The Chosen Yuan? What the new oil scenario predicts about the Dollar

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In mid-March, the Wall Street Journal reported that Saudi Arabia, the world’s largest exporter of crude oil, was in talks with China, the world’s largest importer of the commodity, to price some of its oil exports in terms of the Chinese currency yuan. The Journal reported that “people familiar with the matter said” that such a “move that would dent the dollar’s dominance of the global petroleum market”.

Any move that dents the dollar’s dominance will also impact the global economy. Hence, it becomes crucial to understand what Saudi Arabia’s attempt to get closer to China means.

     

But before we do that, we need to read up on some history.

The past

On 14 February 1945, US President Franklin D. Roosevelt had a visitor onboard the USS Quincy, an American naval ship anchored in the Red Sea. The guest was King Ibn Sa’ud of Saudi Arabia, the country with the largest discovered oil reserves in the world at that point of time.

(Pic Source: US Naval Forces Central Command)

Even though the US was the largest oil producer globally then, America’s obsession with the automobile had led to a swift decline in its domestic reserves. The country needed to secure another source for an assured oil supply. In return for access to the Saudi Arabian oil reserves, King Ibn Sa’ud was promised full American military support to the ruling clan of Al Saud. It is vital to understand here that the American security guarantee was extended neither to the people of Saudi Arabia nor to the government of Saudi Arabia but the Al Saud dynasty.

Saudi Arabia decided to price oil exports in dollar terms. This was primarily because the US emerged as the strongest economy post World War II, and the dollar was at the heart of the new financial system that was emerging at that point in time.

Between 1 and 22 July 1944, a group of bankers, politicians and economists gathered at Mount Washington Hotel in Bretton Woods, New Hampshire, in the US. The US was ready to convert dollars into gold at $35 for an ounce (31.1 grams). This made the dollar the premier international currency of choice, as it was the only currency that could be converted into gold. This gave the dollar an exorbitant privilege. Other countries had to earn these dollars to pay for commodities like oil. The US could, if required, simply print all the dollars it needed.

This exorbitant privilege continues to this day despite the dollar no longer being convertible into gold. The international financial system that emerged after the World War II remains the major reason. Along with this, Saudi Arabia-led oil cartel, the Organization of the Petroleum Exporting Countries (OPEC), continues to price oil in dollars. Given that most countries import oil, they need American dollars to pay for it. In order to earn these dollars, they need to price their exports in dollar terms. This dynamic essentially ensures the continuation of the dollar-based global financial system.

Interestingly, in the years gone by, other members of the OPEC, like Iran, have tried using a basket of currencies and not just the dollar as the basis of pricing crude. But oil continues to be priced in dollars. Of course, the American security guarantee to the Al Sauds was one reason. But there was another reason as well.

Over the years, the Saudis had built a hoard of foreign exchange reserves and wealth in dollars. And if they shifted the pricing of oil away from the dollar, the international confidence in the dollar would come under threat. This would negatively impact their reserves and their wealth. Hence, it made sense for them to continue to price oil in dollar terms.

If Saudi Arabia and OPEC had decided to abandon the dollar, it would have meant that the international demand for dollars would have come down. But that did not happen. As David Graeber writes in Debt—The First 5000 Years: “The global status of the dollar is maintained in large part by the fact that it is, again since 1971, the only currency used to buy and sell petroleum, with any attempt by the OPEC countries to begin trading in any currency stubbornly resisted by the OPEC members Saudi Arabia and Kuwait – also US military protectorates.”

The present

The dollar continues to be at the heart of the international financial system. The following chart plots the proportion of foreign exchange reserves held by countries in terms of different currencies.

In 1999, the dollar formed more than 70% of the foreign exchange reserves of the countries. It is now down to around 60%. Despite the fall, the dollar continues to be the premier reserve currency globally. The Chinese yuan formed around 2.4% of the global foreign exchange reserves in 2021.

This stems from the fact that most international trade continues to be carried out in dollars. Hence, central banks of countries end up accumulating dollars. The following chart plots the share of exports invoiced across different continents in different currencies from 1999 to 2019.

A bulk of the global trade is carried out in dollars except in Europe, where the euro is the dominant currency. Even in the Asia-Pacific region, nearly three-fourths of exports are invoiced in dollar terms.

