On January 19th, 2018, was revealed the “public” part of the new USA national defense strategy. It is being regarded strictly as a military document, although we seem to forget that there are actually two postulates that have long been known: “War is an extreme form of political conflict” and “Politics is the most concentrated expression of economics.” The author of the second aphorism is Vladimir Lenin. Although opinions on the man himself are far from being unambiguous, no one disputes the accuracy of the aphorism itself. And by combining both aphorisms, we get the following: «War is an extreme form of economic conflict.»
For the Аnalytics magazine Geoenergetics.com, the unshakable truth remains a fundamental thesis: the economy of the modern world is based on energy. This thesis is a controversial one, so let’s try to see what the new US military strategy is like if you “tear off” the cover of not even its most tricky secrets, and how exactly China intends to fight it.
China being the US’ No.1 strategic competitor
Here is a quote taken from the American document:
“Inter-state strategic competition, not terrorism, is now the primary concern in U.S. national security. China is a strategic competitor using predatory economics to intimidate its neighbors while militarizing features in the South China Sea. Russia has violated the borders of nearby nations and pursues veto power over the economic, diplomatic, and security decisions of its neighbors.”
In relation to both China and Russia, the term “strategic competitor” is used. If you take a closer look at it, both cases mention the words “economics” and “economic” respectively. There is an obvious conclusion to be drawn: the United States are not talking about recounting nuclear warheads and their carriers, but rather about the economy.
Flight of production to China
Why has China been given such an “honor”? China has come a long way to inevitably get to this high rank. A lot of time has passed ever since 1979, when Deng Xiaoping proclaimed a course towards China’s openness, and we thus won’t cover in detail the events that have taken place for the past 50 years. China has become the world’s first industrial superpower, and it is worth mentioning it. Initially, China, opening regions and cities one after another for foreigners, offered the most comfortable work features: tax and customs benefits, as assistance with production facilities connected to all communications, as well as an incredibly cheap, diligent workforce. And the investors did not hesitate, the idea was simple: we will transfer production, let the Chinese work hard, because the main profit comes from patents, engineering and design, which will remain at our disposal. Sounds beautiful, of course, but production is far from always obeying the desires of managers. Actually, it has laws of its own.
The easiest way to understand this is the example of an abstract American factory, which moved to China to sew fashionable American pants there. But fashion is a capricious lady: yesterday pants with two buttons were in fashion, and tomorrow there will be demand only for pants with three buttons. Designers come up with the buttons, managers give the order. But if the design changes, the Chinese seamstress must receive specific tasks from the technologist, and the American technologist is a little bird flying through the seas and oceans and whose travels end up being quite expensive. It is cheaper to take a Chinese student, train him in production technology, and then return him to China and let him work for a Chinese salary.
This is of course a very simple example. In more complex industries, Chinese with a brilliant American education became technologists, engineers, designers and industrial designers. At every stage of the “flight of heads” from America, Chinese factories appeared, starting with outright fakes, utterly worthless but incredibly cheap. Qualifications grew, the quality improved, and the professions of designers, engineers, and technologists steadily went out of fashion in the states where manufactures have left. Now the new US president can repeat “Make America great again” at least five times a day, but he has no answer to the simple question: Who is it that has to make it great? Lawyers and managers, journalists and dentists? Returning production to the United States after Trump’s tax reform is indeed profitable. But who will be working with the machines?
All the abovementioned ones? Or offsprings of families that have been living on welfare for generations? China has convincingly proved that it is able to copy products of the highest complexity and now we are witnessing how developments made in China begin to cover all stages from conceptualization to drawings, from pilot production to mass production. The road to this has taken almost half a century.
GDP and TSP
Nowadays, GDP (gross domestic product) has been adopted as the only macroeconomic indicator of the development of a state’s economy. The GDP is the market value of all goods and services produced per year in all sectors of the economy on the territory of the state, regardless of the nationality of the factors of production used. It doesn’t matter whether plants operating on your territory are owned by national or foreign legal entities since the entire volume of its products will be counted in GDP. According to the IMF, in 2016, The USA’s GDP was $18.624 trillion, while China’s was $11.232 trillion. China ranks second in the world, but the gap between the United States and China itself is big enough for there to be no reason to worry. But in terms of purchasing parity, the IMF also gives slightly different numbers: 18.624 trillion dollars for the United States (which remains unchanged), while China’s GDP is different and amounts to 21.286 trillion dollars. This means that one can buy more goods and services in China than in America for the same amount of dollars. And now the cause of the United State’s anxiety becomes apparent.
