DEDOLLARISATION - GEOPOLITICS AND MACROECONOMICS OF RESERVES

This is a three-part post on the march towards dedollarisation. The previous post looked at the motivations for dedollarisation. This part looks at the geopolitics vs macroeconomics and a concluding part will be second guessing BRICS+ new currency system.

One of the first reserve manager to be acutely aware of the risk of holding too much USD was China. The Belt and Road Initiative is a Chinese attempt to recycle their massive dollar holdings consequential to explosive economic growth, and rebalance trade imbalances. China is also the founding member of BRICs, an economic block which has dedollarisation as one of its objectives.

BRICS was formed in 2009 with original members Brazil, Russia, India, China, and South Africa. It has now expanded to include Iran, Egypt, Ethiopia, and the United Arab Emirates. There are now many other countries whose membership is pending. The organisation aims to stop using the USD in their trade with each other and thereby reduce their holding of the currency in their foreign reserves.

Currencies are held by countries as part of their foreign reserves due to their importance in world trade. Geopolitics and macroeconomics have a lot to do with that and since these factors are dynamic, the composition of world reserve currencies are always in flux.

The World Reserve Currencies Visualisation Chart

This visualisation from 'Visualcapitalist' shows changes to world reserve currencies from 1900 to 2022. The visualization chart shows the dynamics of the shares of currencies as reserves. The running commentary shows the geopolitics and macroeconomics behind the dynamics of reserves currencies.

At the turn of the 20th century, European colonialists Britain, France and Germany were the most powerful countries. The British Empire was the strongest and more than half of world reserves was in pound sterling.

* French franc : Towards WWI it gained share due to its strength as a financial centre and growth in its African colonies. The FRF grew at the expense of Sterling. After WWI, France suffered in its rebuilding and FRF lost ground and faded away. 1927 France recovered from devastation of WWI. It returned to the gold standard and its Poincaré Stabilization Plan succeeded in stabilising the economy. The FRF gained ground again in its use as foreign reserves. By 1936 on, France suffered political instability and labour unrest. Devaluation of FRF by 30% caused its decline thereafter.

* Deutschemark : Industrialisation and colonial expansion made DEM stable and strong 1900-1914. From 1915-1923 WWI, war debt, suspension of gold standard, money printing, hyper-inflation and war reparation destroyed the DEM. In 1923 the DEM disappeared as it was replaced by Rentenmark. The next year Germany and Rentsmark disappeared, to be replaced by Weiner Republic (1929-1939) and Reichsmark. After WWII, the DEM returned in 1948 in Germany's reconstruction. Germany experienced an economic miracle in 1960s onwards as industrialisation took off. The DEM returned as a stable and important reserve currency which was able to sustain the re-unification of West and East Germany in 1990s. Germany then prepared for transition to the Euro and in 2002 the DEM was withdrawn.

* Swiss franc: In 1928 CHF gained importance as it returned to gold standard and its neutrality and banking secrecy made it a heaven for parking funds when Europe was still unstable.

* Yen : Japan rose from the ashes of WWII to achieve economic takeoff in 1960s. Much thanks to government interventionism policies and US aid. In 70s and 80s Japan became a global player and Yen became an important reserve currency. In 1985, after the Plaza Accord meant to devalue the USD, Yen appreciation impacted its export competitiveness. Yen's decline as reserve currency started. By the 1990s to current date, Japan's economy stagnated due to deflation and its reserve status remained flat.

