Title: The Rise of Petroyuan

In October, China established a payment versus payment (PVP) system for transactions involving Chinese yuan and Russian ruble. The system allows simultaneous settlement of transactions in two different currencies. The China Foreign Exchange Trade System (CFETS) proposes to introduce similar programs with other currencies based on China’s huge multi-decade, multi-trillion-dollar Belt and Road Initiative (BRI).

While the BRI will expand links between major economies in Asia, Africa, Europe and Latin America, many of the member countries are possible candidates for yuan-denominated payment transactions. In particular, Russia, Iran and Central Asia, China’s major oil and gas suppliers, are moving ahead toward a new status quo.

In December, Iran announced it would join the Russia-led Eurasian Economic Union (EEU) in early 2018. Along with Russia, Iran, and four Central Asian states, the EEU’s combined GDP would be $1.9 trillion, close to that of India. The EEU is also likely to have a central role in the BRI, and thus in future yuan-denominated transaction systems. Indeed, already since 2015, Iran has eliminated the U.S. dollar from foreign-trade transactions.

The Rise and Eclipse of the Petrodollar

After the 1945 Yalta Conference, which effectively divided Europe, the ailing President Franklin D. Roosevelt met Saudi Arabia’s King Ibn Saud. Bypassing the British, Roosevelt and Saud agreed to a secret deal that required Washington to provide Saudi Arabia military security in exchange for secure access to Saudi oil.

Despite periodic pressures, the pact survived for quarter of a century until the 1971 “Nixon Shock.” As the dire U.S. economic prospects led President Nixon to the unilateral cancellation of the direct international convertibility of the U.S. dollar to gold, the postwar Bretton Woods system of international financial exchange was replaced by a regime based on freely floating fiat currencies.

To deter the marginalization of the U.S. dollar, Nixon negotiated another deal to ensure that Saudi Arabia would denominate all future oil sales in dollars in exchange for U.S. arms and protection. As other Organization of the Petroleum Exporting Countries (OPEC) nations agreed to similar deals, global demand for U.S. dollars—the “petrodollars”—soared.

The U.S.-Saudi strategic partnership weathered seven decades of multiple regional wars, but it also contributed to the severity of the twin energy crises in the 1970s, the consequent runaway inflation and sky-high interest rates, and the subsequent debt default of many developing economies in the 1980s and early 1990s.

Oil prices began to soar again in the 2000s fueled by China and other large emerging economies, post-Iraq War instability, and financial bubbles in the West. Oil prices flirted with $150 in the summer of 2008. Meanwhile, China overtook the United States as the world’s largest oil importer.

When the United States Federal Reserve began to pave way for rate hikes in 2014, the value of the dollar started to climb, though slower than expected. Oil prices have since plunged and are likely to stay relatively subdued for the time being.

Today, Saudi Arabia remains the world’s fourth-largest military spender and its defense expenses account for more than 10% of its GDP (three times more than the United States in relative terms) as it seeks regional primacy. Last May, the U.S.-Saudi strategic partnership was cemented for years ahead as President Trump signed a $110 billion arms deal with Saudi Arabia, the largest in U.S. history. Ironically, these bilateral deals occur in a world economy in which oil markets are priced in a currency that is burdened by debt and overstretched.

The Rise of Petroyuan

In the West, Chinese efforts are often portrayed as Beijing’s game to undermine the dollar’s global dominance. Yet it is not in the interest of China to deflate the value of its U.S. Treasuries, which are held in U.S. dollars and still amount to $1.1 trillion.

As the world’s leading oil importer, Chinese currency should have a central role in oil pricing. Since 2012, China has hoped to price oil in yuan using gold-backed futures contracts in Shanghai. The implementation of such a move depends on policymakers’ balancing act between market stability, which is seen as vital since the 2015 market volatility, and internationalization, which requires reduced capital controls and is needed to attract overseas oil traders and producers.

Many of China’s major oil suppliers in the Middle East and central Asia already accept the yuan in payment transactions. Russia, Iraq, Indonesia and other countries, many of which play a vital role in the BRI, have engaged in non-dollar trades. Oman, too, has a role in the plan, as evidenced by the Chinese contractors who are turning the dusty fishing village Duqm into a U.S.$10.7 billion Sino-Oman Industrial City.

Saudi Arabia’s decision to adopt the yuan for some of its oil exports would serve as a catalyst for a broader shift. Major Chinese players participating in Aramco’s initial public offering—a deal in which some speculate Hong Kong could serve as a venue for 5% stake (roughly $100 billion)—could sway Saudi views even further toward the yuan.

As long as Washington, at least officially, supported global engagement in the past, the U.S. dollar was sustained by America’s international alliances. With Trump’s “America First” stance, that era is fading. Pakistan is a case in point.

Recently, the White House suspended U.S. international aid to Pakistan. As a result, Islamabad announced that the Chinese yuan can now be used for bilateral trade and investment activities, which will support the proposed Chinese-Pakistan $57 billion economic corridor—another BRI pillar.

U.S. coverage is slipping because structural conditions that supported its dominance have been softening since 1971. As long as emerging and developing economies depend on the U.S. dollar, they remain exposed to U.S. currency risk and U.S. sovereign debt (which now accounts for more than 106% of the U.S. GDP), not to mention the fluctuating politics of U.S. sanctions regimes. The status quo is untenable.

As Chief of the People’s Bank of China Zhou Xiaochuan noted amid the 2008 financial turmoil, it is regrettable that economist John Maynard Keynes’s farsighted global currency (bancor) proposal was not adopted at Bretton Woods in the 1940’s.

Today, global currency diversification is vital because an overconcentration of foreign assets denominated in the U.S. dollar could bring huge collateral damage.

What we are witnessing is not an overnight effort to replace U.S. dollar with Chinese yuan in international transactions, but a progressive shift to deploy yuan in those transactions in which Chinese economy plays central role. This shift relies on the multiplication of bilateral transactions. It is gradual, linear and accumulative. Chinese petroyuan is replacing U.S. petrodollar, one transaction at a time.

However, if investors one day lose faith in the U.S. dollar—say, due to a U.S. debt crisis, a major Trump policy blunder, a divisive bipartisan struggle for the White House or still another military engagement—the shift away from the U.S. dollar could turn accelerative, geometric and disruptive.