Where We Stand: The present and the future of the dollar

(Business travel prevents my weekly discussion of the price action.  It will return next week, but a macro discussion is offered below). 

Economists and policymakers generally recognize that growth will be weaker than was anticipated at the end of last year. Price pressures are going to be stronger and last longer than previously projected. The supply shock has been exacerbated by Russia's invasion of Ukraine and the social restrictions in China stemming from Covid.  

With the major central bank meetings past, the highlight in the week ahead will be the flash PMI readings. The risks are on the downside.   And if those risks do not materialize, many will assume they will later. At the same time, major and many emerging market central banks feel compelled to continue the tightening cycles. The Swiss National Bank and the Bank of Japan are notable exceptions. So is the People's Bank of China, which is more likely to ease policy than tighten.  

While a recession has been a risk scenario, we worry that the odds are increasing, and it could become the base case. Fiscal policy is tightening. Monetary policy is tightening. The rise in energy and food prices acts as a large tax on consumption. It weakens discretionary spending. Russia's invasion of Ukraine exacerbates many of the economic headwinds that were already bedeviling policymakers. Some see more dangerous implications. In particular, the freezing of Russian reserves and banning trading with the central bank may hasten the dollar's demise, warn the doomsayers. Ironically, many share the perspective of Beijing and Moscow that the West is in decline. It is an old refrain. Oswald Spengler's book with that title was published in 1926.  

Indeed, many times over the past quarter of a century or so, some observers argue that the dollar's role as the numeraire-the main reserve asset, invoicing currency, and benchmark for most commodities will end. Purported successors have included the Japanese yen, the euro, the Chinese yuan, and even crypto. The argument now is that the sanctions imposed on Russia, and especially the Russian central bank, will expedite the shift away from the dollar. It sounds reasonable, and I, too, have expressed fears in the past about the implications of the broad sanction regime.  

However, the critical issue that I identified in my 2009 book Making Sense of the Dollar remains largely unaddressed. There is no compelling alternative. Europe has shown itself to be as willing to sanction Russia's central bank as America. That would seem to preclude the euro, even though the Sino-Russian multi-year energy deal announced before the war will be settled in euros, and Russia's central bank boosted its euros reserves as it shifted out of dollars.  

Even with some common bonds, the European bond market remains fragmented, yields are low.   Its breadth and depth are nothing like the US Treasury market. To move out of the dollar and US Treasury market is to give up yield, liquidity, and security. We already live in a multiple reserve currency regime. The most authoritative source of central bank reserve holdings is the IMF. Despite the handwringing and chin-wagging, as of the end of Q3 2021, foreign central banks held more dollars than ever before (~$7.08 trillion). Of those holdings, nearly half ($3.43 trillion, as of early March) are held in custody at the Federal Reserve. 

After the dollar's 59.15% share of allocated reserves, the euro is a distant second at 20.48%. It is smaller than the sum of its parts. I mean that the only legacy currencies, like the German mark, French franc, Belgian franc, etc., together accounted for a greater share of global reserves than the euro does now. The yen is the third most used reserve currency, with an almost 5.85% share. Reserves themselves are highly concentrated. The top 10 holders accounted for more than 62% of reserves. Nearly 30% of the central banks' reserves are accounted for by China and Hong Kong. The Chinese yuan cannot really be a reserve asset for the PBOC or Hong Kong. And when everything has been said and done, the Hong Kong dollar remains pegged to the US dollar. The Hong Kong Monetary Authority hiked rates 25 bp within hours of the Fed's move. 

Before Bretton Woods collapsed, a Yale economist, Robert Triffin, warned of its coming demise. The essence of the argument was that there was a contradiction at the heart of the practice of using a national currency as the dominant reserve asset. To be used as a reserve asset, the supply of the currency must increase in line with the demand for reserves. Yet as the supply increases, its credibility preserving its value decreases.

