The world of banking is getting ready to face a dollar-loan default pandemic. Companies and countries borrowed heavily in United Stated Dollars relying on the continued access to international trade dollars as a source for repayments.
International trade was grinding to a halt because of Corona Virus. Domestic trade might pick up a little bit as we exit the hammer phase and enter the long dance, but international trade will likely remain subdued for the entire duration of the dance phase. Massive defaults are looming because markets have dried-up and the dollar rally is uncontrolled.
Emerging markets have piled-up on a lot of US dollar denominated debt. Emerging market currencies are weakening against the dollar. The trend has been exacerbated by the COVID-induced recession.
The Federal reserve has injected trillions into the economy but the dollar has not weakened. Conventional economics tell us that if you increase the supply of a good in the market, the price must adjust downwards. This hasn't happened. Why is that? It is because there is a mal-intermediation problem stopping the flow of the supplied goods into the market.
Lets explore the variables at play.
The dollar is the reserve currency of the world. It is the de facto currency for international trade. The demand has increased due to a flight-to-safety induced by corona virus. But, international trade has ground to a standstill due to COVID so transactional demand of the US dollar has also been reduced.
Over and above this, the USD has been hoarded. Some players have hoarded physical bank notes, notably the USD50 note, so we can call them “Cash Barons”. The largest hoarders of currency are:
- The US stock market
- Central banks of developing countries
The ever increasing international usage of the dollar has to be met by an ever-increasing supply
The supply of dollars can be observed by the increase in Total Assets on the Fed’s balance sheet as a good proxy for M1. Its a deliberate choice not to use the actual M1 money supply curve. The chart below shows how the Fed’s balance sheet grew from $1 trillion in pre-crisis 2008 to $3 trillion in Jan 2013.
The Fed kept on pumping money into the economy throughout 2014 to $4.4 trillion and started reversing the trend in Jan 2018 until corona virus hit the economy. The Fed then quickly increased its total assets from $4.3 trillion to $6.5 trillion.
The chart above zooms in on the last 2 months. 2 trillion increase in money supply in 2 months; its printing on steroids, Robert Mugabe style. The chart below shows the increase in M2 money supply to $16 trillion. The shape mirrors the increase on Total assets.
Clearly supply has increased dramatically in a way that was supposed to reflect in a weakening dollar or a least a stable dollar. But alas, the dollar rally is unabated. Where is the money going? There is an argument that the transmission mechanism has not yet worked and the funds will eventually hit international currency markets and put a stop on the dollar rally. But we know in currency markets, the signal of printing should be enough to actually weaken a currency in markets.
The Fed’s balance sheet could grown to $10 trillion by early next year. What will be the value of the dollar when we get to this level? We will wait to see if this decreases the value of the dollar relative to other currencies.
The thesis, for now, is that an increase in money supply is not necessarily making more dollars available because the dollars are getting stuck in the financial system and there is an element of hoarding. China and Japan are leading the hoarding pack followed by developing country central banks
The Mal-Intermediation Problem
Financial markets , especially banks are supported to perform the function of financial intermediation which is basically playing a middlemen between different economic players , mostly deficit-spending units and saving units.
Dis-intermediation is commonly known as a process whereby those who have extra money to save and those who need extra money to spend avoid financial intermediaries. This can take the form investing directly in securities markets or lending in between themselves instead of using banks. This is happening , and more.
Mal-intermediation is a slightly different process. In this situation, intermediation is taking place but instead of money moving from savers to borrowers who want to spend it, its moving from savers to those who want to invest it in securities and not necessarily those who want to consume goods and services. Instead of money moving from the Central bank into the real economy, it is piling up in stocks, and this is happening via banks as well. It is intermediation. However, it is not the most beneficial.
Why is this a problem?
- Because its starving the real US economy of dollars
- Because its starving the global economy of dollars needed in lubricating international trade
How is this happening?
The general public is heavily indebted and cannot access funding more from banks. Financial corporations are also highly geared but are allowed to increase leverage as long as they invest in financial markets. Rich okes have access to almost unlimited funding, their only real limitation is use of funds (economic opportunities). Increased money supply via quantitative easing is mostly going to financial corporations and rich okes and eventually ending up in stocks. Right now the real economy is dying whilst NASDAQ and S&P 500 are having a rally of their own. They reached a bottom around the 22nd of March and have had a rally since.
The graphs below show a near-perfect V-shape recovery for stocks markets
Stocks are rallying because money has been pumped into the markets. Monetary policy tools are not really transferring money supply into the real economy and international trade.
