Feds and its Fibs II

This blog is a continuation from Feds and its Fibs I.

Inflation is weakening of the value or ability of money to purchase goods & services. If I used to buy a kilo of apples for Rs. 100 some years back but I can buy only 750 gms today for the same Rs. 100, that implies there has been inflation. So, if there is severe inflation in the US as I have referenced in the previous part, it is but natural to wonder why has the US$ appreciated against most world currencies unlike what happened with Argentina or Venezuela or Zimbabwe or Sri Lanka when these countries started facing high inflation vs their respective historic averages. For instance, vs. the INR, US$ rate has moved from 72.99 to 79.71 in the past one year (it had briefly crossed the 80-mark as well) and vs. the EUR, it has moved from 0.84 to a parity of 1. (I have deliberately ignored CNY because of the managed floating system China follows where the CNY is pegged to the US$ based on the People's Bank of China's reference rate). This economic principle defying behaviour is the greatest shield the US$ and the USA has had over past so many decades.

As we saw, the value of any commodity is a function of supply-demand. The same holds true for the US$ as well. The doubling of the Fed balance sheet from Apr 2020-Apr 2022 is not an isolated instance. The same had happened during the 2008 financial crisis when the Fed Balance Sheet went from ~US$ 1tn to ~US$ 2.2tn. The Federal policy of printing money out of thin air with no concern about financial consequences is not a new one because the US had to bear no consequences while reaping the benefits of unchecked 'free money'. As the Fed continued printing money by the truckloads thereby increasing supply for US$ in the global economy, the countries world over kept lapping it up. The 'demand' for US$ always outstripped the supply of the US$ via money printing. Any amount of domestic monetary de-valuation was always offset by international demand based artificial valuation. This demand is so because the US$ is the world's reserve currency - the safest and the most stable given the power equation that has existed since the end of World War II where Europe was battered and the Soviets isolated. According to the IMF, the US$ comprised ~72% of the global forex reserves as of 1999. However, this number has since come down to 59%, as of 2021. Not only does the US$ act as a reserve currency that Central Banks the world over hold and consider fairly equivalent to gold, it is also unsurprisingly the world's major trade & finance currency. Though exact freely available data is difficult to come by, general trends can be inferred based on available content. So based on the same, it was observed in an ECB report of 2017 that 60.3% of international debt and 43% of global payments were denominated in the US$ (SWIFT has pegged this at ~51.9%). To make debt, interest and other payments, individuals or institutions or governments, had to either ensure they held US$ in their reserves or bank accounts, or sell the currency they hold and convert it into US$. On account of multiple factors though, the share of US$ in global payments has marginally come down to ~40%, according to ECB's Jul 2021 paper. By all means, this is expected to go further down for reasons I'll get to soon. Thus, while the twin necessity of reserves and trade & finance ensured the dominance of the US$, the past few years is witnessing a marked change in trends highlighting the major difference between US' inflation problems in the past (say the two decades after removal of the gold standard in 1971) and US' inflation problem today in the post-COVID era.

Another key difference is how countries across the globe are perceiving the US and the US$, the former as a military superpower and the latter as a financial heavyweight.

First the Military: One would recollect that in 1999, the then Iraqi Dictator Saddam Hussein announced that Iraq (then the 2nd highest crude producer) would invoice its crude oil exports in EUR instead of US$. By Nov 2000, he had put the announcement into action. In Mar 2003, US invaded Iraq going after non-existent WMDs that the UN itself had confirmed. Within a month's time, Baghdad fell and Saddam was captured. Eventually, he was executed three years later. It is important to note that the US had, at least publicly, not 'found' shale reserves within its borders and hence was heavily dependent on imports of crude oil from the Middle East. Given this dependence, it would have gone to any extent to protect its trade and status as a crude oil guzzling economy. This entire saga of Saddam's murder by the US government entrenched the term 'petro-dollar' and was a lesson to the whole world that the US should not be messed with when it came to US$ trade denomination. From the time of Saddam Hussein's ill-timed dare, with the benefit of hindsight of course, to today - neither the US is the same nor is the world. Power centres have emerged across the globe and US is no longer undisputed though it is still numero uno. The US has traversed from the highs of Iraq where a bully went in and bullied a nation into submission, to the lows of the infamous and shaming defeat & withdrawal in Afghanistan. Post Afghanistan, the world witnessed how the Taliban took over and the "world's strongest military" looked on. In the interim, the world was a spectator to, first Putin's annexation of Crimea in 2014 and then the Russian invasion of Ukraine in early 2022. The US kept talking in 2014 and it kept talking in 2022 as well where it led Ukraine into an avoidable self-destruction only to abandon the nation the moment the Russians arrived (note: the arms & ammunition they send are simply sales for their war economy given how everything else is taking a hit). If I daresay, the US is now doing the same to Taiwan! In all this, a chink in the US armour has been conclusively exposed - that US is all talk and no action. That US is a superhero in its Hollywood movies, but zilch when it comes to actual boots on the ground.

