Why the Petroyuan Is Off to a Slow Start
The Chinese have recently launched oil market future contracts in its local currency, the yuan. This is big news because oil trading has been done in U.S. dollars since the 1970s. Many consider this special status one of the reasons why the U.S. dollar is the world’s reserve currency.
But 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 that predicted Japan would overtake the United States.
Today, more than two decades later, Japan continues in secular stagnation, and China and the yuan are far away from overtaking the United States or dethroning the U.S. dollar.
Let’s start with the facts: The U.S. dollar is the most widely used currency globally and is actually growing in use. According to the Bank of International Settlements, transactions in U.S. dollars account for almost three times more than those in euro and twenty times more than in yuan. A futures contract for oil denominated in yuan won’t change that fact.
The biggest mistake made by China in its launch of the yuan oil contract was to think that a currency with capital controls and an expensive futures market that trades for barely a few hours a day would be a good incentive for global oil transactions. So the “yuan oil contract” has crashed at birth, for good reasons.
It is monstrously expensive, at more than twice the cost of U.S. dollar contracts. 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.
Also contrary to popular opinion, neither the yuan nor the contract is backed by gold. China’s total gold reserves are a fraction of its money supply (less than 0.007 percent), and if the yuan collapses, the nascent “Petroyuan” falls with it. The mirage of thinking the yuan is guaranteed by gold reserves is only comparable to “flat earth” theories.
Then there’s the fact that the market is only open for a few hours per day: 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 stock market. While the rest of the international oil contracts have 24-hour trading, the Chinese local currency energy market (INE) trades eight hours a day.
It has excessive margin requirements, more than double the U.S. equivalent. The margin required to participate in China’s futures is 7 percent of the contract value, rising to 10 percent the month before delivery and 20 percent in the last three days before delivery.
In the United States, the margin is 3.4 percent of the contract value, according to Goldman Sachs and Bloomberg. To the above, we must add two other barriers: a fee to exchange the yuan to other currencies of 3 percent 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.
Indeed, the trading volumes in the oil contract prove there aren’t many people interested at the moment and there aren’t even many contracts tradeable at the moment. Typically for China, they also count double as the volume at the creation, and the closure of the contract is counted as two, whereas every other exchange counts a round turn as one.
In fact, the volume of this contract does not even reach a fraction of the oil trading figure of China’s own state oil companies.
It is simply impossible for one currency to displace another in the liquid and flexible energy market when there are capital controls and exchange restrictions of this magnitude.
These mistakes have not been made due to lack of intelligence. A large part of the cohort of economists and experts advising governments just ignores the importance of liquidity, openness, and credibility. This is not the first time experts do not understand why capital controls mean “no-go” if the goal is to achieve international status.
The adoption and internationalization of a currency do not happen because it is decided by a government. The credibility and use of the currency are not imposed by a government, however powerful it may be. That is why the internationalization of the yuan is failing.
China and the European Union had the opportunity to implement serious monetary policies, guaranteed by physical reserves, and defend a sound money standard. But both wrongly decided to make the same mistakes as the United States, and in a world of collective monetary madness, the global reserve currency is still the best of the bunch.
The Petroyuan is still-born because it tries to copy the mistakes of the Petrodollar with higher costs and tighter political restrictions.
Daniel Lacalle is chief economist at hedge fund Tressis and author of “Escape From the Central Bank Trap,” published by BEP.