Petroyuan’s Crash at Birth

Economist and book author Daniel Lacalle pretty much sees things the way I do regarding the petroyuan hype. Lacalle compiled some amusing stats in his post on the Petroyuan’s Lacklustre Birth.

Crash at Birth

Every time I read that the yuan is going to dethrone the dollar and that China is going to monopolize the oil market in its local currency, I remember those films and reports of the late 1980s predicting the imminent Japanese supremacy and how it would absorb the West. Today, more than two decades later, Japan continues in secular stagnation.

The biggest mistake made by China in its launch of the yuan oil contract has been to think that a currency with capital controls and an expensive market that trades for barely a few hours a day would be a fantastic incentive for global oil transactions.

Key Stats

• It is monstrously expensive: more than twice the cost per lot compared than US dollar ones. The transaction fee for Shanghai futures is about $3.20 per lot, compared with about $1.50 for U.S. oil contracts, according to Bloomberg.
• It is not “backed by gold“. China’s total gold reserves are a fraction of its money supply (less than 0.007%) and if the yuan collapses, the nascent “Petroyuan” falls with it. The mirage of thinking that the yuan is guaranteed by gold reserves is only comparable to Flat Earth theories.
• It trades for only a few hours. One hour and a half in the morning, one hour and a half in the afternoon and a few hours at the close of the Chinese market. While the rest of the international oil contracts have twenty-four-hours trading, the Chinese local currency energy market (INE) trades eight hours a day. The implantation and internationalization of a currency does not happen because it is decided by a government
• It has excessive margin requirements, more than double those of the equivalent markets in US dollars. The margin required to participate in China’s futures is 7% of the contract value, rising to 10 percent the month before delivery and 20 percent in the last three days before delivery. In the U.S., the margin is 3.4% of the contract value, according to Goldman Sachs and Bloomberg.
• To the above, we must add two other barriers. A translation exchange to other currencies of 3% and, above all, an economy that has capital controls in which the Chinese government can decide by decree if you can or cannot get your money back when it pleases you.
  The petroyuan is born fatally wounded because it tries to copy the mistakes of the Petrodollar with higher costs and tighter political restrictions.

No Success Story For China

I agree with every point above made by Lacalle with one possible exception. I am unsure if China thought it would be a huge success.

For China it is a matter of pride to have the exchange at all. If one wants to label that a “success” be my guest.

Death of Dollar Silliness

The idea that the yuan will soon replace the dollar as the world’s reserve currency is ridiculous for currency reasons, political reasons, and economic reasons.

I wrote about this many times previously including this October 25, 2017 take called Gold-Backed Petro-Yuan Silliness.

A massive amount of hype is spreading regarding China’s alleged ambitions to dethrone the dollar. The story this time involves China’s plan is to price oil in yuan using a gold-backed futures contract. Even if that were true, the impact would be zero. CNBC is now in on the hype: China has grand ambitions to dethrone the dollar. It may make a powerful move this year.

Repeat after me: It’s meaningless what currency oil is quoted in. Once you understand the inherent truth in that statement, you immediately laugh at headlines like that presented on CNBC.

1. Currency Requirement: If China wants to assume the role of having the world’s reserve currency, something I highly doubt actually, it will need to have a free-floating currency.
2. Bond Market Requirement: If China wants to assume the role of having the world’s reserve currency, it will need to have the world’s largest bond market.
3. Political Requirements: China will need property rights protection and a global willingness of countries to hold the yuan in order for the yuan to be the world’s reserve currency.
4. Balance of Trade Requirement: China would have to be willing to run trade deficits instead of seeking trade surpluses via subsidized exports. Please read that last sentence over and over again until it sinks in. Mathematically, whether they like it or not, China and Japan have massive US dollar reserves as a result of accumulated trade surpluses.
5. Reserve Currency Curse Requirement: Having the world’s reserve currency is a curse because it necessitates a willingness to have endless trade deficits . Mathematically, as long as China runs surpluses, foreign holding of yuan will not match foreign holding of dollars. A mathematical corollary to having massive trade deficits year in and year is the need to have the world’s largest bond market. Adding gold into the yuan-futures mix does not alter the picture other than to add costs.
6. Capital Controls Requirement: The currency must move freely without capital controls. (added 2023-03-30)

China flunks six out of six requirements for taking over the role of having the world’s reserve currency.

Petroyuan Success

Curiously, the petroyuan is a success story, not for China but rather for the US.

Here’s the short version: The huge irony in all the petroyuan hype is that it is a direct result of forthcoming US energy independence. That’s a US achievement, far bigger than the symbolic gain by China.

For discussion, please see PetroYuan is a Huge US Success Story, Not a Chinese One.

Mike “Mish” Shedlock