On March 26, the Shanghai International Energy Exchange opened its first oil futures contracts to the markets. The contracts are denominated in yuan and convertible into gold, making it the first time a country has made an official contract to swap oil for gold.
Mainstream opponents at Bloomberg downplay the event by stating that because Middle East exporters’ currencies are pegged to the dollar, switching to yuan pricing would introduce foreign-exchange risk to their budgets. While it may at first seem so, having a yuan that is convertible into gold is a very enticing incentive to get countries to use yuan oil futures. It is particularly attractive for China’s biggest oil suppliers such Russia, Angola, and Saudi Arabia. In addition, the contract does not require China to use state-owned gold, but physical gold being sourced through the market. It helps that Shanghai already has the largest physical gold market, and in time, liquidity in the yuan futures contracts will follow.
The advantage for China to use yuan denominated oil futures is that the contract bypasses the dollar, and with it, the need to go through exchange rates. China is the world’s largest oil importer, and paying for imported crude oil in yuan demonstrates how the country is moving away from being dependent on the dollar. Similarly, because the contract ultimately allows swapping oil for gold, it competes with the status quo of exchanging US treasuries for gold. This is not good for the U.S., since the dollar’s credentials as the reserve currency depend on its link to global oil trade.
Why are the yuan denominated oil futures contracts historically significant? In short, China’s ability to connect its currency to oil and gold parallels the US’s rise in how it came to be the world’s reserve currency. Following the catastrophes of WWII, European governments such as England and France were faced with heavy debts. The war had not only taken a toll on its citizens, but on the countries themselves. Because they were on a gold standard, their ability to borrow was severely limited. As a result, they turned to inflating their supply of paper and bank notes. This endangered their ability to redeem their currencies in gold, and led to the abandonment of the gold standard. On the other side of the Atlantic, the United States stood economically unscathed, and still tied to its gold standard.
During the Bretton Woods Conference of 1944, it was decided that since the US owned the world’s largest supply of gold, it made sense to make the dollar into the world’s reserve currency. After all, gold proved reliable after the inflated fiat currency failures in Europe. In the 1960s, the US abused its reserve status and printed more dollars to fund programs to fight poverty and the Vietnam War. Countries, led by France, panicked and demanded their share of claims to the US’s gold supply. In 1971, President Nixon closed the gold window, severing the last tie between the dollar and gold.
Before the dollar could lose its credentials, Secretary of the State Henry Kissinger negotiated with Saudi Arabia in 1973 to require all sales of its oil to be paid in US dollars. Unlike China’s gold-convertible oil futures contracts, this linked the fiat US dollar to oil. However, historical evidence demonstrates that gold-backed currencies are stronger and more stable than fiat currencies. By moving in the direction of the former, perhaps China will not make the same mistakes the US did.
By the end of its first trading week, the yuan denominated oil futures dropped due to a stronger yuan. While it makes investing in the contract for holders of other currencies expensive, the upside is that it gives them a higher purchasing power. It may be too early to tell, but one can’t help wonder if it may partly be due to its convertibility into gold.