Following an article in the Nikkei Asia Review, which reported China will shortly introduce an oil futures contract priced in yuan, there has been some confusion about what it means. The article pointed out that in combination with existing gold futures priced in yuan, an oil exporter to China contracting to accept yuan could use these two futures contracts to take delivery of physical gold in payment for oil.
I was quoted in that article as follows:
"It is a mechanism which is likely to appeal to oil producers that prefer to avoid using dollars, and are not ready to accept that being paid in yuan for oil sales to China is a good idea either,"i
The mechanism of introducing an oil for yuan contract could hardly be clearer, yet the rumour mill went overtime into Chinese whispers. Some analysts appeared to think China was authorising a new oil for gold contract of some sort, or that China would be supplying the gold, both of which are untrue.
The purpose of this article is to put the proposed oil for yuan contract, which has been planned for some time, into its proper context. It requires knowledge of the history of how China’s policy of internationalising the yuan has been developed, and will be brought up to date with an analysis of how the partnership of China and Russia is taking over as the dominant power over the Eurasian land-mass, a story that is now extending to the Middle East.
This fulfils the prophecy of the founder of geopolitics, Sir Halford Mackinder, made over a century ago. He described the conjoined continents of Eurasia and Africa as the World Island, and that he who controls the Heartland, which lies between the Volga and the Yangtze, and the Himalayas and the Artic, controls the World Island.ii The Chinese-Russian partnership is well on its way to controlling the World Island, including sub-Saharan Africa. We know that successive Soviet and Russian leaders have been guided by Mackinder’s concept.
Events of recent months have accelerated the pace of the Heartland’s growing dominance over the World Island, and become pivotal to the balance of global power shifting in favour of the Heartland. Even political commentators in the mainstream media are hardly aware this is happening, let alone future implications. Financial commentators and economists are even less informed, despite the monetary consequences being of overriding importance for the impact on the wealth of nations and their peoples.
This is the backdrop to China’s internationalisation of her currency. To enhance our understanding of the implications of the introduction of yuan futures contracts, we must begin with the relevant monetary developments.
The Hong Kong – London axis
For a considerable time, China has followed a policy of replacing the dollar as its settlement currency for the purposes of trade. After all, China dominates international trade, and on a purchasing power parity basis, her economy rivals that of the US, and if it hasn’t done so already will soon overtake it. From China’s point of view, being forced by her trading partners to accept and pay in dollars is an irritating anachronism, a hangover from American imperialism.
Furthermore, China’s strategic military analysis has convinced her that America uses the dollar as an economic weapon, wielding it to sustain global hegemony and to support her own economy at the expense of others. Therefore, there are clear strategic reasons for China to do away with the dollar for as much of her international and trans-Asian trade as possible.iii
For America’s part, she has strongly resisted moves to have the dollar replaced as the world’s dominant trade currency. America has a tough grip on all commodities, because international physical and derivative markets are priced almost exclusively in dollars. Furthermore, nearly all currency hedging has the dollar on one side of the transaction. This allows the Americans to exercise enormous control over international markets, and even to artificially inflate commodity supplies through the creation of futures contracts, keeping prices lower than they would otherwise be. By these means, America has suppressed the relationship between monetary and price inflation, increasing the apparent stability of the dollar. This is central to the illusion of American monetary hegemony. Therefore, China’s policy of doing away with the dollar is, from the American standpoint, a fundamental challenge to her post-war global domination, and amounts to a declaration of financial war.
China’s problem in displacing the dollar is the lack of an international market for the yuan. Furthermore, with strict exchange controls limiting the ability of Chinese citizens and businesses to trade on the foreign exchanges, it was always going to be an uphill struggle to provide the necessary liquidity in the yuan to make it acceptable to foreign counterparties. China had to come up with a plan, and it made sense to use the existing financial links between Hong Kong and London to develop international markets for her own currency.
We can date public awareness of China’s strategy to June 2012, when Hong Kong Exchanges and Clearing made a successful offer for the London Metal Exchange. While noting that Hong Kong is an autonomous region, and that, officially at least, China does not meddle in Hong Kong’s affairs, China has a direct interest in important acquisitions of this sort. China is the world’s largest importer of base metals, and London is the global metal pricing centre for warehouse stocks and physical delivery.
