Is the fall of the mighty dollar around the corner ?
In this article we will look at the dollar-based financial network and the alternatives to it. First, we’ll explore the function of the US debt market for emerging countries and how it has led to debt and currency crisis. Then we’ll look at the weaponization of the dollar by the US to sanction countries judged as threats and those countries’ responses to it, particularly from China. Finally, we’ll analyze the possible alternatives to the dollar-based financial system such as Libra and cryptocurrencies, and how their development could play out in developed and developing nations.
At the end of WWII, 44 nations signed the Bretton Woods agreement, establishing the U.S. dollar as the world’s reserve currency, pegged to gold. However, in 1971, President Richard Nixon took the U.S. dollar off the gold standard, allowing the United States to control the supply of its currency.
US debt market
Since then, the dollar has been the most used currency for international trades. Foreign countries can sell to each other in dollars without having exposure to each other’s (less liquid and unstable) currencies. These U.S. dollars are deposited in local banks’ accounts and then lent to local companies. Emerging countries previously contracted loans which were denominated in US dollars to fund their construction initiatives and develop their infrastructure. However, often, these loans were granted with high-interest rates and short term scheduled payments, giving them a short window in case things went south, which they often did.
The Turkish debt and currency crisis
Turkey is a great example as they contracted substantial amount of loans denominated in USD to stimulate its infrastructure and construction. However, the country’s high reliance on imports made it vulnerable to exchange rate risk. Ultimately, its excessive current account deficit, and large amount of debt led to a currency and debt crisis. How did this play out? Large current account deficits tend to devaluate the local currency as you import more than export, which in turn increased Turkey’s import prices and fed inflation. The devaluation of the currency also made Turkey’s borrowing costs increase since its debt was denominated in USD, and its primary source of revenue was generated in Lira. This situation led Turkey to re-borrow to afford payment on its principal and not declare bankruptcy. It is only offering a short-term relief because these “re-borrow” loans usually have higher interest, essentially creating a vicious circle for those economies and losing investors’ confidence in the economic capabilities of the country, creating capital flight, further devaluating the state currency. Thus, the central bank of Turkey decided to raise the interest rate and inject liquidity into the system, which hammered local companies’ ability to access the debt market, effectively tightening the economy when it needed easing the most. Easing its monetary policy would have helped the business environment at the cost of letting its currency fall. Either way, they still mainly depend on the US monetary policy.
Many more countries, especially in South America, have suffered a similar situation. Argentina, Costa Rica, Venezuela, and others had a debt and currency crisis, some have already defaulted on their debt obligation. Chile, Peru, and Brazil have suffered significant devaluation of their currency in the past two years.
US monetary policy impact on emerging countries
In parallel, the United States enjoys the benefit of having the most attractive government-issued debt, in the form of U.S. Treasury bonds, which countries use as a way to increase their savings. It has been particularly true, after a period of unusually low rates, the increase of its rates has made its debt more appealing to investors, creating a shortage of dollars and at the same time, creating an exchange rate shock for emerging countries. These fluctuations feed through the credit markets, causing surges and withdrawals of capital that can cause financial crises in these emerging markets. Euro-denominated debt does not give a reliable option to investors seeking ultra-safe investments apart from US Treasuries, as the most relevant debt, the German government bonds, are in short supply due to Germans’ aversion to debt.
Weaponizing the dollar
The weaponization of the dollar-based global financial network and the consequences it may have for the future is even more frightening than the debt market. Many countries have grown fed up about its excessive power.
The United States uses SWIFT as its dollar-based global financial network. The system enables financial institutions to send and receive information about financial transactions in a secure, standardized way. Most of the international trade around the world rely on it, thus being prevented access can be very harmful. The US sanctions’ reach is global: it uses standard sanctions to prevent its citizens from trading with any given country, but also secondary sanctions to penalize third parties from doing business with a sanctioned country.
Iran has been banned access to the SWIFT system since 2012, which ultimately put the country out of the international stage, creating currency fall overnight, hyperinflation, and goods shortages. Venezuela has been given similar sanctions, which has paralyzed its oil exports and banking system. The US has restricted Russia’s movement of money in the SWIFT system, amid possible interference in the American election of 2016 and due to recent attacks on Ukraine. Even company officials have been targeted, such as the Chinese telecoms company, Huawei’s CFO, who has been arrested for allegedly violating US sanctions on Iran and leading the US to block the transfer of technology on his company. Turkey has suffered severe tariffs on its steel and aluminum exports that contributed to its currency crisis.
Other countries had to stand by these sanctions as they cannot afford the possibility of severing their access to the SWIFT system or other US penalties. For example, upon US sanctions toward Huawei, the British chipmaker Arm had to stop dealing with the Chinese company. France, Germany, and Britain have tried to circumvent the US’s Iran restriction to SWIFT by only trading food and medicine with Iran, however abiding to all other trading sanctions, even though they had trade agreement with Iranian companies.
Ways around US sanctions and lower reliance to the dollar
The sanctions have been wakeup calls for many sovereign nations like China and Russia as an unacceptable geopolitical risk. Since then, these countries have been looking for ways to gain the capability to control their current account, balance of payment, and the ability to print their currency.
