The banking crisis and the indispensable dollar

Welcome to Trade Secrets. The big news in global governance was the announcement last night of the US Federal Reserve and five other big central banks reactivating the daily dollar swap arrangements they used during the financial crisis and once again (with nine central banks that time) in the early months of the Covid-19 pandemic. Below I discuss the indispensability of the US currency in the world financial and trading system. Separately, I’ll look briefly at US-China trade and issue a bit of a mea culpa for complacency in the face of the conflict between Washington and Beijing.

Better Fed than dead

A year ago, as the US was imposing sanctions on Russia, we had another of those occasional spasms of speculation about the death of the dollar. Supposedly, some combination of China, India and countries in the Middle East would start trading oil in some other currency and weaken the dollar’s international use.

I said it would be nonsense, and it has been. The US has expanded its weaponisation of the dollar against Russia, including an unprecedented freezing of central bank assets, without creating any kind of serious rival.

The network effects of the US currency’s dominance remain overwhelming. The conventional measures and explanations often miss the point or confuse cause with effect.

It’s not really about foreign exchange reserves, governments’ own borrowing or trade invoicing. Reserves matter less since so many emerging markets have abandoned pegged exchange rates; EMs have moved towards local currency sovereign debt issuance; and trade being invoiced in dollars saves US companies paying for currency hedges, but it’s not a decisive advantage.

All of those are, in fact, more consequences rather than cause. It’s the network effect of the dollar’s role in the plumbing of global finance — the international payments system and as a funding currency for non-US banks — that ensures its dominance. See this chart (from the Fed’s own account of the phenomenon) here.

And that is backstopped by a competent, practised, activist central bank prepared to provide dollar liquidity via its big counterparts when required. (Not all the central banks, to be fair, which causes some irritation to those outside the charmed circle.) The swap lines are now becoming a standard feature of a crisis: the Fed also extended them in 2020 as the shock of the Covid pandemic dried up banks’ funding.

It’s comforting for the Fed that because it’s lending to other countries’ central banks, they, not the US, are taking on the risk of extending credit to the private sector. There’s a long debate (going back to the argument about the Triffin dilemma in the 1960s) about the costs incurred by issuing the world’s dominant currency. But this liquidity provision isn’t a significant burden or danger to the US economy or taxpayers.

Now, many have pointed out that non-US banks relying on dollar funding is intrinsically risky because it creates mismatches in liquidity and maturity for those banks borrowing and lending in dollars, making them vulnerable to market volatility. The IMF warned about this several years ago, as did the Committee on the Global Financial System, a gang of bigwig policymakers under the aegis of the Bank for International Settlements.

Fair point, but what is anyone going to do about it? The conclusions about reducing those risks were mainly about better financial regulation and banks’ risk management. No one is making a serious effort to engineer a big shift to a multipolar currency system. The arrangement we have isn’t ideal, but so far the Fed has done enough on more than one occasion to prevent global system meltdown, and there’s no real prospect of anyone else taking over.

Conscious decoupling from China

For years I’ve been at the confident end of the spectrum that globalisation, broadly defined, is doing a pretty good job of surviving the most recent shocks, Covid among them. Have I been too optimistic? In one specific way, maybe.

Along with others I’ve cited the rise in the value of goods trade between the US and China as evidence that Washington’s efforts at conscious decoupling haven’t achieved much. Along comes the irritatingly well-informed Chad Bown of the Peterson Institute in Washington to point out that the record in bilateral trade last year in value terms was more an artefact of high commodity prices and concerns over food security thanks to the Ukraine war than anything else.

Using a more meaningful relative measure, American exports to China are now 23 per cent lower than if they had kept pace with the world’s exports to China overall during the period 2018-22. US sales of cars, Boeing aircraft, semiconductors — all have collapsed. Former president Donald Trump’s “phase 1” deal with his counterpart Xi Jinping, whereby China promised to buy a lot more American goods, was basically pointless.

Now, this doesn’t mean globalisation is imploding. Much of this trade will simply have shifted to other countries instead. But it does underline that a shock such as Covid that supply chain managers can try to work round isn’t the same as a determined, powerful government plugging the gaps as soon as they appear.

Trade links

Japan and Korea have ended disputes over reparations for forced labour during the second world war and improved diplomatic relations, paving the way for more co-operation on trade and technology policy. Tokyo lifted export controls on chemicals supplied to Korea’s semiconductor industry and Seoul dropped a WTO case it had brought on the issue.

The South China Morning Post says that China’s Belt and Road Initiative, celebrating its tenth birthday, will focus on smaller, less risky and more profitable trade-related infrastructure projects rather than the controversial and often expensive mega-schemes that became its hallmark.

Via Scott Lincicome at Cato, the story of the small, affordable Volkswagen electric vehicle that won’t be available to American consumers because it wasn’t made there.

FDI Intelligence has a look at whether Lula, reinstalled as president in Brazil, can revive the EU-Mercosur deal.

The Trade Talks podcast looks at the possibility of reviving the World Trade Organization.

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Trade Secrets is edited by Jonathan Moules