Is China set to junk the global dollar hegemony?

Beijing will soon launch a yuan-denominated crude oil futures market that may eclipse the hitherto dominant dollar-based Brent and West Texas Intermediate (WTI) exchanges. In an additional challenge to the dollar’s role as the global reserve currency, the new “petro-yuan” will be convertible into physical gold at the Shanghai and Hong Kong gold exchanges.

China had shrewdly plotted the dollar’s dethronement for years. While less than one percent of New York’s COMEX transactions are converted into physical gold, the Shanghai Gold Exchange offers unfettered convertibility for the yuan.

Beijing’s move, originally pencilled for launch in 2018, was accelerated due to the continued weakening of the dollar and the anticipated appreciation of its historically undervalued currency. A stronger yuan is also expected to attract more gold to Shanghai and Hong Kong.

More significantly, the petro-yuan will enable oil exporters such as Russia, Venezuela and Iran to bypass US sanctions by trading yuan for gold. Earlier attempts to peg oil to the yuan had flubbed as China lacked sufficient diversification in its domestic petroleum infrastructure. This threshold has since been crossed, along with official gold stockpiles that have risen from 395 tons in 2000 to 1,828 tons in 2016. China’s private gold holdings are much larger.

Eurasian Gold Standard?

China's gold-buying spree also coincided with massive bullion purchases by Russia’s central bank as well as India’s insatiable demand for the shiny metal. According to a 2015 report by the World Gold Council, India’s estimated stockpile of 22,000 tons was worth over $1 trillion! The Indian obsession with gold is timeless. After all, Pliny the Elder’s two-millennia-old lament on the haemorrhage of Roman gold to India still echoes through the vaults of the latter’s ancient temples.

Global traders will naturally prefer an oil-for-gold deal instead of promissory notes in the form of paper US Treasuries. Massive gold reserves can also be wielded as trump cards during negotiations over preferential trade ties and defence technology transfers – a causal bonanza which modern India woefully ignored in its strategic calculus.

Ultimately, the RIC (Russia, India and China) nations may "weaponize" their gold holdings to ring-fence the Greater Eurasian economy from surging exogenous risks. China and Russia are coincidentally among the top three gold producers in the world while China competes with India in terms of annual gold consumption.

The myriad potentials of a RIC-based geo-economic continuum, initially anchored on a gold-backed yuan, will shift the epicentre of a future global order to the East.

Incentives and Penalties

Mass participation in China’s oil futures market may effectively internationalize the yuan, bridging the chasm between offshore (CNH) and onshore (CNY) yuan which traditionally hindered the currency’s mass appeal.

Beijing’s petro-yuan strategy naturally includes incentives and penalties. Saudi Arabia, the lynchpin of the global petrodollar regime, has seen Chinese imports slashed from 25% in 2008 to 15% in 2016. This graduated reduction was counterbalanced by imports from Russia and Angola, with the latter even elevating the yuan as a parallel currency in 2015.

Due to self-defeating sanctions imposed by the West, China now pays for Russian oil in yuan which the latter uses to buy Chinese goods and gold. The gold standard, abandoned by then US President Richard Nixon in 1971, is finally returning to the international scene.

Looming trade war

A yuan-precipitated de-dollarization may threaten the economies of US allies. Europe may be forced to choose between the caprice of US foreign policy diktats and monetary accommodation with Beijing.

The Trump administration is largely out of options here. It may retaliate against China’s perennial intellectual property infringements and prompt Beijing to offload $1 trillion in US Treasuries into global markets. This countermove will destabilize the US economy and send the dollar into a tailspin. With North Korea providing a nuclearized backdrop to US-China relations, open economic warfare may soon break out between both nations.

This is Washington’s game to lose. China would not have risked challenging the dollar if not for serious doubts cast over declared US gold reserves which, according to the most recently tally, amount to 8,000 metric tons. Along with the ongoing fake news pandemic, it is becoming increasingly difficult to source non-conflicting economic data from the US.

A 2014 report by the Brookings Institution even questioned the real state of the US fiscal gap: Was it $210 trillion as calculated by renowned economist Laurence Kotlikoff or $13 trillion as claimed by the Congressional Budget Office? Three years on, few have dared proffer a definitive answer. If Kotlikoff’s calculation proves to be correct, no amount of gold in the world can plug fiscal gaps of triple digit trillions!

Possible Global Fallouts

Saudi Arabia, whose treasury is being rapidly depleted by a ruinous war in Yemen; billion-dollar Wahhabi obligations abroad; and rising domestic discontent due to social welfare cuts, may have little choice but to trade in yuan. China may sweeten Riyadh’s currency switch by buying a 5% stake in state-owned Saudi Aramco through an initial public offering next year.

Once Saudi, Russian and Iranian oil are denominated in yuan, Beijing may dominate nearly 40% of the global oil market, inducing similar currency shifts in other key commodity sectors.

If Saudi Arabia accepts the petro-yuan trade, its US security umbrella – amounting to more than $300 billion per annum – may be withdrawn, risking greater geopolitical turmoil throughout the Middle East and North Africa. In hindsight, US President Donald J. Trump’s state visit to Saudi Arabia earlier this year now appears like a desperate attempt to prop a wilting petrodollar. Riyadh therefore may cautiously apportion its crude sales in both the dollar and yuan for the foreseeable future. Whatever the outcome, Asia should brace itself for turbulent times ahead and accommodate a gold-backed petro-yuan instead of paper US treasuries until a multilateral gold standard appears on the horizon.

This article first appeared as an Opinion piece in the Business Standard on Sept 13, 2017