* Pound sterling : Britain did not suffer much in WWI due to support from its colonies. it was politically stable, and its maritime trade still prospered. In 1925/1926 Britain suffered from serious labour unrest and over-valued pound sterling when it returned to the gold standard. Its exports floundered and the USD overtook GBP as number 1 reserve currency. By 1928 after GBP found its equilibrium to gold, its strength improved again. When Great Depression came, Britain acted fast to abandon gold in 1931so it gained ground over FRF and USD. The formation of the Sterling Area (1939-1972) which comprised its ex-colonies who used GBP as its currency, or their currencies pegged to GBP, centralised their Sterling reserves in London. This greatly helped Britain to manage the currency and GBP soared to 80% of world reserves, surpassing US which was still trying to get out of the depression. In 1944 Bretton Woods Agreement, USD was pegged to gold and all other currencies were pegged to USD. This was the beginning of the fall of GBD. In the 50s and 60s, industrial strife and socialist policies caused Britain serious balance of payments problems and GBP declined. Could have been worse but for the Sterling Area. In 1967 GBP was forced to revalue. 1979 Sterling Area ceased. GBP has never recovered.

* ECU : Euro Currency Unit is not a real currency. It is a basket of currencies as a precursor of Euro. It was officially introduced in 1979 and gained quick acceptance. It proved to be a stable unit of account for European central banks.

* Euro : Euro was introduced in 1999 and replaced ECU. Euro's share of use as reserve currency grew greatly when DEM was replaced by Euro in 2002. It has proven stable as a reserve currency and was able to ride out the 2009 European sovereign debt crisis and Brexit in 2016.

* USD : US emerged after WWI as a creditor nation and USD was in demand as reserve currency after 1914. Then the Roaring Twenties followed. US flourished and its financial institutions became important globally. In 1929 the stock markets collapsed as a the Great Depression set in. US was late in leaving the gold standard in 1933 and USD suffered. USD retreated all the way till 1947. In the WWII period, US became the producer of goods for the free world. Its economy boomed following the war. With Bretton Woods agreement in 1944 USD was fixed against gold and all currencies pegged to USD. With post war boom and all currencies pegged to USD, the currency USD was in great demand all the way to 1973 counting for 85% of world reserves. By 1973 with US running out of gold, Richard Nixon took the dollar out of gold standard. All currencies in the world became fiat (some currencies were pegged to more stable currencies). In 70s/80s, Germany and Japan economies boomed and DEM and JPY, together with the popularity of ECU, reduced USD share of reserves.

The US is the world's largest economy representing 25% of global GDP and the USD ranks highest as reserve currency, having 55% share of world reserves currencies. In comparison, China is the second largest economy with 18% of world GDP but having Renmenbi at a mere 2.5% as reserves currency. Clearly, the economic size, although an important factor, is not the crucial determinator of the use of a country's currency as reserves by the world.

The key determinant for use of a currency as reserves is the willingness of the market to accept the currency, which itself is dependent on many factors such as political stability, macroeconomics, financial and capital markets, transactional finance costs, etc. This is clearly demonstrated in the ex-Sterling Area and the Euro where economic blocks provide the high aggregate demand for the relevant currencies. It is the same as USD, the currency most companies in the world price their products and services thus creating the massive demand.

The Petrol Dollar:

The greatest ignorance and misinformation about the petroldollar goes like this. In 1974 the evil Jew, Henry Kissinger, as US Secretary of State, forced the Saudi Arabia government into an agreement to price their oil in USD in exchange for American protection. As dominant member of OPEC, Saudi's use of USD to price oil influenced all oil producers to follow suit. This created the huge demand for USD which is largely the reason why it is now the biggest reserve currency. Now the fear is with dedollarisation, oil producers may switch to other currencies, making the USD a lame duck. That 50 year old US-Saudi agreement expired in 2024.

The great misinformation is an evil Jew Henry Kissinger forced the Saudis to use USD. Islamist Brotherhood propaganda may well want this out there for posterity. The reality is this. Saudi oil was first discovered in 1938 by Americans. It follows they started to price oil in USD which by then was the currency with the eco-system to finance oil transactions which involve massive capital movements. Major oil producing countries end up with huge chunks of USD. All countries having a huge trade imbalance must find a way to sort out their balance of payments. Not doing so will eventually place huge upward pressures on their local curreny. Saudis built up of USD holdings need to be recycled, if possible, back to US. At the same time, in the 60s, with the growing power of OPEC, US sought to work closely with Saudi Arabia in foreign policies on the Middle East. The negotiations culminated in a Technical Cooperation Agreement (TCA) signed by Secretary of the Treasury William Simon and the Saudi Arabian Minister of Finance and National Economy Abalkhail dated 13 February 1974. Four months later, Secretary of State Henry Kissinger visited Riyadh. Kissinger and King Fadh signed a Joint Communique for Economic Cooperation on 7 June 1974. Kissinger's communique was for public consumption. The TCA was the implementing agreement which was for 5 years and extendable thereafter every 5 years. There is no 50 year agreement as everyone thought. I have seen the orginal TCA but lost that link. Here is the link to an extension of the TCA.