Not only that, there is a second widely used macroeconomic indicator in the economy of socialism: the TSP (total social product). It is a combination of material goods (means of production and commodities) created in all sectors of material production. Nowadays, we tend to forget a bit about TSP, but this doesn’t make it any less relevant. TSP is basically GDP without accounting for services. Roughly speaking, it is the production of everything that can be “touched”. Why do we tend to forget about it, you may wonder? To us, the reason seems quite obvious: if we remove services from the statistic, the figures of the US won’t look very convincing, to put it mildly, against the background of countries producing all kinds of raw materials, or against the background of China, aka the “main workshop of the world”. After all, if one cannot be a leader, then one should at least try to seem like one.
However, the authors of the new US national defense doctrine are serious specialists who understand perfectly well that China overtook the States very, very significantly in terms of TSP. This is precisely why China has been named as the first strategic competitor, and why despite nuclear parity, Russia came only in second place. The “War is an extreme form of economic conflict” formula we have pointed out is, as you now see, not a theory, but the very reality of our world.
Dollars and Treasuries in China’s Reserves
What else besides the GDP figures is the US’ world leadership based on? It is no secret that the dollar was and still remains the main currency of world trade and the most important accumulation tool, as well as the reserve currency of the central banks of all countries. Yes, China does produce a huge mass of goods: its export volume amounted to $2.06 trillion in 2016, or 13.6% of world exports, including $554 billion worth of high-tech products. Russia is not among the main consumers of Chinese goods, and the United States traditionally takes the first place: in 2016, China’s exports to the States amounted to $385 billion. It is indeed traditional, since from the very moment when China began to increase its exports, the main flow of its goods was directed to where demand was massive and most solvent. Deliveries of American goods and services to China in 2016 amounted to only $115 billion, which means that China earned $260 billion from America.
The reason is quite simple: what, in fact, can America provide to China, in addition to selling technology? What is so valuable that is produced in the USA that is not produced in China? Consumer goods? No. Electronics? No. One can continue to come up with various groups of goods, anyway one will come to the conclusion that the US’ asset in trade with China is precisely services and technologies, the volume of which is not enough to cut off the flow of computers, telephones, television equipment, integrated circuits, all kinds of clothes, dishes, shoes, and more. What can the United States do to restore trade balance? There is only one option: to supply China with what it needs the most.
What China buys is also by no means a secret. In 2016, China acquired the following on the world market: oil for 116 billion dollars, iron ore for 58 billion, pipe gas for 7.55 billion, LNG for 8.94 billion, and coal for 9.62 billion. And the list goes on, of course: wood, lumber, gold, copper and other metals. This is something that is rarely spoken out loud: to restore the trade balance with China, the States must either become a supplier of raw materials or achieve an active return to the homeland by American companies located in China. There is an obviously economic conflict here and the war could potentially turn into its most extreme form. China certainly does not need an armed conflict with America, since said conflict will become a global, nuclear one. In order not to provoke the United States, China is simply forced to figure out where to put all its dollars, since America is not able to “redeem” them. On December 7th, 2017, the Xinhua News Agency reported that as of November 2017, China’s gold and foreign exchange reserves amounted to 3 trillion, 119 billion US dollars. Holding such amounts in foreign currency is very uncomfortable, because China has become the largest holder of US government bonds, having bought up treasury bonds by almost $1.2 trillion, and having ousted Japan from the first place in terms of volume. What can China do with these “goods” after having been declared the main economic opponent of the States? A mass “dumping” of bonds in such a volume will inevitably lead to a sharp depreciation and economic losses in China. Waitig until America manages to find a way to «take its production back” or drastically increases import duties for Chinese goods despite the WTO regulations? The United States has just demonstrated that the latter option is possible, and it did so by raising the duties on solar panels manufactured in China by several times. The European Union has more than once shown in recent years that it does not qualify as a reliable, predictable partner. There will be a roar heard from across the ocean, and 28 EU states will rush headlong to impose duties and sanctions, without even trying to think about whether such actions are beneficial for them or not. Yes, there are different trends in Europe, even attempts to resist the US dictatorship have been recorded, but China cannot influence US-EU relations, and even more so after the emergence of the new national defense doctrine of America.
