George Soros Has Got a Backache Again and This Time It’s Because of China

george-soros-quantum-fund
George Soros has got some of the biggest macro calls right over the years. How does he do it? If you were to get around to reading all the books that Soros has written over the years, you will come to realise that he follows something known as the theory of reflexivity to get in and out of financial markets.

Nevertheless, his son Robert, offers another explanation for his success in Michael Kaufman’s Soros: The Life and Times of a Messianic Billionaire. As Robert puts it “My father will sit down and give you theories to explain why he does this or that. But I remember seeing it as a kid and thinking, Jesus Christ, at least half of this is bullshit, I mean, you know the reason he changes his position in the market or whatever is because his back starts killing him. It has nothing to do with reason. He literally goes into a spasm, and it’s his early warning sign.”

Soros himself has had his doubts about how he makes money. As he writes in The New Paradigm for Financial Markets – The Credit Crisis of 2008 and What It Means: To what extent my financial success was due to my philosophy is a moot question because the salient feature of my theory is that it does not yield any firm predictions. Running a hedge fund involves the constant exercise of judgement in a risky environment, and that can be very stressful. I used to suffer from backaches and other psychosomatic ailments, and I received as many useful signals from my backaches as from my theory. Nevertheless, I attributed great importance to my philosophy and particularly my theory of reflexivity.”

And from the looks of it, seems like George Soros has had a few backaches of late. This time his worries are coming from China. Speaking at an economic forum in Sri Lanka, Soros recently said: “When I look at the financial markets there is a serious challenge which reminds me of the crisis we had in 2008…Unfortunately China has a major adjustment problem and it has a lot of choices and it can actually transfer to the rest of the world its own problems by devaluing its currency and that is what China is doing.”

Over the years, the Chinese yuan has been largely pegged against the American dollar. The People’s Bank of China, the Chinese central bank, has ensured that the value of the yuan has fluctuated in a fixed range around the dollar. This has been primarily done in order to take away the currency risk that the Chinese exporters may have otherwise faced.

In a world where so many things have changed in the aftermath of the financial crisis which started in September 2008, the value of the Chinese yuan against the dollar has been one of the few constants.

Over the last few months, the value of the Chinese yuan against the dollar has gradually been allowed to fall. In August 2015, the People’s Bank of China pushed the value of the dollar against the yuan, from 6.2 to around 6.37. In November 2015, one dollar was worth around 6.31 yuan. By the end of the year, one dollar was worth 6.48 yuan, with the yuan gradually depreciating against the dollar.

In the new year, the yuan has depreciated further against the dollar and one dollar is now worth around 6.58 yuan. So what is happening here? It is first important to understand how the People’s Bank of China has over the years maintained the value of the yuan against the dollar.

When Chinese exporters bring back dollars to China or when investors want to bring dollars into China, the Chinese central bank buys these dollars. They buy these dollars by selling yuan. This ensures that at any given point of time there is no scarcity of yuan and there are enough yuan in the market, in order to ensure that the value of the yuan is largely fixed against the dollar.

Where does the People’s Bank get the yuan from? It can simply create them out of thin air, by printing them or creating them digitally.

The situation has reversed in the recent past. Money is now leaving China. Hence, the total amount of dollars leaving China is now higher than the dollars entering it. And this has created a problem for the Chinese central bank. Between July and September 2015, the net capital outflows reached $221 billion. “[This] occurred for the sixth straight quarter and reached a new record of $221 billion,” wrote Jason Daw and Wei Yao of Societe Generale in a recent research note.

The fact that more dollars are now leaving China than entering it, changes the entire situation. When investors and others, decide to take their money out of China, what do they do? They sell their yuan and buy dollars. This pushes up the demand for dollars. In a normal foreign exchange market this would mean that the dollar would appreciate against the yuan, and the yuan would depreciate against the dollar.

But remember that the Chinese foreign exchange market is rigged. The People’s Bank of China likes to maintain a steady value of the yuan against the dollar. What does the Chinese central bank do when more dollars are leaving China? In order to ensure that there is no scarcity of dollars in the market, it buys yuan and sells dollars. This is exactly the opposite what it has been doing all these years, when more dollars where entering China than leaving it.

