The US dollar enjoys a special privilege in the world due to its dominance in the global oil trade.
The agreement that created this dominance was predicated on the United States being the largest oil importer in the world, which is no longer the case.
China is rolling out a new gold-backed yuan oil contract next month as part of its attempt to replace the US dollar’s dominance of that commodity trade.
Given the US’s rise as a potential energy exporter and other factors, China may succeed in this goal.
If the dollar loses its privileged status, it will likely lead to inflation and rising interest rates in the USA along with difficulty maintaining the current standard of living.
I recently encountered a blog post by respected commentator Mish Shedlock entitled, “Petro-Yuan Futures Launch In March: Ignore The Hype, It’s A Good Thing.” In this article, Shedlock argues that the new futures will pose no threat to the US dollar as the global reserve currency even if the futures do result in oil being priced in yuan. While Shedlock does certainly make some interesting points, I do disagree with his overall conclusion. This article will explain why.
First of all, I would suggest reading the original article linked above to get a full grasp of Mr. Shedlock’s argument. The discussion here will merely be a short summary of the initial article along with my conclusions about it.
In short, Shedlock states that it does not matter what currency oil is valued in as all currencies are basically interchangeable. He does however believe that we may be nearing the end of the days of the Middle East selling their oil for US dollars but that has nothing to do with the launch of the petro-yuan oil futures. Rather, it is a direct result of the shale oil boom in the United States, which could turn the United States into a net oil exporter by the end of the decade and thus the country would no longer need to import oil from the Middle East.
Shedlock concludes however that this would have little impact on the US dollar’s status as a reserve currency and that the United States would be better off as an exporter of energy than with oil continuing to be priced in dollars.
The Rise Of The Petrodollar
In order to understand the flaws in this argument, it is important to understand how the United States got into the position of controlling the world’s primary reserve currency. It has its roots in a 1944 conference held at the Mt. Washington Hotel in Bretton Woods, New Hampshire that was attended by 730 delegates from all 44 Allied nations. After 22 days of deliberation, the delegates eventually devised a monetary system in which the United States dollars would be directly convertible into gold and all other currencies would be pegged to the dollar.
As the United States owned approximately two-thirds of the world’s gold at the time, this system made sense and it put the gold standard into place as fiat currencies were widely considered to be one of the root causes of the second World War. This also resulted in the US dollar becoming the reserve currency since all other currencies were pegged to it (and the dollar itself was directly convertible into gold).
However, in the 1960s, the United States had a growing trade imbalance and a rapidly growing public debt due to its declining dominance of the world’s economic output and expenses related to the Vietnam War. This, combined with monetary inflation due to Federal Reserve policies, resulted in the US dollar being increasingly overvalued. Some foreign nations were becoming increasingly disenchanted with the privilege that this situation provided to the United States compared to its partners in the Bretton Woods system.
Some nations, led by France, began to convert their dollars into gold, putting pressure on the gold reserves of the United States to the point where only $3.2 billion worth of actual gold was backing $14 billion held by foreign central banks. In 1971, West Germany left the Bretton Woods system and both France and Switzerland demanded physical gold in exchange for their dollars.
Finally, in August 1971, President Richard Nixon suspended the convertibility of US dollars into gold in an attempt to remedy these problems. While it did stop the problem of declining gold reserves, it also sparked widespread speculation against the dollar due in part to the high trade deficits, mounting debt load, and high unemployment in the United States at this time.
This led to its own problems, including a high inflation rate in the United States. This also led to problems with international trade since foreign currencies were appreciating so rapidly that it was difficult to price goods appropriately. The United States began to look for a solution for these problems.
In 1973, Secretary of State Henry Kissinger negotiated an agreement with Saudi Arabia, the largest oil exporter in the world then as now. In the agreement, the Kingdom would require all sales of its oil to be paid for in US dollars and in exchange the United States would provide Saudi Arabia with weapons and protection. As the United States was its biggest customer at the time, the arrangement made sense. Other oil exporting nations followed Saudi Arabia’s lead on this out of convenience and soon the international oil trade was being conducted in dollars.
This generated artificial demand for US dollars globally since nations that imported oil were essentially forced to maintain holdings of US dollars in order to pay for their needed oil. It also led to a growing stockpile of US dollars in oil exporting nations. This setup makes the dollar more valuable than it would otherwise be due to the artificial demand.