An US-Saudi Arabia Economic Cooperation Commission (ECC) was set up to implement the TCA. Here is the link to the report by government to Congress House Committee on Foreign Relation on the ECC. It was about (1) fostering closer political ties through economic cooperation, (2) assisting Saudi industrialization and development while recycling petrodollars and (3) facilitating the flow to Saudi Arabia of American goods, services, and technology. Both TCA and ECC says nothing about the pricing of oil nor any military cooperation. It was basically about technology transfer for mutual benefit. 

The Yom Kippur War broke out in October 1973. OPEC cut production and placed an embargo on countries that supported Israel. The market reacted and crude oil rose up more than 3 to 4 times from out US$25/barrel. At that kind of price level, it made it more imperative for Saudi Arabia to recycle their USD hoard.

It is correct pricing oil in USD drives a huge demand for the currency. Based on US$84 per barrel of crude today, and world demand of 100m barrels daily, US$84b is required to grease the physical commodity trade. However, the reality is much much more USD is required to drive the oil trade daily. USD liquidity is also needed in the derivatives, foreign exchange and credits markets. The derivatives for commodities is several times that of the physical market. Using a conservative factor of 5, another USD420b is needed daily. For FX and credits markets, assume a factor of 0.1 each, another USD17b is required. In total about USD520b is needed daily to drive the oil trade. The point is, oil producers can price their crude in any currency, such as Renmenbi, but the reality is other currencies do not have developed financial markets that can support the oil trade.

Offshore USD :

Most people think it is the petroldollars that make the world go round for USD. It is actually the offshore USD that provides the liquidity. These are the USD parked in various financial centres like Hongkong, London, Zurich, Singapore, Tokyo. In Singapore, the offshore USD is primarily in the Asian Currency Unit (ACU). 

BRICS+

The original BRICS was formed in 2006 as an economic block. It originally comprised of Brazil, Russia, India, China, South Africa and by now has added Iran, Egypt, Ethiopia, and the United Arab Emirates and rebranded itself BRICS+. There are many other countries that have applied for membership which is expected to grow. In the wake of the Russo-Ukraine war, the US weaponised the USD and SWIFT, the international payment system, by unilateral sanctions against Russia. Many countries not beholden to the West suddenly see the high risk of USD as a core reserve currency. The need for a payment system as an alternative reserve currency has taken more urgency.

BRICS had plans for a common currency and a system for trade settlement independent of the USD. It's been almost 2 decades and the original grouping has nothing to show. It had once seemed that BRICS will settle on using RMB as their common currency given the size of China's economy. 

Internationalising the Renmenbi :

China is now the second largest economy in the world, making up about 17% of world economy.  Beijing has long understood that as its economy grows larger, it needed to internationalise the RMB. It has moved in many ways to achieve this objective. China's Belt and Road Initiative was one big picture plan to promote the use of its currency. China too has tried to encourange an offshore Renmenbi. Designated clearing houses have been set up in their offshore centres to handle RMB transactions. It has arranged many swap facilities with central banks to provide RMB liquidity. It has nurtured a dim-sum bond market, ie RMB-denominated bonds issued overseas. Several Free Trade Zones have been set up in some cities like Shanghai. These allow for freer moment of RMB for foreign investors.

China’s Cross-Border Interbank Payment System (CIPS) was launched in 2015. In 2016 IMF added RMB to its basket of currencies for the Special Drawing Rights. RMB-denominated oil spot prices are now quoted in many exchanges and in 2018 RMB-denominated oil futures was listed on the Shanghai International Energy Exchange. . 