The trouble is that China cannot create dollars out of thin air, only the Federal Reserve of the United States can do that. China does not have an endless supply of dollars. The foreign exchange reserves of China as of December 2015 stood at $3.33 trillion. In December 2015, the foreign exchange reserves fell by $107.9 billion. They had fallen by $87.2 billion in November. In fact, between December 2014 and December 2015, the Chinese foreign exchange reserves have fallen by a huge $557 billion, in the process of defending the value of the yuan against the dollar.

While, China has the largest foreign exchange reserves in the world, it is worth asking what portion of these reserves are liquid? The Chinese central bank has invested these reserves in financial securities all over the world. As of October 2015, $1.25 trillion was invested in US government treasuries.

The question is how quickly can these investments be sold in order to defend the value of the yuan against the dollar? As economist Ajay Shah wrote in a recent column in the Business Standard: “For a few months, reserves have declined by a bit less than $100 billion a month. We may think that, with $3 trillion of reserves, the authorities can handle this scale of outflow for 30 months. Things might be a bit worse. Questions are being raised about the liquidity of the reserves portfolio. There are only a few global asset classes where the Chinese government can easily dispose of $100 billion of assets per month. A lot of the reserves portfolio might not be in these liquid asset classes.”

Given this, China does not have an endless supply of dollars and cannot constantly keep defending the yuan against the dollar. This explains why it has gone slow in defending the yuan against the dollar, in the recent past, and allowed its currency to depreciate against the dollar.

The question is why is all this worrying the world at large, Soros included? A weaker Chinese yuan will make Chinese exports more competitive. This will mean a headache for other export oriented economies like Japan, Taiwan, South Korea, Germany, and so on. They will also have to push the value of their currencies down against the dollar. Hence, the global currency war which has been on a for a while, will continue. Further, a weaker yuan might lead to China exporting further deflation (lower prices) all over the world.

But what is more worrying is the fact that residents and non-residents are primarily the ones withdrawing their money out of China. The non-residents withdrew $82 billion during the period July to September 2015. The residents withdrew $67 billion, after having withdrawn $102 billion between March and June 2015.

When any economy is in trouble it is the locals who start to withdraw money first. This is clearly happening in China. And that has got the world worried. Also, China is a major consumer of commodities and any economic slowdown in China, will lead to a fall in commodity demand. This isn’t good news for many commodity exporting countries in particular and global economic growth in general.

The column originally appeared on the Vivek Kaul’s Diary on January 13, 2016

Why The Rupee Is Falling Despite The Oil Price Collapse

rupee
As I write this one dollar is worth around Rs 67.1. The last time the rupee went so low against the dollar was sometime in late August 2013. Is this a reason to worry?

In August 2013, the oil prices were at a really high level. The price of the Indian basket of crude oil on August 23, 2013, had stood at $109.16 per barrel. As on December 14, 2015, the price of the Indian basket stood at $34.39 per barrel, down by 68.5% since then.

One of the reasons for the fall of the rupee back then was the high oil price. India imports 80% of the oil that it consumes. Oil is bought and sold internationally in dollars. When Indian oil marketing companies buy oil they pay in dollars. This pushes up the demand for dollars and drives down the value of the rupee against the dollar. This happened between May and August 2013, as the price of oil shot up by close to 11%.

Further, those were the days of high inflation. The consumer price inflation in August 2013 had stood at 9.52%. In order to hedge against this high inflation people had been buying gold. India produces very little gold of its own.

In 2013-2014(April 2013 to March 2014) India produced 1411 kgs of gold. In contrast, the country imported 825 tonnes of gold during 2013. Gold, like oil, is bought and sold internationally in dollars. When Indian importers buy gold, like is the case with oil, it pushes up the demand for dollars and in the process drives down the value of the rupee. This phenomenon also played out in 2013.

Hence, the high price of oil and the demand for gold, drove down the value of the rupee against the dollar, between late May 2013 and late August 2013. But these reasons are not valid anymore. The price of the Indian basket of crude oil is less than $35 per barrel. And the demand for gold is subdued at best.

So what exactly is driving down the value of the rupee against the dollar? In order to understand this, we need to go back to the period between May 2013 and August 2013. While gold and oil played a part in driving down the value of the rupee against the dollar, there was a third factor at work as well. And this was the major factor.

