Europe’s Instex special purpose vehicle became operational last month, providing the EU and other countries an opportunity to gain valuable experience in circumventing Washington’s sanctions. This is happening at the same time that India’s planned purchase of Russian S-400 defense systems is likely to be transacted outside the dollar. Moreover, Pakistan’s increasing trade with China is likely to be denominated in yuan, and China is encouraging other countries in the BRI to do the same. The proportion of Chinese and Russian bilateral trade that is transacted in their respective currencies has more than doubled in the last six years. And while these threats to the dollar’s pre-eminence mount, global central banks bought another 145.5 metric tons of the yellow metal in Q1—the largest Q1 purchases in six years, as shown in the chart below.
Although foreign countries have long sought to diminish the dollar’s role in global trade flows, two initiatives constitute the most serious meaningful threats to the established currency order: Europe’s Instex and China’s Belt and Road Initiative. Instex (the Instrument in Support of Trade Exchanges) is the new clearinghouse designed to facilitate trade between Iran and Europe, which allows companies to avoid payment across borders and circumvents the dollar as a transaction medium.
Because Instex was developed primarily for humanitarian goods, and thus will not be used for Iranian oil sales, its near-term impact will be modest for Iran’s economy. However, as we wrote in WILTW October 19, 2017, the knowledge and experience that Europe gains from executing Instex could have devastating long-term effects on the dollar. The more transactions that Instex processes, and the more experience gained in attracting other participants to the scheme (China, Russia, etc.), the bigger the potential dividends for Europe and other countries that want to avoid Washington’s strong-arm tactics.
The Wall Street Journal recently described the mechanics in which Instex would facilitate a sale of German medicine to an Iranian buyer: “The German exporter wouldn’t get paid by the buyer, but by another European company that is separately importing goods from Iran. Similarly, in Iran, the buyer of the medicine would pay the exporter of the other goods. No dollars at all would be involved, which means the U.S. would have no jurisdiction. Instex incorporates a ‘sovereign shield’ that puts government officials who can’t be prosecuted by the U.S. in the top positions, which protects individual bankers from U.S. pressure.”
University of California-Berkeley professor Barry Eichengreen, one of the foremost authorities on currency markets and no stranger to these pages, said recently: “Rome wasn’t built in a day. These pilot projects augur what is to come. It will just take time to get there.”
Ironically, Eichengreen’s research has found that the countries that rely on the U.S. nuclear umbrella, such as Germany and Japan, tend to keep a larger share of their foreign reserves in dollars than countries such as France. Therefore, a strong argument can be made that attacking U.S. allies for not shouldering more of their national-defense burden could carry hidden costs for Washington. Yet more unintended consequences!
The important thing to remember is that the collective will “to get there” has been intensified by the weaponization of U.S. tariffs and sanctions, being used against allies and adversaries. As Former Treasury Secretary Jack Lew said in 2016: “The more we condition use of the dollar and our financial system on adherence to U.S. foreign policy, the more the risk of migration to other currencies and other financial systems in the medium term grows.”
John E. Smith, who until last year was in charge of the U.S. Treasury’s sanctions arm, recently told Foreign Policy magazine that Trump’s use of America’s financial clout to achieve policy aims is a new order of magnitude than what was done previously. He said: “The Trump administration is far more willing to confront even allies and seek to force changes to their foreign-policy position using threats of sanctions, as well as trade threats. We’re hearing now from France and Germany what we used to hear from China and Russia.”
The more that traditional U.S. allies are willing to establish and test new systems that undermine the dollar’s global role, the easier it will become for adversaries such as Russia and China to carry out their own anti-dollar agendas. Our theory of contagion: a global trend will continue until proven otherwise.
The portion of bilateral trade between Russia and China that is denominated in rubles has grown from less than 7% six years ago to more than 18%, and this percentage is likely to grow as China expands its BRI through the Eurasian economic ecosystem. The more trade that China is able to execute in yuan with sanctioned companies, the more difficulty that the U.S. would encounter in stopping it. And, as we described last week, if China continues on its present course, it will control key access points to the Indian Ocean, thus giving it enormous leverage over South Asia trade flows—and that leverage will bolster its ability to transact in yuan.
Yuan internationalization has been a very slow process, but with only a 2% share of global FX reserves, the yuan has only one direction to go over the long term, and that is upward. The BRI will be an important catalyst in raising that percentage over time, explained Bruno Maçães in his book Belt and Road—A Chinese World Order. (See WILTW July 11, 2019.) We quote:
Predictably, the Belt and Road is offered as a means to further develop the renminbi as a global trade and investment currency by creating opportunities for its greater use in international transactions, especially those related to energy development and investment in infrastructure. Through the initiative, Chinese companies will make increasing amounts of overseas investment, some of which will be denominated in renminbi, as will most of the fundraising required for the Belt and Road initiative, while encouraging companies to use the currency for cross-border trade and cash management. Moreover the Chinese authorities are actively planning to start paying for imported crude oil in yuan rather than the dollar…
China’s increasing economic and military involvement throughout the land-based and sea-based portions of the BRI represents a major expansion of its geopolitical influence, and de-dollarization via expansion of yuan-based payments plays an important role in this. But China also has domestic reasons to push for greater yuan internalization, too.
Consider the following: As China’s aging population causes households to run down their savings, the historic current-account surpluses will turn into an inexorable trend of current account deficits, as shown in the following charts. And as those current-account deficits increase, China will either have to use up its foreign currency reserves or borrow more money from foreigners—which it would rather borrow in its own currency than the dollar, which Beijing cannot print at will. As a result, de-dollarization has increasingly become a national imperative for the Chinese, without which its other regional ambitions would be very difficult to achieve.
These trends underscore the investment rationale for gold, which has been a key theme of ours this year. It is probably no coincidence that China and other central banks have been ramping-up their gold purchases aggressively in recent years (see WILTW February 28, 2019), to provide a counterweight to Washington’s trade policy and sanctions. Moreover, if the Trump administration moves to intervene in the global currency market to weaken the dollar—yet another mercantilist policy designed to bolster Trump’s re-election chances—then the case for owning gold will only become stronger.
Gold is also poised to perform strongly as global bond yields continue falling. Shortages of high-quality collateral, such as German bunds, are intensifying as markets anticipate another wave of central-bank liquidity and/or lower policy rates, in response to weakening growth and trade-war uncertainties. The chart below shows that the gold price is positively-correlated with the amount of negative-yielding debt outstanding. The opportunity cost of owning gold always falls when interest rates are under pressure, but in today’s absurd markets, gold’s lack of cash yield is superior when compared to assets that generate a negative yield-to-maturity.