What makes a currency valuable?
In the past, the value of a currency was largely derived from the fact that it was fully backed by precious metals. Precious metals which are scarce and possess a wide range of properties that made them a solid choice from a monetary perspective at that point in time. The world ultimately ended up moving on to hybrid systems for reasons that are beyond the scope of this article, which ultimately led to the Bretton Woods system where other currencies were linked to the US dollar, which was linked to gold.
In other words, currencies went from being directly linked to gold to being indirectly linked to gold, a situation that seemed reasonable enough in light of the fact that the United States possessed two-thirds of the world’s gold after World War 2.
However, the US took advantage of its privileged position and ended up running worrisome deficits so as to fund anything from the Vietnam War to Lyndon Johnson’s Great Society, a state of affairs which troubled other nations and made them decide to convert their US dollars to gold en masse. The United States realized that the gold outflow trend was unsustainable and, as such, effectively abandoned the previous system altogether as of 1971, with Richard Nixon making it clear that US dollars were no longer redeemable in gold.
As such, currencies effectively went from being fully backed by gold, to being indirectly backed by gold, to… well, being backed by what exactly?
The US dollar did remain the de facto world currency but in light of the fact that Richard Nixon was worried about other nations potentially abandoning it, a plan was forged together with the Secretary of State Henry Kissinger to “entice” oil-producing nations to keep the dollar by offering services such as the protection of their oil fields in exchange for the nations in question giving the dollar exclusivity and refusing to accept anything else. The first such agreement was made with the Saudi royal family and by 1975, all OPEC nations agreed to:
- Only accept US dollars for the oil they export
- Invest in US bonds
Lo and behold, the petrodollar system was born. To put it differently, the US dollar went from being backed by gold to being at least partially backed by the US military. If we are to take a step back and strip the problem down to its very core, we will realize that a currency has to be backed by “something” in order to be widely-used… but not necessarily something tangible and easily identifiable.
To get right to the point, the US dollar is backed by confidence at this point. Yes, confidence. Confidence that its military will continue representing the world’s #1 force by far, confidence that the US will continue to be the top player economically speaking and so on.
Needless to say, there are many perks associated with representing the world’s reserve currency. For example the fact that you import cheap products and effectively export inflation, the fact that you can run larger deficits yet still easily find interested parties when issuing bonds and the list could go on and on. Of course, other nations (or entities such as the European Union, with its euro) would like to be in this position as well.
Nations such as, of course, China.
Would China be interested in the petrodollar being replaced with the petroyuan?
It most definitely would.
Is China ready?
Most definitely not, for reasons such as:
- Not even its main selling point, the nominal GDP, being large enough. Yes, China has the #1 GDP in nominal terms but the US is still quite a bit ahead and as far as the European Union is concerned, we end up with a GDP even greater than that of the US if we add up the Gross Domestic Products of all EU members
- Militarily speaking, once again, China is not even remotely close to ready, for reasons we have referred to in our article about its military sector, which can be accessed by clicking HERE
- China’s geopolitical “clout” has improved tremendously, especially in Africa, but again, its geopolitical influence is not nearly impressive enough to warrant a credible switch from a petrodollar to a petroyuan system
Will China eventually get there?
That remains to be seen.
For the time being, it’s doing something China has never had a problem doing throughout its very long history: playing the waiting game. By taking things one step at a time, one alliance at a time (even if it means buying its way toward influence through initiatives such as the Belt and Road Initiative, the AIIB and so on) and one reform at a time (for example the Xi Jinping administration’s goal of reforming the military sector, of curbing corruption/nepotism, etc.), China is signaling that:
- It wants to eventually take center stage
- It understands it is not ready yet
- It is willing to patiently work toward getting there as well as willing to reach for its proverbial wallet to ensure that happens
However, “realism” is the operative word.
The stakes are high (with there being quite a few forces at play to maintain the dollar-centered status quo), there is competition (the EU, for example, even with its many problems) and China is still transitioning from its current “not quite there yet” status to representing a safe haven destination and an economy that can be considered developed based on more than just “overhaul” metrics such as nominal GDP.
Needless to say, the ChinaFund.com team will continue having its ear to the ground and enabling clients to do the same, with more details about what we can do for you and/or your organization in this respect being available in the Consulting section of ChinaFund.com (or, to send us a direct message, the Contact section can be used).