China’s New Bid to Destroy the US Dollar
The US dollar took another blow this week.
On Monday, the yuan-denominated Chinese oil futures kicked off trading.
I’m sure Trump is a little miffed. Here’s Trump lobbing $60 billion worth of tariffs at the Middle Kingdom, and China just goes about its business. Business that, importantly, doesn’t involve the US dollar…
This week, traders around the world settled down to play with the yuan oil futures on the Shanghai International Energy Exchange (INE), which is a unit of the Shanghai Futures Exchange (SHFE).
The creation of the yuan oil futures exchange has been in the works for six years. But market instability had spooked officials, delaying its debut.
China’s energy needs — and frustration with the US dollar dominance — are dependent on outside oil. In 2017, the Middle Kingdom imported 420 million barrels of crude oil, up 10% on the year before. That’s roughly 8.4 million barrels per day of imported oil.
The numbers for the first session look good.
Over 15.4 million barrels of crude for September delivery swapped hands over two-and-a-half hours. That’s a smidge over the one tenth of what goes through the Chicago Mercantile Exchange (CME).
Initial trade was solid. The yuan oil futures price closed 3.92% higher on the first day.
But there could be a problem looming…
Government interference threatens yuan futures trading
It will come as no surprise to learn that Chinese news outlets talked up the success of the first day’s trade.
Never mind the rumours suggesting the Chinese government is encouraging local financial firms to support the new oil futures platform. One energy consultant told Reuters: ‘The government [in Beijing] seems determined to support it, and I hear a number of firms are being asked or pressured to trade on it, which could help.’
Bloomberg reported that big-name international commodity trading firms are joining in on the action, including Glencore and Trafigura Group.
However, big commodities brokers’ early uptake of yuan futures isn’t a confirmation that the futures contracts are good, or even useful. They are probably just curious to see what it’s all about.
In saying that, commodities brokers were always going to try and access the yuan oil market.
It’s their job to know ‘what’s what’ in commodity markets. Digging in and discovering price movements and volume in Chinese oil futures is an important part of their long-term analysis for energy markets. And if you aren’t trading all the oil futures exchanges, then you aren’t really on top of oil markets.
Based on the past three days analysis on yuan oil futures, the mainstream seems convinced China has created a new international crude benchmark, one to rival the international Brent crude contract. And maybe even the more US-centric West Texas Intermediate (WTI) crude.
I’m not entirely convinced the new crude benchmark is the long-term goal here.
First, there’s the distance. Never before has oil trading been set up so far away from the place it’s being dug up. Major oil futures are traded on the Dubai Mercantile Exchange and the Chicago Mercantile Exchange (CME). The oil is traded near where it was drilled.
Then there’s the fact that yuan-denominated crude is stored in China. To overcome this, the INE ensured that the price of delivery is factored into the yuan oil contracts. Which means the INE provides an estimate of the shipping costs. With other exchanges, the cost of delivery of the crude falls on the person who bought the contract, in this case the futures trader.
And we can’t ignore the potential impact from pressured traders either. If the rumours are true — that Chinese authorities are pushing firms into trading the yuan oil futures — this will artificially inflate the volume of contracts being traded. Making the yuan crude look more popular than it really is.
Limiting the usability of the yuan oil futures further are tough trading rules.
The INE has set only three two-and-a-half hour yuan oil futures sessions each day. That’s in contrast to the almost uninterrupted six-day-a-week WTI futures trading on the CME.
Furthermore, yuan oil contracts won’t be allowed to rise or fall more than 5% a day without authorities stepping in. The reasoning behind this is that officials want to make sure they are active in preventing market bubbles forming.
Which, by the way, is not even the slightest bit true.
Intense government oversight of stock markets is more about control and financial engineering than ‘bubble’ prevention.
All of this will impact the usefulness of yuan oil futures.
Overthrowing the ‘King Dollar’
The media likes to remind investors that China will be heavily ‘monitoring’ how the yuan oil futures trade. That’s a nice euphemism for ‘manipulating’.
There’s no doubt that China is keen to establish some sort of crude pricing dominance in the global market. But they’ll twist and contort their yuan oil futures market along the way.
The pervasive government oversight could prevent Chinese yuan oil futures becoming a genuine oil benchmark.
And the presence of the all-knowing, all-watching and all-seeing Chinese government could potentially lead to a lack of trust in yuan oil futures.
Then again, yuan oil contracts are not about setting a new benchmark.
Instead, yuan-denominated futures contracts are about spreading the yuan throughout the financial system.
Right now, few people want yuan, except locals. At present, only 16% of Chinese trade is settled in yuan. And that’s inside China. Global share of yuan payments for trade sits at 1.78%, way behind the US dollar, euro, pound, yen and the Canadian dollar.
The US dollar dominates the international payments system.
All of which is to say that China’s yuan oil contracts are about upsetting the US dollar power structure.
Spreading the yuan into the financial system is one step towards building credibility for the currency.
For now, there remains broad trust, however flagging, in the US dollar, and very little in the yuan. Pushing more yuan into the financial system may encourage more people to accept it.
Either way, one thing seems clear: Trump may be keen on ramping up his trade war with China. But China’s out to destroy the US dollar.
Editor, The Daily Reckoning Australia