May 28, 2024

Can de-dollarization trigger global financial reset?

Is dollar getting weaker?Is dollar's dominance in question? Can China and India fill in the gap?

In the past several decades two trade blocks i.e. Russia – European Union and the other famously known as Chimerica flourished and witnessed enormous synergies (the term Chimerica was coined for America and China basis symbiotic relation between the US and China). 

It was a win-win preposition for the US, China, Europe and Russia. While Europe was largely dependent on Russia for soft commodities, metals and energy (oil & gas) imports, the US helped China to get affiliation of WTO in early 2000 and since then literally outsource its manufacturing to China. Post recent Russia – Ukraine conflict the geo-economic dynamics of these trade blocs have fallen apart and the consequences of the same are even more evident now. 

Rarely a diplomat is as vocal as the EU top diplomat Josep Borell, who mentioned in his speech:

“We delegated our security to the United States. Russia and China provided the basis of our prosperity by providing cheap energy and cheap goods. This is a world that is no longer there”.

Josep Borell, High Representative of the Union for Foreign Affairs and Security Policy

At the very start of 2023 with the US banking crisis we got a glimpse of what is in store possibly for the future. The developed markets are behaving like once fragile emerging markets. Furthermore, in recent FOMC minutes FED staff projected a “mild recession” starting later in 2023. 

The West, after four decades had to face consequences of high inflation and high interest rate regime, leading to first visible casualty in terms of run-on banks saga unfolding and losses due to mark to market bonds. 

For now, Silicon Valley Bank, Signature Bank and many such banks are taken care of by the FED by giving them access to liquidity windows. Bigger questions to figure are:

  1. How will the US government fund ~5% interest rate on $31 trillion debt ?
  2. Who has absorbed/ accounted/ unaccounted MTM loss on $31 tn debt in the last 9 months? How many are swimming naked?
  3. FED reserve equity will turn negative due to losses on its bond portfolio. Powell said FED can pay bills with negative equity/have negative income
  4. Can the FED have negative equity? It’s a Central Bank of $ which is the world’s reserve currency and can press a button to print dollars endlessly even if it means at the cost of the rest of the world.

Dollar status in question

It is estimated that the printing cost of a 100 $ bill for US FED is just 17 cents. All this while the US has been printing currency at will. Thanks to President Nixon’s policies of 1970’s due to which $ enjoys reserve currency status and can afford endless printing money:

1971 – $ debasement from gold standard was treachery leading to ponzi fiat currency that is not backed by anything which became reserve currency due to 1973 petrodollar agreement between US and middle east (Oil for security) compelling OPEC nations to invoice energy trades with the rest of the world in dollar.

The nations with surplus dollar reserves used to invest back in US treasuries and this cycle continued. With this cycle the rest of the world has been funding the US lifestyle and paying heavily for the socialistic freebies of US citizens – pension, medicare, education etc (it’s called dollar privilege).

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Whoever challenged to change the oil trade invoicing to euro or gold in the past for e.g. Saddam Hussain or Gaddafi met their fate.

Incrementally nations are realising that all real things, hard commodities should be valued much higher in dollar terms or dollar must go much much lower (as Zoltan Pozsar of Credit Suisse quotes that Russia has been teaching collective west that currency is not just piece of paper printed out of thin air but is precious metals, agri commodities, energy – oil & gas).

Crisis emerged from US that rest of the world had to cope with: 

  • 2001 – dotcom bubble bust was the first big lesson for rest of the world that was wasted
  • 2008 – Global financial crisis was patched and band aided
  • 2020 was abusing the system (US debt/GDP) > 120% and printing money leading to hyperinflation and high interest rate
  • 2023 -2025 is a reset period most likely

De-dollarization is a reality 

After World War II, in an interesting sequence of events, the British pound was replaced by the dollar as the reserve currency of the world. Dollar has been weaponised over the past years- a recent reference to freezing of Russia’s dollar reserves has worked like a moment of realisation for most of the countries with dollar reserves.

Incrementally other nations do not want to run the risk of US sanctions hence the quest for new reserve currency. It is not an impossible task given that once a colonial power Great Britain’s pound sterling also lost its reserve currency status to dollars. 

