Perspective on Risk - April 18, 2023 (Decoupling Update)
Central Banks Prepare For War; China Rare Earth Metal Exports; Who Pays The Cost of Decoupling? Evaluating The Threat To Dollar Hegemony; Some More De-Globalization Perspectives
Central Banks Prepare For War
Kidding. Sort of. Read this speech: Central banks in a fragmenting world (Lagarde)
Read This Speech
Christine Lagarde, the President of the ECB, gave an interesting speech at the Council for Foreign Relations that didn’t get much press. I encourage all of you to read the speech, and reflect on our past discussion of Zoltan Poszar’s framework.1
We are witnessing a fragmentation of the global economy into competing blocs, with each bloc trying to pull as much of the rest of the world closer to its respective strategic interests and shared values. And this fragmentation may well coalesce around two blocs led respectively by the two largest economies in the world.
All this could have far-reaching implications across many domains of policymaking. And today in my remarks, I would like to explore what the implications might be for central banks.
In short, we could see two profound effects on the policy environment for central banks: first, we may see more instability as global supply elasticity wanes; and second, we could see more multipolarity as geopolitical tensions continue to mount.
On Twitter, Isabella Kaminska summarized her take on the speech fairly bluntly.
there's a war coming, and you're either with us or against us.
this is going to be inflationary and there may even be temporary supply-side disruptions.
dollar hegemony has allowed the US to completely dependent on imports for at least 14 critical minerals & Europe depends on China for 98% of its rare earth supply. Supply disruptions on these fronts could affect critical sectors in the economy such as the auto industry & its transition to EV production
sanctions may have eroded dollar neutrality and undermined confidence in the property rights that back the dollar system.
Central bank independence is probably going to be counterproductive at this point and aligned cbanks would be better off supporting each other out when needed
we have one shot not to become the USSR circa 1990, and we need to focus on throwing every remaining bit of capital we have at achieving energy and manufacturing independence.
we can't depend on the private sector to achieve the realignment so we're going to manage the economy centrally in a coordinated way to achieve escape velocity.
We're heading into a new space race type situation - and we're hoping we (the west) can innovate our way out of the problem more quickly than the competition.
about 40-50% of US short-term assets are in the hands of governments which have a huge bearing on "the fundamentals" (i.e. commodities).
central banks will become strategic capital allocators in their own right, and not just through swap lines.
We won't be able to compete or economize enough in terms strategically focused capital allocation unless we (at least temporarily) resort to the same sort of lengths authoritarian regimes are prepared to go to. Notably CBDCs.
China Rare Earth Metal Exports
Directly following up on Lagarde’s concern (see bullet #3 above), and in reaction to US prohibitions on the export of high-end chip technology, China Plans to Ban Exports of Rare Earth Magnet Tech (Japan News)
China is considering banning the export of technologies used to produce high-performance rare earth magnets deployed in electric vehicles, wind turbine motors and other products, citing “national security” as a reason, it has been learned.
Beijing is currently in the process of revising its Catalogue of Technologies Prohibited and Restricted from Export — a list of manufacturing and other industrial technologies subject to export controls — and released a draft of the revised catalog for public comment in December. In the draft, manufacturing technologies for high-performance magnets using such rare earth elements as neodymium and samarium cobalt were added to the export ban.
China is estimated to hold an about 84% share of the global market in neodymium magnets and an over 90% interest in samarium cobalt magnets.
If China bans the export of such technologies, it would be difficult for the United States and Europe, which do not traditionally manufacture rare earth magnets, to newly enter the market, thus making those countries totally dependent on China, according to a European source.
Who Pays The Cost of Decoupling?
How Much Does Deglobalization Cost? (Interconnected)
I highlighted Kevin Xu’s Substack before in talking about the cost of decoupling from China, specifically the cost of building TSMC’s semiconductor foundry in Arizona. He listened to TSMC’s quarterly earnings call where they state:
“We're not able to share with you a specific cost gap number between Taiwan and U.S., but we can share with you that the major reason for the cost gap is the construction cost of building and facilities, which can be 4 to 5x greater for U.S. fab versus a fab in Taiwan.”
Evaluating The Threat To Dollar Hegemony
In past Perspectives, we have discussed the various views on the threat to USD dominance. Some are asserting this could happen quickly, while others are strongly discounting that idea.
I think the best way to consider this risk is through the lens articulate by Hyun Song Shin in his OddLots talk (specifically starting at 23:44)/ Here he outlines several roles (or steps) for a currency:
Invoicing transactions
Trade Financing
Investing and borrowing
Currency hedging
Each of these is reinforced by the other, and the dollar’s role in invoicing is far beyond the US’s trade position.
Invoicing
From this perspective, it is logical for China and other countries to seek to invoice transactions in non-dollar currencies. Information on invoicing is very hard to come by: for instance, I have been trying to understand how South American agricultural trade with China is invoiced? Is it in Real and Peso, Yuan, or dollars?
