NEW YORK – The American banking system is broken. That doesn’t portend more high-profile failures like Credit Suisse. The central banks will keep moribund institutions alive.
But the era of dollar-based reserves and floating exchange rates that began on August 15, 1971, when the US broke the peg between the dollar and gold, is coming to an end. The pain will be transferred from the banks to the real economy, which will be hungry for credit.
And the geopolitical consequences will be enormous. The confiscation of dollar credit will accelerate the shift to a multipolar reserve system, benefiting the Chinese RMB as a competitor to the dollar.
Gold, the “barbaric relic” detested by John Maynard Keynes, will play a greater role because the dollar banking system is dysfunctional and no other currency – certainly not the tightly controlled RMB – can replace it. Now at a record price of US$2,000 an ounce, gold is likely to rise further.
The greatest danger to dollar hegemony and the strategic power it gives Washington is not China’s ambition to expand the international role of the RMB. The danger stems from the exhaustion of the financial mechanism that has allowed the US to accumulate a $18 trillion negative net foreign asset position over the past 30 years.
Germany’s flagship Deutsche Bank reached a historic low of EUR 8 on the morning of March 24, before recovering to EUR 8.69 by the end of that day’s trading. debt – peaked at about 380 basis points above LIBOR, or 3.8%.
That is the same as during the banking crisis of 2008 and the European financial crisis of 2015, although not as much as during the March 2020 Covid lockdown, when the premium was above 5%. Deutsche Bank will not go bankrupt, but may need official support. It may have already received such support.
This crisis is very different from 2008, when banks raised trillions of dollars in dodgy assets on the basis of “liability loans” to homeowners. Fifteen years ago, the credit quality of the banking system was rotten and leverage was out of control. The credit quality of banks today is the best in a generation. The crisis stems from the now-impossible task of financing America’s ever-expanding external debt.
It is also the most anticipated financial crisis in history. In 2018, the Bank for International Settlements (a kind of central bank for central banks) warned that $14 trillion in short-term dollar loans from European and Japanese banks used to hedge currency risk was a time bomb waiting to explode (“Has the derivatives Volcano Already Started to Eruption?”, October 9, 2018).
In March 2020, dollar credit got bogged down in a hunt for liquidity as the Covid lockdowns kicked in, leading to a sudden lack of bank funding. The Federal Reserve put out the fire by opening multi-billion dollar swap lines to foreign central banks. It expanded those swap lines on March 19.
Accordingly, the dollar balance of the world banking system exploded as measured by the volume of foreign claims in the global banking system. This opened up a new vulnerability, namely counterparty risk, or banks’ exposure to massive amounts of short-term loans to other banks.
America’s chronic current account deficits of the last 30 years amount to a trade of goods for paper: America buys more goods than it sells, and sells assets (stocks, bonds, real estate, etc.) to foreigners to make up the difference. to make.
America now owes foreigners a net $18 trillion, roughly equal to the cumulative sum of these deficits over 30 years. The problem is that the foreigners who own U.S. assets receive cash flows in dollars, but have to spend money in their own currency.
With floating exchange rates, the value of dollar cash flows in euros, Japanese yen or Chinese RMB is uncertain. Foreign investors must hedge their dollar income, that is, short sell US dollars against their own currency.
That is why the size of the foreign exchange derivatives market exploded along with America’s obligations to foreigners. The mechanism is simple: if you receive dollars but pay in euros, you sell dollars against euros to hedge your currency risk.
But your bank has to borrow and lend the dollars to you before you can sell them. Foreign banks borrowed perhaps $18 trillion from US banks to fund these hedges. That creates a huge vulnerability: if a bank appears unreliable, as Credit Suisse did earlier this month, banks worldwide will call for lines of credit.
Before 1971, when central banks kept exchange rates steady and the United States covered its relatively small current account deficit by transferring gold to foreign central banks at a fixed price of $35 an ounce, none of this was necessary .
The end of the gold peg to the dollar and the new floating exchange rate regime allowed the United States to run huge current account deficits by selling its assets to the world. The populations of Europe and Japan were aging faster than those of the US and had correspondingly greater needs for pension assets. This arrangement is now coming to an end.
A reliable gauge of global systemic risk is the price of gold, and in particular the price of gold relative to alternative hedges against unexpected inflation. Between 2007 and 2021, the price of gold tracked inflation-indexed US Treasury Securities (“TIPS”) with a correlation of approximately 90%.
However, starting in 2022, gold rose while the price of TIPS fell. Something similar happened in the aftermath of the 2008 global financial crisis, but last year’s move was much more extreme. Below is the residual of the regression of the gold price against TIPS with a term of 5 and 10 years.
Looking at the same data on a scatter chart, it is clear that the linear relationship between gold and TIPS remains, but both the baseline has shifted and the slope has steepened.
In fact, the market is concerned that buying inflation protection from the US government is like passengers on the Titanic buying shipwreck insurance from the captain. The gold market is too large and too diverse to manipulate. No one has much faith in the US consumer price index, the yardstick against which TIPS payouts are determined.
The dollar reserve system will not go out with a bang, but a whimper. The central banks will intervene to prevent dramatic failures. But bank balance sheets will shrink, lending to the real economy will decline and, in particular, international lending will evaporate.
In the margin, local currency financing will replace dollar credit. We have already seen this happen in Turkey, where the currency imploded in the period 2019-2021 when the country lost access to funding in dollars and euros.
Chinese trade finance has largely replaced the dollar, supporting Turkey’s remarkable economic turnaround over the past year. Southeast Asia will rely more on its own currency and the RMB. The dollar frog cooks slowly.
It is a stroke of luck that Western sanctions against Russia over the past year have prompted China, Russia, India and the Persian Gulf states to find alternative financing arrangements. This is not a monetary phenomenon, but an expensive, inefficient and cumbersome way to get around the US dollar banking system.
However, as dollar credit declines, these alternative arrangements will become permanent features of the monetary landscape and other currencies will continue to gain ground against the dollar.
Follow David P Goldman on Twitter at @davidpgoldman
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