So if everyone is worrying about the Dollar decline, we already know that things are not the same for the Dollar, as they were in 2008. At that time, there was a global knee-jerk during the risk-off trade. This time, the cost of insuring against a US default has risen above that of 2008 (CDS), because markets are scared of a government default next month.
How did all this come about?
The immediate causa proxima is the over-reach of the Sanctions Regime by the US, in trying to clamp down on Russia (& Iran-Venezuela before it) by confiscating their USD reserves. This has set off a kind of Bank Run on the dollar, visible below the surface…..almost everyone outside the US allies is looking for an option to hold their Store of Value in a non-Dollar holding,
So stay with the thought. Once the intent is there (and there’s no way this credibility can be earned back), can the actions be far behind? The point is NOT whether you can leave this “cinema hall on fire”, it’s that you are no longer interested in the movie (read: US Dollar) and are looking for some way to get out.
Importantly, a large number of sins of the US government that were earlier forgiven (large Twin Deficiits, a high CAD + a high Fiscal Deficit, both funded by foreign Central Banks), will now suddenly be remembered and will come home to roost.
The real causes were the massive money-printing of the last 20 years, peaking with the pandemic. With these dollars held abroad being used to fund the American deficits, two major “markets” sprang up: a “petrodollar” market that consisted of oil surpluses in the Middle East, which was used as currency between non-US countries, these dollars never came back to the US to be claimed. The same thing happened to the huge Central Bank Fx assets that came about as a result of the huge & consistent CAD run-up by the US. Japan, China, the Far East, and these days, even India, are holding a combined $5-7trn of these dollars, about 20% of American GDP.
And now these countries, particularly Japan, to a lesser extent China, and certainly India, find themselves riding a tiger: if they stop accumulating these reserves, their industrial capacities must find alternative markets. If they try to find alternate investment avenues (especially investments in their domestic economies), they’re just ‘passing the parcel’ till the dollars end up back in the US. And if they try to sell their Dollar holdings, they will end up tanking the Dollar.
So this tangle of Feedback Loops is what is keeping up the Dollar. Don’t be fooled by the Luddites who are still talking about “where will they go”? Anywhere, but the Dollar, will soon be the answer. Focus on the INTENT of the USD holder, not his options: supply (of currency investments) will create its own demand.
What Is The Immediate Case Against The Dollar?
Besides, of course, the avalanche of sentiment in many nations, by the expropriation of Russia-Iran-Venezuela reserves, was just a single trigger.
1. The Trust Deficit:
But the case against the Dollar has many layers, not least a rule embedded in the principles of human behavior: that whenever unfettered Trust is offered by the masses to the Kings, that Trust has been belied. There are almost no exceptions in history; individuals may have kept the Trust, we don’t know, but not a single government in history has codified & maintained its reputation.
And this goes back to Bretton Woods & Nixon’s cutting of the link between Gold & the Dollar. What started as a minor “adjustment”, has grown so large that it accounts for 6-7% of global GDP and 25% of American GDP. Yes, that’s the size of foreign Central Bank holdings of US Treasuries, which would disappear the day the Dollar loses its current status. And there’s no way to judge the size of private holdings. These are the dollars America has to “buy back” through export surpluses; or it has to inflate it away, more likely.
2. Savings Repression (aka Cheating the Savers):
Despite the fact that the battle against American inflation is not over, the US is likely to have slowed down, even reverse, the trajectory of rate hikes, leaving the country in an extended period of “savings repression”. Obviously, savers will flee to places where they get better yields, principally the Emerging Markets, which seem to have a better hold over Inflation, with higher real rates.
3. Foreign Central Bank Actions:
Importantly, either Yen or Yuan, currencies with structural surpluses against the Dollar, and Current Account surplus as a whole, could see a material currency appreciation, which would also weaken the Dollar. Even India has a Trade Surplus with the US, although it has an overall Current Account Deficit. So, external factors could also play a material role in the weakening of the USD. A small hardening of Interest Rates in the Yen could send it soaring.
6. US Debt Ceiling Woes:
A sudden government close-down, or debt default (even if temporary), is not discounted by markets yet. This is an even risk, with sudden but cataclysmic consequences: for sure, it will contribute to great volatility. A settlement will bring back the government to borrow a huge $1trn, definitely at higher rates, which will harden the Dollar for a while,
So that’s where the Re comes in?
Now consider that the $5-6trn Central Bank Fx Reserve is now looking to go somewhere. Who can absorb it? China, of course, but they have their Trust issues. Plus, since they own more than half of the said reserves, they are both investors & investees. At the moment, we see their Belt & Road initiative soak some of their dollar surpluses. Despite setbacks like Pakistan & Sri Lanka, the program has opened up new trade routes & given China considerable leverage in both trade & geopolitics.
But India is perhaps the most ‘investible’ country in the world right now. This comes from:
- A large, young population, made up of poor, educated people with rising economic productivity & democratized learning (thanks to the Digital Stack & high internet acceptance).
- The adoption of new technologies will accelerate, thanks to a plethora of new digital platforms that deploy new ideas, from agriculture to education.
- Great macros, falling indebtedness across retail, corporate, and even government. This displays rising economic productivity (again, the Digital Stack). From this, a particularly clean Banking system to deploy any external savings that are seeking institutional mechanisms to help lock into any Big Trend.
- Large problems need addressing: from Climate Change to Infrastructure to Cleantech to Sustainability & The Circular Economy. There’s no dearth of big problems that need innovators, risk-taking capital, and hungry customers & to provide large runways for growth.
- Et al
A ‘stable economy’ has the following abiding characteristics. And if it doesn’t, then things must be trending back to these ‘stable’ conditions. If they do not, then you spin out of control, like Pakistan/Sri Lanka:
- Inflation: spending and output should be in line with capacity. Otherwise, supply constraints will cause structural inflation, which squeezes out some customers. That’s regressive, and things should be reverting back to the equilibrium. An ideal would be a 6% real growth, 5% inflation (~roughly 50:50) for developing economies, and half of this (2% growth, 2% inflation) for the developed world.
- Debt growth should be in line with Income growth. Interest rates should reflect this: a rise in Indebtedness would put upward pressure on Interest Rates, with genuine risk premiums. Similarly, deleveraging will lower credit costs, but reduce potential GDP.
- Both of the above impact risk premiums. The spreads of bonds over cash, and equity over bonds, should be watched. Markets are out of equilibrium whenever these spreads get excessive.
If you judge India against the world on these parameters, you’ll find few comparable economies, even in the developed world.
So What Decides The “reserve-ness” of a Reserve Currency?
If a currency has two functions: as a means of exchange & as a Store of Value, the former is Flow & the latter is Stock. Reserves are Stocks, so the reserve-ness of a currency comes from the Stock function.
So what is the point in arguing that a currency (the Re, in this case) doesn’t qualify because it is not a dominant trading partner? Neither is the CHF, or even the USD (compared to its share of 63% in Central Bank Reserves, the US has a mere 25% of global GDP). India will attract “safe haven” flows, not because of its dominance in world trade, but because of its Investibility.
Reserves are about Store of Value: the tacit understanding being TRUST, the perishability of the value embedded in the currency. That is dependent upon macro-stability, not the share of global trade.
On Trade Account, India has a Merchandise Deficit with the BRICS (Brazil because of commodities, South Africa because of minerals, China because of widgets & Russia because of Oil). This is a combined $120 bn, of which China is $100 bn, while Russia now accounts for the rest. But with the US & Europe, India accounts for a $50bn surplus ($30bn for the US & the rest $20bn from Europe). Being a service economy, this pattern is unlikely to change in the near term.
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