Second the Economics: The US responded with sanctions after sanctions against Russia post the latter's invasion of Ukraine. Western Europe merrily jumped onto the runaway train without a care about its geo-political and economic implications at home. Putin had already declared a "de-dollarization" policy of Russia when it came to its reserves and trade but followed that up by asking Russian crude oil exports to be invoiced in either RUB or gold. He has since further doubled down by opening high discount crude trade with major Asian countries, especially India (7x since the advent of the war). Russia and India have now set up a new crude oil trade route via Iran that is estimated to reduce travel time from 40 to 25 days and freight costs by ~25%. Not only this, Rupee-Ruble agreements have been signed to bypass the demand for US$ and US sanctions (India has a similar agreement with Iran). The Russian share in India's crude imports has since jumped from 2% to 10%. The new route is further expected to increase this share which is consequently eating into the Middle East's share in India's crude imports. This is resulting into the Middle East getting rubbed the wrong way for which it holds the US responsible. Saudi Arabia has now accelerated its discussions on similar currency agreements for crude oil trade, especially with China. The Chinese leadership, even before the advent of the Russia-Ukraine war, has been extremely aggressive regarding increasing the share of the Renminbi Yuan in global trade while operationalizing an alternate financial messaging system, Cross-Border Interbank Payment System, as a competition to SWIFT which is now gaining traction especially with a country like Russia that has to face US sanctions. Nevertheless, as things stand today, after over six months from invasion day, the US$ has depreciated more than 50% against the RUB - it was 1 USD = 138 RUB in Mar 2022 and today, 1 USD = 60 RUB - in direct contrast to how other currencies have moved against the US$. The country's real interest rate has come down into the vicinity of the US' one (~-6%) after going down well below -10% momentarily at the start of the war after which the Russian Central Bank hiked the rates above 20% to keep inflation in check. While we have already looked into the inflation problem in the US, it is noteworthy to touch upon Western Europe for the sake of completing this point on economic myopia for Western Europe too is witnessing record inflation levels. Germany is facing a 40-year inflation peak of 8.8% on the back of rising gas costs, an energy commodity it relies on Russia for. Western European nations are implementing a rare energy rationing policy as Russia cuts down its gas exports to these nations. To borrow a famous dialogue, 'Winter is coming'.

With the differences established, we look at future outcomes. Given this huge evidence that is coming up, a global de-coupling from the US$ is truly underway without a doubt. This would mean that the shield of assured global demand of US$ has started cracking. The more this happens, the more will the ability of US to dump its inflation problem onto the globe diminish. If it can't dump the waste it creates due to faulty monetary & fiscal policies, it is going to raise a big stink within its own borders. A big economic stink is always a precursor to civil unrest. What with US' extreme socialist policies, any problem is going to exponentially grow. While this may take a few years or even a few decades, as long as countries stay committed to the 'de-coupling', the fall of the US$ would inevitably come to pass. By fall, I simply mean a much needed rebalancing. US would continue to be one of the top players but it would also be subjected to the fair laws of economics and it would also have to bear the consequences of its actions henceforth. Not only am I hopeful for this rational rebalancing, I am fairly confident that the policy makers across the globe, especially post-COVID, have realized the urgent need of Atmanirbharta. With the conviction of this need, de-coupling will happen without a doubt. Indications of the same are clearly visible with how stock markets are responding to the Fed's rate hikes. As rate hikes make investments in the subject country more attractive, a hike in the US' interest rates would tend to pull out money from developing economy stock markets like India. However, the strength of this phenomena has greatly reduced over the past two years. Though FIIs have pulled out money, DIIs have lent stability to the market. 

Finally, what does all this mean for Bhaarat? As mentioned across the two parts a couple of times, the Modi Government's policies have been spot on - the handling of COVID, the economic ramp-up during & post-COVID, the massive food distribution programme that ensured we didn't spiral into a civil war and the deals that have been struck with Russia, Iran and the likes that have kept inflation and currency fall in check. In fact, MOEA S Jaishankar's repeated brutal takedowns of European hypocrisy have been a delight to watch. Additionally, the 10% ethanol blending, digitization of gold, Make in India and Atmanirbhar Bhaarat have all contributed to a lower demand for the US$. There is one action though that I hope the Modi Government has in its policy pipeline. It is vital to note that 85% of India's exports and 97% of its imports are invoiced in US$ which gives an idea into the weakness of the INR in external trade. However, our economic might has increased quite a bit over the past eight years. Out of the numerous examples for it, one recent one is the requests nations sent in regarding wheat exports after the central government had put in a temporary hold on the same to cater to domestic demand. If the Government can develop an incentive structure that can aggressively push for INR trade at least in commodities like wheat or for goods/services where the risk of customers walking away is fairly low or in cases where the bilateral trade deficit with a country is small, it would reduce the necessity to bank on the dalal (i.e. middleman) that is the US$. I am aware there are great challenges to this even after RBI's recent announcement on INR invoicing which Ajit Ranade has explained beautifully in this Mint article but if there is any leadership that one can hope from, it is the current one. 

As far as the citizenry goes, let us continue to prefer goods & services that result in money circulation within our country itself. Being vocal for local would reduce our import bill, thus the demand for the US$ as well. For investment in gold, a digital alternative or sovereign gold bonds mean lower demand & consequently lesser import of physical gold, again resulting into lower demand for the US$. If the recent past is any indication, the language of economics - whether used to communicate pleasure or pain, is a language that every global citizen and institution understands irrespective of all other limitations.

Economic boycotts, economic preferences and economic choices - they all work! Economics is the strongest and most probable path towards peace and progress of a society. Economic blunders or ego, would fell the greatest of giants as the US would experience soon. Bhaarat needs to tap into its economics at every level to chart its course in the coming storm that the fall of the US$ would bring upon the global economy. I wish that the great economist Chanakya's Arthashastra guides us all in the times to come.

Jai Hind!