With this in mind, there have been recent press on a desire for Russia, China and others to invoice transactions in non-dollar currencies. Here are four stories that highlight the difficulty of moving off the dollar, the key being the unwillingness of counterparties to accumulate large sums of alternative currencies for investment.
First, for instance, Russia is selling oil to India. India is willing to pay rupees, but reportedly Russian refiners don’t want to hold ruppees, so the transactions are being invoiced in United Arab Emirates dirham, which are pegged to the dollar.
Another example: Exclusive: China's CNPC set to seal mega Qatari LNG deal -sources (Reuters)
China National Petroleum Corp (CNPC) is close to finalising a deal to buy liquefied natural gas (LNG) from QatarEnergy over nearly 30 years from the Middle Eastern exporter's massive North Field expansion project, three people with knowledge of the matter said.
"CNPC has agreed on the major terms with Qatar in a deal that will be very similar to Sinopec's," said a Beijing-based state-oil official who declined to be named as he is not authorised to speak to the media.
A third story: Iraq-China Trade to be settled in Yuan (Iraq-Business News)
The Central Bank of Iraq (CBI) said on Wednesday that it plans to allow trade from China to be settled directly in yuan, in a renewed attempt to stabilise the value of the Iraqi dinar.
In a statement, it said foreign trade financing will be conducted through direct channels in China using the Chinese yuan currency.
Sounds like a trade of convenience for both sides. Pettis notes there is less here than meets the eye.
Finally, in Brazil’s Lula calls for end to dollar trade dominance (FT)
Brazil’s president Luiz Inácio Lula da Silva has called on developing countries to work towards replacing the US dollar with their own currencies in international trade, lending his voice to Beijing’s efforts to end the greenback’s dominance of global commerce.
“Every night I ask myself why all countries have to base their trade on the dollar,” Lula said in an impassioned speech at the New Development Bank in Shanghai, known as the “Brics bank”.
“Why can’t we do trade based on our own currencies?” he added, drawing loud applause from the audience of Brazilian and Chinese dignitaries.
This week, the Brazilian branch of the state-owned Industrial and Commercial Bank of China settled its first transaction directly in renminbi in the country, Chinese state media reported.
Michael Pettis, however, explains why transactions will continue to be invoiced in USD (or else hedged back to USD eventually) in a Twitter stream.2
Lula's question is very much a politician's question, in other words, and not that of someone who is familiar with the global balance of payments.
He doesn't realize that what matters is not the currency in which Brazilian trade is denominated. It could be dollars, RMB, reais, euros or even Malaysian ringgits. What matters are the assets in which exporters want to to accumulate the proceeds of their exports.
For the world meaningfully to switch from dollars to RMB, exporters will have to want to hold their accumulated surpluses in RMB and, much more importantly, China will have to give up control of its monetary policy and abandon its surpluses for permanent deficits.
It is extremely unlikely that Brazilians will accumulate RMB assets in exchange for its surpluses, and even if they did, it is almost impossible that China would accommodate them. To do so would force a very disruptive political and economic adjustment on China.
Trade Finance
Trade financing statistics show that there has been some trend in invoicing and the financing of trade away from the dollar. I think it is significant that SWIFT volumes in renminbi is closing in on the Euro (sans Sterling).
Renminbi’s share of trade finance doubles since start of Ukraine war (FT)
Trade financing data from Swift, the international payments and financing platform, shows that the renminbi’s share by value of the market had risen from less than 2 per cent in February 2022 to 4.5 per cent a year later. Those gains put China’s currency in close contention with the euro, which accounts for 6 per cent of the total.
Both are, however, still a tiny fraction of the dollar’s share. This stood at 84.3 per cent in February 2023, down from 86.8 per cent a year earlier.
With The Same Facts, Some Argue De-dollarization is Quickly Happening
Stephen Jen argues De-Dollarization Is Happening at a ‘Stunning’ Pace.
Adjusting for exchange rate movements, the dollar has lost about 11% of its market share since 2016 and double that amount since 2008, they said.
“The dollar suffered a stunning collapse in 2022 in its market share as a reserve currency, presumably due to its muscular use of sanctions,” Jen and Freire wrote. “Exceptional actions taken by the US and its allies against Russia have startled large reserve-holding countries,” most of which are emerging economies from the so-called Global South, they said.
The US currency now represents about 58% of total global official reserves, down from 73% in 2001 when it was the “indisputable hegemonic reserve,” the Eurizon pair said.
Policymakers Understand The Risk Posed By The US Sanctions Regime
Technology > Geopolitics?
Barry (we’re tight) brings his usual outsider’s perspective to the question in Will Geopolitics or Technology Reshape the Global Monetary Order?
The presumption has been that geopolitics will reshape the global monetary and financial order in China’s favor. But technology may have the final say. And, if it does, it may alter that order in a very different way.
He begins by providing some more information on payments arrangements.