The LME earlier this year decided to offer a series of precious metal futures contracts, priced in dollars, centred on gold. The gold contract has been a great success, something guaranteed when you bear in mind that the Industrial and Commercial Bank of China, owned by the Chinese state, is a lead sponsor of these precious metals contracts. By this action, China is parking its tanks on the London Bullion Market Association’s lawn. At some stage in the future, the LME will almost certainly offer deliverable futures contracts priced in yuan, not just for precious metals but for base metals as well.
In October 2013, fifteen months after the acquisition of the LME, Boris Johnson as Mayor of London led a trade mission to Beijing. British trade missions are a major feature of Foreign Office duties, the way Britain develops bilateral trade relationships. These trade missions, being planned through diplomatic channels, are prearranged and coordinated well in advance. Therefore, it was unusual to find that George Osborne, the Chancellor of the Exchequer, at very short notice got up a second trade mission, and met Johnson in China.
The reasons for this turn of events were never properly explained; however, we can work them out. In May 2012, David Cameron had met the Dalai Lama in London, which caused a diplomatic furore with China. Despite this earlier public spat and the point having been made, Osbourne was sent to China. While it is likely his trade mission was a cover for UK Government efforts to smooth things over, subsequent events suggest financial cooperation between Hong Kong and London was discussed, and Chinese plans to use Hong Kong and London to enhance the yuan’s international liquidity were agreed in principal. Following Osborne’s visit, David Cameron himself went to Beijing for discussions with President Xi the following month, confirming the importance to Britain of bilateral financial relations with China.
The following year, the UK took the unusual step of issuing a 3bn yuan bond, both as an indication of intent, and to help kick-start the offshore yuan market in London. This was followed by Britain being the first non-Asian nation to join the Asia Infrastructure Investment Bank as a founder member in March 2015 (announced by none other than George Osborne). The AIIB, which was set up by China and headquartered in Beijing, is the first supra-national organisation independent of the Bretton Woods institutions, which are all controlled by the US. These institutions, led by the World Bank and the IMF, as well as several regional development banks, were how the US, using the dollar, dominates the world’s finances. The establishment of the AIIB was an unwelcome development for America, and the US expressed acute disappointment that Britain had decided to join.
And lastly, after six or seven years of lobbying the IMF, the yuan was finally included in the SDR basket from 1 October last year, further promoting it as a trade settlement currency to be included in foreign countries’ reserves.
There can be no clearer evidence of China’s intention to replace the dollar with her own currency, than the sequence of events outlined above. She identified that Britain’s interests were aligned with her own, enabling her to cut out America from future developments. She has obtained arms-length control over London’s physical metal exchange. She had set up a non-dollar rival to the World Bank and IMF, ensuring future Asian development financing is under her control. And, with more than 80 member countries eventually joining the AIIB, she has successfully picked off America’s allies. The inclusion of the yuan in the SDR basket can be taken as an acknowledgement of China’s importance on the world stage.
The eventual intention is to price in yuan everything imported into and exported from China. Much trans-Asian business is already settled in yuan, and even remote Angola settles her oil sales to China in yuan. It will in time involve developing yuan futures contracts for all the tradeable commodities the state deems significant. The most important of these is a standard oil contract. But before we cover the genesis of the oil contract, we should remind ourselves about China’s gold strategy.
Cornering the physical gold market
It is only relatively recently that Western capital markets have become aware that Chinese demand for physical gold absorbs large quantities of annual mine production, and that the country is now the largest mining nation by far, extracting it at a rate of over 450 tonnes per annum. Knowledge of China’s overall demand is restricted to deliveries out of the Shanghai Gold Exchange’s vault into public hands, running at about 2,000 tonnes per annum, which with India’s public demand accounts for nearly all global mine extraction of about 3,000 tonnes.
The SGE was established in 2002, yet China began to embrace capitalism in 1980, when the first Special Economic Zone was established. China at that time showed reserves of 395 tonnes, a figure that was unchanged until 2001, when it was increased to 500 tonnes, and the following year to 600 tonnes, which it remained until 2009. Over this time, the Chinese economy enjoyed enormous capital inflows from 1980 until the early 1990s, when Western companies set up manufacturing facilities. These were followed by growing export surpluses thereafter. The Peoples Bank of China (PBOC), the state-owned central bank, was managing the currency, neutralising these flows by buying mostly dollars.