In the aftermath of the financial crisis which started in the September 2008, when the investment bank Lehman Brothers went bust, Western central banks led by the Federal Reserve of the United States, cut their interest rates to close to zero percent. Ben Bernanke, the then Chairman of the Federal Reserve of the United States, was instrumental in this.

The idea was that at low interest rates people will borrow and spend more, and economic growth would return in the process. While that happened, what also happened was that financial institutions borrowed money at low interest rates and invested it in financial markets all over the world.

In May 2013 just a few months before his term as the Chairman of the Fed was coming to an end Bernanke hinted that the “easy money” policy being followed by the Federal Reserve could come to an end. This meant that interest rates would go up in the months to come.

If the interest rates went up, the financial institutions would have had to pay a higher rate of interest on their borrowings. This would mean that the trade of borrowing at low interest rates in the United States and investing across the world, wouldn’t be as profitable as it was in the past.

This led  foreign financial institutions to start selling out of financial markets around the world including India. Between June and August 2013, the foreign institutional investors sold stocks and bonds worth Rs 75,291 crore in the Indian stock market as well as debt market.

They were paid in rupees when they sold their investments in stocks as well as bonds. They had to convert these rupees into dollars. In order to do that they had to sell rupees and buy dollars. When they did that, the demand for the dollar went up. In the process the value of the rupee against the dollar crashed. One dollar was worth around Rs 55 in middle of May 2013. By late August it had almost touched Rs 69.

In the end the Federal Reserve did not raise interest rates, the Reserve Bank of India got its act together and the value of the rupee against the dollar stabilised in the range of Rs 58-62 to a dollar.

What did not happen in May 2013 is likely to happen on December 16, 2015 i.e. tomorrow. It is likely that Janet Yellen, the current Chairperson of the Federal Reserve, will raise interest rates. This means that the financial institutions which have borrowed in the United States and have invested across the world, would have to pay a higher rate of interest on their borrowings. This may make their trades unviable.

Also, financial markets do not wait for central banks to make decisions. They try and guess which way the decision will go and make their investment decisions accordingly. It is now widely expected that the Fed will raise interest rates tomorrow. Given that, the foreign financial investors have been selling out of the Indian financial markets since November. Between November and now, the foreign institutional investors have sold stocks and bonds worth Rs 15,035 crore. In the process of converting this money into dollars, the value of the rupee has been driven down against the dollar.

At the beginning of November, one dollar was worth around Rs 65, now it is worth more than Rs 67. Also, as the rupee loses value, the foreign institutional investors lose money. Let’s say an investment is worth Rs 65 crore. If one dollar is worth Rs 65, then this investment is worth $10 million. If one dollar is worth Rs 67, then this investment is worth only $9.7 million. In order to prevent such losses, bonds investors are selling out of Indian stocks and bonds. And this is pushing down the value of the rupee. So after a point, the rupee loses value because the rupee loses value.

The trouble is that Indian politicians have turned the value of the rupee against the dollar into a prestige issue. But what is worth remembering here is that we live in a word where things are connected and given that the value of a currency is bound to fluctuate. Sometimes the fluctuation will be higher than usual. But that doesn’t mean that things are going wrong.

(Vivek Kaul is the author of the Easy Money trilogy. He tweets @kaul_vivek)

