Will U.S. Sanctions on Russia weaken the Dollar as a Reserve Currency?
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Our corporate finance columnist Les Nemethy looks at three crises brewing in the world today, all of which may be amplified by the war, and ponders what it might mean for the American currency.
An energy crisis is taking shape, caused by poor transition planning from fossil fuels to alternative energies. We have shut down nuclear reactors (for example, in Germany) and underinvested in fossil fuels (drilling is at a fraction of previous levels), while alternative energies are ramping up too slowly. Nor do they provide baseload capacity when the sun does not shine, or the wind does not blow.
An impending financial crisis is driven by much higher levels of debt than during the 2008-9 Great Financial Crisis (now exceeding 360% of Global GDP), vulnerability arising from high record equity valuations, and the highest inflation since the early 1980s still on an upward trend.
Then there is the food crisis. Two of the main inputs to agricultural production, energy and fertilizer, have soared over the past year. European ammonia prices have sextupled! We have only begun to see this reflected in foodstuff prices. Furthermore, Russia and Ukraine account for some 25% of global wheat exports; supply chains have been broken and prices have skyrocketed since the war. Middle Eastern countries, such as Egypt and Lebanon, seem especially vulnerable.
These three crises could presage riots and/or the election of more populist or extremist governments and have the potential to reinforce each other. Additional waves of COVID may further catalyze them.
In this already risk-laden environment, add Western sanctions on Russia to the mix. You can bet your bottom dollar this will propel all three crises, but this article focuses on how workarounds to the sanctions are being negotiated. While in the short-term, everyone marvels at the power of the U.S. dollar and how deprivation from the U.S.-dominated global financial system can bring a nuclear power to its knees, workarounds are likely to decrease long-term demand for the dollar. Let’s look at two types of workarounds already being discussed in the press:
1. Energy trade. China is increasing its energy purchases from Russia; these will likely be dominated in yuan, not dollars. Similarly, India is negotiating energy purchases from Russia, dominated in rupee/ruble. The so-called petrodollar system, whereby demand for USD was underpinned by the Saudis and others selling energy for dollars, is unraveling in slow motion before our very eyes.
2. Reserve assets. U.S. sanctions have frozen most of Russia’s reserve assets. Much of Russia’s USD 640 billion in reserves was held in Western bank accounts. Every government in the world will probably reconsider and rebalance how it holds reserve assets. These are likely to contain more gold and alternative currencies and fewer U.S. dollars. Indeed, the same argument can be applied to rebalancing individual and corporate investment portfolios, given the Canadian government’s sudden freezing of bank accounts of hundreds of trucking strike supporters.
The above workarounds should be considered in light of the fact that there have been negative factors influencing demand for USD in the years prior to sanctions.
• U.S. Federal Government debt has increased past 100% of GDP;
• there has been massive money printing;
• there are huge financial and budgetary deficits;
• there are colossal unfunded social security liabilities;
• America has a net NIIP (international investment position) of -62%, which means that foreigners own far more assets in the United States than the other way around.
All of the above make the U.S. economy, however powerful, vulnerable to crises.
I do not expect the U.S. dollar to collapse tomorrow. In fact, it may even rise considerably in the short- to medium-term. In the event of a war or crisis, the dollar will continue to be viewed as a safe haven.
As U.S. Treasury Secretary Janet Yellen likes to point out, there is no alternative to the dollar as the world’s reserve currency. Indeed, 59% of global reserves are denominated in USD).
I do, however, see a long-term downward trend for the U.S. dollar, possibly over decades, which, if current trends continue, will result in the loss of global reserve currency status, either to a basket of currencies (similar to the Bancor that John Maynard Keynes proposed at Bretton Woods) and/or to a gold-backed currency.
Why would the loss of reserve currency status matter? Former French President Valéry Giscard d’Estaing called it an “exorbitant privilege.” Barry Eichengren, an American economist, once wrote, “It costs only a few cents for the Bureau of Engraving and Printing to produce a USD 100 bill, but other countries have to pony up USD 100 of actual goods in order to obtain one.”
Due to enormous budget deficits, the States will need to sell very large amounts of treasury bonds in the coming years. To sell more treasuries in a weak demand situation, interest rates may need to rise, stressing the highly leveraged global financial system. This effect is likely to be felt long before the loss of reserve currency status.
Les Nemethy is CEO of Euro-Phoenix Financial Advisers Ltd. (www.europhoenix.com), a Central European corporate finance firm. He is a former World Banker, author of Business Exit Planning (www.businessexitplanningbook.com), and a previous president of the American Chamber of Commerce in Hungary.
This article was first published in the Budapest Business Journal print issue of March 25, 2022.
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