Category: Reserve Currencies

The New Global Monetary Regime

The U.S. dollar has been the lynchpin of the global monetary system since the end of World War II, promoting the geopolitical strategic interests of the United States and serving as a “public good” to facilitate the globalization of trade and finance. However, today the rise of China and growing threats to globalization present significant challenges to the long-term hegemony of the dollar. At a time when China aims to change the present dollar-centric monetary order, the dynamics of economic and domestic political forces in the U.S. also put into question its usefulness.

The weight of the dollar in global central bank reserves peaked in 2000 and has been falling gradually since then (chart 1). Today, the global economy has returned to a state of multipolarity last seen prior to WW1 when both Germany and the United States threatened the hegemony of pound sterling. In terms of its share of global GDP and trade and its status as a primary creditor to the world, China’s desire to shape a less dollar-centric global monetary system is legitimate (chart 2). China today has become the largest trading partner of most countries around the world and is the dominant importer of most commodities, so it is not surprising, given growing tensions with the U.S., that it does not want to have to rely on dollars to transact foreign trade (chart 3)

Chart 1

Chart 2, Countries share of world GDP, trade and capital exports

Chart 3, The largest trading partner of countries around the world

The current dollar fiat global monetary order also has become a burden for the U.S. economy. Since the 1950s, the U.S. has gone from being the dominant manufacturing power and exporter of the world and its primary creditor to the present day hyper-financialized and speculative economy with net debts  of $30 trillion to the world. Moreover, the political mood in America has turned against the neoliberal policies of the past decades — anchored on the free flow of trade, capital and immigration and current account deficits  — which seriously undermined American labor.

The gradual strengthening of a multipolar global monetary order will add  instability and costs and further the geopolitical deterioration and rising inflation that we have seen so far in the 2020s. A world of less trade, more of it non-dollar centric, and declining global trade imbalances will be very different from the experience of past decades. Over the short-run, the  dollar’s strength is likely to continue, driven by its safe-haven status in unstable times and the diminished supply of dollars resulting from more balanced global trade. Over the longer term, the dollar could weaken considerably from its currently overvalued levels. A decline in dollar hegemony implies a weaker dollar over time, but it is good to remember that because of powerful network effects reserve currency regimes are very sticky (e.g.,  more reserves were still held in pound sterling than in dollars until 1963).

The 75-year U.S. dollar reserve currency system has been unique in terms of its global reach, but in myriad ways it appears to be following in the steps of the previous regimes centered around the pound sterling, the Dutch florin and others before it.  These currency regimes lasted for around a century going through distinct phases:

  1. Economic, trade and creditor dominance. Expansion of productive capacity and capital accumulation.
  2. Excess capital accumulation, leading to financialization and speculation at the expense of the productive sector.
  3. Economic decline, as new powers seek hegemony.

The  current dollar reserve currency regime has followed this pattern since its launch at the Bretton Woods Conference in 1944.

Bretton Woods I (1945-1971)

The U.S.  imposed a dollar-centric monetary system at the Bretton Woods Conference. Disregarding the argument made by John Maynard Keynes for a global bank that would resolve current account imbalances,  all currencies  were anchored to the dollar at a fixed price for gold. The U.S. came out of the war with by far the largest economy in the world, as a huge net creditor to the world and as the dominant manufacturing and trading nation, all of which secured reserve currency status for the dollar.

In the 1950s, the U.S. ran current account surpluses with its major global trading partners, which were largely rechanneled into aid and direct investments for the reconstruction of the war-torn economies of Europe and Asia. However, by the early 1960s, Japan and Europe had recovered and were running current account surpluses with the U.S., which were registered as increases in each country’s “gold” reserves held at the U.S Federal Reserve. Growing opposition to the system was best expressed by France’s finance minister Valerie Giscard D’Estaing who decried the “exorbitant privilege” enjoyed by the U.S. (the supposed advantage of paying for imports by printing dollars). The system showed its first crack when France sent a navy frigate to New York to repatriate its gold reserves. The depletion of U.S. gold reserves at a time of “American malaise” (e.g., political assassinations, racial riots, the Vietnam War fiasco), led President Richard Nixon to “close the gold window”  in 1971, putting an end to Bretton Woods I.

The Chaotic Interlude (1971-1980)

America’s insouciance with regards to unilaterally breaking the dollar’s tie to gold and imposing a pure fiat currency system was expressed by Treasury Secretary John Connally’s comment, “it’s our currency but it’s your problem.” The result was a collapse of confidence in American monetary stewardship and a flight to dollar alternatives. Dollars as a percentage of total central bank reserves fell from 50% in 1971 to 25% in 1980, replaced mainly by gold but also by Deutsche mark and Japanese yen.

