Several weeks ago, I published a well-received article to this site discussing how China has been actively making a push to reduce the dominance of the U.S. dollar in international finance and its privileged status as the global reserve currency. Since that time, the nation has made further progress towards this goal. In addition, a few political developments, most notably the United States launching missile strikes against various targets in Syria, has likely encouraged more nations to support this Chinese initiative. In this article, we will discuss these developments and what the potential consequences could be.
The Petrodollar Standard
Let us begin with a short discussion of how the U.S. dollar came to be recognized as the global reserve currency. It began with the Bretton Woods agreement in the latter stages of World War II. Under the Bretton Woods System, the United States would fix its currency to gold and all other nations that participated in the system would fix their currencies to the United States dollar. The reason why the U.S. dollar was chosen as the base currency was that the United States had the largest gold reserves at the time so it was felt that the United States would be best able to deliver the physical gold backing its currency should a holder demand such.
The Bretton Woods System began to break down in the 1960s. As Germany and other European nations began to reconstruct their devastated economies, the United States found itself representing an increasingly smaller proportion of the world economy. When combined with the growing U.S. public debt from the Korean and ultimately the Vietnam Wars, the U.S. dollar found itself increasingly overvalued. This was not agreeable to some European nations, which began to redeem their U.S. dollar holdings for gold, draining America's gold reserves. Finally, in 1971, President Richard Nixon ended the direct convertibility of the U.S. dollar to gold, effectively ending the Bretton Woods System.
Once Nixon took this action, widespread speculation against the U.S. dollar took place around the world, resulting in sharp inflation in the United States. In an effort to stem this problem, then Secretary of State Henry Kissinger traveled to Saudi Arabia to begin work on a treaty with the ruling family. Under the terms of this treaty, which was signed in 1973, the Kingdom would require that all sales of oil be paid for using U.S. dollars. The United States would provide the Kingdom with weapons and protection in exchange. Other OPEC nations began following a similar policy for convenience. This move thus required those nations desiring to import oil to maintain a surplus of U.S. dollars, thus creating an artificial demand for the currency that would not have existed were this requirement not in place. This increased the value of the U.S. dollar above what the fundamentals alone would create. In addition, the requirement that all international oil transactions be performed with U.S. dollars resulted in oil-exporting nations amassing a stockpile of U.S. dollars that needed to be put to use. The logical use was to simply lend them back to the U.S. government. This greatly increased the demand for U.S. Treasuries and allowed the United States to borrow a greater amount and at a lower interest rate than it otherwise could.
Enter the Petro-Yuan
When the United States made the agreement with Saudi Arabia, it was the largest importer of oil in the world and the Kingdom's largest customer. Neither of these things are true anymore. Last year, China became the largest importer of oil in the world at 8.4 million barrels per day compared to 7.9 million for the United States. As the United States increases its oil production over the coming years as a result of the fracking boom, the gap between the two nations will widen ever further. In addition, China imports more oil from Saudi Arabia than the United States does and has been doing so for quite a few years. This situation gives China the leverage over the Kingdom that the United States once had, especially as China is also a nuclear power that is capable of fulfilling the protection mandate. It should therefore be no real surprise that China has indeed been working to use this situation for its own benefit.
On Monday, March 26, 2018, the Shanghai Futures Exchange launched its first futures contract that is open to foreign investors. This contract, a yuan-denominated oil future, has the potential to become a rival to the dollar-denominated Brent and WTI contracts that serve as the current benchmarks, according to many market analysts. By all indications, the initial launch went well, with volume easily matching that of the more widely-known Brent crude oil contracts:
Source: Zero Hedge
Perhaps piggy-backing on the success of this launch, China has begun to negotiate the purchase of oil with yuan instead of U.S. dollars with some of its trade partners. According to Reuters, Russia and Angola, two of the largest producers of oil in the world, are amenable to the plan and both countries have sought to break the U.S. dollar's dominance in recent years. If China does indeed implement its plan to pay for oil in yuan and these two giant oil producers go along with it, then it would serve as a major blow to the system. This is especially true if other major oil exporters, such as Saudi Arabia, get on board with this plan.