The column originally appeared on Huffington Post India on December 15, 2015

Oil and dollar: Why Obama’s love for Taj lost out to Saudi King’s death

Obama

Barack and Michelle Obama were supposed to be in Agra on January 27, 2015, visiting the Taj Mahal. Instead they will now be going to Saudi Arabia to pay respects to  King Salman bin Abdulaziz, the recently crowned King of Saudi Arabia and the family of the late King Abdullah bin Abdulaziz, who died on January 23. Bloomberg reports that keeping with religious tradition, Abdullah was was quickly and quietly buried on the day he died.
A newsreport in The Indian Express points out that the “Supreme Court had earlier directed all visitors to the Taj Mahal to disembark at the Shilpgram complex, 500 metres away, and board an electric vehicle to the entry gate.” This was deemed to be a security risk by the Secret Service that guards President Obama and hence, the visit was cancelled.
This reason has since been denied by the White House. A more plausible reason lies in the shared history of Saudi Arabia and the United States. As Adam Smith (George Goodman writing under a pseudonym) writes in Paper Money: “In 1928, the Standard Oil Company of California, Socal, had failed to find oil in Mexico, Ecuador, the Philippines, and Alaska. As a last resort, it bought concession from Gulf on the island of Bahrain, twenty miles off the coast of Saudi Arabia, and found some oil. Socal sought out Harry St. John Philby, a local Ford dealer…who was a friend of the Saudi finance minister, Sheikh Abdullah Sulaiman…For 35,000 gold sovereigns, Socal got the concession for Saudi Arabia. Sheikh Abdullah Sulaiman counted the coins himself. Socal’s Damman Number 7 struck oil at 4,727 feet in 1937.”
This is how Saudi Arabia’s journey as an oil producer started. The United States was the world’s largest producer of oil at that point of time, but its obsession with the automobile had led to a swift decline in its domestic reserves.
President Franklin D. Roosevelt realized that a regular supply of oil was very important for America’s well-being. Immediately after attending the Yalta conference in February 1945, Roosevelt travelled quietly to the USS Quincy, a ship anchored in the Red Sea. Here he met King Ibn Sa’ud of Saudi Arabia, the country which was by then home to the largest oil reserves in the world. Ian Carson and V.V. Vaitheeswaran point this out in their 2007 book, Zoom—The Global Race to Fuel the Car of the Future.
Car production had come to a standstill in the United States during the course of the Second World War. Automobile factories became busy producing planes, tanks, and trucks for the War. Renewed demand was expected to come in after the end of the War. Hence, the country needed to secure another source for an assured supply of oil.
So, in return for access to the Saudi Arabian oil reserves, King Ibn Sa’ud was promised full American military support to the ruling clan of Sa’ud. It is important to remember that the American security guarantee made by President Roosevelt was extended not to the people of Saudi Arabia nor to the government of Saudi Arabia but to the ruling clan of Al Sa’uds.
Over the years, Saudi Arabia further returned the favour by ensuring that Organization of the Petroleum Exporting Countries (OPEC) continued to price oil in terms of dollars despite the fact that it was losing value against other currencies, especially in the 1970s.
Attempts were made by other members of the OPEC to price oil in a basket of currencies, but Saudi Arabia did not agree to it. This ensured that oil continued to be the international reserve and trading currency. Most countries in the world did not produce oil and hence, needed dollars to buy oil. This meant that they had to sell their exports in dollars in order to earn the dollars to buy oil.
If Saudi Arabia and OPEC had decided to abandon the dollar, it would have meant that the demand for the dollar would have come crashing down, as countries would no longer need dollars to pay for oil. Hence, oil will continue to be priced in dollars as long as Al Sa’uds continue to rule Saudi Arabia because they have the security guarantee from the United States.
Further, Saudi Arabia remains a close ally of the United States despite the fact that the late Osama bin Laden was a Saudi by birth. Osama was the son of Mohammed bin Awad bin Laden and his tenth wife, Hamida al-Attas. The senior bin Laden was a construction magnate who was believed to have had close ties with the Saudi Royal family.
Since 2008, a lot of shale oil has been discovered in the United States and the production of oil in the United States has gone up by four million barrels per day to nine millions barrels per day, with almost all of the increase coming from increased production of shale oil. This is only a million barrels per day lower than the daily oil production of Saudi Arabia.
Given this, why does the United States still need to continue humouring Saudi Arabia? It is now producing enough oil on its own. James K. Galbraith has an answer for it in The End of Normal: “There is no doubt that shale is having a strong effect on the American economic picture at present…But the outlook for sustained shale…production over a long time horizon remains uncertain, for a simple reason: the wells have not existed long enough for us to know with confidence how long they will last. We don’t know that they won’t; but also we don’t know that they will. Time will tell, but there is the unpleasant possibility that when it does, the shale gas miracle will end.”
Jeremy Grantham of GMO goes into further detail in a newsletter titled The Beginning of the End of the Fossil Fuel Revolution (From Golden Goose to Cooked Goose: “The first two years of flow are basically all we get in racking…Because fracking reserves basically run off in two years and can be exploited very quickly indeed by the enterprising U.S. industry, such reserves could be viewed as much closer to oil storage reserves than a good, traditional field that flows for 30 to 60 years.” The process used to drill out shale oil is referred to as fracking.
Hence, shale-oil might turn out to be a short-term phenomenon. As of now shale oil is not going to replace cheap traditional oil, which is becoming more and more difficult to find. As Grantham points out: “Last year for example, despite spending nearly $700 billion globally – up from $250 billion in 2005 – the oil industry found just 4½ months’ worth of current oil production levels, a 50-year low!”
It is worth remembering that the United States consumes 25 percent of the world’s daily production of oil and half of its daily production of petrol, or what Americans call gasoline. The fact that it is using way too much oil becomes even more obvious given that it has only five percent of the world’s population. Given this, it still needs Saudi Arabia.
Hence, the Obamas need to go to Saudi Arabia and offer their condolences on King Abdullah’s death as soon as possible. The Taj Mahal will have to wait.

