Month: May 2022

Talk of the yuan replacing the U.S. dollar as the global reserve currency is mostly idle because China neither provides the conditions for this to occur nor appears to desire this outcome over the short term. Nevertheless, over time, the U.S. dollar’s hegemony is fraying, leaving a vacuum which will be filled by alternative currencies.

The conditions for a currency to establish itself as the dominant global instrument for trade transactions and storing wealth are shown by history. First, reserve currency status is a function of a country’s dominance of economic output (GDP), trade and net creditor status. Second, certain arduous requirements need to be met:

• Trustworthiness
• Institutional strength (rule of law, property rights)
• Large economy and reliable trading partner
• Free movement of capital and strong banking system
• Large and liquid sovereign bond issuance providing safe assets
• Willingness to provide global currency liquidity

 

No previous reserve currency has had the scale or scope that the U.S. dollar has had over the past seventy years, being generally limited by the country’s geographic hegemony. For example, the British pound was the leading reserve currency for a century (aprox. 1814-1914) because of its global empire and naval domination but it still left much of the world uncovered and faced competition from European rivals (France, Germany).

Post W.W. II U.S. dollar hegemony was secured because of America’s near total economic dominance. However, over time this has changed dramatically. The following chart from the IMF, which measures GDP, trade and net creditor status, shows the evolution over time: the U.S. goes from absolute dominance in the 1950s to a much weaker position today. By this measure, China has already surged and is poised to assume more influence.

 

 

The following three charts show this in detail: 1. Share of global GDP; 2. Share of global trade; 3. Net creditor status. The first two are shown for both the U.S. and China; the third shows the evolution of the U.S. net creditor position, from 20% positive in 1950 to over 80% negative in 2022 (China’s positive net creditor position is estimated to be about 15% of GDP, similar to the U.S. position in the 1950s).

 

On the other hand, with regards to the “institutional” and policy characteristics required to establish reserve status China lags far behind.

• Trustworthiness – Though trust in the U.S. has declined in recent years because of the heavy-handed use of “sanctions diplomacy” it retains considerable advantages over China. China has antagonized a great many potential partners by engaging in provocative “wolf warrior” diplomacy. Moreover, China is even more prone to sanctions diplomacy than the U.S., as shown recently by retaliations against Korea, Australia and Lithuania for criticizing China’s policies.
• Rule of Law – China’s lack of due process and judicial independence makes it a poor safe haven. Though the recent freeze on Russian assets held abroad by the U.S. and other western countries have created a terrible precedent, by and large investors still expect to be treated fairly by U.S. courts.
• Large economy and reliable trading partner – This is China’s strong point and where it can increasingly contend with the U.S..
• Free movement of capital and strong banking system – China fails on both counts. It has strict capital controls, mainly to keep domestic capital from fleeing. Also, it remains fully committed to managing its currency to preserve export competitiveness. Its banks are agents of the state and can be considered “highly liquid but insolvent.”
• Large and liquid sovereign bond issuance providing safe assets – China is improving quickly on this count, but is still way behind the U.S., and the lack of rule of law and the presence of strict capital controls will impede progress.
• Willingness to provide global currency liquidity – This is the biggest impediment for China to move forward on reserve currency status. The global economy needs a constant and predictable increase in the volume of the reserve currency. Under the British Gold Standard gold output increased by over 2% a year to keep the system liquid. Under the U.S. fiat currency system, the U.S. has run persistent current account deficits to feed dollars into the global economy. Since 1980, the U.S. has run annual current account deficits of on average -2.7%. This global liquidity is the counterpart to the growth in the U.S.’s negative net creditor position. Meanwhile, since 1980 China has run current account surpluses of 2% of GDP, allowing it to build its net creditor position. There is no evidence at this time that China would  change the mercantilist policies that support its export competitiveness and sustain current account surpluses, and until it does the yuan cannot increase its global hegemony.

Conclusion

Over the past twenty years China has become the primary buyer of global commodities. For example, China has replaced the U.S. as the biggest importer of oil. This raises the possibility that the dollar’s stranglehold on the pricing of most commodities may not persist. U.S. sanctions diplomacy against major oil producers such as Iran and Russia have already thrown these countries into the arms of China and reportedly have resulted in a significant amount of Chinese imports being invoiced in yuan. At the same time, China has established close diplomatic ties with Saudi Arabia which may be considering similar arrangements. A deal with the Saudis would be a watershed event, given how important the U.S.’s deal with the Saudis in 1974 was in securing the dollar’s hegemony  in the 1970s. However, unlike the Iranians and the Russians, the Saudis have options. In the end, the Chinese will need to convince the Saudis to invest in the Chinese capital markets which brings us back to the inadequacy of the yuan as a reserve currency for the reasons listed previously.

