An approaching financial crisis is driven by much higher levels of debt than during the 2008-9 Great Financial Crisis (now exceeding 360% of Global GDP), vulnerability arising from high record equity valuations, and the highest inflation since the early 1980’s, still on an upward trend.
A food crisis. Two of the main inputs to agricultural production—energy and fertilizer have soared over the past year. (European ammonia prices have sextupled!) We have only begun to see this reflected in foodstuff prices. Furtthermore, Russia and Ukraine account for some 25% of global wheat exports—supply chains have been broken and prices have skyrocketed since the war. Middle Eastern countries, such as Egypt and Lebanon, seem especially vulnerable.
The three crises could presage riots and/or the election of more populist or extremist Governments, and have the potential to reinforce each other. They may be further catalyzed by additional waves of Covid.
In this already risk-laden environment, add Western sanctions on Russia to the mix. You can bet your bottom dollar this will propel all three crises, but this article focuses on how work-arounds to the sanctions are being negotiated. While in the short-term everyone marvels at the power of the US dollar and how deprivation from the US dominated global financial system can bring a nuclear power to its knees, work-arounds are likely to decrease long-term demand for the USD. Let’s look at two types of work-arounds already being discussed in the press:
1.Energy trade. China is increasing its energy purchases from Russia; these will likely be dominated in yuan, not dollars. Similarly, India is negotiating energy purchases from Russia, dominated in rupee/ruble. The so-called petrodollar system, whereby demand for USD was underpinned by the Saudis and others selling energy for dollars, is unraveling in slow motion before our very eyes.
2. Reserve assets. US sanctions have frozen most of Russia’s reserve assets. Much of Russia’s $640 billion in reserves was held in Western bank accounts. Every Government in the world will probably reconsider and rebalance the way it holds reserve assets—and these are likely to contain more gold, alternative currencies, etc. —and fewer US Dollars. Indeed, the same argument can be applied to rebalancing individual and corporate investment portfolios— given the Canadian Government’s sudden freezing bank accounts of hundreds of trucking strike supporters.
The above work-arounds should be considered in light of the fact that there have been negative factors influencing demand for USD, in the years prior to sanctions:
- US Federal Government debt has increased past 100% of GDP;
- massive money printing;
- huge financial and budgetary deficits;
- colossal unfunded social security liabilities;
- The US has a Net International Investment Position (NIIP) of -62%, which means that foreigners own far more assets in the US than the other way around.
I do not expect the US dollar to collapse tomorrow. In fact, in the short- to medium- term, it may even rise considerably. In the event of a war or crisis, the US dollar will continue to be viewed as a safe haven, causing the USD to rise.
As Janet Yellen, US Treasury Secretary, likes to point out: there is no alternative to the USD as the world’s reserve currency. (59% of global reserves are denominated in USD).
I do, however, see a long-term downward trend for the US Dollar, possibly over decades, which — if current trends continue — will result in the loss of global reserve currency status, either to a basket of currencies (similar to the Bancor that Keynes proposed at Bretton Woods), and/or to a gold-backed currency.
Why would the loss of reserve currency status matter? Valery Giscard d’Estaing called it an “exorbitant privilege”. Barry Eichengren, an American economist once wrote: “It costs only a few cents for the Bureau of Engraving and Printing to produce a $100 bill, but other countries have to pony up $100 of actual goods in order to obtain one.”
Due to huge budget deficits, the US will need to sell very large amounts of treasury bonds in the coming years. To sell more treasuries in a weak demand situation, interest rates may need to rise—stressing the highly leveraged global financial system. This effect is likely to be felt long before loss of reserve currency status.