(Vivek Kaul is the author of the Easy Money trilogy. He tweets @kaul_vivek)

The article originally appeared on www.Firstpost.com as on Jan 26, 2015 

The extortionate privilege of the dollar

3D chrome Dollar symbolVivek Kaul

On May 31, 2014, the total outstanding debt of the United States government stood at $17.52 trillion. The debt outstanding has gone up by $7.5 trillion, since the start of the financial crisis in September 2008. On September 30, 2008, the total debt outstanding had stood at $10.02 trillion.
In a normal situation as a country or an institution borrows more, the interest that investors demand tends to go up, as with more borrowing the chance of a default goes up. And given this increase in risk, a higher rate of interest needs to be offered to the investors.
But what has happened in the United States is exactly the opposite.
In September 2008, the average rate of interest that the United States government paid on its outstanding debt was 4.18%. In May 2014, this had fallen to 2.42%.
When the financial crisis broke out money started flowing into the United States, instead of flowing out of it. This was ironical given that the United States was the epicentre of the crisis. A lot of this money was invested in treasury bonds. The United States government issues treasury bonds to finance its fiscal deficit.
As Eswar S Prasad writes in The Dollar Trap—How the US Dollar Tightened Its Grip on Global Finance “From September to December 2008, U.S. securities markets had net capital inflows (inflows minus outflows) of half a trillion dollars…This was more than three times the total net inflows into U.S. securities markets in the first eight months of the year. The inflows largely went into government debt securities issued by the U.S. Treasury[i.e. treasury bonds].”
This trend has more or less continued since then. Money has continued to flow into treasury bonds, despite the fact that the outstanding debt of the United States has gone up at an astonishing pace. Between September 2008 and May 2014, the outstanding debt of the United States government went up by 75%.
The huge demand for treasury bonds has ensured that the American government can get away by paying a lower rate of interest on the bonds than it had in the past. In fact, foreign countries have continued to invest massive amounts of money into treasury bonds, as can be seen from the table.
foreign debt US
Between 2010 and 2012, the foreign countries bought around 43% of the debt issued by the United States government. In 2009, this number was slightly lower at 38.1%.
How do we explain this? As Prasad writes “The reason for this strange outcome is that the crisis has increased the demand for safe financial assets even as the supply of such assets from the rest of the world has shrunk, leaving the U.S. as the main provider.”
Large parts of Europe are in a worse situation than the United States and bonds of only countries like Austria, Germany, France, Netherlands etc, remain worth buying. But these bonds markets do not have the same kind of liquidity (being able to sell or buy a bond quickly) that the American bond market has. The same stands true for Japanese government bonds as well. “The stock of Japanese bonds is massive, but the amount of those bonds that are actively traded is small,” writes Prasad.
Also, there are not enough private sector securities being issued. Estimates made by the International Monetary Fund suggest that issuance of private sector securities globally fell from $3 trillion in 2007 to less than $750 billion in 2012. What has also not helped is the fact that things have changed in the United States as well. Before the crisis hit, bonds issued by the government sponsored enterprises Fannie Mae and Freddie Mac were considered as quasi government bonds. But after the financial mess these companies ended up in, they are no longer regarded as “equivalent to U.S. government debt in terms of safety”.
This explains one part of the puzzle. The foreign investors always have the option of keeping the dollars in their own vaults and not investing them in the United States. But the fact that they are investing means that they have faith that the American government will repay the money it has borrowed.
This “childlike faith of investors” goes against what history tells us. Most governments which end up with too much debt end up defaulting on it. Most countries which took part in the First World War and Second World War resorted to the printing press to pay off their huge debts. Between 1913 and 1950, inflation in France was greater than 13 percent per year, which means prices rose by a factor of 100. Germany had a rate of inflation of 17 percent, leading to prices rising by a factor of 300. The United States and Great Britain had a rate of inflation of around 3 percent per year. While that doesn’t sound much, even that led to prices rising by a factor of three1.
The inflation ensured that the value of the outstanding debt fell to very low levels. John Mauldin, an investment manager, explained this technique in a column he wrote in early 2011. If the Federal Reserve of the United States, the American central bank, printed so much money that the monetary base would go up to 9 quadrillion (one followed by fifteen zeroes) US dollars. In comparison to this the debt of $13 trillion (as it was the point of time the column was written) would be small change or around 0.14 percent of the monetary base
2.