Russia already accepts renminbi in payment for fully 14% of its exports. Its sovereign wealth fund holds $45 billion worth of renminbi securities and deposits, and Russian companies issued $7 billion worth of renminbi-denominated bonds last year.
China has recently concluded renminbi clearing arrangements with Pakistan, Argentina, and Brazil. Just last month, Iraq’s central bank announced a plan to allow direct renminbi settlement for trade with China.
But goes on to explain how technology is driving changes beyond what geopolitics would imply. Fast payments is reducing transaction costs and financial frictions!
Rather than putting their eggs in China’s basket, other countries, in Asia and elsewhere, have been seeking to use their own currencies for cross-border payments. Singapore and Thailand have connected their real-time fast payment systems, PayNow and PromptPay, enabling customers of participating banks to transfer funds between the two countries using just a mobile number. Similarly, Bank Negara Malaysia and the Bank of Thailand have expanded their ringgit-baht direct settlement framework to enable Malaysians and Thais to make direct payments through qualified commercial banks. Five Southeast Asian central banks have signed an agreement to link their fast payment systems, bypassing the need to use either the dollar or the renminbi for cross-border transfers. And Indonesia, during its G20 presidency, established a Local Currency Settlement Task Force to identify regulatory reforms to encourage the practice.
These trends reflect not so much geopolitics as developments in technology. Because payment systems like PayNow and PromptPay are digital natives, they are readily linked, removing the need to use the dollar or renminbi when transferring funds. The currencies of these smaller countries have also become easier to hold and cheaper to trade with the rise of digital foreign-currency platforms featuring automated market-making and liquidity-provision algorithms. This, in turn, makes such currencies more attractive for payments and as a form of international reserves.
Summarizing
So what to conclude from all of this?
Russia is clearly avoiding the dollar system due to sanctions.
China is trying to increase the use of the yuan/renminbi for invoicing trade.
Moving away from the dollar is hard because counterparties (even Russians!) don’t want to have to invest non-dollar currencies. Until China strengthens its legal framework for investors, reduces its geopolitical risk, and opens its capital account, increase invoicing in yuan will likely just lead to greater swaping from yuan to dollar.
It comes down to this: Foreigners decision to safeguard their excess savings by acquiring American assets causes dollar dominance. The US has no choice but to run a trade deficit in order to give foreigners the dollars they need to acquire US assets.
The broader threat to ‘dollar dominance’ may be technology. Looks like I am going to have to write that post on central bank digital currencies after all.
The consensus seems to have moved from ‘not gonna happen’ to ‘not gonna happen any time soon.’
Some More De-Globalization Perspectives
In Whither Globalization? And What Would that Even Mean, Anyway?, Matthew Klein makes five points that run somewhat counter to the current narrative that the US is the driver of deglobalization.
For the world as a whole, economic and financial integration peaked around 2008, but this global average masks major differences among countries
In practice, China has been the main champion of deglobalization, decreasing its reliance on imports from the rest of the world, while curtailing the relative importance of the rest of the world as an export market
Despite this, China’s own rapid growth has ensured that the rest of the world has been becoming increasingly reliant on imports from China and increasingly reliant on China as an export market even as China itself deglobalizes
From this perspective, the recent shift in U.S. policy looks more like a desire for reciprocity more than anything else
Collectively, the rich democracies are far more integrated with each other than they are with China—and are an overwhelmingly large economic bloc versus the rest of the world
Brad Setzer shares a graph from Gavekal that shows China’s growing export globalization.
Tyler Cowan argues in Deglobalization Is the New Globalization (Bloomberg) that we are not per se witnessing deglobalization, but as has been our view, the formation of competing decoupled blocks.
National industrial policies aren’t a move away from a more globalized economy so much as an extension of it.
For better or worse, industrial policy is back. The European Union is placing “green tariffs” on carbon-intensive imports. The US is giving green-energy subsidies to domestic firms. Guaranteed access to high-quality semiconductor chips is a priority for various nations …
It would be a mistake, however, to think that these policies represent a move away from globalization. In fact they are an extension of globalization — and they likely will enable yet more globalization to come. …
Even the most successful “nationalistic” industrial policies rely on a highly globalized world. If carried out strictly on a one-nation basis, industrial policy is doomed to fail. Globalization has been so thorough, and has gone so well, that at least a little industrial policy is now thinkable for many nations.
[An] example of industrial policy enabled by globalization is Operation Warp Speed, as implemented during the early stages of the pandemic. The Moderna vaccine involved components from Spain, the Netherlands, France, South Korea and Switzerland, while Pfizer drew upon trade and cooperation with Canada, the UK, Germany, Belgium and other nations.
Today’s industrial policy is not an alternative to globalization. It is preparing the world for the next round of it.
Reference Resources
Global trade in 2023 (Chatham House)
I covered Zoltan’s work in lots of posts, but these three Perspectives are the core:
Perspective on Risk - March 2, 2022
http://twitter.com/michaelxpettis/status/1646571050661191680