The Decline of a Reserve Currency

Since the freezing of the Russian central bank’s assets by the Americans and the rise of inflation, many are wondering about the future of the US dollar as a reserve currency. In this article we will take a step back and outline, on the basis of Ray Dalio’s latest book, “The Changing World Order“, the dynamics that occur when a currency ceases to be a reserve currency.

“The times ahead will be radically different from those we’ve experienced in our lifetimes, though similar to many times in history”. With these words begins the latest book by the founder of the $140 billion US hedge fund, Bridgewater Associates.

Ray Dalio is convinced that no empire or currency lasts forever, yet almost everyone is surprised and ruined when they fail. The man who predicted the economic crisis of 2008 describes the current economic and political environment by delving into centuries of economic ups and downs. 

Through the study of four empires: the Dutch, the British, the American and the Chinese, Ray Dalio developed a framework for assessing the level of wealth and power of the archetypal empire, using eight parameters: 1) education, 2) competitiveness, 3) innovation and technology, 4) economic output, 5) share of world trade, 6) military power, 7) power of the financial center, and 8) reserve currency status.

His analysis of the emergence and decline of the Dutch guilder, the pound sterling and the US dollar as reserve currencies is of particular interest in understanding the world of tomorrow. In this informative video, Dalio explains that empires rise and fall in a predictable pattern known as the “big cycle”. He believes that a new world order is imminent.

The power of a reserve currency

If a currency has to fulfill two functions, namely a medium of exchange and a store of value, not all money printed by governments is of equal value. A reserve currency has the particularity of being accepted throughout the world for transactions and savings. 

Having a reserve currency is among the greatest powers because it allows a country to borrow more than it could otherwise afford. People around the world want to save in it, which enables the country to borrow more at a lower rate. This is what the French Minister of the Economy called in 1960 when referring to the power of the dollar: the exorbitant privilege.

An empire that borrows and spends a lot seems very strong at first glance. In reality, its finances are actually weakened because borrowing supports the country’s power beyond its fundamentals. By living beyond its means, the empire finances domestic over-consumption and engages in numerous international military conflicts to increase its power.

Inevitably, the country begins to borrow excessively, which contributes to the accumulation of large debts to foreign lenders. In the long run, a country always ends up servicing its debt by creating a lot of money and credit, which depreciates the value of its currency.

When investors start to sell government bonds aggressively

According to Dalio, a country that ceases to have a reserve currency always comes to a traumatic end. In concrete terms, this means large devaluations caused by debt crises.

Signs that such a situation is approaching are when: 1) a country’s debt level is very high, 2) the central bank already has its interest rates at 0%, 3) it is already printing money to buy its bonds, and 4) it faces a financial crisis.

In this situation, the traditional approach is for governments to increase the supply of money and credit to stimulate the economy. The problem is that interest can no longer be lowered and money printing only stimulates the financial market without impacting the real economy.

By creating a lot of money, the government reduces the value of money and credit, which is good for debtors but very bad for holders of money and credit.

People then start selling their government bonds en masse and turn to inflation-hedging assets and other currencies. In other words, holders of debt whose real return keeps falling want to sell that asset for other reserves of wealth.

Once it is widely perceived that money and debt assets are no longer a store of value, the status of a reserve currency is at risk. As Ray Dalio explained in his recent conversation with Larry Summers, the central bank is then faced with a Cornelian choice: raise interest rates to make bonds more attractive, at the risk of contracting a highly indebted economy, or print massively to buy debt that no one wants, thereby depreciating the value of money.

History has shown that central bankers generally prefer the second option and that there are very high risks in holding interest-bearing cash as a store of wealth, especially at the end of debt cycles. 

As Dalio points out: “One of the most important questions investors need to regularly ask themselves is whether the amount of interest that is being paid more than makes up for the devaluation risk they face.”

Research & Insights #20

Oil & Gas. According to the New York Times, the European Union is preparing a phased ban on imports of Russian oil products. The measures should not be introduced until after the second round of French elections, to be held on April 24, to avoid the impact on pump prices harming President Emmanuel Macron’s re-election chances.This approach is intended to give Europe, and Germany in particular, time to find alternative suppliers. In 2020, Russia provided a quarter of the European Union’s oil supplies and a third for Germany. The EU has imposed several rounds of sanctions on Russia, but so far Russian oil and gas have been excluded because of the high level of dependence of some EU member states on energy supplies. Germany’s Vice Chancellor, Robert Habeck, recently spoke out against an immediate gas embargo on the grounds that it would threaten social peace in the country. Despite the war, Gazprom continues to supply Russian gas for transit to Europe through the territory of Ukraine.