The Petrodollar System and The Golden Age of the dollar (1980-2000)

An agreement between Saudi Arabia and the United States in 1974 (the U.S. Saudi Arabian Joint-Commission on Economic Cooperation) committed Saudi Arabia to invoice petroleum sales in U.S. dollars and hold current account surpluses in U.S. Treasuries in exchange for defense guarantees and economic support. The pact  guaranteed ample global demand for dollars and reinstated America’s  “exorbitant privilege”  of running perpetual current account deficits (chart 3).

Fed chairman Paul Volcker’s success in quelling inflation and President Ronal Reagan’s neoliberal pro-business agenda put an end to the 1970s malaise and set the stage for the golden age of the dollar. This period was characterized by a persistent decline in inflation and interest rates, underpinned by stable prices for oil and gold and deflationary forces from both domestic sources (deregulation, lower taxes, decline of unions, immigration) and international sources (globalization, lower tariffs, free flow of capital) (chart 4)

Confidence in the dollar returned and central banks increased the weight of dollar reserves, from a low of 25% in 1980 to a peak of 60% in 2000, while gold reserves fell from 60% in 1980 to 12% in 2000. Low and declining inflation gave birth to the Fed’s “great moderation” thesis and allowed it to promote the great financialization of the economy, all buttressed by growing current account deficits and foreign capital inflows. With Wall Street at the core of the process, this period saw the U.S. become a huge net debtor as foreign countries accumulated surpluses and became the financiers of U.S. debt and other assets. This period also saw the widespread elimination of capital controls around the world and the growing influence of “hot money” tourist capital flows into foreign assets (chart 5).

Chart 5

Bretton Woods II (2000-2012)

China’s “opening up” under Deng Xiaoping during the 1980s, the maxi-devaluation of the RMB in 1994 and accession to the WTO in 2000 drove China’s “economic miracle” and the commodity super-cycle (2002-2012). China’s rise inaugurated a new global monetary regime which has been dubbed Bretton Woods II. Like in Bretton Woods I, the U.S. promoted the growth of a potential rival through trade and investment (under the premise that China would become more democratic and market-oriented over time).  Once again imbalances emerged, as China’s mercantilist policies led to massive current account surpluses with the U.S. which were parked in U.S. Treasury bills.  “Chimerica,” as the symbiotic relationship came to be known, made China the factory floor for the U.S. consumer.  The China “trade shock” accentuated the deflationary forces of the 1990s. This enabled the Federal Reserve to pursue loose monetary policy despite soaring commodity prices, which broke the “petrodollar” anchor of price stability of the prior twenty years.

Without the stability of the price of oil and gold that was at the core of the “Petrodollar system” Bretton Woods II was an anchorless pure Fiat Reserve Currency Model relying entirely on the faith and credit of the Federal Reserve. Since 2000, recurring financial crises (2001, 2007, 2020) have been met by a desperate and increasingly unorthodox Federal Reserve determined to combat deflationary forces by supporting extremely high levels of debt and equity prices through quantitative easing and international swap lines.

Rising tensions between China and the U.S. since Xi Jinping took power in China in 2011 have undermined “Chimerica.” Since 2017, China has been reducing its holdings of Treasury bills, and no longer recycles its current account surpluses into Treasury bills.  The sanctions imposed on Russia after the invasion of Ukraine and acrimonious relations with Saudi Arabia have further undermined the appeal of recycling current account surpluses into Treasuries.

In Search of a New Regime: Bretton Woods III?

 As Nobel Laureate Joseph Stiglitz has said, “the system in which the dollar is the reserve currency is a system that has long  been recognized to be unsustainable in the long run.” Eventually the “exorbitant privilege” and its geopolitical benefits turn into an “exorbitant burden” of deindustrialization and foreign liabilities.  Moreover, for the first time since WWII, the world’s largest trading nation, China, does not support the  regime. This raises the question of what comes next?

China has declared its determination to move the current world monetary order towards a less U.S. centric model. Given the deterioration in China-U.S. relations and the prospect of economic decoupling, it is likely that China’s trade and current account surpluses with the U.S. will dwindle over the next decade.  Without a reliable substitute for the U.S. consumer, China now aspires to a symbiotic relationship with natural resource producers, whereby it ‘barters” manufactured goods in exchange for commodities. China’s rapprochement with Russia and its diplomatic advances in the Persian Gulf and the steppes of Central Asia are evidence of this focus on creating a new global payments system which focuses on commodities and bypasses the highly financialized dollar correspondent network promoted by the U.S. China aspires to do the same with large economies like Brazil and Indonesia. A Xi visit to Saudi Arabia, rumored to be scheduled for next month, would be of great concern to Washington.

