Perspective on Risk - Apr. 12, 2022 (Pt. 2)
Welcome back. We concluded Part 1 with the following observations:
Since 2000 the share of the dollar in global reserves has fallen from 70 to 59 percent in 2021.
[T]he shift out of dollars has been in two directions: a quarter into the Chinese renminbi, and three quarters into the currencies of smaller countries that have played a more limited role as reserve currencies.
Lots of people are talking about this as a turning point in world history and possibly in the economic order.
The current regime is Eurodollar centric and is based on recycling: banks create eurodollars and OPEC and China buy U.S. Treasuries with eurodollars.
There is an asymmetry between the financial system that remains spectacularly euro-dollar centered and the new multipolarity of power, trade and economic activity.
Covid supply chain disruptions, the ongoing frictions with China and the recent sanctions against Russia are causing policymakers and pundits to question the existing regime to address the asymmetry.
This is ultimately a geopolitical issue.
Western Currencies Have Been Increasingly Weaponized
Typically, when we think of sanctions, we think of the US action against N. Korea, Venezuela and Iran. But the use has been broader than general awareness
Is The World Deglobalizing?
Yes, but only moderately to date.
Adam Pozen notes that there are several dimensions to globalization, not just trade levels:
There were longer term forces at work. Basically since 2000, the US has been withdrawing from globalization in contrast to this image of globalization being irreversible; the US has been doing less immigration, less trade, less trade deals, less foreign investment
Magnus adds:
I keep bumping into people who say it can't happen because the level of interdependence between Western economies and China is so high. But it is happening. Look at the self-reliance strategies in China, look at the regulatory and legal systems, the laws that are being passed to promote state-owned enterprises. Or take data management, the bifurcation of digital standards, which means European and American firms in China have to develop separate systems, one that works in China and one they are more comfortable with. The same is true in innovation, research collaboration, as well as in aspects of trade.
Pozen notes:
What is going to decouple very quickly is the issue of technological standards, openness of ideas, business networks, and soon cross-border investment. And those are things that are more important for the long-term than trade.
What Are The Incentives to Create This Multi-Currency World?
Michael Schuman believes the world is already splitting in two. He writes in the Atlantic:
The Russian invasion of Ukraine and a series of COVID-related shutdowns in China do not, on the surface, appear to have much in common. Yet both are accelerating a shift that is taking the world in a dangerous direction, splitting it into two spheres, one centered on Washington, D.C., the other on Beijing.
China’s leaders have already been unwinding their ties to the world. In recent years, Chinese President Xi Jinping has set in motion policies aimed at creating a new Pax Sinica—an altered world order built by Beijing.
He (Xie) has taken steps to decrease his country’s reliance on (and thus vulnerabilities to) the U.S. and its allies, stressing a “self-sufficiency” campaign to ensure that China controls the production of items key to the economy by securing supply chains and replacing imports with homegrown alternatives, including microchips and jumbo jets. His Belt and Road Initiative (BRI), ostensibly a development program to build infrastructure in needy nations, is in reality designed to promote Chinese political and business influence in emerging countries and bind them to China through trade, finance, and technology.
Technologically, the lines are being drawn more starkly. China has already separated itself from the global internet with the Great Firewall and is investing heavily in its own chip, AI, and electric-vehicle industries to overtake the technological leadership of the U.S. and its friends in Europe and Asia.
Magnus agrees stating:
They released this 5500 word statement about the bond between the two countries, united against the US, NATO and the West. That geopolitical bond is important, because Xi and Putin share the view that the time is right to act in a peacock-like fashion on the world stage. They are convinced that the US is weak and will inevitably decline. In that sense, I think it’s an error to see China as a neutral party. They have repeated Russian propaganda about the war, including false assertions as far as we know about Ukraine having biochemical weapons.
Xi Jinping and Wladimir Putin have met 38 times, which is more than Xi has met any other head of state. … The climax of this coziness was the meeting of Xi and Putin on February 4th in Beijing, before the opening of the Winter Olympics.
Schuman essentially argues that the geopolitical incentives to disentangle, which were already in place, have gotten stronger:
Economically, too, Beijing and Moscow are looking to each other to decrease their reliance on the West and its allies: China has long sought to wean itself off the dollar, an exercise Russia is undertaking in real time.
This great disentangling may never become a complete divorce. … Unlike the Cold War, when the U.S. and Soviet blocs were clearly delineated, the two segments of the coming world will likely remain somewhat connected.
Magnus notes:
The way the West has sanctioned Russia, including its central bank, sends out a strong message to China that they must sanction-proof their economy and their financial system – if indeed they can, which is questionable.
China wants to de-americanize its supply chains, just as the Americans want to de-sinify theirs.