Defence. Russia has successfully carried out a first test launch of a Sarmat intercontinental ballistic missile (ICBM) from the Arkhangelsk region, the Russian Defence Ministry announced Wednesday. Vladimir Putin congratulated the military, stressing that this unique weapon will force all those who try to threaten Russia to think twice. According to the Russian president, the new system has the highest tactical and technical characteristics and is capable of evading any modern missile defence system. It is the largest nuclear missile ever designed. The Pentagon commented on the event through its spokesman, John Kirby, who said it was a “routine” test that posed “no threat” to the United States or its allies. The Sarmat has been under development for years, so its test launch is not a surprise to the West. However, it comes at a time of extreme geopolitical tension due to the war in Ukraine.

Central Bank. Russia announced a likely further cut in interest rates and increased budget spending to help the economy adjust to Western sanctions. As a reminder, the Bank of Russia marginally lowered its key interest rate on April 8 to 17%. The country recorded 16.7% inflation in March and the World Bank expects the Russian economy to contract by more than 11% for the year 2022. The current rise in inflation is due to low supply, not high demand, according to Elvira Nabiullina. She repeated in the lower house of parliament that the goal is to bring inflation down to 4% by 2024, while the economy adjusts to Western sanctions. The latter mainly affect the financial market but should now “start to affect more and more the economy.” The main issues are the massive changes required in logistics and technology supply chains. Over time, logistics networks will be reconfigured and shortages of some consumer goods should disappear. Problems along technology supply chains will be more difficult to resolve.

Russia-China Relationship. Trade between Russia and China has surged since Moscow was cut off from Western imports. In 2022, January-March trade turnover between the two countries reached US$38.17 billion, up 28.7% from the same period last year, according to state news agency RIA Novosti. Russian imports from China rose 25.9% to US$16.44 billion, while its exports to China jumped 31% to US$21.73 billion in the first quarter of the year. In March alone, Russia exported US$7.84 billion worth of goods to the Chinese market. The bulk of Chinese imports from Russia are energy, mineral and agricultural products. China has been Russia’s largest trading partner for more than 10 years. Beijing has called on the West to lift the unprecedented sanctions imposed on Russia. Just days before the war in Ukraine, Vladimir Putin and Xi Jinping announced a “no-limits” partnership with plans to increase bilateral trade to US$250 billion by 2024.

Weaponization of the US dollar threatens its domination

American sanctions on Russia’s currency reserves could gradually prompt many countries to bypass the US currency.

On February 28, the United States and its European allies froze the assets of the Russian Central Bank following the Russian military intervention in Ukraine. Half of the Central Bank’s assets held in the form of foreign exchange reserves and gold (US $300 billion) have been blocked by the West. 

By weaponizing the dollar to preserve its global economic and geopolitical position, the United States risks jeopardizing its greatest power: its control over the world’s reserve currency and capital market system. Zhang Yanling, former executive vice-president of Bank of China, said the sanctions would “cause the US to lose its credibility and undermine the dollar’s hegemony in the long run”. 

The Russian response was not long in coming. A few weeks later, Vladimir Putin signed a decree stipulating that “unfriendly countries” will have to pay for Russian gas in rubles from April 1. This announcement caused the price of natural gas to rise and the ruble to strengthen against the dollar.

The inertia of the dollar as the reserve currency should not be underestimated.

Ray Dalio, founder of the US $140bn US hedge fund Bridgewater Associates, believes that the conflict between Russia and the West is the first battle in the long war for control of the world order. According to him: “When this first round comes to an end, most people will probably misconstrue it as the end of the fight, but it will only be the beginning.”

The end of the US dollar has been predicted countless times and the inertia of a reserve currency that dominates international transactions should not be underestimated. So why should this time be any different?

In theory, a currency can be held in the form of debt or money and must fulfill two essential functions: a store of value and a medium of exchange. 

In practice, the US dollar has ceased to be a store of value since its purchasing power began declining faster than its bond yield. And for countries that are not geopolitically aligned with Washington, the weaponization of the greenback prevents it from being a reliable medium of exchange.

Vyacheslav Volodin, speaker of the Russian Duma lower house of parliament, recently said: “Anyone who keeps money in dollars today can no longer be sure that the US will not steal their money.” Countries such as China, Russia, India and Saudi Arabia, are already reducing the share of dollars used in trade, financial transactions or central bank reserves. 

