Could US sanctions and closer Middle East ties fuel the rise of China’s petroyuan?

A string of energy-rich economies appear to be moving closer into China’s orbit, expanding economic ties and potentially fuelling the rise of the petroyuan, analysts say.

Chinese Foreign Minister Wang Yi ended a week-long tour on Tuesday of Saudi Arabia, Turkey, Iran, the United Arab Emirates, Bahrain and Oman, vowing to help protect their core interests against foreign interference amid rising pressure from the United States.

Facing sanctions itself, China could be looking to secure long-term deals with Middle Eastern nations using the yuan as a form of payment so that all parties can circumvent potential restrictions associated with the US dollar payment system, analysts said.

“It would be a policy goal for both China and those Gulf States to be able to use an alternative to the US dollar,” said Steven Dooley, currency strategist for the Asia-Pacific at Western Union Business Solutions. “If they do use the petroyuan for circulation through the Middle East, the currency would become more important as part of the global financial system.”

In 2018, China launched yuan-denominated oil futures contracts in Shanghai, known as the petroyuan, with the aim of internationalising its currency and competing with US petrodollars, which have underpinned the existing system of oil valuation for decades.

The petrodollar dates back to the Bretton Woods Conference in 1944, where the US dollar was agreed upon to become the new global currency in the post-war monetary system.

In the early 1970s, the Bretton Woods system collapsed when former president Richard Nixon ended the gold standard and introduced a fiat US dollar-based system. Nixon subsequently struck a deal with Saudi Arabia, the world’s biggest oil exporter, to buy oil and provide the kingdom military aid and equipment.

In return, the Saudis would “recycle” billions of dollars in revenue back into US treasuries, financing American spending.

The deal established the petrodollar system, creating a lifetime of demand for dollars from wealthy Middle Eastern countries based on demand for their crude oil.

Petrodollar hegemony allowed the US to maintain influence over the rest of the world and perpetually finance its current account deficit by issuing dollar-denominated assets at low interest rates.

As the world’s largest buyer of oil from Saudi Arabia, China could duplicate the strategy to dictate oil pricing terms, analysts said.

Currently, when China imports from producers as Saudi Arabia, Angola, Russia or Oman, transactions are beholden to dollar valuations, making China vulnerable to the petrodollar system.

“[China can] allocate its oil demand to Saudi Arabia. In exchange, Saudi’s will buy better yielding bonds. China will use this capital as part of their ‘dual circulation’ or domestic focus of growing the middle-class entrants. Hence, more demand for the renminbi,” Patrick Eng, a partner at investment firm Sparkill & Co, said in online research recently published by SmartKarma.

The petrodollar’s advantage as a reserve currency might be starting to wane amid US sanctions on multiple countries, with regional trade partners or foreign production companies seeking to limit risk exposure to the dollar and dollar-centric monetary system, according to analysts.

And the petroyuan could emerge as an attractive alternative, allowing business to be exclusively conducted in the Chinese currency to safeguard finances from US foreign policy and sanctions.

China and Russia have already been forging rouble-yuan deals to ditch the US dollar and use local currencies in international trade. The share of dollars in Russian exports to China plunged to 39 per cent in 2019 from 75 per cent in 2018, according to data provided by ING Bank, reflecting a shift in invoicing of oil contracts into euros.

Similarly, the share of dollars in Chinese imports to Russia declined to 61 per cent in 2020 from 72 per cent in 2018 , reflecting the increasing roles of the euro and yuan.

Russia’s central bank holds around US$68 billion equivalent in yuan in foreign exchange reserves, about 14 per cent of its total, suggesting upside potential for use of the yuan in Russian trade and financial flows.

Last month, Russian Foreign Minister Sergei Lavrov called for Moscow and Beijing to reduce their dependence on the dollar and Western payment systems to push back against what he called the West’s ideological agenda.

The timing of the statement coincided with fresh foreign policy tensions for Russia, with the US and European Union discussing a new round of sanctions over cyber attacks and the use of chemical weapons on critics.

Dmitry Dolgin, chief economist for Russia and the Commonwealth of Independent States at ING Bank, said Russia was unlikely to immediately shift to invoicing its oil exports in yuan.

“Another way to assure de-dollarisation is better cooperation in the banking sector. Chinese banks are present on the Russian market, but their share is quite low at the moment,” Dolgin said.

The Covid-19 crisis could act as a catalyst in shifting the current geopolitical architecture, helping China promote economic development in oil rich nations that leads to demand for the petroyuan, analysts said.

During his diplomatic tour, Wang said China and the Middle East would boost investment and trading in energy, and also cooperate more on 5G and artificial intelligence. China has so far provided 38 million doses of Covid-19 vaccines to 17 Middle Eastern nations.

China has become Iran’s most important commercial partner after the two countries signed a 25-year strategic partnership last week.

The deal is touted as being worth between US$400 billion and US$600 billion, including an expansion of China’s presence in Iranian banking, telecommunications, ports, railways and dozens of other projects. In exchange, China will receive a regular and heavily discounted supply of Iranian oil, although Chinese and the Iranian foreign ministries insist no detailed contract has been signed.

In Saudi Arabia, state giant Saudi Aramco said last month it would ensure China’s energy security is its highest priority for the next 50 years, and that Chinese demand was close to pre-pandemic levels.

“This statement does indicate that yuan is likely to be used for the payment for China’s future purchase of oil from Saudi Aramco,” said Guoxiong Zhang, the director of the Economist Corporate Network in Shanghai. “If that happens, more trading on crude oil will be using yuan.”

Warren Patterson, head of commodities strategy at ING Bank, said in theory having petroyuan-listed commodity futures available to foreigners would help facilitate oil exports to China being settled in yuan rather than dollars.

But there are still a number of obstacles, including restrictions on the yuan’s convertibility and the tricky relationship with the US, Patterson said.

“It’s unlikely that we see Saudi Arabia move away from the dollar, given that this would only hurt the relationship between the two countries,” Patterson said. “While there is the potential to see some Saudi flows to China transacted in [yuan], I think the USD will remain the preferred currency of choice for the Saudis.”

Zhang said China’s efforts to grow its offshore yuan markets will also help alleviate limitations with the convertibility of the currency.

The People’s Bank of China last week pledged to enhance the yuan’s exchange rate flexibility, signalling less policy resistance towards recent movements in the currency. 

Dooley, from Western Union Business Solutions, said bilateral agreements between China and oil producing nations that were settled in yuan, as well as an increase in yuan-denominated contracts used for hedging and speculation, could see a significant rise in the petroyuan in the coming decades.

Global trade in 2018 was worth about US$20 billion, but yuan transactions accounted for only about 1.8 per cent. If they doubled to 3.6 per cent, that would mean an extra US$360 billion taken out of the system, Dooley said.

“A year ago we had no idea Covid-19 was about to hit. So the way the world develops can be incredibly unexpected,” Dooley said.

“The way that these kinds of big shifts in financial markets tend to occur, is that they take a lot longer to develop than you think. But once they occur, they can occur in a really quick move and you see a regime change very, very quickly.”