Going forward, there are many companies in the business of advanced technology products that will be much more drawn into the crosshairs where they could be at risk of having to satisfy two masters and they cannot predict how their supply chains will be impacted even if one component is affected somewhere in the supply chain. It could have dramatic effects on their manufacturing capabilities. So I think the drive to de-sinify or at the very least to diversify supply chains, will be much stronger in years to come.
What are the Obstacles?
China and Russia have major areas of strategic competition, primarily in the ‘stan countries. Magnus notes:
[T]here is a latent distrust between them, there are elements of friction over the Central Asian republics and China’s commercial interests in the Russian Far East for example, but all in all, they have been cozying up for several years. Bilateral trade between them is minimal if you compare it to China’s trade with the EU or the US, but it has grown from a few billion dollars in 2010 to about 150 billion dollars in 2021.
Russia’s economic role in the region is eroding, and It has come to look with both angst and ambition at Chinese economic activity in the Russian Far East too, where competition with China is rising. Russia has also come to resent a loss of control in the functioning of the main regional organisation – principally about security – the Shanghai Cooperation Organisation (SCO). Set up in 1996, the SCO now comprises China, Kazakhstan, Kyrgyzstan, Russia, Tajikistan, India, Pakistan and Iran. It is a large grouping, representing about three-fifths of the landmass of Eurasia, two-fifths of global population, and about a third of world GDP. … [I]t’s hard to escape the conclusion that it’s essentially designed to enable China to be the principal beneficiary as it seeks, at Russia’s expense, to bring its own coherence and influence to bear on the organisation’s and region’s governance.1
China has an internal tension between its political goals of supplanting the US, and its economic goals of becoming wealthy
There is a huge tension in China’s position, because politically, Xi is committed to Putin for as long as Putin does not become excessively toxic. At the same time, it’s in China’s economic interest to back away from Putin and to avoid all risk of being sanctioned. Don’t forget that China’s rise over the last thirty years has been heavily contingent on its access to an open global economy. China is in an awkward position. They politically need to support Putin, but economically they need to back away from him.
How Are The Economic Blocks Emerging? What Are The Teams?
Pozen summarizes:
The sides are pretty clear that the US, Australia, Japan, Singapore, potentially Canada, UK - they’re all going to be on side democracy - free market. Then there’s going to be China and Russia and Pakistan and maybe some states that feel very dependent on China in the other camp. An then Europe will be mostly, but not completely, aligned with the US - and that’s both good and bad. … Finally there is going to be some wildcard players; India most notably, Brazil, Indonesia, S. Africa.
This can also be seen in quotes compiled by the FT:
The South African president is not alone in pursuing a “balanced” position to the war. “We will not take sides. We will continue being neutral and help with whatever is possible,” Brazil’s Jair Bolsonaro said after Russia invaded Ukraine. Mexican president Andrés Manuel López Obrador also declined to join the sanctions being imposed on Russia. “We are not going to take any sort of economic reprisal because we want to have good relations with all the governments in the world,” he said.
…
India, a country which is eager to maintain the independence of its foreign policy, has been flirting with the idea of providing a payments backdoor to Russia.2
Will Deglobalization Cause The Decline of the US Dollar?
Pozen:
It’s possible, but I don’t think that it will happen any time soon. The flip side is that if we are in a more geopolitically divided world you’re not sure you want to put your money into China because you’re not sure you are going to be able to get it out either. So until there is some viable alternative to the dollar that looks less capricious and less subject to political risk, the dollar is going to remain on top.
The traditional view of central bank foreign exchange reserves is that they exist to pay for external obligations, whether these are foreign-currency denominated debt or to fund necessary imports.
However, the Eurodollar-recycling view of the world would suggest that, at least to a degree, the trade-based reserves are driven from the demand side. It was Western demand for oil, combined with security guarantees and an open capital account with strong underlying legal certainty that encourages the use of the USD as the reference currency for trade. And once a country agrees to be paid in the currency of the buyer, then it makes sense for them to denominate their imports in a similar currency to minimize risk.
To the extent that the world bifurcates into Poszar’s two triangles, the rise of the RMB will depend on China 1) providing a greater degree of certainty about ‘recycled’ investments, and 2) becoming a greater source of end demand.
In the context of the Russian sanctions, the fact that we essentially confiscate sovereign reserves has narrowed the difference in investment certainty between the US and China, though how much this has narrowed remains up for debate.
As Poszar notes on the Odd Lots podcast:
I also get it that China has a closed capital account, and people like to have open capital accounts, but for Christsakes, what's the difference between an open capital account that ex-poste can be shut in the case of the CBR, versus a closed capital account that you know, that overtime is going to open up.
Similarly, China continues to rise as a source of end-demand relative to the rest of the world.