This process of paying for oil using US dollars has also led to a phenomenon known as petrodollar recycling. As already mentioned, the fact that oil importing countries were paying for their oil using US dollars resulted in growing stockpiles of dollars in the central banks of those countries that export oil, in particular the OPEC nations, Norway, and Russia. In many cases, this was more money than these nations could efficiently invest in their own economies.
The logical thing for these nations to do then was invest in US dollar-denominated assets abroad, especially US Treasuries. This influx of money into treasuries increased the demand for them and held interest rates down, thus allowing the US government, businesses, and individuals to borrow money more cheaply than they otherwise could. Thus, the United States was able to enjoy a higher standard of living than it could otherwise afford.
Enter The Petro-Yuan
The agreement with Saudi Arabia that established the US dollar as the dominant currency in international trade was created at a time in which the United States was both Saudi Arabia’s largest oil purchaser and the largest oil importer in the world. However, things have changed since that time. In April 2015, China supplanted the United States as the largest oil importer in the world. China is also Saudi Arabia’s biggest oil buyer. The communist nation has already begun to use some of its leverage with the Kingdom and has put some implicit pressure on it to begin settling oil purchases with the yuan.
The Saudi riyal is also one of only a handful of currencies that is directly convertible into yuan. China already actively conducts business with two other major oil exporting nations, China and Russia, using yuan. It is interesting to note that both of these countries have been targeted by the United States for economic sanctions over the past few years.
China has now doubled down on its move to increase or even supplant the use of the US dollar in the oil trade with its planned launch of oil futures denominated in yuan on the Shanghai and Hong Kong exchanges next month. The Chinese government apparently admits that many global businesses, individuals, and nations may be hesitant to embrace the idea of trading real resources for a heavily government-controlled currency, which is why the yuan used in these contracts will be directly convertible into gold, similar to the US dollar prior to 1971.
This is a move that I predicted in several articles published here when I noticed that China was seemingly importing far more gold than the official figures were indicating. This feature could certainly make these contracts much more accepted than Shedlock seems to believe.
It is, after all, not hard to imagine a scenario in which an oil exporter would rather have a gold-backed currency (or even physical gold itself) than a fiat currency from an increasingly erratic, money printing nation with out of control public debts and deficits. That alone could allow this new contract to rapidly become the new standard in the oil trade, particularly with the prospect of the United States no longer being an oil-importing nation.
Should the petro-yuan supplant the US dollar as the standard currency in the oil trade, it will have a few effects on the United States economy, none of them good. The first of these is that oil importing countries will no longer have to maintain a stockpile of US dollars in order to purchase oil. Thus, the demand for US dollars will likely decline and this would cause the value of the US dollar to decline relative to other currencies. All else being equal, that would cause the inflation rate in the United States to increase, perhaps dramatically.
A second effect that the rise of the petro-yuan would have is that the OPEC and other oil exporting nations would no longer be accumulating large surpluses of US dollars to reinvest in US treasuries. Instead, these nations will be accumulating stockpiles of yuan and possibly gold. While these assets could still conceivably be invested in US treasuries, there is no guarantee that these nations would do this and it could result in declining international demand for Treasuries, which would cause prices to fall and rates to rise.
This would not only increase borrowing rates for the US Government and further strain the federal budget, but would result in higher borrowing costs across the economy including mortgages, corporate debt, auto loans, and student loans. Higher interest rates cause economic slowdowns, which is why the Federal Reserve raises rates near the top of an economic cycle.
In his article, Shedlock states that other countries will continue to hold US dollars by virtue of the nation’s large trade deficit with the rest of the world. While he is correct, that alone would not be enough to provide the US dollar with the privileged status that it enjoys today by virtue of its dominance in the oil trade. Simply receiving US dollars when Americans purchase imported goods does not produce artificial demand internationally for the currency. It also stands to reason that the US trade deficit will decline as a result of the nation becoming an energy exporter, resulting in the supply of dollars leaving the country declining.
China has been seeking to supplant the US dollar’s privileged status in international finance for quite some time. The communist nation’s newest move to introduce a new yuan-denominated oil contract backed by gold is only the latest step in its long-term efforts. Unfortunately, this may be the step that succeeds, particularly if the United States does become an energy exporting nation. If this happens, the US dollar would become just another currency and this would make it harder for the federal government to run high deficits like it has been over the past fifteen years and likely lead to both higher inflation and higher interest rates in the country.
By Power Hedge
Source: Seeking Alpha