Zolltan Pozsar of Credit Suisse has recently written about a new global commodity anchored reserve currency model which he calls Bretton Woods III. The idea is that in a world torn by geopolitics, sanctions and financial instability  countries will do more trade in other currencies than the dollar and prefer to hold reserves in commodities. Geopolitical tensions this year  — Russia’s invasion of Ukraine and the imposition of sanctions on its trade and foreign reserves, and growing tension in the Taiwan Strait which have resulted  in the  imposition of draconian controls by the U.S. on semiconductor exports  — may have been a watershed which will accelerate financial decoupling.

Does China want the renminbi to serve as a reserve currency?

China, at least in the short run, “wants to have its cake and eat it too.”

China would like to reduce its vulnerability to U.S. sanctions by promoting a new monetary order that is not dollar-centric and do this in a way that allows it to continue to expand its geopolitical influence on Asia and its primary trading partners, mainly commodity producers. However, facing a decade of low growth due to debt, a real estate crisis, poor demographics and plummeting productivity, it also wants to preserve the millions of jobs tied to exports of manufacturing goods. Like all Asian Tigers (Japan, Korea, Taiwan) it needs to pursue the mercantilist policies of the past: an undervalued currency and export subsidies. For now, these mercantilist tendencies imply current account surpluses, which would make it difficult for China to create the expansion of RMB liabilities required in a reserve currency system.

However, under the firm hand of Chairman Xi, China is now rapidly moving to a different economic model that is different from the one followed since the 1980s and at odds with the East Asian model. As it ages rapidly and faces a sharp decline in its workforce, China  will cease to be both the “factory of the world” and the major creditor to the world. This trend will accelerate this decade as China adopts widespread autarkic policies to reduce its vulnerability to potential sanctions from geopolitical adversaries. Over the next decade, China is likely to move to a less production-oriented and more consumer- and finance -oriented economy. This implies more balanced trade and more appropriate conditions for promoting the RMB as a reserve currency.

Conclusion

The move to a multipolar world and parallel monetary regimes will add instability to the global economy during the coming decade. Though declining global trade imbalances are positive in the medium run, the reduction in global dollar liquidity will support dollar strength at first but accelerate alternative reserve currency holdings over time. Commodities will probably play a more important role in future monetary regimes, which will benefit the major global commodity producers.

There is great uncertainty about the reshaping of a new monetary order, but certainty about one thing: more instability.  The quote from Stiglitz concludes: “The system in which the dollar is the reserve currency is a system that has long been recognized to be unsustainable in the long run. It’s a system that is fraying, but as it frays it can contribute a great deal to global instability, and the movement from a dollar to a two-currency or three-currency, a dollar – euro [sic], is a movement that will make things even more unstable.”

The Big Mac Index, REER and Competitiveness in Emerging Markets

Since the imposition of a dollar-centric fiat currency global monetary system by President Richard Nixon in 1971 countries have had to carefully manage their foreign accounts or suffer the consequences. Without the discipline imposed by the golden fetters of the Bretton Woods System (1946-1971), countries that run large current account deficit, accumulate  foreign debt  and welcome “hot money” flows often have  been at the mercy of fickle financial markets and an erratic U.S. Federal Reserve concerned only with the effect of its policies on the U.S. economy. These countries generally have had poor  growth and volatile economies and have suffered from low investment, deindustrialization and capital flight. On the other hand,  countries which have carefully managed foreign accounts, repressed short-term financial flows and “managed ” their currencies have stabler currencies, grow faster, invest more and successfully move up the industrial value chains.

In emerging markets there has been a clear divergence in economic performance between countries with stable and competitive currencies  and those with volatile currencies , with a pronounced advantage for the former. We can separate  countries into three groups:

Convergers are high growth, industrializing countries which follow mercantilist policies and financial repression (China, Taiwan, South Korea, Poland, Vietnam). These countries have successfully converged with developed countries in terms of GDP per capita. They all carefully manipulate their currencies and support industries to achieve competitiveness for their manufacturing exports. These countries have been the great beneficiaries of the dollar-centric monetary system as they have exploited the U.S. current account deficits inherent to the system to their great advantage.

Erratic Convergers are countries have maintained a commitment to manufacturing exports but without the discipline, governance and quality of execution of the “Convergers”(Malaysia, Thailand, Indonesia, Turkey, Mexico). These countries have erratic growth and moderate convergence at best. Their economies and currencies are too volatile to sustain high export growth and move up value chains, and they are typically “sandwiched” between the highly competitive “convergers” and lower-cost newcomers (e.g. Vietnam, Bangladesh).

Middle-Income Trappers are countries without the institutional governance to manage growth (Brazil, Chile, Argentina). These countries experience low growth, high economic and currency volatility and rapid deindustrialization. They are often commodity rich countries that periodically go through boom-to-bust cycles and bouts of “Dutch Disease”   Suffering from similar problems are the “Basket Cases” commodity producers that verge on the border of failed states (South Africa, Nigeria).

