Forgo the dollar

NEW YORK — A staggering $18 trillion — almost equal to one year’s gross domestic product (GDP) — is the amount 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 end was still a fringe five years ago, when America’s net foreign investment was a negative $8 trillion. Now, in research reports from Goldman Sachs and Credit Suisse, one reads forecasts from the end of the dollar era.

Washington’s confiscation of Russian foreign exchange reserves appears to be a self-destructive measure given America’s enormous and increasing dependence on foreign debt. 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 and the economies of its trading partners.

In addition to the US$18 trillion in net foreign investment in the US, foreigners hold about US$16 trillion in bank deposits abroad to fund international transactions. That’s $34 trillion in foreign financing against a US GDP of less than $23 trillion. Foreigners also have tremendous exposure to the US stock and real estate markets.

Nobody – least of all China with its reserves of $3 trillion – wants a run on the dollar and dollar investments. But the world’s central banks are cautiously but steadily reducing dollar exposure.

The trickle of the dollar’s diversification could turn into a flood. What the International Monetary Fund called “the stealthy erosion of dollar dominance” on March 22 suggests a not-so-secret exit from the dollar. Unlike Nebuchadnezzar’s handwriting on the wall, the king’s soothsayers could read the message as bright as day.

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

Accounting for just 8% of world exports versus China’s 15%, the US dollar’s reserve role no longer reflects America’s economic strength. It derives in a perverse way from the rest of the world’s desire to save.

The population of high-income countries is aging rapidly. In 2001, 28% of its population was aged 50 or over; by 2040, the proportion will reach 45%. Aging populations are saving for retirement. The Germans and Japanese save almost 30% of GDP, the Chinese 44%; Americans save only 18% of GDP.

For the past 15 years, American consumers have spent about $1 trillion more on goods each year than has been earned from American exports.

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

Foreigners then invested their export earnings in US tech stocks, but also in government bonds, real estate and so on. The tech boom did far more harm than good to the US economy, turning American teenagers into risk-averse recluse addicted to smartphones and social media, and generating stock market valuations never before imagined.

The result is the largest bubble in world financial history. As the Covid-19 pandemic threatened to burst the bubble, the US government added $6 trillion to the economy as a stimulus package. That reignited the tech bubble, which explains why US net foreign investment fell another $6 trillion between 2019 and 2022 to today’s negative $18 trillion level.

The bubble is so huge that the whole world is in it, and none of the world’s major economies can emerge from it without significant damage.

China is suffering from punitive American tariffs and sanctions on technology imports, while it ships more than $600 billion worth of manufactured goods to the United States each year — almost a third more than before the Trump administration imposed tariffs in 2019 Leaders want to encourage more consumption and less saving, but cannot persuade the Chinese to consume. China therefore continues to export to the USA and saves the proceeds.

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

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

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

If long-term imbalances arise in trade, central banks can balance them out with gold transfers. Several misleading media reports have claimed that the US can prevent Russia from exploiting its gold reserves. That’s inaccurate. The US can keep Russia out of public gold markets, but it cannot keep Russia from trading gold with the central banks of India or China.

According to World Gold Council data, it is no coincidence that the same central banks that bypass the dollar funding system have bought most of the gold over the past 20 years.

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

The value of gold relative to competing US dollar assets is at an all-time high.

In normal times, US Treasury Inflation-Protected Securities (TIPS) offer investors the same protection as gold. In the event of a sudden fall in the value of the dollar and a corresponding increase in the US price level, TIPS will pay investors a bonus proportional to the increase in the US consumer price index (CPI). Over the past 15 years, the parallel movement of gold and TIPS returns has been a remarkably high 85%.

But TIPS and gold diverged on three occasions. The first was the 2008 Lehman collapse that triggered the global financial crisis. The second was Italy’s near-bankruptcy in 2011. The third, and most extreme, occurred after the Ukraine war.

At around $1,970 an ounce, gold is now $437 “rich” for TIPS, as shown in the chart above. The sharp rise in US yields over the past two months would have taken gold prices down under normal circumstances. But executive order seizures of central bank assets are anything but normal. Gold is trading around its all-time high despite rising interest rates.

Another way to view the same data is in the form of a scatterplot of gold versus the 5-year TIPS yield. As mentioned earlier, gold price today is $437 above the regression line.

Coin dealers and money maniacs used to read about the decline of the dollar in their newsletters. But now the most conventional of commentators, Goldman Sachs’ research department, is warning that the dollar will follow the pound’s path. Economists Cristina Tessari and Zach Pandl wrote on March 30:

The dollar today faces many of the same challenges that sterling faced at the beginning of the 20th century: a small share of global trade relative to the currency’s dominance in international payments, a deteriorating net external asset position, and potentially adverse geopolitical developments.

At the same time, there are important differences – notably the less severe domestic economic conditions in the US today than in Britain after World War II. If foreign investors were reluctant to hold US debt – [for example] due to structural changes in world commodity trading – which could result in dollar devaluation and/or higher real interest rates to prevent or slow dollar devaluation.

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

The bottom line is that whether the dollar retains its status as the dominant reserve currency depends primarily on US policy. Policies that allow unsustainable current account deficits to persist, lead to the accumulation of large external debts, and/or high US inflation could encourage 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 (monetary) world order centered on commodity-based currencies in the East that are likely to weaken the Eurodollar system and also contribute to inflationary forces in the West.

A crisis is looming. A commodity crisis. Commodities are collateral and collateral is money, and this crisis is about the increasing attractiveness of external money over internal money. Bretton Woods II was built on internal money, and its foundations crumbled a week ago when the G7 confiscated Russia’s foreign exchange reserves.

What should investors do in this environment? One remembers the old Brezhnev-era joke about the recommended course of action in the event of a nuclear war: “Put on a white sheet and go to the nearest cemetery – slowly, so as not to cause panic.” The smart money runs towards the exit, around don’t cause panic. At some point, the walk can become a run.

Follow David P Goldman on Twitter: @davidpgoldmann