China’s dangerous dollar addiction

Via Edoardo CampanellaFuture World fellow at IE University’s Center for the Governance of Change in Madrid, at Foreign Policy:

The trade war with the United States may soon hit China where it hurts, making it hard for Beijing to satisfy its voracious appetite for natural resources.

Every year, China spends roughly $350 billion just to purchase the copper, coal, iron ore, aluminum, steel, and crude oil it needs to keep the Chinese economy running. And that bill could grow as China eats through even more raw materials to build roads, railways, and ports across Eurasia as part of its Belt and Road Initiative.

The problem is that these commodities are traded in dollars, and the transactions are cleared through the U.S. banking system. To buy them, then, Beijing needs to earn an equal amount of dollars by selling its own goods. Yet Washington, by curbing imports from China—for which it usually pays in dollars and usually to the tune of $500 billion a year—is slowly limiting the number of greenbacks Beijing can get its hands on.

China understands its vulnerability. And its plan for weathering the storm is to challenge the hegemony of the dollar as a benchmark for pricing commodities. Even before U.S. President Donald Trump started to target Chinese products with various import restrictions, Beijing was already busy launching yuan-denominated futures for oil and iron ore—that is, contracts that allow buyers and sellers to exchange future quantities of those commodities at a predetermined price so that they can avoid uncertainty due to price fluctuations. In the coming months, Beijing might try to make the list of commodities that are traded in its domestic currency even longer.

By promoting the use of the yuan for such trade, Beijing hopes to ensure its continued ability to buy the raw materials it needs. Beyond that, though, it wants to consolidate its global economic influence. Instead of obstructing China’s hegemonic rise, then, Trump’s attempted trade war might end up accelerating it.

In normal times, China has a couple of ways to get dollars. It can conduct its business not just with the United States but with all of its trade partners in dollars. As of now, roughly 70 percent of Chinese goods sent abroad are still bought in dollars. The rest (primarily those headed to other East Asian countries) are denominated in yuan. But relying on trade only represents a short-term strategy—and a risky one if trade with the United States falls. Beijing’s long-term goal is turning the yuan into a reserve currency to rival the dollar, which can only happen once the yuan has become widely used in commercial transactions as a substitute for the greenback.

Politically speaking, it would become increasingly uncomfortable for China to build up its reserves of U.S. Treasurys in the middle of an all-out trade war.

Another way to stock up on dollars is for the People’s Bank of China to simply sell yuan to purchase dollar-denominated government bonds issued by Washington. But that strategy comes at the cost of depreciating the yuan and creating domestic inflation. Politically speaking, it would also become increasingly uncomfortable for China to build up its reserves of U.S. Treasurys in the middle of an all-out trade war. Such purchases, after all, benefit the U.S. economy by keeping its interest rates low. That’s why, if anything, as tensions with the United States escalate, China would have good reason to sell part of its $1.2 trillion stash of U.S. Treasurys. Doing so would push up interest rates and hurt the U.S. economy.

Instead of trying to stockpile dollars to pay for its natural resource addiction, China has opted to push for those commodities to be traded in the yuan. In March, it launched yuan-denominated oil derivatives on the Shanghai International Energy Exchange. Just a year before, China had overtaken the United States as the world’s largest net importer of crude. So time had come for Beijing to establish an Asian benchmark that reflected Chinese consumption.

For now, the exchange is mostly used by domestic customers. But, eventually, China will have to lure in international traders if it wants to push the yuan onto the global stage. To this end, the Chinese government has offered tax holidays (for three years) and has relaxed some capital controls for foreign investors.

Although activity on the exchange remains low, it keeps growing. And in even better news for China, Saudi Arabia (the world’s largest oil exporter) is expected to start accepting the yuan as payment for oil exports to China soon. Oil companies in Russia and Venezuela have already done the same, and Iran, too, has gotten on board. (Yuan-denominated crude contracts have provided a way, albeit probably short-lived, for Iran to get around U.S. sanctions, which are typically enforced when banks attempt to clear dollar-denominated trades, regardless of the location of the counterparty.)

China’s experiments with oil futures followed similar efforts in 2013 to trade in iron ore futures on the Dalian Commodity Exchange (DCE). International investors were allowed to exchange these contracts starting only this spring, after the launch of the oil derivatives. But this market is more mature. In 2017, trade on the exchange reached nearly 33 billion metric tons (in terms of contracts exchanged) compared with global annual trade of about 1.5 billion metric tons (in terms of raw material). This means that the same contract changes hands around 22 times. To put it simply, the deals were in hot demand. In turn, thanks to the DCE and because of Beijing’s massive consumption (more than 40 percent of global demand), iron ore is already one of the few commodities whose global pricing is fixed in China.

Based on its success with iron ore and initial success with oil, China will likely allow international participants to trade in a wider range of yuan-based commodity futures soon. The London Metal Exchange is, for example, planning to introduce yuan-denominated metal products. This is another piece of evidence that transactions might still be settled elsewhere but prices will be set in China. Beijing’s consumption of oil and iron ore is high by global standards, but its consumption of aluminum, nickel, copper, zinc, and steel is even more outsized. In the case of aluminum, for instance, China accounts for about 60 percent of world demand. That makes it a powerful player in these markets.