Low Income Convergers: Poor countries in a high-growth catch-up phase driven by urbanization and basic manufacturing (India, Philippines, Bangladesh). These countries experience high growth and convergence, and they will eventually hit the middle-income trap unless they can improve institutional governance and develop competitive manufacturing exports and move up value chains.

We can see the disparate circumstance of these groups in the charts below. The first chart shows the 30-year volatility of the Real Effective Exchange Rate (REER) for each country. (The REER measures the value of a currency against the country’s trading partners). The following charts show the 22-year implied valuations relative to the USD for each country organized by the groups define above, using data from the Economist’s Big Mac Index.  This index measures the cost of manufacturing a basic commodity product (the Big Mac Sandwich) in a service industry and has proven to be a good measure of a country’s general competitiveness.

Convergers (China, Taiwan, South Korea, Poland, Vietnam).  All these countries have low volatility in the REER, meaning they preserve currency stability, a sine qua non to incentivize investment and export growth. (Vietnam’s high level is distorted by early data but its REER has been more stable over the past 20 years as it has embraced the “China Model” and has become a dynamic exporter. The Big Mac Index data below  confirms this low volatility and, more importantly, persistently high competitiveness.

Big Mac Implied Valuation relative to the USD

Erratic Convergers (Malaysia, Thailand, Indonesia, Turkey, Mexico). Malaysia, Thailand and Mexico have low REER volatility while Turkey and Indonesia are at relatively high levels. All of these countries have experienced at least one severe economic shock accompanied by maxi-devaluations over this 30-year period. The Big Mac data below confirms that Malaysia, Thailand, Indonesia and Mexico have learned from their past mistakes and have sustained high levels of currency competitiveness in support of manufacturing. Turkey, however, is a different story . Though the lira is currently competitive, it has gone through multiple cycles over the past twenty years, mainly caused by “hot money” flows tied to domestic credit cycles. It is remarkable that Turkish manufacturing has remained as competitive as it has given these difficult circumstances.

Big Mac Implied Valuation relative to the USD

Middle-Income Trappers:  (Brazil, Chile, Argentina).  Both Argentina and Brazil experience high levels of currency volatility caused by commodity cycles, “hot money” flows and periodic capital flight. Chile  was previously considered a “converger” but in recent years has looked more like its neighbors, with institutional instability and severe capital flight. The data from the Big Mac Index highlights the difficult circumstances faced by exporters of manufactured goods in these countries. In addition to high volatility, these currencies are always expensive relative to Asia, Mexico and Turkey.  A decade ago, Brazil had the third most expensive Big Mac in the world, and even today it has the most expensive  in emerging markets, even though Brazil is the largest exporter of beef in the world.

Low Income Convergers:  (India, Philippines) These countries can achieve high growth because they start from a very low level of GDP per capita and can boost productivity easily by adopting technologies and by boosting the productivity of labor by migrating workers from subsistence farms to modern industries in urban settings. Neither country is following the North-Asian model of growth led by exports of manufactured goods, though they have specialized in the export of niche services (I.T. outsourcing for India and call centers for the Philippines). These exports added to remittances from workers abroad are important sources of dollars.

In conclusion, we look at what the REER and Big Mac Index tell us about current currency values.

The first chart shows current currency valuations on a Real Effective Exchange Rate (REER) basis for both major emerging market countries and developed economies, using data  for the past 30 years.  This measures a country’s currency relative to its trading partners.  The main outliers at the current time are Turkey and Argentina on the cheap side and Russia on the expensive side. Also, on the expensive side we find India, Vietnam, Nigeria, the U.S. and the Philippines. With the exception of Vietnam which may be statistically insignificant because of its short history as a trading nation, all the other countries give low importance to their export manufacturing sectors. Not by coincidence, most dedicated manufacturers (Mexico, Malaysia, Europe, South Korea Taiwan, Poland, China and Thailand are towards the middle of the chart.

The currency values derived from the Big Mac Index largely confirm the REER analysis. The dedicated exporters all have cheap currencies. Low-income growers (India, Philippines) are shown to be appreciating in terms of REER but remain structurally cheap in terms of the Big Mac Index. Middle-income trapped countries (Brazil)  are depreciating in terms of REER but remain fundamentally uncompetitive in terms of the Big Mac Index

 

 

The yuan’s Long Road To Hegemony

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.

King dollar Will Rise Before it Falls

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.

 

 

 

 

 

 

 

 

 

 

Don’t Fight the Rising Dollar!

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 “dollar Smile” does not favor Emerging Markets

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.