I purposely turned Triffin on his head and suggested it was precisely that the role of the euro and yen would be limited because of their current account surpluses and the lack of deep and liquid bond markets. Yet, the supply of euros and yen are also provided by governments and companies issuing euro and yen-denominated bonds. Their role as reserve assets could increase under different financial and economic conditions, but don't think a shift in the dollar's value of euro or yen reserves attacks the current system. Moreover, when the greenback trend turns lower, the dollar value of non-dollar reserves will increase by definition even central banks do not alter their allocation one iota.    

One of the things that follow from this is that many pessimistic observers who argue that Russia's attack on Ukraine weakens the international order seem to be as if looking through the wrong end of the telescope. The US-centric international order is stronger today than it was a year ago. Violating the rules and norms does not weaken the system as long as those rules and norms are enforced. It is true in sports, civil society, and geopolitics.  

What weakens the system is when the rules are broken with impudence. During the Great Financial Crisis, the Nobel-prize-winning economist Joseph Stiglitz explained that the difference between a prizefight and a barroom brawl are rules and a strong referee. When the referee or law enforcer is compromised, the system suffers. Similarly, I submit that what weakens the international system is when the US, the world's gendarme, violates the norms. It is undermined when it attacks another country without the support of the United Nations, when it threatens to pull out of NATO, or when it leaves the Trans-Pacific Partnership, the Paris Accord, and UNESCO. It's stronger when the US holds the moral high ground, helps enforce the rule of law, and lives up to  being the “beacon of hope,” its Puritan forebearer Jonathan Winthrop called “the city on a hill.”

Some US strategic objectives proved elusive through several administrations. Then in a matter of a few weeks, a few are at hand: the Nordstream 2 pipeline is all but toast, Germany and several other European countries will boost defense spending, and public opinion has shifted more pro-NATO in Sweden and Finland.  

Europe and the US are pulled together by this security crisis. Europe will have to build some facilities to turn liquid natural gas back into gas, but it will likely rely more on the US in the coming years. Similarly, consider that Germany indicated that it would replace its aging Tornado bomber jets (made by Italy, Germany, and the UK) with the 35 of the US-made F-35 Lightning II fighter jets capable of carrying nuclear payloads. Other countries appeared to send older military hardware to Ukraine with the idea to replace it with more modern equipment, from which the US producers will likely benefit.

Another observation that follows is that China's agenda has been set back. The inflationary implications of higher commodity prices that have resulted from Russia's invasion of Ukraine are not the most pressing for Beijing. Remember February CPI was slightly less than 1%. Its PPI (8.8%) has fallen for four consecutive months. Instead, the higher commodity prices are a headwind to growth. It is clear that officials have shifted their emphasis to facilitating growth from structural reforms.  

The tighter US-European relationship seems to reduce the chances that China could push a wedge between them through trade and investment.   President Xi has reportedly launched a diplomatic offensive with calls to several European leaders since the war began. At the same time, seeing the brave efforts by the Ukrainians, Japan, South Korea, and Australia maybe even more resolute in checking China's projection of power in the region and boosting their own defense spending. The speed, depth, and breadth of the public and private response to Russia's invasion are unprecedented and impressive. It would seem to raise the cost of taking Taiwan in Beijing's calculus.  

China accuses the US of building a NATO for the Pacific. The US denies this, but given the architecture, Beijing sees something else (5, 4, 3, 2): Five Eyes, the Quad, the new US, UK, Australia security pact, and several US bilateral pacts with countries in the region. The US-centric world that it chafes under seems stronger than before the Russian invasion. NATO is stronger and will possibly be larger.  

While former US President Trump threatened to leave NATO and reduce US military presence in Europe (which may help to explain why Putin did not do this in 2016-2020), the opposite is likely to be the case. Some resources the US may have wanted to commit to the Indo-Pacific region may have to go to Europe, but the means are elastic. As the pandemic winds down, some of the health dividends will go to military spending. This is true in Europe as well.  

Occasionally, talk surfaces about OPEC taking other currencies for their oil besides dollars over the last several years. A couple of weeks ago, reports noted that if the US sanctions were lifted on Iran, Tehran wanted only euros for its oil and trade. Last week, reports indicated that Saudi Arabia was considering accepting yuan for the oil it sells China.  