In fact, one of the rare occasions in history when a country did not default on its debt either by simply stopping to repay it or through inflation, was when Great Britain repaid its debt in the 19th century. The country had borrowed a lot to finance its war with the American revolutionaries and then the many wars with France in the Napoleonic era. The public debt of Great Britain was close to 100 percent of the GDP in the early 1770s. It rose to 200 percent of the GDP by the 1810s. It would take a century of budget surpluses run by the government for the level of debt to come down to a more manageable level of 30 percent of GDP. Budget surplus is a situation where the revenues of a government are greater than its expenditure3.
The point being that countries more often than not default on their debt once it gets to unmanageable levels. But foreign investors in treasury bonds who now own around $5.95 trillion worth of treasury bonds, did not seem to believe so, at least during the period 2009-2012. Why was that the case? One reason stems from the fact nearly $4.97 trillion worth of treasury bonds are intra-governmental holdings. These are investments made by various arms of the government in treasury bonds. This primarily includes social security trust funds. Over and above this around $4.5 trillion worth of treasury bonds are held by pension funds, mutual funds, financial institutions, state and local governments and households.
Hence, any hint of a default by the U.S. government is not going to go well with these set of investors. Also, a significant portion of this money belongs to retired people and those close to retirement. As Prasad puts it “Domestic holders of Treasury debt are potent voting and lobbying blocs. Older voters tend to have a high propensity to vote. Moreover, many of them live in crucial swing states like Florida and have a disproportionate bearing on the outcomes of U.S. presidential elections. Insurance companies as well as state and local governments would be clearly unhappy about an erosion of the value of their holdings. These groups have a lot of clout in Washington.”
Nevertheless, the United States government may decide to default on the part of its outstanding debt owned by the foreigners. There are two reasons why it is unlikely to do this, the foreign investors felt.
The United States government puts out a lot of data regarding the ownership of its treasury bonds. “But that information is based on surveys and other reporting tools, rather on registration of ownership or other direct tracking of bonds’ final ownership. The lack of definitive information about ultimate ownership of Treasury securities makes it technically very difficult for the U.S. government to selectively default on the portion of debt owned by foreigners,” writes Prasad.
Over and above this, the U.S. government is not legally allowed to discriminate between investors.
This explains to a large extent why foreign investors kept investing money in treasury bonds. But that changed in 2013. In 2013, the foreign countries bought only 19.6% of the treasury bonds sold in comparison to 43% they had bought between 2010 and 2012.
So, have the foreign financiers of America’s budget deficit started to get worried. As Adam Smith wrote in
The Wealth of Nations “When national debts have once been accumulated to a certain degree, there is scarce, I believe, a single instance of their having been fairly and completely paid. The liberation of the public revenue, if it has been brought about at all, has always been brought about by a bankruptcy; sometimes by an avowed one, but always by a real one, though frequently by a pretended payment [i.e., payment in an inflated or depreciated monetary unit].”
Have foreign countries investing in treasury bonds come around to this conclusion? Or what happened in 2013, will be reversed in 2014? There are no easy answers to these questions.
For a country like China which holds treasury bonds worth $1.27 trillion it doesn’t make sense to wake up one day and start selling these bonds. This will lead to falling prices and will hurt China also with the value of its foreign exchange reserves going down. As James Rickards writes in
The Death of Money “Chinese leaders realize that they have overinvested in U.S. -dollar-denominated assets[which includes the treasury bonds]l they also know they cannot divest those assets quickly.”
It is easy to see that the United States government has gone overboard when it comes to borrowing, but whether that will lead to foreign investors staying away from treasury bonds in the future, remains difficult to predict. As Prasad puts it “It is possible that we are on a sandpile that is just a few grains away from collapse. The dollar trap might one day end in a dollar crash. For all its logical allure, however, this scenario is not easy to lay out in a convincing way.”
Author Satyajit Das summarizes the situation well when he says “Former French Finance Minister Valery Giscard d’Estaing used the term “
exorbitant privilege” to describe American advantages deriving from the role of the dollar as a reserve currency and its central role in global trade. That privilege now is “extortionate.”” This extortionate privilege comes from the fact that “if not the dollar, and if not U.S. treasury debt, then what?” As things stand now, there is really not alternative to the dollar. The collapse of the dollar would also mean the collapse of the international financial system as it stands today. As James Rickards writes in The Death of Money “If confidence in the dollar is lost, no other currency stands to take its place as the world’s reserve currency…If it fails, the entire system fails with it, since the dollar and the system are one and the same.”

