Doing without the dollar

NEW YORK – The staggering sum of US$18 trillion – nearly equal to a year’s gross domestic product (GDP) – is the amount that the United States has taken in from foreigners since the Great Financial Crisis of 2008.

The notion that the dollar’s dominance in world finance might come to an end was a fringe view only five years ago when America’s net foreign investment position was a mere negative $8 trillion. Now one reads forecasts of the end of the dollar era in research reports by Goldman Sachs and Credit Suisse.

Washington’s seizure of Russian foreign exchange reserves seems like a self-defeating measure given America’s enormous and accelerating dependence on foreign borrowing. Paradoxically, America’s strength lies in its weakness: A sudden end to the dollar’s leading role in world finance would have devastating consequences for the US economy, as well as the economies of its trading partners.

In addition to the $18 trillion of net foreign investment in the US, foreigners keep about US $16 trillion in overseas bank deposits to finance international transactions. That’s $34 trillion of foreign financing against a US GDP of not quite $23 trillion. Foreigners also have enormous exposure to the US stock and real estate markets.

No one – least of all China with its $3 trillion in reserves– wants a run against the dollar and dollar assets. But the world’s central banks are reducing dollar exposure, cautiously but steadily.

The trickle of diversification out of dollars could turn into a flood. What the International Monetary Fund on March 22 called “the stealth erosion of dollar dominance” prefigures a not-so-stealthy exit from the dollar. Unlike Nebuchadnezzars’ handwriting on the wall, the king’s soothsayers can read the message as plain as day.

Notably, Russia’s central bank cut the share of the US dollar in its reserves from 21% a year ago to just 11% in January, while increasing the share of RMB to 17% from 13% a year ago. Russia’s central bank has also bought more gold than any other institution in recent years.

With just 8% of world export volume versus China’s 15%, the reserve role of the US dollar no longer reflects American economic strength. It derives, perversely, from the rest of the world’s desire to save.

The populations of the world’s high-income countries are aging rapidly. In 2001, 28% of their people were aged 50 years or older; by 2040 the proportion will reach 45%. Aging populations save for retirement. The Germans and Japanese save nearly 30% of GDP, and the Chinese save 44%; Americans save just 18% of GDP.

For the past 15 years, American consumers have spent on goods each year roughly a trillion dollars more than were brought in by American exports.

The import-led consumption boom and the availability of cheap electronics from China and other Asian exporters fed a digital entertainment boom that inflated the stock prices of Apple, Microsoft, Google, Meta and other US software companies.

Foreigners then invested their earnings from exports in US tech stocks, as well as government bonds, real estate and so forth. The tech boom harmed the US economy far more than it helped it, reducing American teenagers to risk-averse recluses addicted to smartphones and social media while generating stock market valuations never before imagined.

The result is the biggest bubble in world financial history. When the Covid-19 pandemic threatened to collapse the bubble, the US government added $6 trillion in stimulus to the economy. That restarted the tech bubble, which explains why the US net foreign investment position fell by another $6 trillion between 2019 and 2022, to today’s negative $18 trillion level.

The bubble is so enormous that the entire world has a stake in it, and none of the world’s major economies can extract themselves from it without significant damage.

China finds itself suffering from punitive American tariffs and sanctions on technology imports, while shipping more than $600 billion of manufactured goods to the US each year – nearly a third more than it did before the Trump administration imposed tariffs in 2019. China’s leaders want to encourage more consumption and less saving but can’t persuade the Chinese to consume. China, therefore, continues to export to the US and save the proceeds.

The world can do perfectly well without the dollar to finance trade. India and Russia can settle trade in their own currencies, with their respective central banks providing rupees and rubles as required through swap lines. Russia’s surplus with India will be invested in the Indian corporate bond market, according to news reports. India reportedly is gearing up to increase exports to Russia by $2 billion a year, a 50% increase from current levels.

China meanwhile is paying for oil imports from both Russia and Saudi Arabia in its own currency. The RMB has appreciated against the US dollar by more than 12% since September 2019 and continues to offer higher real yields than the dollar, as well as a range of investment opportunities, despite China’s exchange controls.

