As the war in Ukraine drags on, the global economy is experiencing upheaval and change. One of the most immediate and profound transformations is the rerouting of basic supplies, including oil, gas, food staples (such as wheat), fertilizer, and various metals. This is both due to the disruptions that the war itself is causing as well as the extensive sanctions Western countries have levied against Russia. These sanctions are not just introducing much uncertainty and instability into trade and financial ties with Russia, but for global trade as a whole.
Although the situation on the ground is evolving rapidly, the bigger picture indicates a coming sea change in several key commodity trades that could reshape geo-economics. Most notable will be the energy trade. One indication of these tectonic shifts is a report by the Wall Street Journal that Saudi Arabia is in active talks to price some of its oil sales to China in yuan.
Such discussions between Riyadh and Beijing have been ongoing for more than half a decade, but seem to have accelerated recently. Given Saudi Arabia’s deep ties with the United States, both in the security and financial realm, such a move is likely to be cautious and restrained. After all, the Saudi riyal is pegged to the U.S. dollar, providing a liquid and so far stable financial backstop.
This deep financial link was forged in 1974, when President Nixon struck a deal with the House of Saud. The Kingdom would invoice oil exports exclusively in U.S. dollars, then recycle those proceeds into treasury bills, other American financial assets, and American exports to Saudi Arabia, especially arms. This enlarged the U.S. dollar’s liquidity and global attractiveness. It forced all oil importing nations to hold dollars in reserve to finance their oil imports, a fact reinforced when Saudi Arabia convinced other OPEC nations to invoice oil in dollars as well. Born was the petrodollar, assuring American global financial hegemony.
This arrangement has persisted for nearly 50 years, but the overall U.S.-Saudi relationship has grown fraught over the last two decades. The decline in ties started as far back as 9/11, but has accelerated recently. Saudi grievances include the Iran nuclear deal and the Pivot to Asia under the Obama administration. The Saudis came to believe that the U.S. was neglecting their strategic interests. This feeling has been reinforced by various barriers to the sale of military hardware, while Washington has refused to offer intelligence and logistics to support the Saudis in their battle against the Iran-backed Houthis in Yemen.
Things have deteriorated further under the Biden administration, including Biden’s release of an intelligence report implicating Saudi Crown Prince Mohammed bin Salman in the murder of the journalist Jamal Khashoggi in Istanbul. Biden’s description of Saudi Arabia as a “pariah” state with “no redeeming social value” made growing animosities more personal. Biden is even thought to be unwilling to directly communicate with the Crown Prince.
Accompanying this rise in tensions are profound geo-economic and financial developments. Saudi trade with the United States has been declining for decades. China now buys three times as much oil from Saudi Arabia as the United States does. In fact, China is the Kingdom’s biggest trading partner, purchasing nearly 20 percent of its exports, and will soon overtake the entirety of the European Union as its biggest international supplier. Trade also has evolved into a much deeper investment relationship between Saudi Arabia and China.
What this indicates is that the petrodollar recycling loop has been broken. Originally, Saudi Arabia and other Gulf Cooperation Council (GCC) economies would sell oil in U.S. dollars to America (and Europe) and then recycle those export proceeds into imports and financial assets from the United States (and Europe). However, now, they are selling oil in U.S. dollars to China and then using those dollars to purchase Chinese goods.
It would thus make business sense to denominate the recycling loop of oil export revenue in yuan. So far, though, the GCC’s established reliance on the U.S. dollar has been too convenient to jettison. This might be changing. The effectiveness of the West’s sanctions against Russia are serving as a rude wake-up call. In particular, Western nations have frozen the foreign reserves held in their financial systems by the Russian central banks, forestalling Moscow’s access to its own reserves and setting in motion a potential default by Russia. The refusal of financial institutions to support Russian energy exports also has put these at risk in their totality, an outcome that was largely unanticipated by Western governments.
While countries on highly friendly terms with Washington might have little to fear, others are likely to worry that they could be next. This creates an incentive to reduce reliance on the U.S. dollar and diversify holdings. A potential deal to use the yuan in Saudi Arabia’s oil trade could be exactly a sign that Riyadh is looking for some counterweight to the U.S. dollar.
The likelihood of such deal has risen since the Kingdom faces much heightened competition for the largest oil market on earth. Given the sanctions, most Russian oil will flow towards Asia. Since Moscow is willing to, in fact now forced, to accept yuan for its oil exports to China, it could carve out a competitive edge. This edge is likely to be further sharpened by providing discounts in pricing and large-scale investments in hard infrastructure, especially pipelines, connecting the Chinese market to Russia.
Given this backdrop, it would seem natural for Saudi Arabia to conduct part of its oil trade with China in yuan. Within five years this could shift 25 percent of its official foreign exchange reserves into yuan, providing substantial currency diversification and a geo-financial hedge against potential dollar uncertainty.
Nonetheless, many analysts continue to downplay the chances of such a deal. First and foremost, the Saudi riyal is pegged to the U.S. dollar, meaning that any effective currency diversification would ultimately necessitate breaking this peg. The peg exposes the Saudis to the U.S. financial sector, and consequently gives the U.S. continued political leverage. Oil priced in yuan would mainly be symbolic for now and benefit Chinese interests.
And while the Saudis have grown increasingly unhappy with their decades-old U.S. security relationship, it remains extremely deep. Over the past decade Washington has supplied the Kingdom with more than $100 billion worth of weapons. Just recently, the Biden administration transferred a significant number of Patriot missiles to Saudi Arabia after urgent resupplies were requested. The missiles are to make sure Saudi Arabia can defend itself against the drone and missile attacks - it experienced more than 400 last year - from the Houthi rebels in Yemen.
So, the situation remains fluid. In the final analysis, Saudi Arabia should be seen as the linchpin in the global oil trade. A move to invoice a part of its oil exports in yuan would be a sign that the world is looking for some counterweight to the U.S. dollar and, over the longer term, could begin to dent the dollar’s dominance in the global petroleum trade and beyond.
Riyadh and Beijing could both benefit from international currency diversification. In fact, the breadth and intensity of financial sanctions against Russia means that any government owning large amounts of U.S. dollars in their foreign reserves, even U.S.-aligned ones, are likely to question the full safety of these reserves. Chances are thus higher now than ever for a metamorphosis in the International Monetary System. Even if this change does not happen overnight, it signals that the search for alternatives to the U.S. dollar will endure.
