European commercial banks. By 1977, Saudi Arabia alone had accumulated about 20% of all Treasuries held abroad. The petrodollar process was also responsible for the massive growth of the Eurodollar market as it was less-regulated rival to US monetary markets, adding to the ubiquity of the dollar.
In the long term, it is clear that a new settlement of China’s oil contracts in yuan –especially one that is accepted by the Saudis –will reduce demand for dollars, though it is not clear whether other Asian countries will quickly follow suit.
There is certainly much to distrust about a futures exchange and price benchmark so firmly under Beijing’s control. Its history of state intervention, capital controls, and favoritism toward Chinese companies could keep non-Chinese players from any initial involvement. The main assumption is that Beijing will push its national oil companies onto the exchange and that the benchmark will greatly improve the risk management capabilities of the country’s “teapot” refiners, small and mid-sized firms that were just given oil import licenses in 2016.
Last year China’s total oil refinery capacity exceeded China’s oil needs by about 3 million barrels a day. Additional refining capacity under construction is expected to surpass 18 m b/d in the next few years, so clearly the country will be facing a glut. Whether this will winnow out the small players or whether the oversupply will be actively sold to the foreign markets now involved in OBOR remains unclear.
Most financial counterparties in a typical marketplace don’t like contracts with only a few dominant buyers or sellers and a government role, but perhaps this futures exchange is simply emblematic — like sovereign wealth funds– of the new institutions of the emerging “authoritarian capitalist” paradigm. According to Juerg Kiener, managing director and chief investment officer of asset manager Swiss Asia Capital: “Iraq, Russia and Indonesia have all joined in non-dollar trades . . . and as China is an importer it will push harder to get yuan contracts.” Pace University researcher Banyan McGuire has explored how Pakistan –a major trade partner and emerging geopolitical ally of the PRC– has recently explored doing all of its bilateral trade in yuan (CYB).
March 26, 2018 will likely covered by China’s state media in a low key way, much like it did the formation of China’s first sovereign wealth fund –the CIC– back in 2007. But its March date may eventually be seen by historians as an essential milestone in China’s hegemonic rise. Though Nixon’s closing of the gold window in August 15,1971 is well-remembered, it was actually in March of 1973, exactly 45 years ago this month, that the West German government finally allowed its Bundesbank to stop buying US dollars. Germany’s exit from the system of fixed exchange rates sealed the fate of Bretton Woods.