China to bring back gold in international settlement with new oil futures

China is working on crude oil settlement in yuan backed by gold to circumvent US dollar settlement

China is planning to bring back gold standards for international payment after several decades. Being the world's largest importer of yellow metal, China is now preparing to launch an oil futures contract denominated in yuan and redeemable in gold. While the yuan is not yet a global trade settlement currency, China will make the plan possible by backing the yuan with gold for settling crude oil imports. China is also the largest importer of crude oil.

So far, globally, the dollar has been a major currency to pay for importing crude oil. China's plan to import oil with yuan backed by gold would be a game changer as gold would become the de-facto payment standard despite the fact that all contracts might not finally be converted in gold.

The oil contract, to be traded on the Shanghai International Energy Exchange, will be China's first futures contract that is open to international firms for trading. There is no official word on when the contract will be launched but testing has been underway since July.

Nigam Arora, an international market analyst and author of the Arora Report, said, "China's move is the beginning of gold standards for trade in a new form. Gold is becoming less of a commodity and more of a currency as the contract is backed by nothing other than gold. If this move takes hold, gold has the potential to go up by several folds."

Another implication of the Chinese contract would be that it would create a new oil benchmark. Currently, Brent and WTI are two different benchmarks accepted globally for crude oil. Nigam said, "If this initiative is successful, it will create a new benchmark similar to Brent Crude and West Texas Intermediate in oil. As far as its impact on gold is concerned, there is not enough freely available gold in the world to back more than a few small initiatives. Of course, if the price of gold jumps many folds, the situation will change."

        Bullion-backed settlements  

• China is now preparing to launch an oil futures contract denominated in the yuan and redeemable in gold
• The yuan is not yet a global trade settlement currency, but China will make this possible by backing its currency with gold for settling crude oil imports
• China is also the largest importer of crude oil
• So far, the dollar has been the major currency to pay for importing crude oil
• The oil contract, to be traded on the Shanghai International Energy Exchange, will be the China’s first futures contract open to international firms for trading
• There is no official word on when the contract will be launched, but testing has been under way since July

According to the World Gold Council's data, the Chinese central bank holds 1,842.6 tonnes of gold as part of its reserves, although the yellow metal's share in China's total foreign exchange reserves is just two per cent. The US is the largest holder of gold with 8,133.5 tonnes in reserves. If the International Monetary Fund's holding is not considered, China is the fifth-largest gold holder in forex reserves, according to the WGC. WGC data show that in 2016, China's gold demand stood at 915 tonnes, compared to India's demand of 666 tonnes.

Till date, the US has been surviving on dollar-based settlements for oil and other trade. For completing any international deal, even those not involving the US, the buyer first had to buy dollars to pay for imports. The euro has assumed a distant-second place for international trade sentiment.

Surendra Mehta, the national secretary of the Indian Bullion & Jewellers Association (IBJA), said, "China is looking to upset the current petrodollar system by introducing gold-backed 'petroyuan' oil futures contracts. Since China is the largest importer of oil globally, this massive shift away from the petrodollar could be bad news for the US. However, it could be great news for gold owners."

China has always had an interest in getting away from the dollar. In the past, their attempts have not been successful. The present initiative is inspired by US sanctions against Russia and Iran. The US has been successful in enforcing the sanctions because it has a large degree of control over the flow of dollars through the banking system. Getting away from the dollar is the best way to evade US sanctions.

However, drawing attention to some issues that might come up, Mehta said, "Despite rising concerns around the US dollar's stability and viability, the yuan is still too illiquid and un-established globally in comparison, causing many exporters to shy away from accepting it." After convincing Russia, China had also attempted to deal with Saudi Arabia for yuan-based oil settlement but it didn't receive a positive response. Hence, Mehta said, "China is taking things one step further with these new gold-backed futures contracts. Gold solves the petroyuan's concerns. Russia welcomed the petroyuan with open arms. While on a standalone basis, the yuan might not be considered acceptable like the dollar, gold backing hedges that concern."

Gold prices will spurt if China's contract succeeds when implemented. Will India's prices go up too? If China’s contracts succeed, the dollar will weaken and, as a result, the rupee will strengthen. Gold prices will shoot up sharply but the rise in Indian gold price will depend upon how much the rupee strengthens, said Mehta.