Dollar Pressure Reduction Technologies
It would be very strange if the Chinese leadership did not think about all these potential risks. What is needed to ensure that economic development does not depend critically on the United States and its allies? It is logically obvious that there is a set of actions connected in a single algorithm. China is taking one step at a time in order to raise its standards of living, that is, to increase the solvency of one and a half billion people, leaving behind all the stories about how its factory workers used to work for a bowl of rice per day. In such a domestic market, the dependence of China’s economic growth on exports will decrease drastically and factories will definitely have work to do. The second step is to raise the standard of living in regions and countries, which, relatively speaking, the West does not pay attention to. In Africa, there are already states where the nascent middle class considers it prestigious to educate their children in Chinese universities, since there are so many investment infrastructure projects implemented on this continent that are initiated by China.
This is exactly what China’s most famous project, the Silk Road, is about. Investments in infrastructure, logistics schemes, and transport development are planned everywhere the road passes. The involvement of local companies in these construction projects also comes down to a raise in the standards of living, to the growth of solvent demand, and to the new directions of Chinese exports. Yes, a small nuance has already begun to show itself there: China offers contractors settlements not in RMB and not in dollars, but in treasuries. These are high liquid, valuable currencies that won’t be cashed by china itself, and in small amounts. The price will not fall and the amount of investment in US bonds will decrease: it’s simple and delightful.
Attacks and defensive actions
Since US leaders, as we can see, are happy to use the military vocabulary, then we will use it as well. The direction toward which China’s attacks are aimed is obvious, and the States really need to defend themselves from these attacks. What do they have in their arsenal, with the exception of warlike rhetoric and puffing out? Exactly what they have been working on in Russia since 2014: sanctions, sanctions and more sanctions, which are also used under various slogans by the EU, Canada, Australia and others. China does not intervene in events in Syria or Ukraine, but instead prefers to carefully study American tactics. But even the States have a hard time coming up with an excuse for sanctions on China’s foreign economic investment projects: the threat to transfer production from China to the United States remains purely a matter of propaganda, not a real one. In order for the Americans to agree to “go back to the machinery” and for the engineering specialties to become prestigious again, it takes time and consent within the American society itself. But there doesn’t seem to be such an agreement there: Democrats and Republicans are enthusiastically fighting each other, as well as their own president.
We have all witnessed the fact that Mr. Trump temperately assesses the situation. During Trump’s November visit to China, Sinopec, a private Chinese oil company, China Investment Corp. state fund (CIS) and the Bank of China signed an agreement with Alaska authorities and Alaska Gasline Development Corp to implement natural gas liquefaction projects totaling $43 billion. In addition, China Energy Investment Corporation has announced its intention to invest $83.7 billion in the development of shale gas in West Virginia. Gallant liberals of all stripes hastened to call this agreement a “successful attack on Gazprom,” “the collapse of the Power of Siberia gas pipeline” and so on.
However, let’s put all emotions aside and figure out what does this actually mean. The USA have agreed to become a raw materials appendage of China, and they have done so voluntarily and with great enthusiasm. If you read the text of the new US national defense doctrine, the absurdity becomes obvious: the States intend to supply energy resources to their main «strategic competitor» in order to compete with the supplies of their second «strategic competitor… How is one supposed to understand that? Well, by addressing this with the original source, aka the opinion expressed on this agreement by the Governor of Alaska Bill Walker:
“There are more steps before a final investment decision is reached.”
Since the Alaskan authorities call the project of the pipeline and the plant unfinished, then why should we assume that this isn’t so? An agreement is an agreement, but only time will tell when will it grow to the level of a binding contract. A much more interesting fact is that few people actually paid attention to the fact that on the Chinese side, the state fund CIS is involved in the agreement, instead of just the gas company and the bank. CIS is the holder of the Chinese Treasury package, which means, if you call a spade a spade, that China agrees to take Alaskan gas for debt. When it comes to the second part of the agreement on deliveries from South Virginia, the only thing one has to do is get a world map and find this state on the east coast of the USA, figure out the supply route through the Panama Canal, type on the calculator and then grin.
Now that sure is a worthy opponent for Russian pipe gas, definitely full of prospects. But Mr. Trump was quite pleased with this agreement as well: therefore, the imbalance in trade with China worries him very thoroughly, and there doesn’t seem to be much confidence that American business will really return its production from the Tianxia to the States.
