To The Moon

In March of last year, it was reported that Saudi Arabia was considering accepting Chinese yuan for its oil exports to the People’s Republic of China. This is a monumental shift: virtually every oil contract in the world is denominated and settled in U.S. dollars. It was also reported that a number of Saudi officials are in favour of diversifying their currency exposure by accepting Chinese yuan despite US officials calling such moves by the Saudi government “symbolic”.

In actuality, this was not an isolated incident. It is merely another iteration of a larger exercise underway in major global economies worldwide – “de-dollarisation” – which will have substantial repercussions for U.S. economy and its financial market.

How It All Started and Ended

In the initial stages of World War II, the U.S. – then a non-combatant – was the Allies’ main supplier of weapons and goods. Its clients paid in gold which had two effects: the depletion of the clients’ reserves made a return to the “gold standard” – wherein the value of the national currency is determined by the nation’s gold reserves – impossible while the U.S. became the majority owner of the world's available gold. After the U.S. entered the war, delegates from 44 Allied nations met in the New Hampshire town of Breton Woods to deliberate on the future. It was decided that, instead of leaving their currencies linked to gold, they would be linked to the gold-backed U.S. dollar. In return, the U.S. promised to redeem U.S. dollars for gold on demand.

The elevation of the U.S. dollar had an implicit covenant: the U.S. dollar would be as stable and only as plentiful as the nation’s gold reserves. As the world’s largest economy instrumental in the renewal of war-torn Europe through the Marshall Plan, oil exporters denominated oil contracts in U.S. dollars while reserve banks worked to ensure that an average of two-thirds of their currency reserves – maintained to battle currency fluctuations – were in U.S. dollars. However, as the Vietnam War increased government spending in the 1960s while then-President Lyndon B. Johnson concurrently pushed forward the “Great Society” domestic programs – aimed at boosting education, Medicare and urban beautification while battling poverty and crime – the U.S. government flooded the market with “paper dollars”, i.e. currency not backed by the nation’s gold reserves. With growing concerns over the dollar’s stability, nations began to cash out their dollars for gold. By 1971, the Breton Woods agreement was in tatters after President Richard Nixon suspended the dollar’s convertibility into gold. While the massive volume of trade involving the U.S. ensured that the U.S. dollar remained prevalent as a de facto global currency, the effective elimination of any connection with the “gold standard” turned virtually every currency into a by-product of governmental discretion.

What maintained the preponderance of the U.S. dollar in the energy trade was a series of secretive deals struck from 1974 onwards, the details of which were only revealed in 2016: the world’s largest oil producer would sell oil to the U.S. in dollars while the latter provided the former military aid. Furthermore, Saudi Arabia would use their dormant dollar reserves to buy U.S. debt in order to finance its spending. One anonymous source from the U.S. Treasury then relayed to Bloomberg News that Saudi investment in U.S. debt is far greater than the official tally. As early as 1977, Saudi Arabia had accumulated about 20% of all U.S. Treasuries held abroad.

Growing supply of U.S. dollars was soaked up by a near-commensurate increase in oil prices by the OPEC+ bloc as the decades rolled past. The U.S. dollar even became the basis for currency transactions: virtually every currency was quoted in U.S. dollars, given their respective countries held substantial supplies of U.S. dollars in one way, shape or form or the other. Only when the U.S. government continued to continually outspend beyond its means well past the collapse of the Soviet Union and the end of the Cold War did this begin to become a growing concern.

Is a Single “Reserve Currency” Needed?

The idea that the U.S. military actions are almost entirely predicated on the threat to its currency is the stuff of many a conspiratorial forum. Even prominent anti-war activists have laid out the idea that the core premise behind the actions against Libyan dictator Muammar Gaddafi lay in his moves in establishing a “gold dinar” – a currency entirely backed by gold – that could be used as a common currency (or even a “reserve currency”) across Africa. Iraqi strongman Saddam Hussein was aiming to move from pricing oil in U.S. dollars to Euros. Beyond some statements from sources close to the U.S. political establishment that have been deemed questionable, these ideas have never found conclusive evidence in their support.