It’s about time for a reserve currency out of the emerging market – more likely a BRICS currency backed/ pegged against a basket of commodities and currencies is an answer to fiat dollar. There are more than 12+ countries willing to join the BRICS association. 

While certain countries like China, India, Bangladesh, UAE, Saudi Arabia, Russia have already started by-passing dollar invoicing and referencing of some of their important large international trades and worked out a mechanism to settle trade in non-dollar currency.

BRICS is more likely to discuss the formula of BRICS currency and its pegging formula at the forthcoming summit at South Africa in August 2023 that will usher in an era of fiat currency vs. commodity backed currency.

BRICS nations

  • Putin on BRICS currency “the creation of an international reserve currency based on a basket of currencies of our countries is being worked on”
  • Brazilian President Luiz Inacio Lula da Silva ” Why should every country be tied to dollar for trade? Who decided that the dollar would be the world’s currency? Why can’t a bank like BRICS bank have a currency to trade between Brazil & China, between Brazil and other BRICS countries.”
  • The New Development Bank of BRICS is committed to shift 30% of loan book/debt to Member currencies to cut out the US dollar.
  • The UAE and India are in talks to use rupees to trade non-oil commodities in a shift away from the dollar, according to Reuters. 
  • Indian refiners have begun paying for most of their Russian oil purchased via Dubai-based traders in United Arab Emirates dirhams instead of US dollars.
  • Bangladesh and Russia agreed to use the yuan to settle payment for a nuclear plant Moscow is building in the South Asian country.
  • For the first time in 48 years, Saudi Arabia said that the oil-rich nation is open to trading in currencies besides the U.S. dollar.

China’s move

What is China, once known as the factory of the word, really up to ?

After Xi-jinping took full control of communist party in Oct 2022 by filling up a new politburo with Xi’s inner circle and ousting old comrades like Li Keqiang, who was premier and Wang yang from the committee and escorting Hu Jintao out of the meeting. The old comrades were said to be pro-exports models and pro-west.

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Xi-jinping and his new politburo is said to be anti-exports and inclined to boost internal consumption …why?

It took China 40 years of global manufacturing to build up a dollar reserve of $3 trillion. The US in just one year during the 2020 pandemic printed and distributed US$ 13 trillion among its citizens: $5.2 for COVID + $4.5 for quantitative easing + $3 for infrastructure.  

China has been vocal about the single handed dollar hegemony that it has started orienting its domestic audience on US hegemony and its peril so much so that the Ministry of Foreign Affairs of the People’s Republic of China has made it official on its website

Xi is trying to boost domestic consumption and wants to go back to festivals and announced an increase in the number of days of celebration to push up economic cycles. Festivals typically improve domestic consumption and spending cycles. China is also reversing its decades old one child policy and increasing the birth rates.  

It has set up Shanghai Petroleum and Natural Gas exchange and incrementally is insisting on settling trades with middle east countries in yuan with intention to promote petroyuan. Meanwhile PBOC has started buying gold with gusto.

India’s move

How is relatively silent India preparing itself for de-dollarization? 

India made changes in its foreign trade trade policy since last year to promote rupee settlement with countries and banks from 18 countries got nod to trade in rupee from Reserve Bank of India. 

Some of these countries include Germany, Israel, UK, Singapore, Malaysia, New Zealand, Mauritius.   

Bilateral trade agreements

The choking of Russia was a wakeup call to the nations on the earth and India was first out of the paddocks to start bilateral trade agreements skipping the US dollar.

Unified payment Interface (UPI)

When the Ukraine war broke out Russia was kept out of the SWIFT system which is an interbank system for inter country settlement. India has so far signed MOUs with 13 countries to integrate UPI that can potentially by-pass Swift system.

India’s precious metal imports have gone up significantly. Its aggregate of private and government holding of gold put together is highest in the world, estimated at ~25000 tons. Additionally, since last year it started emptying the LBMA and Comex vaults of silver by taking physical deliveries like never before. 

