Economic Crisis

Is the US dollar under attack? (Part II of II)

And the first one now

Will later be last

For the times they are a-changin’.

From “The times they are a-changin’” (1965), by Bob Dylan.

Part I explained how and why the dollar is such an important reserve and trade currency, and how the USA relies on this privileged position to remain solvent. But momentum is building to challenge the dollar’s dominance in global trade and investment flows. Is this something that should worry us, and what can we do about it?

In June last year a previously unknown 30 year old computer analyst suddenly became very famous and very hunted. His name was Edward Snowden, and he brought to light the widespread monitoring of global communications by the USA’s National Security Agency (NSA).

American public opinion is fairly evenly split about whether Snowden is a traitor or a hero. Snowden says he simply wanted to inform the public so that there could be a proper debate about what is a reasonable level of surveillance in the name of security.

But either way the US government would like to prosecute him for information theft and spying, so he’s currently holed up in Russia, where he’s been given asylum.

The revelations were wide ranging, and it’s been promised that the most damaging information is yet to come. But perhaps most notable so far is that the NSA has been spying on foreign heads of state.

It’s no surprise that the USA spies on foreign countries and their leaders. But the espionage included spying on friendly allies. Most notably it was alleged that the NSA had bugged the mobile phone of Angela Merkel, the German chancellor.

“…Merkel herself to compare the NSA to the Stasi, the notorious secret police that operated in East Germany before the fall of the Berlin Wall and subsequent reunification…”

Germany is a country where people are highly sensitive to spying. Merkel herself to compare the NSA to the Stasi, the notorious secret police that operated in East Germany before the fall of the Berlin Wall and subsequent reunification of the country in 1990.

And apparently the US hasn’t learnt its lessons. Just this month a German double agent was arrested for passing information to the US. Shortly afterwards the German government announced that it was expelling the local head of the CIA, America’s overseas spy agency, from the US embassy in Germany. This episode has severely damaged relations between the two countries.

The NSA had also been active in Brazil, apparently bugging the mobile phone of Dilma Rousseff, the president, and monitoring Brazilian embassies. They’ve also thrown in a bit of industrial espionage by spying on the giant Brazilian oil company Petroleo Brasileiro (Petrobras for short).

Rousseff made a blistering speech at the UN General Assembly accusing the USA of a breach of international law. She also announced plans to create a new fibre optic connection between South America and Africa so that internet communications could bypass the USA in future, making them harder to intercept.

So let’s roll into 2014, and we get the crisis in Ukraine. Essentially this confrontation looks like it’s about the US, through NATO, trying to get military bases closer to the south western Russian border. NATO is the North Atlantic Treaty Organisation, a cold-war era military alliance between North American and European countries.

It could also be an attempt at revenge by the US for Russia’s decision to protect Edward Snowden. After all, his revelations have embarrassed a large number of powerful people in the US, and created a lot of diplomatic headaches for the country. But whatever the motivation, it’s upset Russia yet again. And unsurprisingly the Russians are standing up for their own interests.

Sadly, many innocent people are caught in the middle, as always. Most recently it appears that a Malaysian Airlines commercial jet has been accidently shot down in the skies over Eastern Ukraine, killing 298 passengers and crew.

As I write it is still unclear exactly what happened and who is responsible, but this is a reminder that all conflicts are messy and unpredictable, and innocent people get hurt. (It also begs the question why there were still commercial jets flying over what is clearly a conflict zone.)

The shenanigans in Ukraine are part of a larger pattern of alienating Russia since the collapse of the Soviet Union. The sensible political strategy would have been to increase co-operation with Russia, draw it closer into Europe, and co-exist on more-or-less friendly terms.

“Forcing a closer economic and political relationship between the world’s most populous country and it most resource rich country is a spectacular own-goal for western diplomacy.”

Instead western politicians, led by the US, seem determined to alienate Russia. This in turn has ensured the worst outcome for the West. Despite decades of mutual suspicion, Russia is getting much closer to China. Forcing a closer economic and political relationship between the world’s most populous country and it most resource rich country is a spectacular own-goal for western diplomacy.

Japanese and South Korean businesses are also reported to be seeking closer ties with Russia, not least to prevent the Chinese getting too far ahead.