Published in a recent note, Zoltan Pozsar, Former Federal Reserve and U.S. Treasury Department official stated “We are witnessing the birth of Bretton Woods III – a new world (monetary) order, centered around commodity-based currencies in the East, that will likely weaken the Eurodollar system and also contribute to inflationary forces in the West.” 

“Demand for commodity reserves will be higher, which will naturally replace demand for FX reserves,” Mr Pozsar said. “Demand for dollars will be lower too, as more trade will be done in other currencies.”

This analysis is consistent with the new monetary paradigm presented last month by IMF’s first Deputy Managing Director, Gita Gopinath, according to which we could see the emergence in the coming years of small currency blocs based on trade between separate groups of countries.

Research & Insights #19

Foreign debt. Russia is getting closer to a potential default on its foreign currency debt. The Ministry of Finance recently stated that it was forced to make payments in rubles to holders of dollar-denominated bonds. For the first time, the attempt to settle the US$649.2 million payment was rejected by a US financial institution on orders from Washington. Russia has a total of 15 international bonds outstanding, with a face value of about US$40 billion. Moscow managed to secure several foreign currency coupon payments on its Eurobonds before Washington stopped the transactions. According to international rating agencies, Russia has a 30-day grace period to make the dollar payment. The Kremlin has rejected the idea of a default by the country, saying that Russia has the necessary funds and is ready to pay its debt. Indeed, Moscow has described the blocking of payments as a failure of the West to meet its financial obligations to Russia. According to the Kremlin spokesman, the freezing of foreign exchange reserves in February was an attempt to push it into an “artificial default”.

Domestic Politics. Some 83% of Russians approve of Vladimir Putin’s actions, gaining twelve points compared to February, according to a survey published on 31 March by the independent Russian institute Levada. This is the first poll since the beginning of the offensive in Ukraine that has not been carried out by pro-government institutes. Only 15% of Russians say they do not approve of the president’s actions (-12% in one month) and 2% have no opinion. Among respondents who support the actions of the Russian Armed Forces in Ukraine, the dominant opinions are that Russia launched a “special operation” to: protect the Russian-speaking population and civilians in Donbass (43%); prevent an attack on Russia (25%); get rid of nationalists and bring order (21%). Vladimir Putin justified Russia’s military offensive against its Ukrainian neighbour by accusing it of having orchestrated a genocide of Russian speakers, and of serving as a springboard for NATO, an existential threat to Russia. Since the beginning of the conflict, Russia has banned some of the largest social networks (Facebook, Twitter, Instagram, TikTok) accused of having a Russophobic line.

Dedollarization. One of the main counter-sanctions taken by Russia against the West was to order, on March 23, that Russian gas exports be paid for in rubles. In fact, the system now allows buyers to pay in the contract currency which is then changed into rubles by Gazprombank. “It is obvious that – even if this is currently a distant prospect – we will come to some new system – different from the Bretton Woods system,” Peskov said.The West’s sanctions on Russia, he said, had “accelerated the erosion of confidence in the dollar and euro.”The Kremlin wants a new system to replace the contours of the Bretton Woods financial architecture established by Western powers in 1944. The government spokesman said the West’s decision to freeze US$300 billion in central bank reserves was a “robbery” that had already accelerated the move away from using the US dollar and the euro as global reserve currencies. The decision to impose payment in rubles has boosted the Russian currency, which fell to record lows after the February 24 invasion, but has since recovered.

Russia-India relationship. Since Russia’s military intervention in Ukraine and subsequent Western sanctions, India has purchased at least 13 million barrels of Russian crude oil, benefiting from deep discounts. By comparison, India had imported in 2021 about 16 million barrels for the whole of last year, according to data compiled by Reuters. Russia is India’s largest supplier of defence equipment, despite increased purchases from the United States over the past decade. Defence analysts say Russian supplies are more cost-competitive and vital to India, which faces a superior Chinese military. As a result of the sanctions, Russia has offered a US$35 per barrel cut from price levels prior to the start of the war in Ukraine to the world’s third largest oil importer and consumer. Indian Oil Corp, the country’s largest crude refiner, has the option to buy up to 2 million tons, or about 15 million barrels, of Urals-grade crude oil from Russia’s Rosneft this year. India and Russia are also trying to work out a rupee and ruble payment mechanism to maintain their trade.