In all of this, China’s goal is not just to fund the purchases of commodities. It also hopes to turn the yuan into a truly global currency in order to boost Chinese soft power, reduce exchange rate risk, and make better strategic use of its large foreign currency reserves.

The problem for China, though, is that the yuan is still a long way from being accepted as a global currency. Only 1 percent of currency reserves held by central banks around the world are in yuan. And the currency was used in just 1.7 percent of transactions denominated in a foreign currency in 2016, even less than the Canadian dollar.

To truly dethrone the dollar, the yuan would have to meet three criteria: It would have to become a medium of exchange, a store of value, and a unit of account. Certainly, oil and iron ore futures denominated in yuan would strengthen the currency’s role as a medium of exchange and unit of account. But even if these financial instruments became widely used among commodities investors across the world, they would be tied to a currency that is not very popular—that is, it is not seen as a reliable store of value. And only the removal of capital controls and full convertibility will fix that problem.

Of course, in the short term, China’s financial maneuvers still make sense. Trading commodities in yuan rather than dollars could turn out to be an important defensive move in the trade war with the United States. Should tensions with Washington escalate, Beijing will still be able to keep its economy running—even if it ultimately misses its goal of promoting the yuan worldwide.

It will be an interesting moment when China asks Australia to accept yuan for dirt…

David Llewellyn-Smith
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  1. trump reminds me a fair bit of US general Patton.
    The US can withstand China far longer than Xi can, etc,
    “Ole Blood and Guts” Merican resolve!
    There is your answer.

    • Direct from the front line.
      China’s economy has ground down to its slowest growth rate since early 2009, as rising trade tensions and the Government’s efforts to tackle debt continue to weigh.
      Patton : Good, lets get that flanking armour and tank destroyers in a little closer.
      Squeeeeeeeeeeeeeze em a little.

      • My Dad was a radio operator based initially in Cairo for operation Torch
        HE would agree with you
        BUT, Patton stormed em, arabs, vichy frogs, dagos, germans, who else??
        THen Italy
        then the invasion
        then france,
        Skippy will know the detail.

    • Remind me, 09 was the GFC
      the current momentum will carry the chinee well into massive debt deflation
      they are gone for all yuan

    • UPDATE:(finally sorted this on line betting, ind were $1.70
      Independent >$1.33, Liberal> $3.00 ,Labor> $ 12.00 , Greens> $51.00
      Say By by to Scomo.

  2. “In 2017, trade on the exchange reached nearly 33 billion metric tons (in terms of contracts exchanged) compared with global annual trade of about 1.5 billion metric tons (in terms of raw material). This means that the same contract changes hands around 22 times. To put it simply, the deals were in hot demand”
    There’s innovation for you – a financial merry-go-round where red is up and red means good luck……….. sigh

  3. It is inevitable……..either that or rupees……..who else is going to buy that much iron ore ?…… is like when you owe the bank 100 million dollars…….either that or nothing

  4. What a joke. The Yuan will never become a major international currency because the CCP won’t relinquish control over it. There is a reason why it is not used internationally and that is because there is almost no CNH out there to use.

    Potemkin currency internationalization. Not real. Fake.

    • You don’t have to trade physical gold — just notes that have a claim on gold. Not perfect, but vastly superior to trading notes that have a claim on ….. nothing. If we’d maintained even a semblance of a gold standard post Bretton-Woods the bubbles we see today would not exist — at least, they might be bubbles but much more modest. Housing would be infinitely more affordable and the stock market wouldn’t accommodate stocks trading at 10x Revenues.

  5. Xi & the PRC have spent too much time listening to their [racist] propaganda as to their cultural superiority and manifest destiny as the world’s dominant power and civilisation together with focusing on the US Democrats & ‘progressive’ media resulting in a complete misread of the POTUS and the ‘deplorables’ …….. lessons for our 1% ers??????

    • You bet. I’ve said it before, and I’ll say it again. Xi, in his vanity, has poked the American eagle too hard and too soon, and like the Japanese nearly 80 years ago, he is going to learn a hard lesson. He’ll be lucky to avoid becoming a source of body parts.

      Trump’s greatest advantage is that everybody keeps underestimating him. “He’s just a child or loony blundering around and somehow accidentally achieving his policy goals. It’s all a chaotic shambles that will soon end when he’s impeached etc etc…”. He must be laughing like a drain every day at the miserable fates befalling his hapless enemies.

      Elizabeth “Fauxocahontas” Warren. Lol.

      • you got it LWS …. and meanwhile the ‘progressives’ believe their BS ….. as so well illustrated by ‘liarwattha’ Warren LOLOL

      • Warren was pretty epic.

        The original troll was a hypothetical 2020 debate where he hypothetically ambushed her on stage with a bet.

        Ie: the bet never actually happened.

        But that got under Warrens skin so badly she did the test, and then, even knowing the result was “maybe 10 generations ago”, she released it.

        Trump’s first words were “who cares?”

        Well, the Cherokees and the SJWs care, and they’re slaughtering her.

        Fucking ouch.