What is germane, however, is that there has been an alternative to the U.S. dollar since a little before the demise of the Breton Woods agreement. The Special Drawing Rights (SDR) formulated by the International Monetary Fund (IMF) in 1969 was conceived as a “supplementary international reserve asset” equivalent to a fractional amount of gold that was equivalent to one US dollar at a time when the latter was backed by gold. Since then, it was variously used a “line of credit” for building currency reserves by developing countries until calls to become more viable as an alternative “reserve currency” grew more strident in the noughties, which met with the IMF’s approval. In the present day, it is a basket consisting of five currencies: the U.S. dollar, the Euro, the Chinese yuan, the Japanese Yen, and the British Pound Sterling.

Intuitively, it could be argued that a basket comprising of currencies in any strong and well-established trade network could act as a means of diversifying away from the U.S. dollar. In recent times, this has in fact been happening.

18 countries – including Germany, Kenya, Sri Lanka, Singapore, the United Kingdom and Malaysia – have agreed to trade in Indian Rupee. China has signed agreements with 41 countries for clearing bilateral trade in Chinese yuan. The BRICS (Brazil, Russia, India, China, South Africa) bloc is considering expanding after Saudi Arabia and Iran formally requested to join the group. The United Arab Emirates and India have started talks to settle the oil trade in Indian Rupees – with Russia and Iran also looking to forge similar arrangements. It seems logical that the Indian Rupee would also be included into the IMF’s SDR in the next couple of years.

The importance of regional trading blocs cannot be overstated: long before the fall of Gaddafi and Saddam, foreign currency reserves around the world have already been “de-dollarising” by the momentum of trade.

The Russo-Ukrainian conflict saw another critical aspect of “King Dollar”: its inherent weaponisation as a more aggressive form of economic statecraft by the U.S. government, thus compelling booming Asian economies staying away from the fray to choose sides. Without alternatives, they run the risk of being railroaded into joining sanctions they don’t approve and losing trade partners. What the seizure of dollar assets owned by key Russian figures that weren’t officially part of the Russian government early on in the conflict proved to the minds of many is that going your own way may be difficult but is hardly a wasted endeavour.

In Conclusion

If the US dollar continues to be deemed risky, the draw imputed in holding it – either as long-term debt or as cash reserves – will likely continue to erode. This is a powerful signal to the U.S. Treasury that finding a buyer for its near-continual issuances will prove to be increasingly difficult. Given that U.S. expenditure far, far outstrips U.S. revenues, the question that emerges: who will relay this to America’s political establishment and can they be enjoined to be more fiscally conservative?

The overwhelming opinion on this from the market is that it is currently well-nigh impossible. If petrodollar reserves diversify away from the U.S. dollar, the resulting increase in the M2 money supply as these once-cloistered greenbacks make their way home will only add to inflationary woes back in America over the course of the next couple of decades.

The more pronounced the inflationary cycle, the more likely is a rate hike cycle. Hence, we’ll likely end up back here in 2022/2023 sooner rather than later.  Given the interplay between U.S. debt and U.S. equities, a dollar play can be made via a play on equities, which Exchange-Traded Products provide. For instance, the tech-heavy Nasdaq-100 ($NASDAQ 100(NDX)$) is represented by the 5X ETP $LS 5X LONG QQQ ETP(QQQ5.UK)$ on the upside and the $LS -3X SHORT QQQ ETP(QQ3S.UK)$ on the downside. The broad-market S&P 500 ( $S&P 500(.SPX)$, $SPDR S&P 500 ETF Trust(SPY)$) is represented by the $LS 5X LONG SPY ETP(SP5Y.UK)$ on the upside and the $LS -3X SHORT SPY ETP(SPYS.UK)$ on the downside.

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