Sell of the US Treasuries
Liquidating US Treasuries holdings is one way to decrease reliance on the dollar system, which China (largest holder of US Treasuries), Japan (second largest holder), Russia, and many other countries have done in bulk. It has been primarily historical for China, as it was initially a prominent buyer of US debt by providing loans to the US, it allowed US customers to buy Chinese goods, leading to large trade surpluses. However, with increased geopolitical tensions with the U.S., China is now using its US debt holdings as a weapon against US sanctions. Essentially, if the Chinese were to dump massive amounts of US treasuries in the market, the interest rate would increase, and the dollar would decrease, affecting US imports.
This point is vital since the US relies on foreign investors to buy its debt in order to fund its operations. To put this into numbers, the US has to pay interest payments on $22 trillion public government debt, which equals to 393 billion (2019 estimates); its budget deficit of 886 billion (2019 estimates), and its US treasuries maturing, evaluated at 1.3 trillion in 2018. Thus, if these countries were to buy less (or sell) US Treasuries, it would hinder the US’s ability to pay for its operation and force it to increase interest rates to attract more investors. It creates a feedback loop where the burden of interest payment increases, the US has to print more money to pay for its debt, which devaluates the dollar and the US needs to increase interest rates to attract investors.
Trade agreement between countries
Other initiatives to bypass the dollar-based financial network have come around trade agreement. Notably, Russia, which is in talks with countries like China, Turkey, and Iran, has been developing an alternative system to SWIFT, called the System for Transfer of Financial Messages (SPFS), explicitly designed to remove the risk of US sanctions. Russia’s largest oil company Rosneft has switched from the US dollars to Euro. Japan is in the process of setting up an international network for cryptocurrency payments. India is now able to pay its Iranian oil imports with its own currency, the rupee, to avoid U.S. sanctions.
The Chinese initiatives
Perhaps, the most significant move toward undermining the dollar as a global reserve network has been the step taken by China, which has sought to elevate the role of its currency. In one front, it has been developing foreign-exchange arrangements with key countries like Canada, Britain, and Brazil, and signing bilateral swap agreements with other central banks, helping to make the renminbi available to other countries. It has recently been particularly useful with underdeveloped and developing countries such as Iran, Pakistan, Malaysia, Russia, among others, which need China’s fast-moving economic development. These countries have even started holding renminbi reserves, and in some cases, have replaced their US dollar reserves for it. Some of China’s state-owned bank has started to issue bonds partially denominated in renminbi in financial centers like London, with the Chinese’s central bank selling one-year renminbi debt to increase the liquidity of its currency, growing the role for the renminbi as an increasingly influential currency in the international debt market. Parallel to this, China has now the ability to purchase oil with its own currency, given the recent development of a trading system in Shanghai.
However, the monsters in the room are the One Belt One Road Initiative and the digitalization of the renminbi. The One Belt One Road Initiative aims to connect China to Central Asia, the Middle East, and Europe through the development of infrastructure projects, to create a new free trade area. China has already pledged approximately $1 trillion into the project and is expected to invest even more. This project could boost the inter-connectivity of these emerging markets massively to China, and prone massive growth.
In addition, the PBoC is digitalizing its state currency. Moving to a blockchain-based digital currency will likely save costs, increase velocity, and improve the convenience of transactions with the ultimate goal of supporting the circulation and internationalization of the renminbi. A digital currency, coupled with the One Belt One Road initiative, could strengthen China’s influence overseas. Chinese state-owned companies with political endorsements do most investments around the project and will be prone to use the digital renminbi for their trades, or at least offer the option. The project’s 60+ country members could increasingly be incentivized by the Chinese government (with discounts) to use the renminbi as a digital, borderless, stable currency to smooth international trade. If the project is a success and uses the renminbi as its reserve currency, the zone could become a considerable portion of the international trades, and the importance of the dollar could be negatively impacted.
Limitations of the Chinese initiatives
It is essential to note that the project is still in its infant stage and China’s autocratic leadership toward capital control and governance could raise concerns toward the goal behind the digitalization of its state currency. Indeed, the PBoC will have greater control over the renminbi, such as tracking user’s identities, controlling the money supply, and a higher degree of surveillance and power over the financial flow of the entire economy around it. These are some characteristics that many would not necessarily be inclined to abide by.
Alternatives to the dollar-based financial network
The Libra alternative
An additional inherent threat to the dollar is the development of Libra, the digital currency developed by Facebook and a consortium of other companies, to be pegged by a basket of sovereign currencies such as the dollar, the euro, the yen, among others.
It is crucial to put into perspective the massive forces that are coming with the project. Facebook has a global reach of more than 2.5 billion users the project would be extremely well funded, and Facebook Inc., having the best UX/UI designers in the world could make Libra seamless to use for anyone through its multiple apps such as WhatsApp, Instagram, Facebook, and Messenger.