It also made sense for the Chinese to diversify the foreign exchange portfolio gained through intervention. The need to increase gold holdings would have been obvious to communist-trained economists at the heart of government. They had had the Marxist belief drummed into them that capitalism would eventually destroy itself, and the capitalists’ paper currencies with it. Rather like Germany in the 1950s and the Arabs in the 1970s, they felt it was prudent to put a significant part of their foreign exchange into gold.
Consequently, new regulations appointing the PBOC to “guarantee the state’s requirements for gold and silver” came into force on June 15, 1983.iv Private ownership of gold and silver remained banned.
It should be noted that state-owned gold declared as official reserves bear little relation to the total accumulated. Anecdotal evidence informs us that bullion is dispersed into accounts in the possession of the Peoples Liberation Army and the Communist Party. Therefore, we cannot know China’s true holdings. All one can do is make a reasonable assessment of how much gold the PBOC is likely to have accumulated since 1983 and before 2002, when private citizens were allowed for the first time to buy physical gold and silver. During this period gold had suffered the greatest bear market in the history of fiat currencies. The scale of redistribution from weak hands into stronger long-term hands was enormous, bearing in mind that Indians, the other great national buyers today, only began to buy gold in significant quantities in the early-nineties, after the repeal of the 1968 Gold Control Act in 1990. It is also known that in 1990-2000, many Middle Eastern portfolios sold gold in favour of equity investment, as did many other private investors with Swiss private bank accounts. Furthermore, central banks were leasing gold in large quantities, artificially inflating physical supply.
Taking all these factors into account, plus mine production totalling 42,460 tonnes over the period, it was easily possible for the Chinese state to secretly amass over 20,000 tonnes by 2002, through a process of gradual accumulation. As to whether they did so, we must look at the evidence from China’s gold strategy. The following bullet list is a summary:
- The introduction of the 1983 regulations appointing the PBOC amounts to a declaration of intent. The PBOC as a central bank has access to capital markets, and commands the state-owned commercial banks. Accumulating gold is a natural extension of the PBOC’s currency management.
- There were both the opportunity and the supply during the greatest bear market gold has ever seen. Between 1983-2002, world mine output added an estimated 42,460 tonnes to above-ground stocks at a time when the West was disgorging both central bank and privately owned physical gold. All that gold went somewhere, so China must have been a major buyer.
- In 2002, the Shanghai Gold Exchange (SGE) was set up by the PBOC to permit the public to buy gold. This signalled that the state had acquired sufficient gold and silver bullion for its own purposes by then.
- The state actively advertised gold ownership through the media, promoting a policy to its citizens of holding gold as sound money. This would help her corner the physical market.
- The state deliberately fostered gold mining, to the point where Chinese mines are now the largest producers in the world by far. Mine output was a record 463.7 tonnes in 2016.
- The state monopolises China’s refining capacity, taking in doré from other countries as well, retaining control over ingot production.
- China now hosts the world’s most important bullion exchange in Asia, has set itself up as a rival to the LBMA in London through the London Metal Exchange, and is developing gold futures markets.
- The LBMA 400 ounce 99.50 standard bar has been replaced by the new Chinese 99.99 one kilo bar as the Asian standard. The large Swiss refiners have been converting LBMA bars into the new standard for customers, particularly those resident in the Middle East.
- Almost all gold acquired by China and her citizens remains in China. Chinese refined bars are almost never seen in Switzerland, the West’s principal refining centre.v
- Gold futures contracts in yuan are now available to international dealers in Hong Kong and Dubai using the SGE gold price as benchmark.
Private ownership of gold in China is now estimated to total over 15,000 tonnes, in addition to anything the state has acquired since 1983. China’s gold policy, which may have commenced as a sensible diversification of reserves, now has strategic implications. China’s gold is now a vital defence against the hegemony of the dollar, and as Major-General Qiao Liang has advised the Peoples Liberation Army, there is a continuing risk that America will try to use its currency as a financial and economic weapon against China.vi
The Chinese state, having secured its physical gold dominance, has little need to acquire more gold in the market: that much was signalled by the establishment of the SGE in 2002. It may well have accumulated further gold since, but this is incidental. Russia is now accumulating gold under President Putin, who belatedly learned of the dangers the Western financial system poses Russia in the wake of American sanctions, and more particularly the financial devastation faced by Iran, when America forced the supposedly independent SWIFT inter-bank settlement system to ban Iranian transfers in all other currencies. Gold smuggled from Turkey via Dubai proved to be Iran’s saviour.
