“The Dollar is our currency, but it’s your problem.”
-U.S. Treasury Secretary John Connally, 1971
Imagine me this:
China and Saudi Arabia reach an agreement on a Chinese ownership stake in Aramco and concomitantly agree to price oil in Yuan.
That agreement – coupled with a renewed focus on Chinese capital account reforms and internationalization of the renminbi - serve as catalyzing events for an acceleration in global de-dollarization.
Meanwhile,
- The Fed is busy de-QE’ing, offering a trillion dollars+ in supply to the bond market
- The U.S. is ramping deficit financing to support the towering trinity of rising entitlement spending, large-scale infrastructure investment and non-revenue-neutral tax reform (big step towards that last night).
- Slowing population growth and ongoing technology improvements are driving increasingly less non-renewable commodity demand (i.e. less dollar demand in which to transact).
Do those events conspire in such a manner as to unhinge yields and crater the dollar?
Probably, no. The inherently complex layering of events/assumptions, variant timelines and the non-mutual exclusivity of those factors probably stymie that risk.
Is some version of that event constellation completely implausible?
Again, no.
Below is an unaltered redux of an Early Look I wrote back in 2014 contextualizing the Exorbitant Privilege conferred by our currency’s reserve status.
Given recent developments and the more conspicuous convulsions in global geopolitics, a recapitulation is probably worthwhile on a number of fronts:
- It’s provides didactic review of the evolution of the U.S.’s external position.
- It details the accrued benefits and cumulative excesses garnered from that dollar hegemony and the currency/sovereign cost of capital implications of its (full or partial) reversal.
- It’s acutely re-relevant given recent China-Saudi Arabia developments and the accumulating bilateral swap agreements across the BRIC and Asian axes
- It’s a gentle ‘hidden in plain sight’ reminder. Events that are often painted with the “slowly-then-all-at-once” brush can generally be seen percolating for years preceding a defining event.
Back to the Global Reserve Currency Contextualization Grind…
Valéry Giscard d’Estaing, the French Finance Minister in 1960, coined the term “exorbitant privilege” in rebuking the U.S.’s ability to issue external liabilities (ie cheap treasury debt) at a discount to the global cost of capital while earning higher returns on foreign equity, debt and FDI holdings.
Simply, as venture capitalist to the world and sole beneficiary of dollar hegemony – we get to borrow low and lend high.
…and borrow we have.
Over the last 34 years, on our way to becoming the biggest debtor nation in history, we have borrowed some $10.4T, with an average annual deficit-to-GDP ratio of ~3.2%.
What does that mean exactly and what are the consequences of such a massive imbalance in the global flow of goods, services, income & assets?
In short, it means we’ve borrowed and/or sold accumulated wealth to finance spending in excess of income – with the tailwinds of globalization and financial integration helping us do so in unprecedented magnitude.
To review:
The global flow of commerce and capital can appear complex and convoluted but, in large part, the same dynamics and constraints that drive spending and borrowing decisions for the individual or household apply to sovereigns as well.
If national expenditures (C+I+G) are greater than domestic output (GDP) – if spending is greater than income – that difference is financed by borrowing from abroad; either by direct issuance of debt or via dissaving and the selling of domestic and external assets.
A creditor/surplus country whose expenditures are less than its income lends that difference to a deficit country by buying the deficit country’s debt/assets. From the opposite perspective, a debtor/deficit nation finances consumption expenditures in excess of income by selling assets or issuing debt to a surplus nation.
Such trade balances have important implications for national wealth because a country’s net investment position with the rest of the world (ie. how many foreign assets a country owns vs. foreign claims on domestic assets) defines a nation’s external wealth – and, in the (very) long run, it’s a country’s level of wealth plus its level of income (ie. GDP) that determines its long-run capacity to spend.
Since ~1980, the U.S. has incurred a persistently negative trade balance, financing current consumption by dissaving and borrowing from abroad.
Interestingly, however, U.S. external wealth has declined disproportionately less than the cumulative trade deficit. Indeed, we have been a net exporter of assets to the tune of ~$600B per year via the trade deficit but our external net wealth has declined only modestly, even risen significantly in many years.
How can a country increase its net wealth? Again, the same as an individual or household:
- Save more (ie. the trade balance: reduce/reverse the trade deficit)
- Be the beneficiary of gifts of assets (ie. the capital account: not really a factor for the U.S.)
- Benefit from capital gains (ie. high positive ROI on external assets)
For a country that is a net debtor, the singular path to earning positive net interest income is by receiving a higher rate of interest on its external assets than it pays on its liabilities.
For the U.S. a few primary factors have driven this:
- The US gets to borrow low: reserve currency, deepest/liquid market, risk-free rating, etc
- The US exports a significant amount of capital to foreign markets: EM and developing market risk premiums are higher but, longer-term, returns are better also. For the U.S., the benefit comes in the form of higher relative capital gains
- EM & Developing Countries borrow high and lend low: This is an oversimplification but it's broadly true. Cost of capital for EM and developing countries is comparably higher and, to the extent a higher proportion of investment capital flows to US/DM treasury debt (vs equity or FDI), the returns are comparably lower.
How do the above factors impact net external wealth and play to the benefit of the U.S.?
Here’s the textbook equation for change in external wealth over a given period:
Change in External Wealth = Trade balance + interest paid/received on prior period external wealth + interest rate differential + capital gains
It’s the two terms on the far right side of the equation that have provided an incremental net benefit to the United States and have underpinned her Exorbitant Privilege for nearly a century.
The data is somewhat mixed and open to debate, but the BEA estimates the US has been the beneficiary (due to the confluence of factors highlighted above) of a positive interest rate differential of ~1.5% and a positive capital gain differential of ~2% for the last 3 decades.
In other words, Exorbitant Privilege has provided an ~3.5% offset to the trade deficit.
In recent years, global central bank policies aimed a lowering interest rates and inflating financial asset prices have served to further perpetuate that privilege.
Indeed, recall the circular flow of QE mechanics:
The Treasury issues debt --> the Fed buys the debt --> the Treasury pays the Fed interest --> the Fed gives the money back to the Treasury.
In addition to directly lowering the cost of U.S. external liabilities via large scale asset purchases, remittances from the Fed – at ~$80B/yr and equivalent to ~35% of federal net interest expense – takes the effective cost of capital for the Treasury further towards 0%.
#FreeLunch…for now
Since 1450 the mean length of dominance for a particular global reserve currency = 94 years.
The current duration of reign in US dollar supremacy? Yup…94 years.
The dollar is our currency, and will remain the Fx alpha male for the forseeable future, but the cost of cumulative excess afforded under a century of privilege will be our problem.
Our immediate-term Global Macro Risk Ranges (with intermediate-term TREND views in brackets) are now:
UST 10yr Yield 2.29-2.40% (bullish)
SPX 2 (bullish)
RUT 1 (bullish)
NASDAQ 6 (bullish)
XOP 32.74-34.00 (bullish)
VIX 9.30-10.65 (bearish)
USD 92.50-93.99 (neutral)
Oil (WTI) 49.60-52.91 (bullish)
Christian B. Drake
U.S. Marco analyst
