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Why The Dollar Will Continue To Decline- Goldman Sachs
Friday, China announced its first public deal in which it used Yuan to pay for coal. It will not be their last Yuan deal. This event along with a million others is indicative of the global USD hegemony slowly ending. The Dollar’s role as the dominant international currency will likely continue to decline over the coming years, reinforcing the view that the Dollar will weaken over the medium term argues Zach Pandl Co-Head of Global FX, Rates, EM Strategy for Goldman Sachs in an April 28th report entitled (De)Globalization Ahead.
‘While domestic currency use is dictated by government rules and regulations, international trade is a different story’ he starts. Since the 1960’s the US Dollar has been the world’s dominant international currency as a function of two key advantages to using it.
- Convenience in transaction
- Lack of suitable alternatives
But both of those advantages are under attack now. On the first advantage; Due to heavy use of sanctions, the dollar is not so convenient to use anymore. As to the second advantage; Digital Yuan, alternatives to Swift, Bitcoin, and (soon to be) blockchained-Gold fix that. Taken together, these developments are serving to accelerate shrinking Dollar dominance from Global FX reserves by reducing the two main Dollar advantages.
The Over-Reliance of Foreign Policy on Sanctions
The heavy-handed use of extraterritorial financial sanctions by the US effectively shuts not just the sanctioned entity, but the Western Financial entity out of the global financial system. The EU understands this. US Sanctions against Iran effect financial pain onto EU countries and threaten their own economic sovereignty. Goldman’s Pandl explains:
For example, an EU business could be prevented from trading with Iran, even if it’s legal under domestic EU law, because its bank could run afoul of US sanctions.
Further, overuse of sanctions act as a deterrent from new growing countries in transacting business in dollars to begin with. Jacob Lew, former Treasury Secretary said in 2016: that the US “must be conscious of the risk that overuse of sanctions could undermine our leadership position within the global economy, and the effectiveness of our sanctions themselves… if they excessively interfere with the flow of funds worldwide, financial transactions may begin to move outside of the United States entirely—which could threaten the central role of the US financial system globally.”
Similarly, as it pertains to sanctions as retaliation for Russian aggression, Henry Kissinger said about the Crimea back in 2014:
“I do have a number of problems with the sanctions [on Russia for its annexation of Crimea]. When we talk about a global economy and then use sanctions within the global economy, then the temptation will be that big countries thinking of their future will try to protect themselves…
His fear was, countries who saw no benefits on balance of remaining in the Swift system, would try to protect themselves against potential dangers, and as they do, they will create a mercantilist global economy. Mercantilism, as we’ve discussed here before practically everyone else, (Rabobank, Goldman Sachs, etc) except for Kissinger:
Mercantilism is an economic practice by which governments used their economies to augment state power at the expense of other countries. Governments sought to ensure that exports exceeded imports and to accumulate wealth in the form of hard currency that can be used for international trade in a low trust environment. Like Gold, Silver, or possibly Bitcoin now.
Sanction Familiarity Breeds International Contempt
Post their invasion of Ukraine, when the Russian government needed its reserves to stabilize the country’s financial system, the US and its allies immobilized them with sanctions. One can argue if it is fair or not. Russian assets needed for a crisis (that they started) were denied them. The fact remains, chronic use of sanctions as a tool diminishes their effectiveness.
It does this by not only desensitizing foreign governments and people, as they are somewhat used to them; but also since sanctions become so predictable, these countries now prepare for them in advance.
For example: Russia and China anticipated a Swift alternative was going to be needed back in 2017. Back then it was reported to us that Russia had been doing oil for Gold deals with China using Blockchain for the Gold verification. The Gold stayed in China’s Shanghai exchange. From that September 3, 2017 post entitled Golden Yuan: Crude Backed By Gold is Here
Deals are being done, Russia/China oil for gold using Blockchain over the past several months. A few months ago $3b trades that way. And the info was that the gold paid to Russia never left the Chinese vault.
They've been planning this for years like any smart government does when sanctions are the go to tool your enemy will use. [ EDIT- Sidenote on Russia/China vs US politics now. The difference between a responsible government and an irresponsible one is: When a responsible government says We're looking into X; it is already a done deal. When an irresponsible government says it they are running for reelection. Russia says "We're looking into" a lot lately- VBL]
Goldman goes on to voice that due to sanction overuse, some countries are left with little choice now but to seek economic refuge away from the dollar:
Will the recent imposition of sanctions on Russia’s central bank over the war in Ukraine be the straw that breaks the camel’s back? Countries hold foreign exchange reserves as a store of value to use in times of crisis.
The bank continues: Nations may worry that the value of their Dollar-denominated financial assets is only as solid as their relationship with the US at the time, which may motivate sovereign investors to search for alternative assets, including a more diversified mix of foreign currency holdings.' "May motivate? You mean has already motivated allies like Israel to diversify their FX risk.