Faults and Limitations of Conventional Monetary Policy Tools
- Discount Rate — Interest rates have gone to zero. The tool is no longer working unless if the Fed goes for a negative interest rate policy. The problem is , low interest rates or zero interest rates are not going to encourage the generality of the populace to borrow more if they are already over-borrowed. Only rich okes, hedge funds and investment firms have the capability do so, at scale. They borrow and invest in stocks.
- Reserve Requirements — These have been scrapped as of early March. After that , the tool cannot go any further in increasing money supply.
- Open Market Operations — This is limited to Treasury Bonds in the traditional sense. The fed has done this on steroids but it hasn't helped the economy that much.
- Quantitative Easing — This is the unconventional purchase of all sorts of securities in markets in order to inject liquidity in the markets. Introduced in 2008, it has been on steroids ever since and is being conducted on increasingly larger scales. This , by its very nature is throwing money into bond markets, which are not exactly the real economy. Portfolio balances can easily be shifted from bonds to stocks by investors.
- Helicopter Money- this is the only tool that will push money directly to the real economy by placing it directly into the hands of the consuming public thus directly affecting consumption , inflation and interest rates in the real economy. This in turn affects the valuation of the dollar as opposed to price inflation of the stock market alone.
Who is benefiting from a Strong Dollar
- China — the usual argument goes like so, “China has manipulated her currency downwards in order to boost exports and its unfair” . But the Federal Reserve is guilty too. They have kept a strong dollar for an extended period of time and this makes it cheap for Americans to import all sorts of goods and services whilst it makes it expensive for them to export their goods and services. A strong dollar is equally responsible for shipping jobs away to China.
- The Stock Markets — As explored above, the markets have been getting most of the new money created.
Solution for Emerging and Developing Countries
- Sovereign nations, especially emerging markets such as South Africa and Brazil, should use swap markets to convert dollar denominated loans into Yuan loans.
- This should then be followed by a policy that encourages companies with dollar denominated loans to also swap into Yuans.
- Next, the developing country should put in place legislation that requires companies resident in the country to use yuan as the invoicing currency whenever trading with a company or individual resident in China. This will force Chinese exporters and importers to use yuan instead of USD for conducting business with the developing country. China, led by the CCP will always prefer the USD instead of yuan, because it is advantageous to them. The real burden is upon the rest of the developing countries to figure a way to force China into using yuan for trade.
- Next step would be to replace the petrodollar with the Euro or Yuan. Oil exporting countries are already buying most of their imports from Europe so there should be a strong case for the euro.
- Scurrying around for the Euro and Yuan will be a lot easier than for the US dollar.
- The end goal is to correct the “mismatch in currency character” for developing countries. This applies to companies , banks and other players in developing economies.
Solution for USA
- Crush the US Stock Markets first to unlock liquidity stuck in there and then introduce new legislation to handle the mis-intermediation. This has to happen, either by regulation or by a natural market correction. Without a crush, mis-intermediaton will continue to starve both the real US economy and the global economy of US Dollars.
- For now, no one wants to exit the mad rally. Tech unicorns have business models that accelerate earnings in times like these. Who wants to exit a position in Amazon stocks when the whole world is being “amazonified” by corona virus? A natural crush of the market might not happen soon. Thus, an engineered crush becomes a necessity.
- A crush is a reset button, that should allow for a change in the direction that new money flows.
- However, a crush will be followed by a rally again, to more dizzying heights if there is no fundamental change in 1) the rules and 2) the underlying distribution of wealth within America
- The Federal Reserve does not love us. If it did, it would pump money until there are inflationary pressures in the US. They would avoid pumping money into stocks by either regulation or by choice of monetary policy tool. A loving Fed would keep pumping , in times like these, until investors stop pumping into the FANG stocks. A loving Fed would keep pumping until there is abundant liquidity in international trade.
- There wouldn’t be a scramble for dollar liquidity if the Federal Reserve acknowledged the need to lubricate international trade with dollars as part of their core mandate rather an extra-curricular activity.
- It is time for developing nations (excluding China) to take the bull by the horns. Address the three elephants in the room:
- Dollar dominance in global trade
- China’s hoarding of dollars
- Federal Reserve dereliction of duty
Developing countries will continue to suffer at the expense of China and the US stock markets if something is not done to address a strong dollar. Most importantly the looming scramble for dollar-liquidity and the looming dollar loan default crisis might affect developing countries’ banking systems in manner that inhibits economic recovery. The solutions have to be implemented now.