Other data points also tell us that the dollar remains the international currency that matters. As of March 2021, around $950 billion of dollar banknotes were held by foreigners. This amounted to around 44.7% of the paper dollars in existence. In December 2002, international ownership of dollar banknotes had stood at 36.4%. This shows the confidence the world at large has in the US currency.

Over and above this, the dollar remains the main currency in international banking. Nearly 60% of international deposits and loans are dollar-denominated.

Further, the currency’s share in foreign exchange transactions remains strong. According to the Bank of International Settlement’s Triennial Central Bank Survey for 2019, the latest such survey available, in April 2019, the dollar was bought or sold in 88% of the global foreign exchange transactions. This share has remained constant over the last two decades.

Given all this data, what can one then make of attempts being made by Saudi Arabia to get closer to China? Is it really a threat to the dollar?

Lesson from the past

International reserve currency systems do not change quickly. When the financial crisis of 2008 broke out, doubts had been raised (this writer included) about the future of the dollar. And here we are, nearly one and a half decades later, with the dollar still going strong.

In fact, the British pound was the international reserve currency before the dollar.

At the end of the Second World War, the combined holdings of the British pound by all central banks stood at $10 billion. This was two-and-a-half times more than the dollar reserves of $4 billion. Post World War II, the share of the British pound in the international reserves slowly started to come down. But even in 1965, the British pound comprised nearly 26% of the total global reserves.

This was when Great Britain was in a bad economic state after World War II. While the US economy has taken some beating over the years, it still continues to grow. The point being it won’t be easy to displace the dollar as the international reserve currency.

What has changed in the oil economy?

Take a look at the following chart. It plots the average daily consumption and production of oil in the US over the years.

American oil production wasn’t able to keep pace with consumption for many years. The gap between consumption and production has narrowed in the past decade, and the US now produces almost all the oil it consumes. But for many decades, the country had to import oil. The following chart plots the total American oil imports and its imports from OPEC countries.

The US was heavily dependent on OPEC to meet its oil demand. In fact, the dependence peaked in 1977, when it imported more than 70% from the cartel. As late as 2017, the US imported close to a third of its oil imports from OPEC. In 2020, the dependence was down to as around 11%.

Interestingly, in 2020, while the US imported around 7.86 million barrels per day, it exported around 8.51 million barrels per day. This made the US a net oil exporter after many years.

Hence, the dependence of the US on Saudi Arabia and OPEC has gone down dramatically over the years. And given that it doesn’t need to bother much about the security guarantee that it gave to the Al Sauds. So in that sense, the US foreign policy in the Middle East need not follow what the Al Sauds want.

As the Wall Street Journal reported: “The Saudis are angry over the US’s lack of support for their intervention in the Yemen civil war, and over the Biden administration’s attempt to strike a deal with Iran over its nuclear programme.”

In this scenario, it makes some sense for the kingdom of Saudi Arabia to try and move closer to China, which buys more than a fourth of Saudi oil exports. And one way to grow closer would be to price oil in terms of the Chinese yuan. This, of course, would hurt the exorbitant privilege of the dollar, given that a country would have an option of buying oil in a currency other than the dollar.

The future

For the Saudi led OPEC to price oil in yuan, several things need to happen. First, the kingdom needs to be able to move its existing reserves and wealth away from the dollar. Interestingly, the Saudi Arabian holding of American treasury bonds has fallen over the years. It peaked at around $184.4 billion in February 2020 and fell to $125.3 billion two months later. As of January 2022, it stood at $119.4 billion, suggesting that it is difficult to move wealth away from the dollar beyond a point. The US government issues financial securities called treasury bonds to finance its fiscal deficit or the difference between what it earns and what it spends.

The size of the American government bond market is close to $23 trillion. It is by far the biggest bond market in the world and the most liquid. A buyer can always find a seller and vice versa. This is another major factor that has ensured that countries like to hold their reserves in dollars.

Further, data from the Organization of Economic Complexity suggests that in 2020, the total Saudi Arabian oil exports to China stood at $24.7 billion. So if the Saudis decide to sell oil to China in yuan, they will get paid in yuan. The country can then use these yuan to buy stuff from China.

