The age of globalisation, which started with the fall of the Iron Curtain, is on the wane. For decades, the world economy became increasingly interconnected as tariffs and trade barriers were removed, business took advantage to build multi-national companies with global supply chains, and capitalism and political liberalism spread even to formal dictatorships, most importantly China. But for some time now, the direction of travel has reversed. Brexit and the elections of Donald Trump are often cited as the hallmark events, but the election of Xi Jinping in China also marked a reversal in the liberalisation of the world’s most populous nation. Now, the Russian invasion of Ukraine is accelerating the fall of globalisation, most obvious in the clamour by European nations to on-shore energy supplies.
As we have discussed elsewhere, the invasion was to a large extend Russia’s response to what it perceives as a threat to its sphere of influence in Eastern Europe. The conflict lays bare the incompatible geopolitical ambitions of Russia and the West and will force Russia’s neighbours to chose sides. A new Iron Curtain may come down in central Europe. This has far reaching consequences, not least for the global financial system which for decades has been built up around the US Dollar.
The US Dollar’s role as reserve currency is in large part due to the so-called Petro-Dollar system, the agreement struck by the US with Middle Eastern oil producers in the 1970s where the US offered military protection in exchange for a pledge to denominate oil transactions in USD. This is what allowed the US to start running large trade deficits without worrying about a dollar devaluation, as they could always find willing buyers for their debt in the USD rich Middle Eastern oil states.
But with geopolitical instability returning, the universal love for the Dollar is waning. Russia has been losing its appetite for a while. Last year, their sovereign wealth fund announced it was removing all USD assets from its portfolio, a response to US sanctions imposed after suspected election interference, cyber attacks and the occupation of Crimea. The Russian central bank has now had that sovereign wealth fund frozen and the US has prohibited USD transactions with the central bank. In response, Russia has announced that it will be demanding payment in Roubles for oil and gas sold to what it deems as ‘unfriendly’ countries and is opening up for gold or Bitcoin as means of payment. Russian banks and companies are reportedly busy opening up accounts with Chinese banks.
Russia’s experience has shown the risk of using the liabilities of a geopolitical adversary as a reserve asset. Russia, like other large energy exporters, has amassed large holdings of USD assets as it ‘recycles’ the USD it receives for oil and gas into US Treasuries. The large foreign currency reserves the Russian central bank had built up was supposed to be a hedge against a run on the Rouble but now, with the currency in crisis, the central bank finds itself impotent.
It’s a wake-up call for other countries who may find themselves on the wrong side of the new iron curtain, most importantly of course China, the largest foreign holder of US government debt, especially in the light of a potential invasion of Taiwan. With US inflation running at close to double digits, negative real yields is another reason to divest. Not only is China having to pay for the privilege of lending money to the US, negative yields could discourage oil producing nations from digging up their oil (why do it only to receive negative yielding USD in return?) and this may lead to a structural bull market for oil, a disaster for the world’s largest oil importer who relies heavily on oil to fuel industrialisation and keep hundreds of millions out of poverty. Beijing is rumoured to be in active talks with Saudi Arabia to price some of its oil sales to China in Yuan.
This could be expected to be met with anger in Washington, where it could be seen as a breach of the Petro-Dollar arrangement. But ironically, a less prominent role for the Dollar may be an area of agreement between otherwise geopolitical adversaries. For decades, the US has, enabled by the Dollar’s reserve currency status, outsourced its manufacturing, not least to China, and paid for the goods with the debt which has been building up on the balance sheets of the trade surplus nations. Though cheap imports have kept consumer prices low, the loss of especially manufacturing jobs has been a much lamented development and was a driving force behind the election of Donald Trump, who pointed out the downsides of outsourcing supply chains, both for domestic employment opportunities and national security (one supply chain which has been heavily outsourced to China is that of the US military industrial complex). Bringing manufacturing jobs back to the US could be a vote winner and would address the continuous trade deficits which will be unsustainable in the long term – you can’t live on borrowed money forever. And relying on a geopolitical adversary not only for supply chain but also for funding – remember that China is the biggest foreign holder of US Treasuries – is undoubtedly causing consternation in the Pentagon.
Giving up the ‘exorbitant privilege’ of having the global reserve currency would be a momentous change. Should the Petro-Dollar system fall, the profligate federal government will have to find other buyers for its debt. It seems inevitable that the Federal Reserve as buyer-of-last-resort will have to pick up most of the slack, which could spell a continuation of the quantitative easing programmes that are supposedly being phased out.
What, then, could replace the USD? The Chinese Yuan is some commentators’ prime candidate, as China inevitably takes over as the world’s dominant economy and the currency is gaining in importance. For example, the Brazilian central bank quadrupled its CNY holdings in 2021 and reduced USD exposure. But the CNY starts so far behind the USD that any prospect of it overtaking the role as the global currency of choice is a long way off (CNY is used is less than 4% of global transactions). China would obviously also have to relax capital controls to present a credible alternative. And importantly, in order to supply the world with currency the issuer of the reserve currency needs to run a continuous trade deficit (this is what is known as Triffin’s dilemma). But China is of course running vast trade surpluses and would have to restructure its entire economy to allow the Yuan to take over from the USD. The CNY obviously also suffers from the same issue as the USD; it is the liability of a government and as such is not politically neutral. Neither is another candidate, the IMF’s Special Drawing Rights.
What is needed is a politically neutral settlement asset. The obvious candidates are gold and crypto currencies, though liquidity is a concern; neither comes close to the USD 30bn market cap of outstanding US government debt. Russia will be happy to have built up a considerable gold reserve but though most central banks hold some gold, most maintain a relatively low allocation. This may soon change. Among digital currencies Bitcoin stands out, but China may be unlikely to embrace it; Beijing has a strained relationship with Bitcoin and has banned crypto mining in the country.
For the foreseeable future there may seem to be little alternative to the USD, but if we are seeing the beginning of a new Cold War, a less dominant role is inevitable. Change is coming to the international monetary system. The consequences could be far reaching.