(Vivek Kaul is the author of the Easy Money trilogy. He can be reached at [email protected])

The article appeared originally in the July 2014 issue of the Wealth Insight magazine

1T. Piketty, Capital in the Twenty-First Century(Cambridge, Massachusetts and London: The Belknap Press of Harvard University Press, 2014)

2 Mauldin, J. 2011. Inflation and Hyperinflation. March 10. Available at http://www.mauldineconomics.com/frontlinethoughts/inflation-and-hyperinflation, Downloaded on June 23, 2012

3T. Piketty, Capital in the Twenty-First Century(Cambridge, Massachusetts and London: The Belknap Press of Harvard University Press, 2014)

Why there is no alternative to the dollar, the Russian threat notwithstanding

 3D chrome Dollar symbolVivek Kaul 

Sergei Glazyev, a close advisor to the Russian President Vladmir Putin, recently threatened that if the United States imposed sanctions on Russia, over what is happening in Ukraine, then Russia might be forced drop the dollar as a reserve currency. He also said that if the United States froze the bank accounts of Russian businesses, then Russia will recommend that all investors of US government bonds start selling them.
How credible is this threat? Is Russia really in a position to drop dollar as a reserve currency? Or is any country in that position for that matter?
There are a host of factors which seem to suggest that the dollar will continue to be at the heart of the international financial system. As Barry Eichengreen writes in 
Exorbitant Privilege – The Rise and Fall of the Dollar, “The dollar remains far and away the most important currency for invoicing and settling international transactions, including even imports and exports that do not touch US shores. South Korea and Thailand set the prices of more than 80 percent of their trade in dollars despite the fact that only 20 percent of their exports go to American buyers. Fully 70 percent of Australia’s exports are invoiced in dollars despite the fact that fewer than 6 percent are destined for the United States…A recent study for Canada, a county with especially detailed data, shows that nearly 75 percent of all imports fromcountries other than United States continue to be invoiced and settled in U.S. dollars”
So, most international transactions are priced in dollars. Most commodities including oil and gold are priced in dollars. Over and above this dollar remains the main currency in the foreign exchange market. 
As Jermey Warner writes in The Telegraph “For instance, if you were looking to buy Singapore dollars with Russian roubles, you would typically first buy US dollars with your roubles and then swap them into Singapore dollars.” 
Hence, a major part of the foreign exchange transactions happens in dollars. 
As the most recent Triennial Central Bank Survey of the Bank for International Settlements points out “The US dollar remained the dominant vehicle currency; it was on one side of 87% of all trades in April 2013. The euro was the second most traded currency, but its share fell to 33% in April 2013 from 39% in April 2010.” 
Over and above this, another good data point to look at is the composition of the total foreign exchange reserves held by countries all over the world. The International Monetary Fund complies this data. 
The problem here is that a lot of countries declare only their total foreign exchange reserves without going into the composition of those reserves. Hence, the fund divides the foreign exchange data into allocated reserves and total reserves. Allocated reserves are reserves for countries which give the composition of their foreign exchange reserves and tell us exactly the various currencies they hold as a part of their foreign exchange reserves. 
We can take a look at the allocated reserves over a period of time and figure whether the composition of the foreign exchange reserves of countries around the world is changing. Are countries moving more and more of their reserves out of the dollar and into other currencies?Dollars formed 71% of the total allocable foreign exchange reserves in 1999, when the euro had just started functioning as a currency. Since then the proportion of foreign exchange reserves that countries hold in dollars has continued to fall. 
