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Meanwhile, the Russian-Ukrainian crisis has raised the possibility that Russia is trading oil with China using the renminbi instead of the USD.

If Saudi Arabia and Russia were to work with China, the amount of renminbi-denominated oil trade could rise sharply and transactions could go through China’s payments system, the Cross-Border Interbank Payments System (CIPS), at the expense of the dollar and the SWIFT System.

This would pose a serious challenge to the US dollar system because, arguably, the dollar’s global reserve currency status is largely based on its importance in energy and commodity markets.

Pivot of dollar supremacy

One of the building blocks of the past four decades, and an anchor supporting the global status of the dollar, was a petrodollar-based global financial system. It was a world in which oil producers sold their products to the United States and the rest of the world for dollars. They would recycle proceeds into dollar assets by investing in dollar bloc markets, supporting the dollar as the world’s reserve currency.

This has made the oil market, and by extension the global commodity market, a critical element in sustaining the United States as the world’s undisputed financial superpower. If this linchpin were to fall, the status of the dollar would begin to crumble.

Saudi Arabia’s acceptance of the renminbi for oil could help erode the dollar’s supremacy. The question is whether Saudi Arabia would want to do this when it is also a major US ally.

It can be said that Saudi Arabia has an interest in getting closer to China. He has grown increasingly dissatisfied with US security commitments to defend the kingdom, as the Wall Street Journal recently reported. Meanwhile, China has strengthened its relationship with Saudi Arabia in recent years by increasing investment and military cooperation with the kingdom.1

One way for Saudi Arabia to balance its interests between China and the United States would be to trade oil with China (and probably also with Asia) in renminbi using CIPS, while trading oil with the rest of the world in dollars via SWIFT.

The threat of the petro-yuan

What threat will the petro-yuan pose to the dollar-based payment system? It is impossible to give a definite answer at this stage as it will take time for the petro-yuan oil negotiations to conclude. We can glean clues from public information about oil relations and trade between China and other major producers.

Some market participants initially estimated that switching oil trading from the dollar to the renminbi could boost $600 billion to $1 trillion in non-dollar transactions per month.2

Take the midpoint of $800 billion. Now consider SWIFT data on global payment currencies. In February 2022 (latest data available at the time of writing), the renminbi was ranked the fifth most used currency for global payments, accounting for 2.23% of the total (Table 1).

Given that approximately $5 trillion in payment messages pass through SWIFT globally each day, or $100 trillion per month (based on an average of 20 working days per month), the 2, 23% of the renminbi would be around $2.23 trillion per month.

If we add the $800 billion in oil trade that would be settled in renminbi, the yuan’s share of global payments would rise to just over 3% in the SWIFT system. Although it would only be an increase of 0.8 percentage points, the RMB would replace the Japanese yen and become the world’s fourth most widely used currency.

The impact on CIPS would be more dramatic. According to CIPS website, the system processed approximately $61 billion in payment messages per day in February, or $12.2 trillion per month. Adding $800 billion would boost volume by nearly 7% to $13 trillion per month.

However, it could go further. If Saudi Arabia and Russia start using the renminbi for oil trading, other countries will likely follow. At this stage, Russia, Iran, Venezuela and Indonesia already settle part of their oil trade with China in renminbi. The volume and scope of renminbi use for international payments could increase as more countries diversify US dollar risk.

Dollar Hegemony – A Case of Slow Erosion

Of course, no one expects the petro-yuan to replace the petro-dollar and the dollar-based payment system anytime soon. There are good reasons to expect that the renminbi’s challenge to US dollar hegemony will be a long process.

To make the renminbi attractive for payments, China will need to liberalize its financial markets and capital account. This means allowing foreigners to trade Chinese assets without capital or bureaucratic controls.

The pace of liberalization has been slow. Given China’s significant debt overhang (with an estimated debt-to-GDP ratio of 284% in 2021), rapid liberalization of its capital account would risk triggering a debt and currency crisis that would cut the grass under the feet of the Chinese system.

A major hurdle is that several major oil and gas producers in the Middle East have currencies pegged to the US dollar, including Saudi Arabia, the United Arab Emirates, Oman and Qatar. Kuwait’s currency is pegged to a basket of currencies dominated by the dollar. These pegs served as an anchor for the stability of these countries when the United States was the largest oil importer in the world.

With China replacing the United States as the world’s largest oil importer, it calls into question the sustainability of these anchors. Inertia could keep them intact for a long time, especially when paying for oil in renminbi – or any currency other than the dollar – raises currency risk that these countries haven’t faced in decades.

Moreover, despite years of financial reforms, China still lacks a large derivatives market to provide sufficient tools to hedge renminbi currency risk.

Ultimately, China must establish the global credibility of the renminbi for it to be accepted. However, it seems that China’s disruption of the future global payments system is likely an emerging reality even before the the renminbi becomes a global currency.

References

1As Saudi Arabia cools on US, it heats up on China.” The Wall Street Journal Podcast, 17 March 2022, full transcript taken from https://www.wsj.com/podcasts/the-journal/as-saudi-arabia-cools-on-the-us-it-warms-to-china/46e7073c-88b3-4708-8440-e4f72c863e3f

2 The Petro-yuan: a major game-changer for global energy markets, the global economy and sanctions.» IAEE Energy Forum, Third Quarter, pp.29 – pp.33. Extract of http://www.iaee.org/en/publications/newsletterdl.aspx?id=748 and “China will ‘force’ Saudi Arabia to swap oil for yuan – and it will affect the US dollar.” CNBC, October 11, 2017. Retrieved from https://www.cnbc.com/2017/10/11/china-will-contrain-saudi-arabia-to-trade-oil-in-yuan–and-thats-going-to-affect-the-us -dollar.html

Warning

All opinions expressed herein are those of the author as of the date of publication, are based on available information, and are subject to change without notice. Individual portfolio management teams may have different views and make different investment decisions for different clients. The opinions expressed in this podcast do not constitute investment advice.

The value of investments and the income from them can go down as well as up and investors may not get back their initial investment. Past performance does not guarantee future returns.

Investing in emerging markets, or in specialized or restricted sectors is likely to be subject to above average volatility due to a high degree of concentration, greater uncertainty as less information is available, there is less liquidity or due to greater sensitivity to changes in market conditions (social, political and economic conditions).

Some emerging markets offer less security than the majority of developed international markets. For this reason, portfolio transaction, liquidation and custody services on behalf of funds investing in emerging markets may involve greater risk.

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