US banking woes portend end of dollar reserve system – Asia Times
NEW YORK – The American banking system is broken. It does not herald more high-profile failures like Credit Suisse. The central banks will keep dying institutions alive.
But the era of dollar-based reserves and floating exchange rates that began on August 15, 1971, when the United States broke the link between the dollar and gold, is coming to an end. The pain will be transferred from the banks to the real economy, which will starve for credit.
And the geopolitical consequences will be enormous. The seizure of dollar credit will accelerate the transition to a multipolar reserve system, benefiting China’s RMB as a competitor to the dollar.
Gold, the “barbaric relic” that John Maynard Keynes detests, 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 USD 2,000 per ounce, gold is likely to rise further.
The biggest danger to dollar hegemony and the strategic power it gives to Washington is not China’s ambition to expand the international role of the RMB. The danger comes from the exhaustion of the financial mechanism that allowed the United States to run into a negative net position of $18 trillion over the past 30 years.
Germany’s flagship institution, Deutsche Bank, hit a record low of 8 euros on the morning of March 24, before recovering to 8.69 euros by the end of the day’s trading, and the credit default swap premium – the cost of insuring its subordinated debt – increased to around 380 basis points above LIBOR, or 3.8%.
It is as much as during the banking crisis in 2008 and the European financial crisis in 2015, but not quite as much as during the Covid-lock in March 2020, when the premium exceeded 5%. Deutsche Bank will not fail, but it may need official support. It may have received such support already.
This crisis is completely different from 2008, when the banks acquired trillions of dollars of unsecured assets based on “liar loans” to homeowners. Fifteen years ago, credit quality in the banking system was rotten and leverage was out of control. Bank credit quality today is the best in a generation. The crisis stems from the now impossible task of financing the US’s ever-growing foreign 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 of short-term dollar borrowing from European and Japanese banks used to hedge currency risks was a time bomb waiting to explode (“Has the derivatives volcano already started to erupt ?”, 9 October 2018).
In March 2020, dollar credit seized in a bid for liquidity as the Covid shutdowns began, provoking a sudden shortage of bank funding. The Federal Reserve put out the fire by opening multibillion-dollar swap lines to foreign central banks. It extended these swap lines on March 19.
Correspondingly, the dollar balance of the world banking system, measured by the volume of foreign claims in the global banking system, exploded. This opened up a new vulnerability, namely counterparty risk, or the exposure of banks to huge amounts of short-term loans to other banks.
America’s chronic current account deficits over the past 30 years amount to a goods-for-paper trade: America buys more goods than it sells, and sells assets (stocks, bonds, real estate, and so on) to foreigners to make up the difference.
America now owes a net $18 trillion to foreigners, roughly equal to the cumulative sum of these deficits over 30 years. The problem is that the foreigners who own US 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, sell US dollars short against their own currencies.
That is why the size of the currency derivatives market increased along with US liabilities 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 the dollars and lend them to you before you can sell them. Foreign banks borrowed perhaps $18 trillion from US banks to fund these hedges. That creates a giant vulnerability: If a bank looks dubious, as Credit Suisse did earlier this month, banks will pull credit lines in a global race.
Before 1971, when central banks kept exchange rates at a fixed level and the US 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 regime of floating exchange rates allowed the US to run massive current account deficits by selling its assets to the world. The population in Europe and Japan is aging faster than the US, and had a correspondingly greater need for pension funds. That arrangement is now coming to a messy end.
An infallible measure of global systemic risk is the price of gold, and especially the price of gold in relation to alternative hedges against unexpected inflation. Between 2007 and 2021, the price of gold followed inflation-indexed US Treasury securities (“TIPS”) with a correlation of around 90%.
Starting in 2022, however, gold rose while the price of TIPS fell. Something like this happened in the wake of the global financial crisis in 2008, but last year’s move has been far more extreme. The remainder of the regression of the gold price against 5- and 10-year maturity TIPS is shown below.
If we look at the same data in a scatterplot, it is clear that the linear relationship between gold and TIPS remains in place, but it has shifted both the baseline and steepened the slope.
In fact, the market is worried 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 diverse to manipulate. No one has much faith in the US Consumer Price Index, the gauge against which TIPS payouts are determined.
The dollar reserve system will not go out with a bang, but a whimper. Central banks will step in to prevent dramatic failures. But bank balance sheets will shrink, credit to the real economy will decline and especially international lending will disappear.
At the margin, financing in local currency will replace dollar credit. We have already seen this happen in Turkey, whose currency imploded during 2019-2021 when it lost access to dollar and euro financing.
To an important extent, Chinese trade finance replaced the dollar, supporting Turkey’s remarkable economic turnaround over the past year. Southeast Asia will rely more on its own currencies and the RMB. The dollar frog will cook in slow increments.
Coincidentally, Western sanctions against Russia over the past year 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 of bypassing the US dollar banking system.
As dollar credit diminishes, however, 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