Currency mobility

China has full current account mobility. This means there is no restrictions on the movement of RMB in trade and services related transactions and remittances. However there is no full capital account mobility. There are still certain restrictions on movement of capital for investment related activities. It is the same status as India.

How RMB is faring

RMB settlements over CIPS has seen over RMB 480b ($75 billion) in Q4 2015 to RMB 33t ($4.6 trillion) in Q3 2023. The RMB oil futures in Shanghai International Energy Exchange has seen remarkable growth.

China has done much, but it is still a long way to go. Yet RMB's share of reserves is only 2.5%.+. It needs to build confidence in RMB which requires to demonstrate stability in the currency, politics and the economy. 

Is it geopolitics?

After Russia invaded Ukraine in February 2022, G7 and several countries including some global corporations, sanctioned the Russians. The US weaponised the USD and SWIFT which heightened the risks of using USD as reserves currency. The chart above shows an increase in RMB payments over SWIFT. Although its share in global payments is small, its volume has doubled from 2+% to 4+%. According to SWIFT, the RMB was the 4th most used currency in cross-border payments overall. It's even more impressive for trade-related payments where RMB capped at 6% and is in 2nd place after USD. RMB's share is actually much higher than 4% since SWIFT report does not capture payments over the CIPS, China's own payment system. Is geopolitics really pushing countries to consider alternative reserves currency?

What is the real trend

In free and open economies, markets reponse to, amongst other issues, financial costs. In deciding which currency to price products and services or conduct their transactions, the cost of currencies is always in play. Take the case of the RMB payments after the Russian invasian. Why did the volume of trade-related payments increase so much? Import-export sector is underpined by trade financing which is short term funding of 3,6,9 or 12 months generally. Interest differentials has a bearing on the cost and determination of currency to use. The chart below shows the short term interest rates of USD and RMB.

The short term interest rate of USD has been pretty much cheaper than RMB in recent past. USD lends itself as the cheaper source for trade financing. The two interest rates intersect at about the time of Russian invasion and the differential rose to more than 250 basis points. Suddenly, the RMB became cheaper as a source for short term financing. Markets respond to this dynamics and switch to RMB funding which leads to increased volumes in RMB settlements.

The reason for the spike in USD short term rates is due to FED action to bring US high inflation rates down. China's inflation was not as high as the US and had no need to raise the interest rate which remained relatively stable. Going into the foreseeable medium term future, it does not appear the FED is in a position to bring the rates down to the era of almost zero rates of the past as high inflation persists.

What central banks do

The traditional narrative is central banks keep in reserves certain foreign currencies relative to the country's need for liquidity in those currencies. With China being an important trading partner for most countries, one would assume the RMB should command a high percentage in use as world reserve currency. RMB started to appear as reserve currency in 2015 and peaked in May 2021 at 2.8%. In 2024 Q1 it was down to 2.15% (per IMF). The visualisation video above also shows that somewhere 2013/2014 onwards, central banks began to hold reserves spread out over smaller currencies - RMB, CHF, AUD, CAD and over 3.5% of other currencies (SGD included). In reality, central banks hold their reserves in currencies that are widely traded, stable, offers relatively better returns, and diversified,. Specific currency liquidity risks can be mitigated by arranging swap agreements with the relevant central banks. Central banks will even hold reserves in gold when they view long term demand trends. All the BRICKS+ countries are building their gold reserves. 

China will do all it can to internationalise RMB, transactions in the currency may increase, but central banks are unlikely to put a lot of their reserves in it. The reason is RMB is not freely and easily convertible, which is a structural change that Chinese Communist Party is unwilling to reform..

Conclusion

Niels Graham and Hung Tran of Atlantic Council GeoEconomics Center warned "... policy makers to disaggregate these macro effects from the very real geopolitical backlash against sanctions and similar tools that are also pushing countries to explore dollar alternatives."  

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