If you keep slapping a child for misbehaving, that deterrent eventually loses its effectiveness. Similarly, using a tool to discipline a country diminishes future threats to use it. Worse: It breeds resentment. Russia, Iran, China, are all economically growing up after years of sanctions. And they are not happy. Extensive knowledge of or close association with someone or something harsh leads to a loss of respect for them or it. Abusers get abused eventually.
New Alternatives On The Block(chain)
China has taken significant steps to modernize and open up its financial system, leading to a wave of fixed income portfolio inflows in recent years. Since 2016, fund holdings of Chinese bonds have grown 6 fold. Official (unofficial is much higher we bet) Yuan allocations have increased by almost 400%.
China Yuan Ascendant
Goldman expects both these trends to continue citing the Yuan’s attractive real yields, cheap valuation, China’s growing clout. Israel is the most recent country to ramp up its Yuan holdings, citing philosophical reasons for its changes.
Staying with China, and as botched as their rollout has been of it so far, their efforts to develop the first major central bank digital currency (CBDC) may also help facilitate international use of the Yuan, perhaps first by Chinese tourists abroad and partner countries in the Belt and Road Initiative. It is our feeling, when you run an authoritarian economy and have a captive citizen audience, you can afford to screw up your roll out. Worked for Microsoft for decades right? China isn't tactically too bright and state bureaucracies don't reward innovation. It helps to be strategically smart, as they are. In the long run....learn Mandarin.
More Alternatives: Gold, Bitcoin, and Blockchain
The Western conflict with Russia demonstrates the use case for Bitcoin as well as underlining the need for countries who may not trust each other to have the ability to transact business. Bitcoin does that best even if the West can't admit it yet. But Gold has many advantages now. The Banks own it (they aren't going to just throw it out), tech advances make it more virtually fungible and verifiable, and of course, it cannot be debased at whim. Gold is practically useless, immutable, and fungible. It is therefore perfect as a store of value. Blockchain makes it less difficult to account for.
Gold served this role as an alternative international money medium to fiat currency in the past. It will do so again. Even before Bitcoin or its brethren rise more. Why? Because the banks own it already. Bitcoin will not be accepted publicly as a strategic asset by incumbent western nations for a while. But a nation that has little gold, plenty of Fiat, and a desire to not be held hostage by US policies will look at Bitcoin, the Yuan, or some other blockchain asset to facilitate trade. Goldman agrees:
While there is no guarantee that Bitcoin will serve this purpose in the future, its foundational blockchain technology demonstrates that a scarce digital medium can be created through cryptographic algorithms and the careful use of economic incentives, and some market participants may prefer this type of digital medium to traditional fiat currencies for certain types of international payments
Translated: If we can use blockchain to verify something that is fungible but not easily moved like Gold, and we incentivize trade partners to use it, say with economic discounts, then they will use it. That is the plan in our opinion. It involves Gold, blockchain and some digital product for international trade. Reticent users will be incentivized to adopt it. And they will use it; along with Bitcoin, Ethereum (Israeli) based money, and Yuan that is at least partly backed by Gold or some commodity basket.
The Euro Has Room to Grow
There are also some who believe the Euro is “punching below its weight” and that positive cash yields, unified fiscal policies, and an increased supply of paper would facilitate its use as a more reliable reserve type currency.
We realize this has been the story for a decade now, but, post the Ukrainian affair, there may be a new motivation to get the Euro up to snuff for its weight class. Europe tends to react constructively in a crisis many feel. Goldman thinks "the policy responses to recent disruptions are likely building a better foundation for the single currency for the future."
The Dollar is Strongest For Now
The outlook for rate hikes in the US relative to other economies will likely remain the primary driver of Dollar exchange rates for the short term. But according to Goldman, the dollar is overvalued:
[T]he balance of risk around the Dollar is skewed significantly to the downside, in our view, due to the currency’s high valuation (more than 10% overvalued on our standard models) and three potential structural changes in global capital flows
Those 3 factors for them are:
- Money flowing back to the Euro due to the end of NIRP bonds
- Weaker US stocks will draw international money out of dollars
- De-Dollarization efforts by official institutions to reduce Swift/ sanction exposure.
As Trade (the dog) Goes…
So goes Finance (dog's tail) eventually…
The dollar is an asset that depends on its own network to be effective. But its network is being eroded; in part by technology, in part by global trade dynamics, and in part by US foreign policy implementation.
Goldman ends with:
The Dollar maintains its role as the world’s leading international currency for many reasons—with reinforcing complementarities or “network effects” a key factor—so this structure will not change overnight. But the shifting tactical and structural trends reinforce our conviction in a weaker Dollar over the medium term.
Finance is derivative of trade. If the trade stops, Financial markets have no foundation on which to support themselves. Paper markets can only exist for so long without fundamentals on which to leverage themselves.
Less trade with the US means less need for US Dollars. Gold, Bitcoin, Yuan, and the Euro all benefit.
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