The U.S. dollar’s role as the global reserve currency has been questioned repeatedly during the 7o years since it was established at the Bretton Woods conference in  1944. Current opposition to the U.S. monetary order and calls for its replacement are nothing new and echo past critics who have complained that the U.S. abuses the system to favor its own interests.  Yet, the dollar system today in many ways is stronger than ever, and  there are currently no viable alternatives.

At the Bretton Woods conference strong opposition to a U.S. centric monetary order  was voiced by Maynard Keynes who argued instead for a decentralized system which would prevent countries from running persistent current account imbalances.  Keynes’s fears proved well-founded,  and by the late 1960’s persistent U.S. current account deficits led France to denounce what it called America’s “exorbitant privilege” (i.e., the ability to pay for imports with printed fiat money).  First France and then several more countries demanded to move their gold reserves back home, which left U.S. dollar reserves depleted and undermined the implicit U.S. dollar-gold connection that had been a key feature of the Bretton Woods agreement. In August 1971, Richard Nixon announced the end to the convertibility of dollars into gold, which gave birth to the current U.S. fiat currency monetary system.

The current dollar reserve system has been unique in both its nature and scope. It is the first major currency  reserve system in 700 years of Western financial  history which is not linked to a metal and relies exclusively on the creditworthiness of the issuer. Second, the U.S. dollar can be considered the first truly global currency, as no previous reserve currency has had its geographical reach.

Nixon’s decision was momentous. It had been assumed that a stable monetary order would require a link to gold. England had been able to maintain a stable gold price for nearly 200 years. The U.S. has secured a stable gold price around $20/ounce since 1792, with the only exception being FDR’s devaluation in 1934, to $35/ounce.  FDR’s decision had been seen to be an adjustment within the system, while Nixon’s was perceived as its full repudiation. The chart below shows the evolution of the USD/gold price from 1931 (before FDR’s decision) until 1980.

Not surprisingly, Nixon’s decision was not well received by global capital.  It led to the first genuine dollar crisis  (chart below) and to a long period of dollar weakness,  high inflation and economic “malaise,” as described by Jimmy Carter. During the 1970s talk of the rise of the Deutsche mark and the Japanese yen as viable reserve currencies was prevalent and both currencies appreciated by more than 40% against the USD.

Two separate events were instrumental in recovering the dollar’s credibility. First, behind the scenes, in 1974 a secret deal was reached between Treasury Secretary William Simon and Saudi Arabia’s King Faisal for the Saudis to agree to invoice all oil exports in USD in exchange for U.S. weaponry and protection. This deal, in essence, defined the terms of the new fiat monetary system, providing a mechanism for recycling persistent U.S. current account deficits back into U.S. financial assets. The new “petrodollar system” allowed for the “neutralization” of the high commodity prices of the 1970s by channeling windfall OPEC oil profits into Wall Street banks, which, in turn, flooded the world with dollar loans.

The second event that established the dollar’s supremacy was the appointment of  Paul Volcker to head the U.S. Treasury in 1979 . He  proceeded to raise  the federal funds rate, which had averaged 11.2% in 1979, to a peak of 20% in June 1981.  Volcker’s super-hawkish policy coincided with the election of Ronal Reagan in November 1980,  and the combination of tight monetary policy with the promise of economic rejuvenation through “supply-side” economics led to a massive dollar rally, lasting t0 1985.

The twenty years between 1980 and 2000 can be considered the golden age of the dollar.  The “Petrodollar System” for recycling U.S. current account deficits back into the U.S. financial system worked smoothly over this period of relative economic and price stability. One of the assumptions of the system was that the U.S. would manage its economy to maintain general price stability and the purchasing power of commodities. We can see in the following chart that this was largely achieved  during this time, as oil prices were kept stable in both nominal and real terms (and at acceptably high prices for OPEC).

This period of faith in dollar supremacy led global central banks to sell  long-held gold reserves in exchange for treasury notes and other U.S. assets. The following chart from Ray Dalio shows clearly why the 1980-2000 can be considered the dollar’s heyday.  We can see that Central Banks aggressively  sold dollars for gold and Deutsche marks during the 1970s, only to about-face when Volcker hiked rates. Central Banks then proceeded to dump gold reserves  for the next twenty years. By 2000, the dollar’s share of central bank reserves was at its all-time high while gold reserves were at all-time lows.

This golden period for the USD unleashed two powerful trends: first, deflation (closely linked to hyper-globalization and the rise of China); second, hyper-financialization and chronic financial bubbles (directly linked to asymmetric policies pursued by an emboldened Fed convinced that modern macro economists had discovered the key to the “Great Moderation.” Naturally, these two trends are interdependent. Hyper-globalization could never have occurred without  a financial system able to absorb enormous inflows of foreign dollar reserves and also systematically increase credit to the U.S. consumer. At the same time, hyper-financialization relied on deflation  persistently repressing interest rates which enabled the Fed “put” to be activated anytime the system was perturbed.