Additionally, we believe that Libra, even if it is simple to use and can be acquired from already existing mobile apps, will need an ecosystem of its own, or being of use in the current economic system to be disruptive. Its usability depends on it being accepted as a medium of exchange and unit of account for goods and services. At the moment, Facebook’s interface is not a marketplace like Amazon, therefore in its current state, Facebook can put Libra in everyone’s hand, but it remains to be seen how they will make it useful, especially for developed economies.
Libra’s consequences for developing nations
In developing nations, especially the ones where the state currency is weak and unstable, such as Venezuela, Argentina, and many others, Libra might not need a marketplace where it is accepted as a MoE and UoA, as it might get more traction as a hedge against inflation and irresponsible monetary policies. Therefore, individuals in those countries might choose to hold Libra as a store of value and only convert it into the state currency when they have to buy goods and services. Furthermore, citizens in those countries are usually reliant on remittances and cross-border payments, which Libra could make cheaper, faster, and more transparent than currently available platforms such as Western Union that charges as much as 15% commission.
Note that even tough citizens of these countries might be better off for the reasons cited above, these countries could be at risk of losing some of their monetary sovereignty, as the local central bank’s control over supply and demand of its currency by adjusting interest rate could be less effective. As citizens start holding Libra as a currency hedge, the state currency supply will increase, resulting in inflation and the devaluation of assets denominated in local currencies.
Libra’s consequences for developed nations
For developed nations, it is still hard for me to see how Libra could be disruptive as its value proposition hardly offsets the friction it might create. Developed nations already benefit from a well-functioning banking system and don’t need Libra for cross-border transactions. As we move toward a more digitalized and internationalized economy where everything is bought online, goods and services could be denominated in several currencies, including Libra. As businesses are further globalized, customers and vendors could buy their goods online with some internet currency. Not putting either alone exposed to exchange rate risk, having a stable currency backed by a large basket of currency, where once the customer buys the good in Libra, the vender can use these Libra to cover its expenditures, refuel its inventory, etc., creating an ecosystem of its own. If this were to playout, and Libra were to be used at scale, countries might start holding Libra reserves, and the dollar would lose some of its allocation as currency reserve in foreign countries.
Limitations of the Libra initiative
These scenarios, for developed and developing nations, do offer a glance at what could happen if the Libra initiative is a success. At the moment, Libra still faces many regulatory risks, as it is not clear where it stands as an asset, and if it is considered a currency, the question is which entity would regulate it. In addition, being mostly backed by US corporation, Libra might only be authorized to circulate under the curtain of a political mandate and exposed to US sanctions already in place, making it only a pretender for the West and developing nations with weaker currencies. For instance, Libra is not expected to be using the yuan in its basket of currency, even though China is the second-largest economy in the world.
The cryptocurrency alternative
Finally, another option to circumvent the dollar hegemony and one that doesn’t suffer from any political mandate might by cryptocurrencies. As we’ve seen, the dollar is used as a weapon to fit US interests, and countries that don’t want to be affected by it have to abide by those sanctions. One way to forego those sanctions would be to have a currency that no single entity can control, such as Bitcoin.
Bitcoin has no barriers to entry as anyone with a cellphone can access the network and download a wallet for free. It is censorship-resistant, no government can freeze your fund or prohibit you from sending them to another address (except by using violence). Transactions are faster, cheaper, and get rid of unnecessary intermediation, facilitating financial integration. It is transparent and tamper-proof, due to its underlying technology, every transaction is recorded on the ledger and cannot be modified. It essentially decentralizes the operation of the financial system outside of sovereign state’s control, effectively reducing the leverage used by the US, as this currency is guaranteed by a protocol instead of a central entity. The list of countries implementing cryptocurrency (although centralized ones) to mitigate the impact of US sanctions is growing, with the likes of Estonia, Russia, Japan, China, and Tunisia.
Limitations of cryptocurrencies
Cryptocurrencies cannot be considered as currencies at this point, as they can only be considered as a medium of exchange but fail as a UoA and a SoV (although depending on which currency you compare it to).
Even though they offer compelling solutions and advantages compared to currently available options, countries like the US will certainly not let its ability to leverage its currency go away. Thus, having a decentralized currency as a world reserve currency or some comparable function is hard to imagine. However, as cryptocurrencies and Bitcoin become more popular, and the knowledge around them grows, they could be used as a check on monetary policy and central banks, effectively forcing accountability upon them. In that world, individuals or countries could decide to steer away from the dollar if the US’s monetary policy is irresponsible. For example, if the fight against inflation is by lowering interest rate and QE, which devaluates the dollar, is judged an unhealthy monetary environment, individuals could decide to hold more Bitcoin, effectively voicing their concern. Another example could be for economic sanctions, where a country could start to develop an ecosystem around Bitcoin or any other cryptocurrency to circumvent these potential sanctions if they find them unjustified. The development of the Bitcoin ecosystem would measure the efficiency of US policies.
Conclusion
It is still challenging to anticipate the term of the magnitude and consequences of these actions and ultimate response in terms of how the market and central banks would adjust; however, it is clear that the US dollar hegemony is under severe scrutiny. The currency race has begun and the US must react quickly not to be left behind.