The biggest recent example of enhanced ties with China is the deal for Russia to supply large quantities of natural gas to its southern neighbour in the future. Announced on 21st May, the plan is to supply US$400 billion of gas over 30 years. It will take a few years to construct the pipeline, but this is a big deal.

But wait, there’s a catch. It’s not really “four hundred billion dollars” of gas. The giant Russian gas company involved, Gazprom, has said it’s preparing to receive payments in renminbi yuan, the Chinese currency.

Suddenly a big piece of energy trade that would usually have been settled in US dollars will be settled in renminbi instead. As an aside, Gazprom is also examining listing its shares in Hong Kong, as another sign of its move closer to China and Asia. As people increasingly become used to the idea of cutting the dollar out of international trade we could see the dam burst. Once the financial mechanisms are in place it will be much easier for large quantities of trade to be conducted in other currencies.

The Russians have also floated the idea of an “anti-dollar alliance”. In June Sergey Glazyev, an advisor to Russian president Vladimir Putin, proposed the idea, specifically with the intention of “undermining the economic strength of the US”.

“If global demand for the dollar is reduced then the ability of the US government to borrow cheaply will also be reduced. That in turn will erode the funds available for military spending, reducing the USA’s ability to project power around the world.”

There is a clear intention here. If global demand for the dollar is reduced then the ability of the US government to borrow cheaply will also be reduced. That in turn will erode the funds available for military spending, reducing the USA’s ability to project power around the world.

Shortly after Glazyev’s pronouncements it was reported that Elvira Nabiullina, governor of the Russian Central Bank, said that Russian is discussing with China and the other BRIC countries (Brazil, India and South Africa are the other three) a “system of multilateral swaps that will allow the transfer of resources to one or another country, if needed.”

Translation: the BRICS are setting up a financial structure that will allow them to trade directly with each other without using the dollar any more.

Importance: five of the most important, upcoming countries in the world – which already make up a combined 27% of the world economy – want to cut the dollar out of their trade relationships.

And don’t expect this to be confined to the BRICs. Other developing countries will probably jump on the bandwagon. In fact this is likely to have been a hot topic of discussion at the BRICS annual summit in Brasilia, Brazil which was held on Wednesday 16th July.

At that meeting it was agreed that the BRICS will set up a new development bank to support infrastructure projects and provide access to emergency funds. The idea is to reduce global reliance on the US controlled International Monetary Fund and the European Union controlled European Bank for Reconstruction and Development. That in turn is a transfer of power from the old rich to the newly rich(er) countries.

And then there’s the French, who are also pretty miffed at the moment. The reason? US regulators have just fined BNP Paribas, France’s biggest bank, US$9 billion for violating US sanctions against Sudan, Cuba and Iran.

Whatever the rights and wrongs of what BNP did or didn’t do, or whether the US should have the right to dictate how foreign banks operate in far flung countries, it’s generally felt that the fine is completely excessive. After all, it’s about one and a half times BNP’s 2013 profits.

Understandably this has upset the French. There’s a risk that France, perhaps along with Germany, could derail EU-US trade talks in retaliation. Plus Michel Sapin, the French finance minister, recently called for a “rebalancing” of the currencies used for global payments.

Basically he was saying that the dollar can and should be used much less in international trade. For example for oil sold between members of the eurozone, or trade between Europe and developing countries such as China.

That’s a pretty impressive list of powerful countries that the USA has upset recently: Russia, Brazil, Germany and France. And of course China is always ready to join in. (One other thing most of these countries have in common is that they own a lot of US treasury bonds. It’s not generally a good idea to annoy people that lend to you…)

This is not least because the US is seeking to increase its political, economic and military involvement in China’s Asian back yard, via the so called “pivot” strategy which started four years ago. (Imagine how the US government would feel if China had a load of military bases throughout the Caribbean and Central and South America?!)

China is already the world’s biggest trading nation, and it’s no secret that it also has the largest population of any country. So in the long run it makes sense for the Chinese currency, the renminbi yuan, to also be the world’s most important currency for trade and investment.

But there’s a catch. China has capital controls which mean the renminbi isn’t easily convertible or available around the world. But steps are being taken to change this. Since 2008 there have been 22 currency swap agreements signed between the Chinese and foreign central banks.

