China's recent introduction of yuan-denominated oil futures has attracted some fairly extensive press commentary. Partly this is down to a habit of over-interpreting everything happening in China as just more evidence of their unstoppable rise to global superpower status, but it is also due to some profound misconceptions about the importance of oil as a commodity. It is widely thought, for example, that oil somehow underwrites the global financial system and guarantees the U.S. dollar's hegemonic status.
Inevitably, stories about the toppling of the "Petro-dollar" and the long yearned for rise of an alternative reserve currency, one not dependent on the whims of a capricious political elite in Washington, have proliferated across the alter-net and on the state-backed media platforms of Russia and China.
But we should be clear: the Petro-dollar does not exist, and really hasn't done in any meaningful way since the 1970s, therefore the "Petro-yuan" has no future. This is not to say that oil will never be traded in yuan, that is likely, but it is to say that trading oil in yuan will not suddenly transform the currency into the global reserve many claim is inevitable.
Origins Of The Petro-Dollar
The myth of the Petro-dollar comes from efforts in the 1970s to prevent the U.S. suffering severe negative effects in its balance of payments from rising oil prices. Until the late 1960s the U.S. had been an oil-exporter, but by also being an oil consumer they had never sought to maximize the rent from oil production by driving prices upwards. OPEC countries, however, never had such qualms and when the opportunity arose as the U.S. became an importer, happily restrained supply to drive prices, and their own national incomes, higher. The U.S. was worried about the resultant trade deficit caused by suddenly having to pay vast amounts for necessary imports, and so secured the agreement of Saudi Arabia to only trade oil in U.S. dollars, meaning the U.S. could pay for oil in their own currency. Saudi Arabia, for their part, accumulated huge reserves of U.S. dollars, investing some of them back into the U.S. economy.
The enormous lake of U.S. dollars this created augmented the role of the dollar as the global reserve currency, being a highly liquid, easily-exchanged claim on the products, services and investment potential generated by the U.S. economy. But this was merely one step in the rise of the greenback as the global reserve. The next step came when other economies–East Asia in particular–followed the lead of the oil producers and also built up huge reserves of U.S. dollars, all of which was made possible by the abandonment of the Bretton Woods fixed exchange rate system in the early 1970s. This practice helped to keep exchange rates for exporters low, and kept a lid on inflation in the U.S., which suited everyone up to a point.
Future Petro-Yuan?
Bringing this up to date, it was a long time ago when the link between oil and the dollar mattered much at all beyond the financial returns of non-dollar based oil companies. Since the 1980s, the dollar has been consolidated as the global reserve currency because of the strength and dynamism of the U.S. economy, and oil exporters have demanded to be paid in U.S. dollars because that's the currency they prefer to hold on to. To do otherwise is to take on exchange risk. Exporters can, and routinely do, accept payment in whatever exchange medium they wish -- tanks, planes and construction services -- but their central banks demand dollars for reasons entirely unconnected to oil. Because the U.S. dollar is a hard currency, easily exchangeable, underwritten by the U.S. taxpayer, and founded upon decades of broadly consistent macro-economic policy management.
Those who believe that oil being traded in U.S. dollars gives the U.S. economy a unique advantage in the global economy have it exactly the wrong way around. The U.S. economy is the central economy in the global system because it is the most open, innovative, and productive economy in the world, and because of this, the U.S. dollar is the most convenient, liquid and reliable medium of exchange. One can imagine another currency challenging it at some point in the future, but only on the basis of the openness of its underlying economy, and the depth of the capital markets denominated in it. And if the euro can't do it yet, why does anyone imagine the yuan is up to the job?
Furthermore, the U.S. dollar's position as the global reserve currency has been underwritten by Chinese economic policy. China has deliberately built up a huge pile of U.S. dollar-denominated reserves which, contrary to much press coverage and occasional threats of a big selloff from China, confirms rather than undermines the dollar's status.
Yuan-Denominated Oil Futures?
When China, like any other economy, allows the trading of oil futures in yuan, the contract merely promises dated delivery of oil in exchange for yuan. The contract does not supply the oil, it does not forward the yuan to an oil producer, it is merely a transaction that allows a buyer guaranteed delivery of oil by paying for it in yuan. The counter-party has to supply the oil in exchange for the yuan. Somewhere along the supply-chain someone will be paying in U.S. dollars, unless the ultimate supplier wishes to hold yuan. And despite the fanfare over the last few years, the yuan still comprises a tiny share of foreign exchange reserves held globally. Indeed, at 1.1% of the total, the yuan is significantly behind both the Australian and Canadian dollars, meaning that–with pound sterling–Queen Elizabeth II's head appears on 7.5 times more foreign currency reserves than Mao's. If China wants to change that, it will need to open up its economy, liberate its capital account and start living up to, rather than repudiating, its reform promises. Shanghai-traded oil futures in themselves have nothing to do with it.
