Petronomics: A Silent War Between China and the United States

Have you ever wondered why it is that the United States debt is incredibly high? Even more so, have you ever asked yourself why it is that the American economy is able to grow despite its ever-increasing budget deficits? The answer to those questions lie in a commodity that impacts the life of every single person on this planet. Without it, the world would be at a standstill and trade would be extremely difficult especially in this era of globalization. This commodity is oil, and the political dynamics behind it enables the United States to cement itself as the world’s main superpower. That said, America’s position is not unrivaled, and the one country that is eyeing to shift the global world order is China.  

Before getting into the dynamics of oil, it is key to understand why oil is so important. Just take a second and imagine a world without oil. Goods and people would not be able to move, which in today’s world of global interdependence, would disrupt the world’s economy. Another important use of oil is in the manufacturing industry. In this industry, oil is used to make synthetic products, and more importantly plastic which is very important in today’s world. On a more macro level, World War 2 was lost by the Axis powers partly because they did not have access to oil to power their tanks, warplanes and warships; hence why the Germans desperately attempted to capture Russia and take control of the oil rigs in the Caucasus which led to their defeat. In short, though people may not realize it, oil is very much embedded in the fabric of modern society.  

So how does oil make the United States a global superpower? The answer to that is the petrodollar. Simply put, the petrodollar is an agreement that the United States had with oil producing countries starting in the 1970's that made them have to standardize their oil prices in US dollar terms. In other words, whenever a country bought oil from an oil producing country, they had to pay them in American dollars. If your country did not have US dollars, your country simply would not be able to get oil. The US at the time was also the world’s largest oil consumer which gave them the power to enforce this system.  

For the United States, the petrodollar agreement was very important because it forced any country that wanted oil to have American dollars in their reserves, thus reinforcing the American dollar as the world’s international reserve currency. The power behind this simple mechanism called the petrodollar was that the US could print more money without significantly affecting inflation because people that demand oil must demand US dollars to make the payments.  

Another factor that helped the American economy grow was a phenomenon called "petrodollar recycling". Through this process, people in the oil producing countries would end up putting the US dollars that they earned from the sale of oil back into American assets because they viewed the US market as a safe market. The growing trust that people in general had for the US dollar was very beneficial for the American economy because the US could print more money and increase deficit spending to finance activities such its military operations and boosting the economy during recessions. As can be seen in the graph below, the US government was able to borrow large amounts of money (by printing it) because of the trust people had in them. 

To further illustrate the power of the petrodollar, the price of oil and the value of the US dollar are almost perfectly negatively correlated. This means that whenever the price of oil increases, the value of the US dollar decreases. The most obvious reason for the oil price-US dollar relationship is that when the US dollar decreases in value relative to other currencies, other countries can purchase more oil simply because the exchange rate gives them more purchasing power. The increase in purchasing power for these countries increases their demand for oil, thus driving up the price of oil. Conversely, when the price of oil drops, the demand for US dollars increases because more countries want the oil and need the American dollars to buy them thus driving up the value of the US dollar. The graph below illustrates this relationship nicely by plotting the value of the US dollar with the price of oil over time. 

With that said, in recent years, China has been a big part of the changing dynamics of what I call “petronomics”, that is the relationship between oil and the world’s economy. For one, as can be observed in the graph below, China was not that big of an oil importer a decade ago but has now surpassed the United States as the world’s largest oil importer.  

The decline is US oil imports was due to the “Shale Revolution”, which saw the United States access oil reserves that were once inaccessible thanks to new drilling methods. With this new technology, many oil experts believe that the United States will eventually become a net oil exporter rather than an importer. With the United States demanding less oil from oil producing countries, American influence in those regions is decreasing because those countries are not profiting as much as they used to. China is looking to take advantage of this by having the oil producing countries adopt the petroyuan, which is very similar to the petrodollar, with the main difference being that oil will be denominated in Chinese yuan instead of American dollars.  

As a matter of fact, China has already begun this process. On March 26th, oil futures denominated in Chinese yuan terms debuted on the Shanghai International Energy Exchange. Simply put, a futures contract is a guarantee to buy an asset (such as oil) in the future at a predetermined price. Businesses would often use these contracts to avoid the risk of a drastic increase in the price of oil, by guaranteeing their price the day they buy the contract. This move makes the Chinese yuan the only currency other than the US dollar that can be used to buy oil futures. In my opinion, China is just laying the foundation for its currency to eventually be the international currency of trade. 

That said, China is in the best position to rival the US. In the 20th century, the United States was able to surpass Great Britain as the world’s main superpower because while European countries were fighting their wars (i.e. the first and second World Wars), the United States factories were producing goods for these countries. During this period, the US was experiencing a trade surplus, meaning that they exported more than they imported. This again forced countries to have American dollars in their reserves to buy American goods. There has since, however, been a shift in global trade, with the US not producing as much as before and now consistently running trade deficits. Instead, China has now taken the role that the US took in the 20th century of producing goods for the rest of the world. By looking at the chart below, one can notice that China is becoming an increasingly important trade partner for the US and that the US imports more than it exports. These two remarks beg the question of why exactly is trade done in US dollars. The answer is that people trust the dollar. 

What does it mean to be the world’s main reserve currency? By being the world’s main reserve currency, business tends to be conducted in this currency because people trust it. Imagine doing business with a company in a country that does not use the same currency as you and neither one of your companies operate in the US. To complete the trade, both parties would agree on using the reserve currency (with the main one being the US dollar) because it is stable, and they trust it. Thanks to this trust, among other benefits, American companies have a much easier access to loans and other sources of capital because they have lower interest rates given that their currency is less risky. By shifting to yuan, anyone transacting internationally will have to use yuan which would just increase China’s power and influence over the world. Venezuela, Iran and Russia are major oil producers and view the petroyuan as a positive because they would be able to avoid sanctions by the United States. The United States, historically, has been able to isolate countries by blocking their access to the global financial system thanks to the petrodollar. Under the petroyuan, this would be more difficult. 

In closing, the US dollar will not be overthrown as the world’s main reserve currency overnight; however, its position is not unrivaled. For the moment, I do not think that China necessarily wants this change to happen now because they are still in their stage of massive economic growth and they benefit a lot from their trade relationship with the United States. Part of their strategy for economic growth is to keep their exchange rate low which makes their goods cheaper abroad. As the yuan begins to be used more in trade, there will be pressure for the exchange rate to go up because the demand for the currency will increase. For this reason, I do not think that the shift towards the yuan as the currency of trade is feasible in the short term. When China’s growth period ends, however, they would be able to take advantage of some of the benefits that were mentioned earlier as their currency becomes the currency of trade.