Over upcoming months, the United States will reinstate a host of economic sanctions aimed at preventing Iran from exporting its oil, and also shutting off supplies of capital goods and replacement parts, as well as food and some consumer goods. The mechanism is largely financial: U.S. banks and financial institutions are enjoined from all direct international transactions with Iran. They are also proscribed from doing business with foreign institutions that themselves do business with Iranian entities.
The effectiveness of these sanctions hinges on the fact that dollars are the numeraire currency of world trade in general, commodity trade in particular. Iran is OPEC’s third-largest exporter of oil, selling 2.1 million barrels per day, on average, to world markets. That is 2% of total world production. Ostensibly, the U.S. financial sanctions will cut off Iran’s oil revenues.
However, those sanctions will only work if Iran’s oil is priced in dollars. China just launched a Shanghai-traded oil futures contract denominated in yuan. It has also started implementing infrastructure to accept payments for oil in yuan directly. In principle, Iran could sell its oil for yuan, running the transactions through China-based financial institutions, futures markets and clearing institutions.
At present, China buys two thirds of Iran’s exports: Abiding by U.S. sanctions would be more than a small inconvenience for China’s oil industries. Refineries are built to process specific kinds of oil. Every source produces its own brew. The Shanghai contract is constructed around a seven-product blend of crudes, weighted to reflect China’s refinery balance. The physical oil behind the Shanghai contract averages an API gravity of 32.0 and a sulphur content of 1.5%. That is “medium sour” in the industry lingo. In contrast, WTI and Brent are both “light sweet” products, with gravities around 39.0 and less than 0.33% sulphur. China’s refinery industry will be hard-pressed to “switch” crudestock sources if the supply from Iran is cut off. This means China will not be sourcing oil from North America or Saudi Arabia to replace Iran’s supply.
Were Iran to accept yuan in payment for crude oil, China is all set up to process the transaction directly in its own currency, to hedge the transaction on futures markets and to hold the reserves in its banking system. China, of course, would welcome the opportunity to increase the use of yuan outside its borders. That would advance its quest for the yuan to become the global transactions and reserve currency. Any other nation could buy oil directly from Iran, paying in yuan and financing the deal through China’s financial institutions, hedging as needed on the newly established Shanghai market.
The risk associated with this “back door” financing of trade with Iran is that it sours the relationship of China’s banking system with the United States: Thus, it poses a threat to the entire trade relationship between the world’s two largest economies. Would the United States cut off all trade with China over China’s willingness to trade with Iran in defiance of unilateral U.S. sanctions? The underlying question is this: Would the United States shut off U.S. consumers and industries from $446 billion worth of imports from China, and would it deny U.S. exporters $153.9 billion worth of revenues, to enforce its trade sanctions against Iran?
The United States has a lot to lose if the dollar’s role as a global transactions currency is undermined. Russia—the world’s second most important oil exporter—is already accepting yuan for its crude oil sales. China has asked Saudi Arabia, the world’s biggest oil exporter, to quote its oil in yuan, too. The rise of the yuan as a global transactions currency is already well underway, as we see it. This can only be a sharp negative for the value of the dollar, and a plus for the yuan, as the transition advances.