December 18, 2022

From a Twitter thread I wrote on December 10, 2022:

1. Xi is visiting Saudi Arabia, so I see we’re going to do the “OMG, the Saudis are going to start accepting the RMB for oil and destroy the dollar” thing, so let me explain why I don’t see that as being in anyone’s real interests.

2. First of all, let me say there’s no reason why China can’t pay the Saudis for oil in RMB, or why they couldn’t have done this for years now.

3. Even if oil is formally priced in dollars, two countries can settle the bill in any currency that is mutually acceptable to both. They can use Dr. Pepper bottle caps if they want.

4. The question is whether that’s convenient and useful to both countries. So let’s ask: why would the Saudis want to be paid in RMB, and why would China want to pay in RMB?

5. If you’re the Saudis, and you’ve just been paid in Chinese yuan, what do you do with them next?

6. One option is use them to pay for Chinese-made goods in RMB. This is a potentially compelling reason. After all, this is why countries wanted the US dollar after WW2, to pay for the things they need.

7. Chinese manufacturers are willing to be paid in RMB. So are Chinese construction companies you can hire to build projects abroad. So, potentially, are people in other countries who then want to buy goods and services from the Chinese.

8. But if you’re running a trade surplus with China, from exporting oil, and don’t want to spend all the RMB on your own needs, what do you do with them? You could invest them.

9. US capital markets are the largest in the world, and highly liquid. You can get large sums of money in and out of assets very quickly, and earn a fairly predictable return.

10. Chinese capital markets are not nearly as large or liquid. The currency is not fully convertible, and permission is required to move large sums of money in and out. The range of investments is comparatively limited, and arguably riskier.

11. If the Saudis don’t want to hold their money in RMB, they could sell them for dollars, to someone who wants to use RMB to buy Chinese goods. That’s true.

12. But note: the RMB is not being used as a reserve currency in this case, only a conduit for trade. The Saudis end up holding (and investing) dollars, even if they accept RMB at the point of purchase.

13. Still, that’s something, isn’t it? Well, we have to ask if this “something” is something the Chinese really want to do …

14. If you’re China, you’re already earning dollars from exporting to the US. Despite trade wars, this remains very big business. They could demand that we pay in another currency, but unless balances in that currency are readily available, they risk losing the sale.

15. So you’re China, and you’re earning dollars. Now you have to choose if you pay for oil in dollars or RMB. You can pay in RMB, and that’s fine, but now you’re stuck holding those dollars you earned.

16. That’s not such a terrible thing – ask the Saudis – but the Chinese have even more dollars than the Saudis and, unlike them, have had a hard time over the years deploying them all in anything more productive than Treasuries.

17. It makes much more sense for the Chinese to pass those dollars on to the Saudis and others, instead of pay in RMB and accumulate untold amounts of dollars.

18. Of course, a number of things could change this equation. Trade imbalances could change, and China could stop accumulating so many dollars. It could start running trade deficits, and want to pay for them in RMB.

19. China could dramatically open its capital markets and make its currency fully convertible, making it more attractive for those who can earn RMB to hold them indefinitely.

20. Finally, the US could put a sanctions squeeze on either China or Saudi Arabia, making it problematic to transact in dollars or hold dollars assets. In that case, they might look for the RMB as an alternative, despite the drawbacks I’ve described.

21. The point is not that purchasing oil with RMB is impossible, but that it’s eminently possible, and you have to ask why they aren’t already doing it, and whether those reasons are likely to change.

22. Contrary to what you may have heard, the reason the dollars is the world’s dominant reserve currency isn’t some backroom deal with the Saudis to price oil in dollars in exchange for military protection.

23. The reason is that the US economy is still the largest and most advanced in the world, it has the largest and most accessible capital markets, and it is willing to serve as the world’s consumer of last resort and (by doing so) export dollars abroad for others to hold and use.

24. If you want to understand how the US dollar might lose its current status and role, look to and understand that equation and what might change it. Same goes for China’s role in the global economy and the RMB.

25. On top of this is a legitimate question whether current arrangements really serve US interests, and at what cost. Is dollar dominance an exorbitant privilege or an exorbitant burden? Or a trade-off with both pros and cons?

Some following thoughts, based on replies:

Someone asked whether Saudi Arabia is really running a trade surplus with China. In 2021, Chinese exports to Saudi Arabia reached $30.3 billion, while China’s imports from the kingdom totaled $57 billion. And the gap has been widening.

Some people misunderstand that I’m saying it’s too inconvenient for China and Saudi Arabia to trade in CNY rather than USD. They counter that either one might put up with a lot of inconvenience to insulate themselves from US sanctions. I actually agree, but this misses the point.

Banking dollars in the US is most convenient. But the Eurodollar market was created to avoid burdensome US banking regulations at the time. It was still a dollar market, however, because the dollar is what people were earning.

The underlying issue is the balance of payments, which is not a mere matter of inconvenience. The import or export of currency is deeply tied to that country’s relationship with and role in the global economy.

This is why AIIB, the new China-sponsored development bank to rival ADB, still makes most of its loans in US dollars, despite being a concerted effort to break away from a US-dominated system.

The most likely response to sanctions isn’t to switch currencies, or to gold, but to come up with new ways to exchange dollars outside of US jurisdiction. THAT I definitely see as a real possibility.

If someone says “They’re abandoning SWIFT”, I’d say “yeah, I’d be looking at that if I were them”. It just doesn’t solve the problem of what they do with their dollars or yuan.

In my view there are three things that could threaten the global role of the US dollar going forward: 1) costly peer war (win or lose) 2) chronic govt spending on consumption not investment 3) overly aggressive weaponization of the financial system, undermining stewardship.