“…there is a steady process of allowing renminbi to be used in international trade, and for foreigners to deposit or borrow renminbi, or to invest in renminbi financial instruments.”

Without getting into too much detail, there is a steady process of allowing renminbi to be used in international trade, and for foreigners to deposit or borrow renminbi, or to invest in renminbi financial instruments. Cross-currency swap agreements between central banks are just part of the essential financial plumbing that allows the currencies to flow between countries.

Right now the renminbi remains at the margins, but the trajectory is clear. In fact on 3rd July it was reported that China is freeing up the exchange rate available in retail banks within China. Up until now the rate has been closely controlled. This is another small step in the process of making the renminbi fully convertible in future.

The big picture is that the dollar’s dominance is steadily waning and the renminbi is on the rise. Recent actions by the US government only serve to accelerate this process.

But how long could it take for the dollar to be replaced? The reality is that this is a multi-decade process. Dollar holders don’t need to panic, but they do need to be aware of the trend (and own some gold as a hedge).

After all the dollar itself was a replacement for British pounds sterling as the main global trade and reserve currency. The British empire was at its peak between around 1870 and 1930. There is something we can learn about what to expect from history, as the pound lost ground to the dollar.

In 1930 a pound bought 4.98 dollars. By 1950, just 20 years later, that had changed to $2.85, a relative fall in value of 43%. By 1985 the pound reached a bottom of $1.04, down 79% from the 1930 level. Since then it has rebounded to $1.71, still down 66% since 1930.

So when did the US reach “peak empire” and what can that tell us? I suspect it was in the late 1980s or early 1990s. This was following the collapse of the Soviet Union, but before China’s economic growth really took off.

“…interesting to note that the US dollar has already lost 29% against the Chinese renminbi yuan over the past 20 years.”

In that context it’s interesting to note that the US dollar has already lost 29% against the Chinese renminbi yuan over the past 20 years. The USD/RMB exchange rate has moved from 8.66 in June 1994 to 6.16 today.

If history repeats itself, and the time taken for the renminbi to usurp the dollar is similar for the time taken for the dollar to replace the pound, we’re looking at a 50 year process, give or take a decade or two. And I think there’s a case to be made that we’re already 20 or so years into that transition.

So let’s say history is repeated. Overall the dollar will lose around 70% against the renminbi over 50 years, and it’s already down nearly 30% over the past two decades. That implies a further 50% devaluation of the dollar against the renminbi in the next three decades.

That may not sound like much over such a long time frame, but it works out at an average loss of 2.3% a year, taking account of compounding. And if the US keeps on upsetting powerful countries then things could change much more quickly.

Of course the shorter term currency moves could be in either direction. The dollar could even gain a lot at times. But in the longer run it’s likely to lose dominance and value, which has major implications for the US economy and future US foreign policy. A relatively weaker country will not be able to project its power overseas in the same way, and will no longer enjoy the privileges of empire.

For now there are few ways to get exposure to the Chinese renminbi. Not many banks based outside China accept renminbi bank deposits, and there’s not much physical Chinese cash in circulation around the world, yet. Plus, most of the renminbi bond funds are best avoided for now. High demand and short supply ensures low returns.

But the Chinese stock market is cheap, with a P/E of just 6.7 and dividend yield of 4.9%. This compare with a P/E of 19 and dividend yield of 2.3% for the S&P 500 in the USA.

So patient investors, which I encourage all OfWealthers to be, should consider buying into an ETF (exchange traded fund) invested in an index of large, stable Chinese companies. The combination of low prices today, growing earnings in future, and an appreciating currency over the long run should provide attractive returns.

Stay tuned OfWealthers,

Rob Marstrand

robmarstrand@ofwealth.com

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Rob is the founder of OfWealth, a service that aims to explain to private investors, in simple terms, how to maximise their investment success in world markets. Before that he spent 15 years working for investment bank UBS, the world’s largest wealth manager and stock trader with headquarters in Switzerland. During that time he was based in London, Zurich and Hong Kong and worked in many countries, especially throughout Asia. After that he was Chief Investment Strategist for the Bonner & Partners Family Office for four years, a project set up by Agora founder Bill Bonner that focuses on successful inter-generational wealth transfer and long term investment. Rob has lived in Buenos Aires, Argentina for the past eight years, which is the perfect place to learn about financial crises.