The rise of China as an economic powerhouse has been accompanied by efforts to internationalize their currency, the Yuan (CNY), with the goal of expanding its global influence. This has been achieved through various means including the establishment of CNY clearing banks in other countries, the development of offshore CNY markets, and the signing of bilateral currency swap agreements. As the CNY gains increasing acceptance in global trade and investment, it could potentially be used as a currency for oil transactions, known as CNY petrodollars.
The petrodollar system is essentially the global practice of exchanging oil for U.S. dollars (USD), rather than any other currency. This means that no matter what country is buying the oil, they typically pay the oil-producing country in petrodollars, which are denominated in USD. So, what happens when a country wants to pay or accept payment in CNY? In addition, how might settling trades in CNY affect the USD’s standing as the reserve currency of world trade?
One of the key drivers of the potential shift towards CNY petrodollars is China’s growing demand for oil and natural gas. As the world’s largest energy consumer, China is heavily reliant on imported oil to fuel its economic growth. To facilitate oil transactions in CNY, China has established CNY-denominated oil futures contracts, which provide an alternative to the traditional oil pricing and invoicing denominated in USD. This move aims to reduce transaction costs and reduce China’s dependence on the USD in its energy trade.
In addition to China’s demand for oil, there are several incentives for oil-exporting countries to accept CNY as payment for oil. For example, using CNY for oil transactions could potentially lower transaction costs for oil-exporting countries as they would avoid the need to convert their oil revenues into USD. In addition, accepting CNY as payment for oil could provide diversification benefits to oil-exporting countries in terms of their currency reserves by reducing their reliance on the USD and potentially enhancing their resilience to global economic fluctuations.
As a result, there may be a gradual adoption of CNY petrodollars by major oil-exporting countries. China has been actively pursuing agreements with oil-exporting countries to use CNY for oil transactions, and there have been instances of oil sales being settled in CNY. This could lead to increased use of CNY in oil pricing and invoicing, further cementing the CNY ’s role in global energy trade.
The CNY may also increasingly be used for trade in commodities besides oil. For example, Brazil is taking steps to allow trade with China to be settled in CNY in addition to USD. This makes a lot of sense since about 30% of Brazil’s exports go to China mostly in the form of iron ore and soybeans. Trading directly in CNY would allow commodity producers the same benefits that oil exporters may realize and thus facilitate broader use of the CNY on the global stage.
The potential shift towards CNY petrodollars, and for international trade in general, could have implications for the USD’s status as the dominant global reserve currency. Historically, the USD has enjoyed a privileged position as the world’s primary reserve currency, with many countries holding substantial amounts of U.S. dollar-denominated assets, such as Treasury bonds, as a store of value and for international trade settlements. However, if commodity-exporting countries increasingly accept CNY as payment for oil and other commodities, there could be reduced demand for USD for oil transactions, leading to a decrease in the use of USD in global trade and investment.
This shift could have various impacts on the U.S. economy and financial markets. For instance, reduced demand for U.S. Treasury bonds could potentially lead to higher borrowing costs for the U.S. government, as Treasury bonds have traditionally been a safe haven for investors. In addition, the shift in global economic and geopolitical dynamics could have broader implications for the international order, with potential implications for global economic stability and cooperation.
However, there are also challenges and risks associated with the internationalization of the CNY and the potential move towards CNY petrodollars. Capital controls and regulatory issues in China could pose obstacles to the free flow of capital and liquidity in CNY markets. The lack of deep and liquid CNY markets could also limit its attractiveness as a global reserve currency.
U.S. Treasury securities are considered one of the most widely traded and liquid government bonds in the global financial system. While Chinese government bonds have gained increasing prominence in global financial markets in recent years, they are still just a fraction of the usage of U.S. Treasuries.
For example, foreign ownership of U.S. Treasuries was around 35-40% of the total outstanding, with countries like China and Japan being major holders. In contrast, foreign ownership of Chinese government bonds is estimated to be less than 10% with limited access and restrictions on foreign investment in the Chinese bond market.
Chinese government bonds are denominated in Chinese CNY, which is not as widely used in global transactions. Investing in Chinese government bonds also carries risks such as currency risk, geopolitical risk, and regulatory risk due to China’s unique economic and political landscape. We note that global trade denominated in CNY is still less than it was prior to China’s currency devaluation in August 2015 according to Capital Economics.
Regarding the USD itself, according to the Bank for International Settlements, the USD was by far the most widely used currency in global foreign exchange (FX) transactions (exhibit 1). Other currencies lag well behind. The euro, the second most traded currency, was used only one-third as frequently as the USD and the CNY less than one-tenth as often.
The USD dominates FX markets in a number of ways. For example, most international debt securities and cross-border loans issued in offshore funding markets are denominated in USD. As of the second quarter of 2022, the amount of debt and loans denominated in USD where neither the issuer/borrower nor the lender is a U.S. resident was roughly 88% of total international USD-denominated debt and 65% of total international USD bank loans. It is unlikely that we would see a major shift away from the USD and into some other foreign currency in these debt and loan markets given the long-term nature of the contracts involved as well as the structure of these markets.
In addition, approximately half of global trade is invoiced in USD while the United States accounts for just over 10% of global trade. Put differently, approximately 80% of the USD’s usage in global trade does not involve U.S. residents or U.S. businesses.
Furthermore, while the percentage of foreign currency reserves held in USD has declined in recent years, the USD still accounts for nearly 60% of the total. Meanwhile, foreign currency reserves held in RMB are less than 2.5% of the total. Central banks clearly have a preference for the greenback.
The CNY has a long way to go to displace other currencies, such as the euro, let alone the USD. The further ahead we look, the more skeptical we become that the CNY could threaten the predominance of the USD. Our work suggests that China’s impressive economic growth is in the past and not likely a long-term phenomenon.
For example, long-term economic growth is primarily driven by the growth rate of the labor force and the productivity growth of the labor force. China’s labor force has begun to decline even faster than previously expected. This reflects their gloomy demographic trends. China also continues to struggle with the massive amount of private sector debt, especially in the real estate sector. In fact, China’s government has been papering over its economic problems through massive amounts of money printing, among other methods (exhibit 3). Though the data from China is incomplete, the relative comparisons show the scale to which China’s government has been far more accommodating in terms of monetary support than the U.S. has been.
China’s interventions can only kick the can down the road for so long. In 10 or 20 years, the story will likely be more about China’s decline, and not their growth. This situation looks similar to what happened with Japan’s impressive growth stagnating since the late 1980s and early 1990s. As China’s economic impact recedes in the years to come, so will its global impact. In the next decade or two, the story will go from the rise of China to how quickly China faded, just as Japan’s growth faded in the 1990s.
The USD’s reserve status may not last forever. These types of currency regimes have shifted over the decades. For example, prior to World War II the British pound was the dominant currency. Though still used in global trade, the pound has since faded to the background while living standards in the U.K. are still quite high. Even if the USD eventually fades in global currency importance, that trend is not likely to threaten living standards in the U.S. either.
In summary, the increasing use of the CNY makes sense for certain countries and is likely not a threat to U.S. investors. And while the USD may on some distant day lose its status as the world’s reserve currency, it isn’t like to be replaced by the CNY.
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