By having control of the physical market for gold, China can threaten to use it to destabilise the dollar, without destabilising the yuan. As such, it is potentially devastating, and used carelessly could trigger an economic collapse in Western capital markets, wreaking financial and economic havoc in America and other advanced nations. China will never be wholly independent from trade with these nations, and severe financial and economic damage to the advanced economies will rebound upon her to some extent. For this reason, she has so far held off using gold as an economic and financial weapon, while she continues to insulate herself from periodic crises in Western economies.
China, with Russia, clearly plans to create what amounts to an enormous internal market, covering most of Asia. It is doing this through trade, in contrast with the way America traditionally wields her influence, through the sticks and carrots of guns and butter. In every minor geopolitical skirmish with America, the Sino-Russian partnership has won. The patient approach of letting American influence diminish through her own errors has made the economic violence of driving up the gold price unnecessary. However, times are changing, and this phase is passing.
The oil connection
The success of the Sino-Russian partnership in outwitting the Americans has overtaken China’s own plans to develop liquidity for a wide range of derivative contracts priced in yuan on its own and other international exchanges. Nowhere has this been more obvious than in the delay of introducing an oil futures contract priced in yuan.
This was first mooted, so far as we are aware, in 2012, when it was intended to introduce a contract based on the high-sulphur grades China commonly used at that time. This contract was to be settled in either dollars or yuan at the oil supplier’s choice. However, the absence of an offshore market for yuan meant this proposal was premature.vii
In 2014, these plans resurfaced, with the Shanghai Futures Exchange chairman quoted as saying that the yuan had become more international and recognised in the market. He added that the proposed contract had support from both the government and financial regulators.viii
At about that time, Guo Jianwei, a PBOC monetary policy official, was quoted in the Shanghai Securities News as saying that the PBOC planned to start yuan-denominated gold and oil futures to help establish a global payment system for the Chinese currency.ix This statement gets to the nub of the reason for introducing oil and gold contracts together, and that is they will internationalise the yuan, probably more quickly than any other measure taken by the PBOC. To back up his quote, Mr Guo then described how the PBOC had agreed CNY2.5 trillion of currency swaps with 23 central banks, pointedly excluding the US.
The oil for yuan story rumbled on, with the Chinese delaying the introduction of internationally tradable oil futures. That is, until Damon Evans reported that not only were traders being trained, but that locally registered entities of JPMorgan and UBS are among the first to have gained regulatory approval to trade the contract.
Geopolitical developments relative to the oil contract
It is natural to assume that China and Russia are controlling, Svengali-like, all the geopolitical outcomes. China has retained an unerring focus on the grand prize of excluding the dollar from all her trade, and with it US monetary influence in Asia. But, being reliant on America to make strategic mistakes, China is not totally in control of events and their timing. For example, the collapse in July of the American campaign in Syria was sudden and unexpected, leaving Russia, in partnership with Syria, Iran, and Turkey to sort out the mess.
Even Mr Netanyahu, the Prime Minister of Israel, has beaten a path to Mr Putin’s door several times. When Turkey, still a NATO member, decided to side with Russia along with Iran, Israel recognised that US protection was no longer good enough to secure her future. When Saudi Arabia was under American influence, Israel had felt as safe as she could be in that turbulent region. But a combination of a Hezbollah/Syrian/Turkish/Iranian axis to Israel’s north, and Prince Mohammed bin Salman’s silent coup in Saudi Arabia has fundamentally altered the balance of power.
Prince Salman is now the heir-apparent to King Salman, having replaced Mohammed bin Nayef, America’s nominee, as heir to the throne. Only last week, King Salman himself visited Moscow as the guest of President Putin. No doubt, the other gulf states will follow the Saudi lead.