Russia and SWIFT
Ever since the United States implemented the first round of economic sanctions against Russia in response to the Crimea incident, there has been a fear among Russians that the United States would attempt to cut Russia off from the global financial system by excluding it from SWIFT, the U.S. dollar-intermediated global financial payment network. The recent escalation of hostilities against the Russian-backed Assad government in Syria has heightened these concerns.
While neither the United States nor its European allies have taken this action as of yet, just the fact that the United States could conceivably do this is one reason why nations such as China and Russia are opposed to the dominance of the U.S. dollar and are actively taking actions to reduce said dominance. In short, the United States has been using its currency as a political weapon and several nations are upset with that.
Russia has been taking steps to protect itself against the possibility of being cut off from the global financial system. According to TASS, the nation began developing its own domestic version of SWIFT in 2013. It also began work on plans to expand the reach of this system to include parties outside of Russia, possibly in conjunction with the New Development Bank. If indeed this system has already been established, then it is quite likely that China has access to it along with the other parties that were involved in the formation of the New Development Bank. While Russia has not yet been cut off from SWIFT, thus making this system unnecessary, it does reduce the dependency on the current dollar-dominated system and thus represents yet another chink in the armor of the dollar as the reserve currency.
As already discussed, the United States derives certain benefits by virtue of its control over the reserve currency. The first of these is that the value of the currency is higher than it would otherwise be based solely on the country's fundamentals. The fact that oil-importing nations are essentially forced to purchase U.S. dollars to acquire oil allows the United States to export its inflation, keeping domestic rates low. It also increases foreign demand for U.S. Treasuries above where it would otherwise be as oil-exporting nations seek a home for the sizable quantities of U.S. dollars that they have from the sale of oil. This allows the United States to borrow more money and at lower rates than it otherwise could. As the U.S. dollar's dominance in the oil trade declines, we can expect both of these benefits to disappear. While both effects would have an adverse impact on the American economy, the declining demand for its debt may be more devastating.
This is largely due to the enormous amount of debt that the country will need to take on in the coming years. As many investors are likely already aware, the United States runs a giant budget deficit that will only be exacerbated by the recent tax cuts. According to the Congressional Budget Office, the United States is expected to have a budget deficit of $804 billion in 2018, which will actually increase over the next five years before stabilizing somewhat in 2023. Due to these budget deficits, the total federal debt held by the public is expected to reach 100% of GDP by 2028:
Source: Congressional Budget Office
When this is put into numbers, we see that America will add nearly $10 trillion to the national debt over the next decade. Clearly then, the nation will need to be able to borrow every cent that it can get at a reasonable interest rate. In order to accomplish this, the nation will need to depend on the current dollar-based financial regime. Thus, the threats to this system that were outlined in this article become a very real concern.
If the United States sees its ability to borrow curtailed due to the declining dominance of the U.S. dollar, then it will obviously need to reduce its deficit, which can be done by either substantial spending reductions or, more likely, significant tax increases. Either one of these options will prove to have a negative impact on the American economy and will certainly have a negative impact on investments, particularly those ones that are dependent on either consumer or government spending. In addition, it is a near certainty that interest rates will increase. This would still have the effect of forcing the U.S. government to either raise taxes or cut spending in order to cover the increased interest costs. A rise in government interest rates would also have the negative effect of raising interest rates throughout the economy, negatively impacting other sectors such as housing and anything dependent on business investment.
Over the past few months, we have seen more moves by the nations of China and Russia to reduce the current dominance of the U.S. dollar in the global financial system. As this process plays out, the United States will begin to lose the benefit that the dollar's privileged status gives it. This will likely lead to rising inflation at home and a gradually weakening economy.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.