What Russia-China relations mean for the dollar

If there was one takeaway from Russia's annual economic shindig in St Petersburg last week, it was that the country is continually looking to its neighbor China for trade and investment. While the United States can't claim that it might be losing a friend with Russia's pivot east, it might be a different story for the dollar, with the alliance having the potential to undercut the domination of the U.S. currency.

"Taken alone, these actions do not mean the end of the dollar as the leading global reserve currency. But, taken in the context of many other actions around the world including Saudi Arabia's frustration with U.S. foreign policy toward Iran, and China's voracious appetite for gold, these actions are meaningful steps away from the dollar," Jim Rickards, portfolio manager at West Shore Group and partner at Tangent Capital Partners, told CNBC via email.

Speaking at a CNBC-hosted event on Friday, Russian President Vladimir Putin outlined his plans for closer links with China and a new Eurasian union. This followed a high-profile deal by Gazprom, the Russian state-backed gas giant, which signed a $400 billion, 30-year deal to supply gas to China.

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The deal looks promising for Moscow, with Europe - the traditional buyer of its oil - hoping to wean itself off Russian dependency, especially with recent tensions following Russia's annexation of Crimea.

Gazprom CEO Alexei Miller and CNPC General manager Zhou Jiping shake hands as Vladimir Putin and Xi Jinping look on, Shanghai, May 21, 2014.
Sasha Mordovets | Getty Images

Despite the details for the deal being scarce, many analysts predict that the oil exports would mean Chinese yuan being exchanged directly, into the Russian ruble. Thus the two countries would bypass the U.S. dollar - the traditional currency used in oil trades and considered to be the international reserve currency of choice.

Medvedev promotes ruble

Meanwhile, VTB, Russia's second biggest bank, has signed a deal with Bank of China that includes an agreement to pay each other in domestic currencies. Added to this, Russian Prime Minister Dmitry Medvedev spoke on Russian TV over the weekend saying sanctions imposed on the country by the EU and U.S. would make Russia use the ruble for trade and would eventually turn it from a "convertible into a reserve currency."

With the two developing nations trading outside of the U.S. dollar, many questions are being raised about what this would do for the greenback and for the U.S. The dollar's status as the global reserve currency has allowed the U.S. to borrow large sums of money, effectively living beyond its means, because there is always a demand for its currency.

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According to Rickards, who has written extensively about the subject, the problem is that in complex systems - such as global financial markets - small trends can rapidly develop into catastrophic collapses.

"The larger problem is that the U.S. is taking the reserve currency role of the dollar for granted and risks jeopardizing confidence in it through (Federal Reserve) monetary policy and the Treasury's cheap dollar policy. Confidence in the dollar can persist for now and then be lost as quickly as happened in the late 1970s," he said.

China diversifies holdings

China has become the largest holder of U.S. debt. Its authorities hold around $3.8 trillion of reserves, the majority of which is denominated in U.S. dollars. However, they have expressed a desire to diversify away from the greenback, and have already pared back their U.S. Treasury holdings. Analysts believe the strength of the euro has been due to China buying the single currency and with the country rivaling India to be the biggest global buyer of gold, it appears this diversification could be well underway.

As China can't easily dump its Treasury holdings due to the market panic that it could cause, Rickards believes that it is creating a hedged position to preserve Chinese wealth.

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"As the U.S. devalues the dollar through inflation, China will lose wealth on the dollar position but will profit on the euros and gold and those profits will offset the losses. So, basically, China is constructing a massive hedge using gold," he said. If the dollar's role as the leading reserve currency is lost, he believes the replacement would come from among euros, gold or special drawing rights (SDRs) - a supplementary asset maintained by the International Monetary Fund.

Garrick Hileman, an economic historian at the London School of Economics believes that the Russia-China deal bolsters the yuan's international trade status and is a candidate for one day becoming a reserve currency. However, he cautions against any thoughts that the dollar's status is in jeopardy.

"Path dependency and other factors make reserve currencies difficult to displace," he told CNBC via email. "Other factors also bode well for the U.S.'s economic prospects and its persistent trade deficit, including advances in the 3-D printing which could lead to a domestic manufacturing renaissance and the shale energy revolution."

Correction: This article has been corrected to reflect that last week's economic summit was in St Petersburg.