The Petro-Renminbi Emerges

Economics, Geopolitical, Premium POM

China & Saudi Arabia to End Dollar Pegs + China’s New Crude Benchmark Index

By JC Collins

It would appear that an agreement of sorts has been reached between world powers over the last week or so.  This would correspond with the annual World Economic Forum meetings in Davos, Switzerland.  Not to mention that Chinese President Xi Jinping and King Salman of Saudi Arabia also met and released a communique titled “Comprehensive Strategic Relationship”, along with another “senior Chinese official” affirming that it is the intention of the People’s Bank of China to “decouple” the renminbi from the US dollar.

Over the last few days a list of interesting things has taken place on the geopolitical front.  First, Saudi Arabia came out and stated its willingness to work with Iraq and Russia on making cuts to crude production.  Second, Israel is throwing Turkey under the bus and openly stating that ISIS has benefited from oil sales to Istanbul.  Third and fourth are the above mentioned Communique, and statement by a senior Chinese official in Davos, regarding the exchange rate arrangement with the US dollar.

Over the last few years there has been a lot of speculation regarding the sale of oil in Chinese renminbi.  There have been agreements made between Russia and China, and China and Iran, etc.  The implementation of two Chinese lead banking institutions, the AIIB and NDB, have spurred more speculation about the rise of the renminbi.  And when the IMF included the RMB in the weighting composition of the SDR basket the writing on the wall became even clearer.

But how would all of this unfold to position the Chinese currency to act as a replacement, or alternative, to the petrodollar arrangement which had been agreed upon between the United Stated and Saudi Arabia over forty years ago?

The first real evidence which supports the creation of the so-called “Petro-Yuan” or “Petro-Renminbi” was released last week in the form of a Communique based on the meeting between China and Saudi Arabia.  In that Communique the following was stated:

First: the political field:

– The two sides agree that, amid the continuing development of the multipolarity in the world and the economic globalization, the strategic and global aspect of the Saudi – Chinese relations is day by day on the increase so that the two countries have each become an important partner to the other at the international arena. The two sides always view their joint relations through a far-sighted and strategic eye and manage to develop this relation with each other as a key orientation tool of their external exchange.

– The two sides are keen to exchange high-level visits and enhance strategic contacts on bilateral relations and regional and international issues of mutual concern, the tightening of strategic cooperation and consolidation of mutual strategic confidence.

– The two sides confirm their interest in the creation of consultation mechanisms between the two countries in different fields and at all levels and will take effective measures to stimulate and facilitate the exchange of individual visits between them and promote contacts and mutual benefit in all fields.

– The two sides confirm anew the mutual support for the vital interests of each other with the Saudi side confirms its firm commitment to one-China policy while the Chinese side confirms its support for the Saudi side’s efforts to preserve the security and stability of its country, develop its economy, improve the living standards of its people and supports the Saudi sides playing a bigger role in the regional and international affairs.

Second: Energy

– The two sides expressed wish to continue enhancing cooperation relations in the field of energy and underscored the importance of oil market stability for the world economy. The Chinese side expressed appreciation of the prominent role being played by the Kingdom of Saudi Arabia to guarantee the stability of the world oil market in its capacity as a safe and reliable oil supplier of the world market.

One would imagine that this would have been the same sort of wording which accompanied the creation of the Petrodollar arrangement between the United States and Saudi Arabia.  But with this realization comes some interesting analytical conclusions.

Political and economic pressure is building on both Saudi Arabia and China to end their pegs to the USD.  China appears to be taking its time to complete this final stage of renminbi internationalization.  The agreement between the Chinese and Saudi’s, as defined the Communique, sets the stage for the next phase of the multilateral monetary transition.

The important piece which needs to fall into place is the start of China’s New Crude Benchmark Index, which is scheduled to be operational within the next month or two.  In the post China’s New Crude Benchmark Index, published back on November 26, 2015, I stated the following:

Unfortunately for Saudi Arabia the existing low crude prices have put pressure on the kingdom, which has already experienced a large decline in its foreign exchange reserves.

This decline is because the Saudi riyal is maintained at a peg with the US dollar of 3.75:1.  The lower the price of crude goes, in addition to an increasing USD, and the pressure to maintain the dollar peg increases, which pushes the country further into deficit spending.

Saudi Arabia could cut production which would help lift crude prices, but would lose market share at the same time.  This is not a good strategy, and an alternative scheme involving China is likely unfolding.

This unfolding strategy was just announced in the official Communique between China and Saudi Arabia.

If Saudi Arabia ended the peg to the dollar and began selling crude priced in renminbi on the Shanghai International Energy Exchange (INE) then China would feel comfortable ending their own peg to the dollar and allowing the renminbi to become more market oriented, as renminbi demand would accelerate.

This would also mean the USD would begin to depreciate at the same time as the renminbi begins to appreciate.  This is likely the missing piece for those who felt that infrastructure development loans denominated in RMB through the AIIB and NDB would not be enough to appreciate the yuan against the dollar.

To bring home the point of a Petro-Renminbi type arrangement between China and Saudi Arabia, the official Communique clearly states “…the Chinese side confirms its support for the Saudi side’s efforts to preserve the security and stability of its country…”, which is basically usurping the American roll of protector to the Kingdom.

In the post The Coming Islamic Revolution in Saudi Arabia, I wrote the following:

The agreement between the United States and Iran, and the lifting of sanctions, which could come as early as this Monday, are tell-tale signs that the strategic balance in the region is shifting.  The only reason the relationship of convenience existed between the US and Saudi Arabia was because of the large petroleum reserves.

We also reviewed how Saudi Arabia acted as a buffer for Israel and that the collapse of the House of Saud would create a vacuum which would threaten Israel.  Some new pieces are starting to fit into place.

With this latest agreement between China and Saudi Arabia, and some of the ancillary events which are beginning to take place, such as agreements on production cuts, we can assume that Saudi Arabia has been able to strike a deal which will ensure its survival.  That fact that the Israeli Defense Minister is openly undermining Turkey’s position in funding ISIS would also strongly suggest that the Kingdom has the support of both China and Israel to survive for another period of time.

Iran and Russia will begrudgingly go along with the wishes of China as the end goal of USD reserve diversification and a reduction of US reserve currency influence will serve a larger purpose.  Watch for both Saudi Arabia and China to move away from their USD pegs, which will correspond with the start of China’s crude index.  – JC