Such talk has surfaced before. China buys about a quarter of Saudi Arabia's oil exports. At $100 a barrel, the oil is worth about $155 mln a day. However, the amount is minor in the foreign exchange market that sees an average daily turnover of $6.6 trillion, according to the Bank for International Settlements triennial survey in 2019. Capital flows and their drivers are more important for the massive 24-hour a day foreign exchange market than trade. Moreover, China did not need to buy the dollars to purchase oil. Instead, it essentially recycles some of the dollars it earns from its record trade surplus (~$676.4 bln in 2021).   

There are other constraints. For example, Saudi Arabia pegs the riyal to the dollar. It has been a critical source of stability. Concretely, what this means is that Riyadh has outsourced its monetary policy to the Federal Reserve. That means that after the Fed hiked rates last week, so did the Saudi Arabian Monetary Authority.  

Saudi Arabia runs a trade surplus with China. What will it do with more yuan? Its companies do not have yuan loans that need to be serviced like they do the dollar.   Saudi Arabia's reserves are valued at around $440 bln. The total yuan held by central banks in reserves as of the end of Q3 last year was almost $320 bln. Saudi Arabia could boost the share of its reserves held in yuan and Chinese bonds, but the impact on the dollar in terms of price or role is likely minor at best.   If Saudi Arabia really wanted to help China, it should export more oil.  

With the yuan shadowing the dollar, the diversification benefit of Chinese bonds over Treasuries is not clear. The 10-year yield premium narrowed to almost 60 basis points last week. The premium has tightened by about 100 bp over the past year. Also, there may not be a compelling business case to accept the buyer's currency. It is not clear what Saudi Arabia receives in exchange for taking the currency mismatch and risk that it entails. Moreover, the yuan is not freely convertible.

In the Great Game of geopolitics, countries that can switch sides are often the epicenter of intrigue by definition.    The tensions between the US and Saudi Arabia are palpable.   There has been a significant divergence of interest: Yemen, Iran, and Afghanistan generated substantial differences. There is no doubt where Saudi Arabia falls in the popular US narrative of a struggle between authoritarianism and democracies. The murder of the journalist Khashoggi in 2018 seemed to be a catalyst.

The Crown Prince Mohammed bin Salman's rise is part of the weakening ties, but there is also a material basis. The US used to import 2 mln barrels a day of oil from Saudi Arabia. At the end of last year, it was a quarter of it and surpassed by imports from Russia (after Canada and Mexico). Saudi Arabia has repeatedly rebuffed US calls to boost output. Many oil producers have not made the investment necessary to increase production.   Riyadh could have forced this to be recognized and compensated for by others boosting the output to bring it to the 400k barrels a day that had been agreed upon by OPEC+.  

In summary, we are concerned US monetary and fiscal policy is becoming pro-cyclical when it works best going against the tide. The median forecasts from the Federal Reserve are not persuasive. Growth this year was reduced to 2.8% from 4.0%. The median dot raised the appropriate level for Fed funds 100 bp in March from December. Yet, the unemployment rate (median forecast) is unrevised to 3.5% this year and next. Perhaps counterintuitively, the dollar has fallen on average, according to the BIS 4% during the past four tightening cycles. The greenback's rally may have some more gas in it, but we think a significant high is near and expect it to finish the year lower than where it is as Q1 winds down.  

Despite these economic challenges, there is no need to accept Putin, Xi, and cynics' argument that America is caught in an inexorable decline. Russia's invasion of Ukraine allows the US to take the moral high ground and be an exemplary and exceptional nation. Several US strategic goals have been achieved in the last three weeks or so. Russia is isolated in a way that the Nogoodnik leader could not have imagined. Beijing may wish there was an alternative, but it knows there is not, so large Chinese (state-owned) banks appear to respect the US financial sanctions. This is not a new development, but large Chinese banks did not violate previous US sanctions, including sanctions on HK officials and companies doing Beijing's bidding. Of the myriad of problems the US and the world face now, some kind of existential challenge to the dollar is not among them.