The petrodollar and the petroyuan
Knowing the thoroughness of China’s strategy, there is no reason to doubt that its leaders perfectly understood that the States would sooner or later recognize China as their main competitor aloud. Will China be defensive, will it be satisfied with the actions mentioned above? he best defense, as everyone knows, is a counterattack, and it’s even better if the counterattack is carefully prepared. The economic leadership of the US is largely due to the fact that ever since post-war times, the dollar has remained the main unit of international trade. No matter how powerful the industrial potential of China is, its export depends on the exchange rate of the US national currency. Not only that: nowadays, energy is the basis of any country’s economy, and China is no exception to the rule. Mother Nature has decided that China is to be poor in terms of energy deposits, and the sums that China spends on the purchase of oil, natural gas and coal will only continue to grow. After all, China has placed one of its bets on the development of domestic demand, on the improvement of the living standards of its population. But this “standard of living” is a beautiful phrase that has a very specific content to it these days. How do we define wealth? One or two cars in the family, air conditioning in the hot season, televisions, all kinds of kitchen appliances and other electricity-consuming appliances. Welfare will grow in China, and therefore more and more fuel will be needed for cars, more and more energy for new and newer power plants. China’s nuclear energy and its development plans will remain outside the scope of this article, since there are a lot of interesting things that are definitely worth considering separately. It makes no sense to analyze the development of renewable energy sources for a country with a population of a billion and a half— the calculations we have already given are quite enough.
In general, China’s need to purchase hydrocarbons from foreign markets is inevitable, even if we imagine that electric cars will become incredibly popular someday. They will buy less oil, but they’ll need to buy more gas, and this transition won’t result in any change in Russia’s supply amounts.
Exchange trading in futures oil contracts with a turnover of about 35 trillion dollars is now conducted mainly on the New York, London and Dubai exchanges. All of these exchanges are controlled by the American holding ICE (Intercontinental Exchange). Naturally, the benchmark prices of oil futures are determined in dollars. It is this very fact that ensures the dollar dominance (42%) in international payments for trade and capital operations, as well as in the foreign exchange reserves of central banks of different countries (63%). Can China be happy about such a situation? The question is rhetorical. For now, let’s focus on oil and take a look at what happened a couple of years ago.
In 2015, China purchased 330 million tons of oil on foreign markets. In 2016, it purchased 381 million tons or 7.5 million barrels per day, which is an increase of 13.6%. In 2017, China overtook the United States in terms of oil imports, bringing the figure to 8.5 million barrels per day. The share of imported oil on the Chinese market in two years increased from 65 to 70%. But at the same time, the dollar exchange rate, the cost of a barrel can be determined anywhere, but not in China, and this is the real threat to its national security. To leave the dollar oil trade is almost the most important task for China, and it is becoming increasingly important every day.
Chinese Stock Exchanges
Attempts to get away from the dollar in the oil trade have already been performed in history by Muammar Gaddafi and Saddam Hussein. We all know the result: on the ruins of both states there was a rampant establishment of democracy and a triumph of human rights. Their example is so inspiring and fascinating that China made its conclusions and began to prepare for this maneuver in a completely different way. In 2002, the Bank of China organized a non-profit organization with the simple name Shanghai Gold Exchange where gold bullions, futures and options are being traded. In 2016, the trading volume amounted to 24,338 tons, which is 43% more than in 2015, while the supply of physical gold from the exchange amounted to 1,970 tons. On April 19th, 2016, an auction was launched at the international division of the exchange to trade a 1 kilogram gold bar with a purity of 99.99% in RMB. 569 tons of such bars were sold by the end of the year. The following question arises: does trading on the Shanghai Gold Exchange influence the formation of world gold prices? The answer is no, because the exchange takes as its basis the ready-made world price, which is being determined on the exchanges of New York and London. Another question: why does China need this? The answer, in fact, has already been heard: gold is being sold for RMB. Not for pounds, not for dollars, but for yuan.