Again, Poszar’s way of expressing this is:
The more trade the rest of the world is invoicing to China in RMB, the rest of the world is to accumulate RMB surpluses.
And this, at the margin, will affect the USD and Eurodollar market.
So now, if all of a sudden, somebody starts to price things in rubles, somebody starts to price things in RMB, the creation of Eurodollars on the margin is going to change. I'm not saying it's going to go down, but the pace of it is definitely going to change.
So Zoltan tells a credible story; I think what is being missed, or perhaps implicitly debated, is the speed with which this will occur. Will the adjustment in reserves continue to be a gradual process (as was shown in Part 1) or could there be a more rapid change?
John McLaughlin, the former Acting CIA Director writes:
Allowing for all the uncertainties, it seems fair to say the coming year will be one in which power alignments shift dramatically — tectonically, one might say. Russia will have forfeited its opportunities to integrate productively into the world; the U.S., whatever stresses it experiences, will have gained access to new opportunities to lead and exert influence; NATO will be a revitalized alliance. And for China, it will be a year of decisions — not about the fundamentals of its system — but about how it wants to represent those fundamentals to the world, in its ongoing competition with the United States for global preeminence.
…
Putin’s invasion of Ukraine has joined the ranks of events that change the world — and change the ways we think about how nations deal with one another.
Poszar makes one more point that is important, but is not fully substantiated in his analysis. He rightfully points out that a more rapid bifurcation would change the structure of both Western and Chinese economies. And that this will change the ratio of consumption and investment in both spheres.
[W]e are basically talking about upping investment in the West at the expense of consumption, which is exactly the mirror image of the problem China has, which is they have too much investment and too little consumption.
This seems inherently correct: if globalization was, in part, about the West financing investments that had a higher return on capital in the formerly unavailable Chinese and Communist markets, the deglobalization of investments and reinvestment into the West will have lower expected returns.3
Where From Here?
Zoltan foresees a world with more supply-side shocks, relative to the pasts prevalence of demand-side shocks. He then posits that central banks do not have the tools necessary to deal with supply-side shocks (probably correct as the real, rather than financial, world is the domain of other sovereign actors):
[T]he bamboozling thing about the last few years is that central banks clearly do not have all the tools necessary to deal with shocks that originate on the supply side of the sphere of commodities and impact on the price level.
For decades the open secret has been that for all their talk about price stability, the one thing that central banks have not had to worry about is prices. Inflation was tamed. That no longer seems the case.
Of course, as is usual, former Fed officials are continuing to state that the actions they have already taken to address past issues were a bridge too far, and that having taken all these actions under their watch, the Fed should now become smaller with a more focused mandate. Witness a recent blog post from Bill Nelson:
Over the past 13 years, the Federal Reserve has consistently solved problems – whether they were partly or entirely of its own creation — by becoming larger and more involved in the financial system. That greater size and involvement has led in turn to still more problems, which the Fed has again sought to fix by expanding its reach into markets. This process has transformed the Fed from an efficiently scaled institution conducting policy with a small imprint on financial markets to a behemoth that is the largest borrower in both the unsecured and secured short-term funding markets.
…
To become smaller and less entangled in financial markets, the Fed needs to do three things: First, taper and stop asset purchases as soon as possible. Second, comprehensively review the regulations that have diminished the U.S. financial system’s capacity to handle flows of securities without government intervention. Third, contract its balance sheet (while controlling balance-sheet volatility) until the interest rate on reserve balances falls below market rates; contract further as demand for now-expensive Fed liquidity declines.4
Zoltan would argue that this proposal is too narrow, focused solely on the Fed, backward looking, and not directed to the future risks.
Summary Continued (TL;DR pt 2)
The world is already deglobalizing
Since 2000, the US has been withdrawing from globalization
The deglobalization to date has been in immigration, foreign investment, and data and regulatory standards more than trade
Both China and the West have some incentives to step back.
Xie has taken steps to decrease his country’s reliance on (and thus vulnerabilities to) the U.S. and its allies, stressing a “self-sufficiency” campaign
China wants to de-americanize its supply chains, just as the Americans want to de-sinify theirs.
Western Currencies Have Been Increasingly Weaponized; Russia is just the latest and largest
This narrows the advantage of the US vs China in the perceived safety and certainty of recycled currency investments.
Companies in the business of advanced technology products that will be much more drawn into the crosshairs where they could be at risk of having to satisfy two masters.
Economic adjustments to the balance of consumption vs investment will need to occur both in the West and China. This will affect at the margin returns to labor and capital.
The speed of this change is uncertain.
Wigglesworth, Ivanova & Smith, Financial warfare: will there be a backlash against the dollar?, Financial Times
This of course could be mitigated by policies that improved returns to capital.
Bill Nelson, I Don’t Know Why She Swallowed a Fly, Morning Consult