In fact in the third quarter of 2008 (around the time Lehman Brothers went bust) dollars formed around 64.5% of total allocable foreign exchange reserves. This kept falling and by the first quarter of 2010 it was at 61.8%. It has started rising since then and as of the first quarter of of 2013, dollars formed 62.4% of the total allocable foreign exchange reserves.
Euro, which was seen as a challenger to the dollar has fizzled out because Europe is in a bigger financial and economic mess than the United States is in. Given this, there is no alternative to the dollar and hence, dollar continues to be at the heart of the international financial system. 
So where does that leave the Russian rouble and the recent threat that has made against the dollar? Here is the basic point. When the entire world has their reserves in dollars, they are going to continue to buy and sell things in dollars. So, when Russia exports stuff it will get paid in dollars, and when its imports stuff it will have to pay in dollars. And unless it earns dollars through exports, it won’t be able to pay for its imports. 
Any country looking to get away from the dollar is virtually destined for economic suicide. Russia can throw some weight around in its neighbourhood and look to move some of its international trade away from the dollar. The Russian company Gazprom, in which the Russian government has a controlling stake, is the largest extractor of natural gas in the world, being responsible for nearly 20% of the world’s supply. 
The gas that Gazprom sells in Russia is sold at a loss, a legacy of the communist days. But the company also provides gas to 25 European nations and this makes it very important in the scheme of global energy security. The company backed by the Russian state has been known to act whimsically in the past and shut down gas supplies during the peak of winter, which has led to major factory shutdowns in Eastern Europe. 
This is Russia’s way of trying to reassert the dominance the erstwhile Soviet Union used to have over the world, before it broke up. But even when Soviet Union was a superpower it could not trade internationally in dollars, all the time, because nobody wanted Russian roubles, everyone wanted the US dollar. 
The next step in the process is likely
to be an effort to price the natural gas which Russia sells through Gazprom in Europe in terms of its own currency, the rouble. Vladamir Putin has spoken out against the dollar in the past, calling for dropping the dollar as an international reserve currency. 
This makes it highly likely that Russia might start selling its gas in terms of roubles. Countries which buy gas from Russia would need to start accumulating roubles as a part of their international reserves. Hence, there is a high chance of the rouble emerging as a regional reserve currency in Europe and thus undermine the importance of the dollar to some extent. Whether that happens remains to be seen. 
The most likely currency to displace the dollar as the international reserve currency is the Chinese yuan. But that process, if it happens, will take a long time. As Warner writes in The Telegraph “
this process is on a very long fuse and basically depends on China eventually displacing the US as the world’s largest economy.” 
While the future of the Chinese yuan as an international reserve currency is very optimistic, it is highly unlikely that the yuan will replace the dollar as an international reserve in a hurry. For that to happen the Chinese government will have set the yuan free and allow the market forces to determine its value, which is not the case currently. 
The People’s Bank of China, the Chinese central bank, intervenes in the market regularly to ensure that the yuan does not appreciate in value against the dollar, which would mean a huge inconvenience for the exporters. An appreciating yuan will make Chinese exports uncompetitive and that is something that the Chinese government cannot afford to do. 
These are things that China is not yet ready for. Hence, even though yuan has a good chance of becoming an international reserve currency it is not going to happen anytime soon. Economist Andy Xie believes that “
There is no alternative to the dollar as a trading currency in Asia.” He feels that the yuan will replace the dollar in Asia but it will take at least thirty to forty years. 
Meanwhile, the Russians can go and take a walk.

The article originally appeared on www.FirstBiz.com on March 7, 2014

(Vivek Kaul is a writer. He tweets @kaul_vivek)