Nothing prevents the 76% of the world’s population whose governments refused to join the sanctions regime against Russia from financing trade in local currency. Asian countries now have $380 billion of swap lines in place, more than enough to accommodate the whole of Asian trade.

To the extent that long-term imbalances emerge in trade, central banks can settle up by transferring gold. Several misleading media reports have claimed that the US can prevent Russia from using its gold reserves. That is inaccurate. The US can keep Russia out of public gold markets, but it can’t stop Russia from trading gold with the central banks of India or China.

By no coincidence, the same central banks that are bypassing the dollar financing system have bought the most gold over the past 20 years, according to the World Gold Council’s data.

China and Russia were the biggest buyers of gold, followed by Turkey, India and Kazakhstan.

Gold’s value relative to competing US dollar assets stands at an all-time record high mark.

In normal times, investors get the same sort of protection from inflation-indexed US government bonds – Treasury Inflation-Protected Securities (TIPS) – as they do from gold. In case of a sudden fall in the value of the dollar and a corresponding rise in the US price level, TIPS will pay a bonus to investors in proportion to the rise in the US Consumer Price Index (CPI). During the past 15 years, the co-movement of gold and TIPS yields has been a remarkably high 85%.

But TIPS and gold diverged on three occasions. The first was the Lehman bankruptcy of 2008, which touched off the global financial crisis. The second was the near bankruptcy of Italy in 2011. And the third, and most extreme, occurred in the aftermath of the Ukraine war.

At about $1,970 an ounce, gold is now $437 “rich” to TIPS, as the above chart shows. The sharp rise in US yields during the past two months would have toppled the gold price under normal circumstances. But the seizure of central bank assets by executive fiat is far from normal. Gold is trading right around its all-time high point despite the rise in interest rates.

Another way to view the same data is in the form of a scatter chart of gold vs the 5-year TIPS yield. Today’s gold price, as noted, is $437 above the regression line.

One used to read about the demise of the dollar in the newsletters of coin dealers and monetary cranks. But now the most conventional of all commentators, the research department of Goldman Sachs, warns that the dollar will go the way of the British pound. Economists Cristina Tessari and Zach Pandl wrote on March 30:

The Dollar today faces many of the same challenges as the British Pound in the early 20th century: a small share of global trade volumes relative to the currency’s dominance in international payments, a deteriorating net foreign asset position and potentially adverse geopolitical developments.

At the same time, there are important differences – especially less-severe domestic economic conditions in the US today than in the UK in the aftermath of WWII. If foreign investors were to become more reluctant to hold US liabilities – [for example] because of structural changes in world commodity trade – the result could be dollar depreciation and/or higher real interest rates in order to prevent or slow dollar depreciation.

Alternatively, US policymakers could take other steps to stabilize net foreign liabilities, including tightening fiscal policy.

The bottom line is that whether the dollar retains its dominant reserve currency status depends, first and foremost, on the United States’ own policies. Policies that allow unsustainable current account deficits to persist, lead to the accumulation of large external debts and/or result in high US inflation could contribute to substitution into other reserve currencies.

Credit Suisse analyst Zoltan Posznar wrote on March 7:

We are witnessing the birth of Bretton Woods III – a new world (monetary) order centered around commodity-based currencies in the East that will likely weaken the Eurodollar system and also contribute to inflationary forces in the West.

A crisis is unfolding. A crisis of commodities. Commodities are collateral, and collateral is money, and this crisis is about the rising allure of outside money over inside money. Bretton Woods II was built on inside money, and its foundations crumbled a week ago when the G7 seized Russia’s FX reserve.

What should investors do in this environment? One recalls the old Brezhnev era joke about the recommended procedure in case of nuclear war: “Put on a white sheet and walk to the nearest cemetery – slowly, so as not to cause panic.” The smart money is walking towards the exit, so as not to cause panic. At some point, the walk may turn into a run.

Follow David P. Goldman on Twitter: @davidpgoldman