Since its peak around 2000, the dollar fiat system has been under stress. The unwinding of the great TMT bubble in 2000 , the Great Financial crisis in 2008 and then a long period of extraordinary “experimental” Fed policy from 2008 until today are manifestations of an unanchored monetary policy. Going back to the previous chart showing historical WTI prices, we can see that the the assumption of price stability which was part of the “Petrodollar anchor” has come completely unglued since 2000, with enormous volatility on both the up and downside.

The only thing left from the Petrodollar regime are enormous current account deficits , now no longer driven by energy imports but rather by Asian consumer manufactured goods (the U.S. is now a net exporter of energy and commodities).  Keynes’s imbalances and France’s “exorbitant privilege” are greater than ever, remaining the essence of the U.S. centric monetary system.

But, as the eminent economist Joseph Stiglitz has noted ,”The system in which the dollar is the reserve currency is a system that has long recognized to be unsustainable in the long run.”  This is because, over time, structural current account deficits erode a country’s manufacturing base and competitiveness. This is even more true when, as has been the case for decades, prominent competitors pursue mercantilistic policies to promote their industrial exports (e.g., China, East Asia, Germany). The two charts below illustrate the essence of these circumstances: first, the persistent U.S.  current account deficits over the past 40 years; second, the U.S. role in absorbing the impact of trade surpluses generated by mercantilist competitors).

As shown below, not only has the U.S. lost competitiveness, it has also sold off  a significant part of its industrial base and corporations to foreign creditors, moving from a positive  international investment position to a highly negative one since 1980. This deterioration in net creditor status has accelerated in the past decade, and foreign creditors have increasingly shunned treasury bills in favor of direct investments, stocks and real estate.

If the current system is untenable, what can replace it?   Talk of a new monetary order built around China is idle,  as the RMB does not meet the basic requirements of a  reserve currency (rule of law, property rights, deep and liquid capital markets, free movement of capital).  Moreover,  a formidable mercantilist  China could never assume the responsibility of providing liquidity to the global market. Most likely, eventually Keynes’s old proposal from Bretton Woods will be resurrected.

Meanwhile, the USD remains king. Ironically,  the system’s  probable slow death will create intense havoc and uncertainty, conditions that favor USD strength not weakness. We have seen this clearly in recent years as the dollar has been strengthening, driven by massive capital flows out of international and emerging markets.

 

 

 

 

 

 

 

 

 

 

Periods of dollar strength are deflationary in the context of the current dollar-centric global monetary system. A strong dollar is generally associated with global inflows into the U.S. either because the U.S. provides superior returns on capital relative to international markets or because high levels of risk aversion drive global capital into the “safe-haven” U.S. capital markets (liquidity, transparency and rule of law).

Periods of dollar strength are the two corners of the “dollar smile” as previously discussed  (Link ) and as shown below.

 

Dollar strength saps liquidity out of international markets, especially in emerging markets where governments and companies  are overly reliant on dollar funding because of shallow domestic capital markets. The combination of higher funding costs for these borrowers and flight capital often results in emerging market financial crisis, 1980, 1997  and 2008 being some of the most painful episodes.  Because of the ongoing surge in the dollar in 2022, we should expect that emerging market economies and asset prices will be under significant stress for the time being.

Because most commodities and a significant amount of global debt are  priced in dollars, a rising dollar depresses global demand and economic growth. This impacts global corporate margins and profitability , including American exporters and domestic industries that compete against foreign imports.

The deflationary nature of dollar strength has a strong impact on global stock market returns because it depresses the earnings of cyclical companies, particularly commodity and industrial companies and banks. Global stock markets in general and emerging markets in particular have much greater exposure to cyclical industries and therefore suffer more during these periods. In the U.S. market, industrials and multinationals with heavy foreign exposure also suffer from a strong dollar. The chart below shows how this phenomenon plays out in the U.S. stock market. During periods of dollar strength (1997-2000) and 2012-2021), the Nasdaq index dramatically outperformed the Dow Industrials Index because the Nasdaq is composed mainly of growthy, long-duration stocks while the Dow includes mainly cyclical businesses such as industrial and banks.

The chart below shows the impact on Dow Index earnings  caused by strong dollar deflationary periods. The three periods of dollar strength since the inception of the fiat dollar regime in 1971 are highlighted by the dark bars.  We can see flat to negative earnings in the first two periods and very choppy earnings in the current third period despite the Trump corporate tax cuts and huge stock buy-backs (the final leg up in earning was driven by the recovery in commodity prices in 2021.)

