First things first, apologies to Dire Straits for the title. This week we would like to examine the implausibility of a genuine currency war for a number of reasons, looking into global financial systems and the way currency (NOT cash) is actually created.
This week we would like to explore a topic that seems to be top of mind for most investors following the significant drop in the RMB against the US dollar and the subsequent labeling of China as a currency manipulator by the Tweeter in Chief and US treasury.
We would like to suggest that this is, as Bill Shakespeare would say, ‘much ado about nothing’. There are certainly loud voices in the media who would like to make us believe that it is quite plausible for the Chinese to use their significant stockpiles of US treasuries as some sort of a weapon should there be a continued escalation of the trade dispute or that the White House might, in turn, seek to devalue its own currency. We would suggest that such a logic is not only implausible but is a gross misunderstanding of the ways in which the global monetary system works in reality. For one thing, in order to control the price of something, one would have to understand how the thing actually works and it is fair to say that not even the Federal Reserve is quite aware of the quantity or supply of currency out there. On the flip side, the Chinese also have a vested interest in maintaining the stability of the USD given the sheer amount of reserves on the PBOC’s (People’s Bank of China) balance sheet and its vitality to keeping stability within its own domestic currency supply.
The above argument might seem quite hard to grapple with. After all, how can a nation’s regulators and central bank not be aware of how much money is available? Moreover, how can a sovereign nation like China require a foreign currency to maintain its own money supply? The answer lies not in traditional economics or what might seem most obvious but rather in the ways in which the global financial system has actually evolved. Fundamental to this is the Eurodollar system and the status of the US dollar as the reserve currency.
An overly simplistic explanation for the reserve currency status & implications:
Let’s begin by understanding exactly why it is that we needed a reserve currency. Think of a Country A exporting to Country B. The merchant in Country B would need some way of paying for the goods they received from Country A. In the early days, this used to be in the form of physical precious metals such as gold or silver. However, things get a little more complicated as the volume of trade increased and the introduction of paper currency (after all it is quite cumbersome to transport shipments of physical gold coinage or physical paper and, in any case, the paper of Country B would be worthless in Country A). In order to circumvent this issue financial institutions effectively created what was known as bankers acceptances. Think of it like a cashiers cheque where you put in the funds required in the local currency and receive the required exchange on the other end. This did not require the physical currencies to be exchanged but financial institutions effectively create IOU’s between each other and these acceptances would then themselves be traded between the institutions.
As trade grew more complex and increased in volumes, the post-WWII leaders came together in what is the now famous (or infamous?) Bretton Woods agreement to create an effective reserve currency. During the negotiations, the US - understandably not wanting to lose control over its own monetary system - negotiated itself out of a single standard currency as was initially discussed (Bankcor) to be run by the IMF and instead volunteered its own currency. In this new system, the USD would effectively become the global standard and the US government through the Federal Reserve would guarantee the currency against gold. This meant that if, for example, Japan wanted to export to Sweden, the transaction would be Yen - USD - Swedish Krona. It also means that Sweden would have to maintain a certain amount of USD for this transaction to take place just as Japan would have requirements for USD to meet its own obligations. This meant that even transactions where the United States is not a party would require the use of US currency. In order to avoid this issue, bankers acceptances were used as an alternative where physical money would not be required but liabilities between banks would be exchanged with a bookkeepers pen.
So how exactly did we come to a scenario where physical USD reserves came to be vital to the global system? And how exactly did we end up with a scenario where the Federal Reserve effectively became the central bank of the world? The answer lies within the system itself. Firstly, in order for Bretton Woods to work, the US had to maintain an increasing amount of gold bullion (rising directly in proportion with the amount of global trade) and, in the event of an actual call, this was never sustainable. When the Johnson administration effectively dismantled the agreement by breaking the convertibility of the dollar to gold what we saw was the lifting of the artificial ceiling on the increase in the money supply. Due to various crises through much of the mid-20th century, this was also a time when the other great currency (Pound Sterling) was increasingly running out of popularity in the wake of the Suez crisis. This had a dual impact. Firstly, increasing the power of the Federal Reserve to increase domestic supply while, secondly, meaning the global system also required more USD for lack of alternatives and the increasing trade. To put it simply, this means that increasing the supply of USD does not have the same inflationary impacts of other currencies since there is always an artificial demand for the US dollars within the system (this also keeps the rates the US government pays for its fiscal deficits low since again there is continued demand for US dollar denominated securities and treasuries). This also means that the Federal Reserve, through the raising and lowering of interest rates, has the capacity to disproportionately impact global growth since transactions are conducted via the US dollar. A dollar squeeze will impact credit growth on a global level.
Coming back to the question of currency devaluations, what we are suggesting is that given the artificial demand for US dollars, it is next to impossible to devalue on a relative basis unless you de-dollarise the rest of the planet.
In addition, remember how we previously mentioned that regulators hardly know the extent of supply out there? Let us come back to that point here. Due to the centrality of the USD to the global financial system, what has occurred over the preceding decades has been the proliferation of what has been termed the Eurodollar market. Eurodollars are essentially time deposits (a deposit in a bank account that cannot be withdrawn before a set date or for which notice of withdrawal is required) denominated in US dollars outside of the United States. Imagine as an Australian investor you have a time deposit in New York with Bank Y worth $1000, and decide that you would receive a better rate in London with Bank B for the same amount. You then decide to transfer the said amount to Bank B from Bank Y. Assuming that Bank B also has a dollar deposit with Bank Y, when the transfer occurs Bank B in London now has a $1000 in credits. Using the reserve requirements system of 10%, Bank B of London then lends out $900 to a corporate doing trade with the US. When said corporate does business with the United States, the $900 comes back into the domestic banks checking account. Assuming again a reserve requirement of 10%, given that there is $100 USD in the checking account of Bank B at Bank Y of New York's account as their reserves, the net change to the domestic supply is effectively 0 while the global supply increased by $900.
Due to the fractional and reserve system, in this way, there is a gradual accumulation of dollars outside of the US which is not necessarily backed by physical currency (again, bookkeepers pen or interbank liabilities). This still does not necessarily become a problem until Bank Y decides to set up a subsidiary in London which effectively transforms the transaction into an interbank loan not subject to a reserve requirement. Continuing with the same example, Bank Y of New York lends to Bank Y’s subsidiary in London an amount of $1000 USD and can then not only use the multiplier and internalise the profits by lending through the local subsidiary (since loans to subsidiaries wouldn’t be subject to reserve requirements) but profit by moving the money back and forth and keep it away from the regulators. In a globalised banking system where this has been taking place over six decades, this makes it an increasingly Herculean task to keep a track of exactly how much liquidity is created since most of these, even outside of the transactions of the original bank, would be interbank and intrabank liabilities.
Which brings us to the first major reason why it would be an exceptionally difficult task to actually start a currency war from the US perspective, namely that there is both an artificial demand for the USD and regulators cannot really keep track of the amount of supply there is in the global markets.
Next week we will look at the other side of the equation, namely why the Chinese would not want a currency war for fear of tightening and destroying their own domestic supply.
Markets & Commentary
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