In 2022 alone India has imported 9450 tons of silver. Precious metal reserves have always been important in switching the reserve currency.

US to restore manufacturing, fund massive deficit with weak $

Emphasis on re-industrialisation of the US is perhaps as it has gauged that the supply side inflation problem will continue for west and will only mellow down temporarily in the short term due to high base effect. But in the long run China, India and other EM countries refuse to export deflation and import inflation from the West as they have been doing since the 1970s. 

Meanwhile, the rest of the world will demand more realistic value of its commodities from the west and settlement of trade in non-fiat currency which cannot be printed out of thin air.

Dollar depreciation much faster than inflation is also the only way out to fund massive US deficits. Rest of the world will need a big incentive in the form of high rates and a weaker dollar to buy and hold US assets again.

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Some of the countries have even stopped investing in US treasuries for instance China had already stopped buying US treasuries since 2014, Saudi Arabia is now buying real assets and investing in its own economy. While US banks are losing deposits to money market funds so they will not have incremental deposits to fund ever expanding U.S. deficits.  

With intention to industrialise itself, the US introduced inflation reduction act to present itself as a viable option for industries finding Europe operations unviable due to energy security issues and high cost. 

For the US to kick start manufacturing, which it is trying to do at the cost of its allies like Europe, Taiwan and South Korea will require massive capital investment, weak dollar to be competitive against countries like China and India and low labour inflation.

Lastly, the FED pivot in interest rate or a pause in hike will only weaken the dollar more. 

Final thoughts

The global financial reset lead by de-dollarization will have following implications:

  1. The mounting debt of US with lower demand for dollar due to de-dollarization, countries reducing exposure to US treasuries and increasing bilateral trades (non-dollar) among countries can trigger a big reset: 
  2. This time if the US prints more currency out of thin air it won’t be able to transfer the cost to the rest of the world. Instead it will be hyper inflationary for its own citizens.
  3. Empirical evidence suggests that whenever interest expenditure of an empire has exceeded the defence budget, it has marked the end of their dominant position. This has happened in the past with Spanish, Dutch, Ottoman and British empires. Current circumstance suggests similar fate for US given its high debt and elevated interest rate 
  4. For US industrialisation to succeed and its goods to be competitive the US will have to cut down its labour cost. Trim social benefits of US citizens (like recently France did pension reforms) along with cuts in its defence spending.
  5. BRICS+ will set the new multipolar order. Gold-as-settlement-medium concept is returning. Argentina, Iran, and Algeria have formally applied to join the extended BRICS bloc, and according to the foreign minister of Russia, Sergei Lavrov, other nations that are interested “include Egypt, Turkey, Saudi Arabia, the United Arab Emirates, Indonesia, Argentina, Mexico, and a number of African nations”.  
  6. Commodity prices particularly precious metals like gold and silver will realise higher value as the BRICS arrive at a formula to peg its currency against hard commodities and basket of currencies.
  7. Nations and sectors (service and export sectors) with high dependency on west for its growth will go through temporary pain during the transition period and will need to re-orient its economy. Possibly the reason why China is re-orienting its population away from export-led growth to internal consumption policy like India has always had.

The global financial reset driven by de-dollarization is likely to have significant implications, including mounting UUS debt, reduced demand for the US dollar, and increased bilateral trade among countries.

This could trigger a big reset, with potential hyperinflation for US citizens if the US prints more currency out of thin air. The current circumstances suggest that the US may suffer a similar fate to past empires whose interest expenditure exceeded their defense budget. 

To succeed, the United States may need to cut labor costs, trim social benefits, and reduce defense spending. The BRICS+ countries will likely set the new multipolar order, with gold-as-settlement-medium returning and commodity prices, particularly precious metals, realizing higher value. However, nations and sectors heavily reliant on the West for growth may experience temporary pain during the transition period and need to re-orient their economies.

By Nilay Mehta

Nilay H. Mehta has over 15 years of experience in various wealth management advisory and asset management roles. He is financial advisor and trend watcher in global and domestic macro-economics and strategy. He has a comprehensive understanding of asset classes and their application in structuring investment portfolios, as well as extensive expertise in financial product research.

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