The charts below show the strongly negative effect that a strong dollar has on corporate earnings in emerging markets. The first chart shows that earnings  (in nominal dollar terms) for Global Emerging Markets (MSCI EM Index) were highly depressed during the last two phases of dollar strength (1997-2002) and 2012-2021.  The following chart shows the poor earnings performance of Chinese stocks, over the past decade despite  the RMB’s appreciation over the period, which is a testament to the poor governance and the deflationary effects of overinvestment in industrial capacity and debt expansion. Next, we see the same for Brazilian corporate earnings which by the end of 2021 have still not returned to 2012 levels in nominal dollar terms, despite very strong earnings growth for commodity producers in 2021. Same for India, which barely returned to 2012 earnings level in nominal terms in 2021 even though the Indian economy has enjoyed high rates of GDP growth. Mexico and Korea show a similar story. The one outstanding exception is Taiwan, which has seen good earnings growth because of strong links to the  global technology sector.

The history of emerging markets shows that practically all earnings growth comes in periods when the dollar is depreciating. The current dollar upcycle will eventually turn, bringing better prospects for investing in EM assets. Rising inflationary pressures and buoyant commodity prices may portend that a change is coming.

 

 

The U.S. dollar’s recent surge against both developed and emerging market currencies has extended the current dollar upcycle into its tenth year. Since the end of the Bretton Woods gold-anchored monetary system in 1971, the dollar’s viability as a fiat reserve currency  has relied on the credibility of the Federal Reserve and the willingness of foreigners to own U.S. assets. Since 1971, a relatively predictable 16-18 year cycle has occurred, with 8-9 years of dollar strength followed by 8-9 years of dollar weakness.

Given the short life of the current dollar fiat-global reserve currency system and its absolute uniqueness in historical terms,   it is difficult to generalize and define trends. However, we can say that we are currently in a third upcycle for the USD in what appears to be a declining trend. This is highlighted in the charts below. The second chart details the current dollar upcycle, which started in early 2011. The current upcycle is now in its eleventh year, and, with the recent surge of the DXY to the 103 level, we are now at the long-term downward sloping trendline. We are currently seeing a triple top for the DXY as it has returned to peaks previously reached in 2017 and 2020.

The prolongation of the current dollar upcycle  may have several explanations. Both in 2017 and in 2020 the dollar experienced significant weakness which seemed to indicate the beginning of a downtrend. However, both these downtrends were aborted by market -shaking events that drove investors into U.S. assets: In 2017-2018, Brexit, the Trump tax cut and the  Powell pivot from hawk to dove; in 2021, the extraordinary combination of U.S. fiscal and monetary stimulus and surprisingly strong U.S. economy. Furthermore, the 2017-2022 period has been marked by the strong returns of U.S. equity markets driven by the phenomenal operational performance during the pandemic of America’s “winner-take-all” tech hegemons. Finally, the Russian invasion of Ukraine and China’s economic problems (bursting of the real estate bubble and mismanagement of COVID) have accentuated flows into  U.S. safe haven assets, mainly stocks and real estate.

The current strength of the dollar relies on the notion of American exceptionalism. The U.S. goes through periods of “exceptionalism” and “malaise” which have influence on investor appetite for U.S. dollar assets and set the course for the dollar. Despite all of its stark deficiencies, relative to the rest of the world today the U.S. looks very stable and attractive for investors and it is sucking up excess capital which drives dollar strength.

The chart below schematically describes a framework for understanding the drivers of the U.S. dollar. This so-called “Dollar Smile” framework , which is built on the insights of macro traders like George Soros and others, pinpoints how the dollar behaves in diverse economic environments.

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At the two corners of the mouth, conditions exist for a strong dollar. The right corner represents periods of U.S. exceptionalism when the U.S. leads the world in economic growth and attracts global savings. The left corner represents periods of global crisis when capital flows to the safety of financial havens, especially the U.S. with its large and liquid capital market. The current dollar upcycle over the past eleven years has been supported by one or both  corners of the smile at different times.

At the bottom of the smile, conditions exist for a weak dollar. These are periods of synchronized global growth when the rest of the world is relatively stronger than the U.S. and is attracting capital (e.g. the 1970s in Europe and developed Asia; emerging markets, 2000-2012).

At the present time, the dollar is supported by high levels of economic uncertainty arising from geostrategic conflict and the consequences of an extended period of global fiscal and monetary adventurism. The left corner of the smile is likely to dominate currency movements for the foreseeable future, which portends a strong dollar. Under these conditions, emerging market countries will continue to see persistent capital flight and their assets are not likely to offer attractive returns.