Another Shanghai stock exchange that focuses on futures has recently established a division called the Shanghai International Energy Exchange so that foreign suppliers and traders can trade in physical oil and RMB-denominated futures contracts. None of the official documents mention anything about gold; it was a complete coincidence that the exchanges ended up in one city. It happens. Of course, oil traders can buy gold for yuan in any other place, just as they can not buy it – it’s up to them. Indeed, there are actually not that many cities in China: there is no place for an oil exchange, except in Shanghai. In fact, this means that before our very eyes, China is beginning to «build» a petro-yuan, offering all oil suppliers not wanting to entirely depend on the American dollar, for one reason or another, a way to go without it. The yuan is needed in order to buy some goods and equipment in China, and it’s no problem. The yuan entered the IMF currency basket, and therefore it may become part of the foreign exchange reserves of interested countries. What about not trusting the renminbi whose rate is not being determined on the exchange, but in the power corridors of Beijing? That’s no problem either: buy gold.
Will there be anyone interested? Yes, and in fact, there already is: Angola and Iran are selling oil to China for yuan, and Venezuela is ready to discuss supplies for yuan. Of course, a lot depends on the position of Saudi Arabia, which so far does not want to refuse an agreement with the United States on the trade of its oil solely in dollar. China made its Chinese proposal to the Saudis back in 2015, and the Saudis promised they would think about it. They think slowly, but the fact that in terms of oil supplies to China, just in the year 2015, Russia has bypassed Saudi Arabia is yet another coincidence. The kingdom continued to speculate in 2016, and that year, shipments from Angola to China came in second place. The results of 2017 have not yet been summed up, but it cannot be ruled out that, by chance, Iran may come in third place… But all this, of course, is a series of ridiculous accidents, nothing more. There are really quite a few of them in the history of the formation of the petroyuan, quite enough to gather a collection, actually. Events unfold quickly, so let’s just list the dates.
On January 1st, 2018, China Central Television announced that the second line of the Russian-Chinese Skovorodino-Mohe-Daqing oil pipeline had been successfully commissioned that day. This means that starting this year, China will receive an additional 15 million tons of oil (110 million barrels) from Russia annually. On January 18th, 2018, the Shanghai International Energy Exchange was about to start its first trades in oil futures: all the necessary legal grounds for this were completed, and programmers were also ready to work. However, there was a technical issue: due to an overlay, the start of trading was postponed for a month or two. On January 19th, the media discovers the content of the new US national defense doctrine, but, of course, the cancellation of the auction and some technical problems have nothing to do with that. And the signing of a memorandum of cooperation on January 26th by the Shanghai International Energy and the St. Petersburg International Commodity and Raw Materials Exchanges has nothing to do with all these event either. “It is planned to jointly develop new exchange-traded financial instruments and to develop a model for trading Russian oil varieties to Chinese companies, as well as the procedure for the admission of these companies to exchange trading on the SPIMEX”.
If we leave the irony aside, then, in our opinion, over the course of just one month, several significant events took place right before our eyes. The commissioning of the second line of the pipeline finally consolidated the primacy of Russia in the Chinese oil market. The Chinese leadership did not start trading in oil, anticipating in advance what the content of the US national defense doctrine would be: roughly speaking, the States have put China and Russia in the same boat, declaring both of them as their «strategic competitors.» A pause due to «technical problems» on the Shanghai Oil Exchange is then being used to finally agree with Russia on the abovementioned varieties of Russian oil.
In the world of oil there are only two reference grades: North Sea Brent and North American WTI. The main Russian oil grade, Urals, is not a reference. The price of Russian oil is a derivative of the price of WTI, and this is one of the reasons why the volume of oil trade on the St. Petersburg Exchange remains scanty, not more than $250 million per year. But if it is Urals that is to become the main grade on the Shanghai Oil Exchange, things can change quickly enough and Urals could potentially become another reference grade.
The funny thing is that there’s nothing the States can do about it because of the “shale revolution”. After the oil price rose above $60 per barrel, there has been an increase in the production of shale oil in the United States, thereby increasing the chance that America’s dream of getting rid of its dependence on the Persian Gulf countries might come true, since it will have enough oil of its own. But the fulfillment of this dream will also imply a decrease in the role of the United States as the world’s main importer of oil and, consequently, the growing influence of China as a country whose oil market will only expand. A market that will operate in RMB, that same market whose main supplier will be Russia, and where a new reference oil grade, Urals, could potentially appear.
It is left to point out that the prospects of the Brent grade are not very radiant, and for a reason unrelated to any kinds of energy wars, the deposits of the North Sea simply physically end. Having its oil as a reference grade would be a huge step for Russia in strengthening economic influence in the international arena, and it is therefore important to keep a close eye on the further development of events.
Translated by Ellina Hensen
Original text: geoenergetics.ru