Instead of President Trump, Putin finds himself, very suddenly, the ring-master for most of the Middle East. And while we cannot rule out a counter-move from the Americans, it should be noted that the Arabs dislike the Americans and much of what they stand for. However, notwithstanding its national antipathy, Saudi Arabia went along with Kissinger’s plan in 1973 to use the dollar for oil payments, and to buy US Treasuries and to deposit surplus dollars in American banks. In return, America guaranteed it would protect Saudi Arabia from outside influences. Also, part of the deal was Saudi Arabia would not support Israel’s enemies.
Now that the Kissinger deal is unravelling, it is reasonable to assume the financial deal, the Middle East’s support of the petrodollar to the exclusion of all rival currencies, will also come to an end, more rapidly than thought possible only four months ago. But for this to be realised requires an alternative settlement currency to be available. And while Russia and China have already agreed joint investment projects involving both their currencies, Saudi Arabia is almost certainly not ready to accept the yuan as a full currency replacement for the dollar.
The rest of the world is watching closely. America’s allies officially remain onside with America, but in terms of foreign relations, interests guide relationships, not the other way around. We saw this when Britain joined the AIIB, demoting the special relationship with America. Central banks, holding massive quantities of the dollar, will be particularly jittery. Knowing this, will China dare make a move to undermine the dollar and trigger a run against it by providing the means for oil exporters to sell oil for yuan and then yuan for gold in international futures exchanges? If Shanghai fails to offer the facility, other markets, such as Hong Kong or Dubai, where there are already yuan gold contracts, could do so.
Realistically, China now has limited control over the timing of her planned moves, and this is particularly true about the prospective oil future priced in yuan. China imports over 8 million barrels of oil per day, for a total annual value of $150bn. She imports oil from a wide variety of sources, including Russia, Angola, Saudi Arabia, Iraq, Brazil, Iran and Venezuela. Some of these countries are on the US black-list (such as Russia, Iran and Venezuela) and others may prefer gold to dollars. If we assume that one-third of China’s oil imports are converted into gold, that amounts to 1,200 tonnes of gold at current prices to be sourced annually in a tight gold moarket.
The effect on the dollar could be catastrophic. Not only would the dollar sink as it loses its exorbitant privilege, but finding the extra physical gold would drive up the gold price. Inevitably, foreign holders of the dollar would probably join in by dumping the dollar and any fiat currencies aligned with it and join the rush for gold.
The ideal way for China to replace the dollar as the dominant currency for her cross-border trade is to encourage her oil suppliers to accept payment in her own currency, the yuan. It is clear from statements made in 2014 by Guo Jianwei, a PBOC monetary policy official, that China had already planned to wean her oil suppliers off the dollar by introducing both oil and gold futures denominated in yuan, allowing them to take at least part-payment in gold. Persuading them to do so without unduly disrupting global capital markets should have been a gradual process, perhaps spread out over the best part of another decade. Instead, geopolitical developments have accelerated the time-table following the election of President Trump, who is noticeably lacking in diplomatic patience. His latest renegation of the Iran nuclear deal is for Asian observers classic US perfidy.
China’s energy suppliers are not yet prepared to accept the full exposure to the yuan that oil sales contracted in yuan implies. Meanwhile, it is becoming apparent that the petrodollar has a limited life, the duration of which has been significantly shortened by America’s withdrawal from the Syrian conflict. The balance of interests is therefore undergoing a seismic change, with the dollar facing the real prospect of becoming redundant for the most significant aspect of its global use.
But if you dump your petrodollars, what do you buy? This is the question which China’s geopolitical and monetary policies must now address.
Perhaps the reason why China has been forced to bring forward plans to introduce the oil futures contract priced in yuan is indirectly due to America abandoning control over the Middle East. If so, the loss of American influence over the Eurasian continent will accelerate, and the status of the dollar will sink with it.
iiThis was Mackinder’s 1904 concept. In 1919 he refined it by defining the Heartland as East Europe.
iiiSee Major-General Qiao Liang’s analysis, reported here: http://chinascope.org/archives/6458/76
ivSee for an English translation, http://www.lawinfochina.com/Display.aspx?lib=law&Cgid=1671
vThis and the previous bullet points were confirmed in private conversation with a senior director of one of the large Swiss refiners.
viSee footnote iii above.
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