More De-Dollarization!

Every few years, de-dollarization charges back above the proverbial fold in the financial pages and reclaims the macro narrative limelight.

It’s important for younger market participants to understand that the de-dollarization story (I’ll be generous and not call it a “fairy tale” this time) isn’t new. At fairly regular intervals, some event (or series of events) rekindles interest in the idea of a world where trade and finance don’t revolve around the US dollar, Treasurys and US government paper.

There’s nothing inherently “wrong” with that notion. The issue is one of practicality. As countless US politicians have noted (in some cases begrudgingly and despairingly) in the context of the ACA, it’s not a good idea to jettison a system without having a replacement — no matter how much you dislike that system. No one wants chaos.

There are innumerable reasons why it might be advantageous for the world to have a backup plan or otherwise move in the direction of de-dollarization at the margins. The US could experience an existential crisis of government, for example. Fitch hinted at that last month. Or the US could suffer some manner of natural disaster sufficiently dire to impact the nation’s capacity to serve as a political, financial and economic anchor for the rest of the world. (Don’t laugh. Because Mother Nature isn’t joking around anymore+.)

Beyond that, emerging markets have some clear incentives to diversify (the dollar-based world order means Fed policy shifts reverberate, sometimes in inconvenient ways and at inopportune moments) and the dollar’s status gives the US enormous leverage in critical geostrategic arrangements (what happens to the Saudi monarchy if the riyal peg breaks and the US stops guaranteeing the Kingdom’s security?). Dollar dominance also puts America’s geopolitical adversaries at a hopeless disadvantage in conflict scenarios given Treasury’s capacity to pull the plug in the event a country like Russia gets any “bad ideas.”

But, again, the issue is practicality. The system is the system. And to say it’d be difficult to replace (or even to compliment) with some parallel system would be an understatement of laughable proportions. That, more than anything else, is what made Zoltan Pozsar’s 2022 missives so befuddling. If anyone knows how intricate the system is, and how embedded it is in global trade and finance, it’s Pozsar. The familiar figure below is a friendly reminder that economic clout as measured by, for example, the combined GDP of the BRICS, doesn’t mean much.

You could easily argue (as I have) that the only thing capable of dislodging the dollar is a war that America loses decisively, a change in America’s system of governance or, again, a natural disaster that sets the US back several centuries. Empires can fall overnight, but they can also last a very long time. We tend to lose track of this, but America is a very, very young country. Pax Americana is a mere 70 years old. Pax Romana lasted three times that long.

If you follow the evolution of Pozsar’s thinking on this, you know he’s focusing more and more on central bank digital currencies, and the idea they’ll allow direct exchanges between countries, obviating the need for superfluous dollar- or euro- conversion. While feasible, the question at the end of the day is simple: What are you ultimately going to do with those other currencies? Let’s say you sell some gas for rupee. Now what? What if you need to import a bunch of Western medicine? How are you going to pay for it? Not with rupee. If you have to convert your rupee back to dollars (or euros) then what was the point?

Pozsar recently suggested those sorts of fringe arrangements (so, basically bartering your scrip, domestically-produced goods, natural resources and so on, for someone else’s scrip, goods and natural resources) might help nations preserve their “precious” hard currency reserves so that when they do need medicine or other key imports, the money is there. Here’s a quote to that effect from the transcript of a recent interview with Bloomberg’s Odd Lots podcast:

I think there [are] also a number of other headlines which are important to keep an eye on because individually they might not sum up to much, but in totality, probably pinpoint a trend. You know, Ghana and Russia basically had an oil-for-gold deal whereby Russia ships oil to Ghana and Ghana pays gold for the oil that they receive. I mean, the basic idea was that a country that uses FX reserves, US dollars mostly that also mines a lot of gold, it’s kind of pointless for them to spend their precious dollars on oil when they can just swap gold for oil and kind of get their oil that way and then they have, you know, FX reserves left for other stuff. You know, pharmaceuticals for example.

But there’s something self-defeating about that in the context of the de-dollarization debate: It basically says the only reason for setting up alternative trade arrangements is to protect dollar- and euro-reserves countries might need. A new system lets a country pay for pharmaceuticals and other key imports in something other than dollars (or other hard currency) so that in the event of friction with the West, countries can’t simply be starved out.

And that’s to say nothing of the fact that not everybody who might benefit from such fringe arrangements mines gold. What if I want to set up a deal for Russian oil but all I have to trade for it are — I don’t know — coffee beans?

As for the idea that the BRICS might set up a basket comprised of their currencies, commodities and so on, and swap units of that basket on a distributed ledger (i.e., “BRICS coin”), I’m compelled to suggest that’s far-fetched. How would you redeem one of those units if you wanted to? What would you get? A gift basket with a renminbi bond certificate, three rubles, a pound of Brazilian sugar, a quart of oil and a card that says “Thank you for using BRICS coin!”?

Anyway, JPMorgan’s Marko Kolanovic weighed in this week on the de-dollarization debate as part of a longer missive documenting recent geopolitical shifts and what they might mean for markets. It’s not uncommon for my preambles to end up longer than the analysis I meant to editorialize around, and this piece is no exception. So, consider everything said above the context for Marko’s comparatively brief comments below.

Via Marko Kolanovic

In the context of recent geopolitical shifts, there has been a lot of talk about de-dollarization of the global economy. We believe that in the next crisis, USD will most likely strengthen, and the potential decline in global use of USD will be a more gradual and complex process in which geopolitics will indeed play a big role. A likely goal of competitors and adversaries of the US is to remove its so-called ‘exorbitant privilege’ — the benefits the United States has due to its own currency being the international reserve currency. For emerging powers, that is essentially a risk of their trade surplus and reserves invested in USD assets being used against them or even possibly seized in an extreme scenario. De-dollarization risk is not that all of a sudden emerging powers stop using USD or even replace it with some new, perhaps commodity-based joint currency. Rather, de-dollarization risk for Western economies mostly relates to inflation and their debt burden. Historically, imported deflation via trade with the global South and East, outsourcing less profitable segments of economy, recycling of trade surpluses into USD assets, and domestic energy independence (US shale growth), were key ingredients to the USD supremacy. Imported deflation and debt demand has allowed Western central banks to successfully navigate every recent economic crisis with a combination of monetary and fiscal measures. In a world of economic de-coupling or outright conflict and more expensive energy, all of these should be at risk, and could trigger inflation and a debt spiral for Western economies. The recent US debt downgrade is a reminder that, albeit low, there is a risk of such a scenario. This risk is magnified by environmental ‘arbitrage,’ where carbon intensive industries such as manufacturing, commodity production, etc., were outsourced to the East, leaving the West industrially fragile and susceptible to inflation shocks. Some of this manifested the past year, e.g. with an inability to produce enough natural gas, cheap food, or artillery shells.