The overall Saudi Arabian imports from China in 2020 had stood at $31.8 billion. So, all the yuan earned by selling oil can be used to buy Chinese imports.

Theoretically, it is possible to price the oil trade between Saudi Arabia and China in yuan. Nonetheless, it is worth remembering that the US still has the biggest military globally. In the past, attempts made by countries to price oil in currencies other than the dollar haven’t ended well.

As Graeber writes: “When Saddam Hussein made the bold move of single-handedly switching from the dollar to the euro in 2000, followed by Iran in 2001, this was quickly followed by American bombing and military occupation.”

Secondly, while pricing oil for China in yuan terms might work at a theoretical level, many other factors come into the picture for OPEC to be able to price a major part of its oil exports in yuan terms to countries other than China as well.

What will Saudi Arabia and other OPEC countries do with all the yuan that come in? They can possibly buy Chinese imports. But what happens beyond that? All money needs to earn some return. It can’t sit around idle. The Chinese bond market, while being very big in size, is highly illiquid.

The overall size of the Chinese bond market (corporate, financial and government bonds) was around $18.6 trillion at the end of 2020.

Most of these bonds were held by government-owned banks and were not actively traded. This means that if OPEC prices oil in yuan terms, it will not have many investment avenues for the money that it earns by selling oil. That is a problem the dollar doesn’t have. By selling oil in dollars, the money that countries earn can easily be invested in US government bonds and other securities priced in dollars.

Also, the Chinese government will have to allow money to move freely in and out of China.

For that to happen, the Chinese government will have to set the yuan free and allow the market forces to determine its value, which is not the case currently. The value of the yuan is fixed against the dollar. If the yuan is set free, it is more than likely to appreciate against the dollar. This will make Chinese exports expensive, and that’s something the Chinese government won’t like.

Hence, any pricing of a good proportion of OPEC oil in Chinese yuan terms, if at all that happens, will only happen at a slow pace. The major reason for this is that money cannot move freely in and out of China, making the Chinese bond market highly illiquid.

Also, allowing money to leave China freely would mean that Chinese savings can also leave China. This is at the heart of the Chinese development model, wherein the government has been able to channel massive savings into areas it wants to. The government wouldn’t want to give away this advantage.

Further, the Chinese need to be okay with the idea of foreigners owning Chinese bonds, like the Americans are. As Robert D. Blackwill and Jennifer M. Harris write in War by Other Means: “A notable step in his direction unfolded in March 2012, when Japan became the first major developed country to receive Beijing’s blessing to invest in Chinese sovereign debt [government bonds].”

China is gradually coming around to this idea. A study carried out by the Bank of Finland Institute for Emerging Economics points out: “About 10% of China’s government bonds are in foreign hands.”

In 2021, a third of the US government debt was held by foreigners. Interestingly, this was at 40.2% in 2019. Foreign ownership as a proportion has fallen over the past two years primarily because the US Federal Reserve, in the aftermath of the covid pandemic, has printed money and bought government and other bonds to drive down interest rates.

There is another point that needs to be considered here. As Blackwill and Harris write: “The world has no modern precedent for a global reserve currency that is not administered by a democratic country.” While this might sound like a Western way of looking at things, it does matter, given that not many rich-world democratic countries will trust China and have their foreign exchange reserves in yuan and invest those reserves in Chinese government bonds.

This explains why despite the rapid rise of China, the total percentage of foreign exchange reserves in Chinese yuan in 2021 was at just 2.4%. The percentage of reserves held in the British pound was much greater at 4.7%. The Japanese yen was at 5.9%.

While the future of the Chinese yuan as an international reserve currency is very optimistic, it is highly unlikely that it will replace the dollar as the international reserve currency in a hurry. In fact, as the Chinese economist Andy Xie had said in the aftermath of the 2008 financial crisis: “There is no alternative to the dollar as a trading currency in Asia.” He felt that the yuan would replace the dollar in Asia, but it would take 30 to 40 years. To make a long story longer, what Xie said back then remains true.

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Written by Vivek Kaul. Edited by Saikat Chatterjee. Produced by Nirmalya Dutta. Send in your feedback to newsletters@livemint.com.