Amid all the discussions about the sanctions – and counter sanctions- against Russia, an extremely important issue is rearing its head; what is the future of the Petro-Dollar? And, more broadly, what is the future for the dollar as the sole Global Reserve Currency? Those defending the role of the Dollar (not surprisingly almost everyone already heavily invested in the existing $ system) tend to view it as a case of there being no alternative and in particular pointing out that there is no way that the Chinese Yuan could replace the $. However, in our view, that is a straw man argument, for the likely alternative to the Dollar as Reserve Currency is not the Yuan, but rather a variation on something proposed by Keynes in the aftermath of the second World War, a truly international trading currency, the Bancor. And the most likely vehicle is something already in place, the Special Drawing Rights of the IMF, the SDR. Meanwhile, with the latest announcement that the Russians want payment for Oil and Gas in Rubles, the Petro-dollar system looks dead and the dominance of the $ in international trade has clearly peaked. The implications for the FICC desks at Wall Street banks are potentially enormous.
The announcement that Russia wants payment for its Oil and Gas in Rubles and also that it will buy gold at a fixed rate of 5000 Rubles a gram (equivalent to Rub155,5515 a troy ounce) has undoubtedly helped the currency recover most of its sanction related losses (enhanced today by hopes for a ceasefire), but it also marks a policy shift for the end of the 50 year concept of the Petro-Dollar. This will, by definition reduce the $’s role in world trade, with knock on effects for the leveraged markets that trade in $s, especially FX.
Ruble Round Trip raises questions for the $
It also raises questions about the prospect of the end of the $ as the sole reserve currency – a situation that has existed for even longer, and prompts us to return to the suggestions made during the second world war, when the Economist J M Keynes proposed that, post war, the world should adopt a supra-national currency in order to effect trade, something he termed ‘The Bancor’, after the French word Banque. It would not actually be a currency, rather a unit of account and the idea was that it would limit the ability of countries to run substantial deficits or surpluses. At the time, the world was on the gold standard, so Gold had a central role, but history tells that the Bretton Woods system that emerged post war instead established the US$ as the world’s sole reserve currency, as it currently remains.
The fact is, that by fully weaponising the US $ and ‘freezing/confiscating’ Russia’s foreign currency reserves, the Biden administration has effectively thrown the whole existing system into question. What, after all, is the point of selling the west ‘stuff’, if the $’s that were credited for you in return are subsequently just wiped off the ledger for displeasing the politicians in Washington? (Note that we are studiously avoiding judgement on Ukraine, rather we are pointing out the obvious consequences of the latest actions). It is worth once again reproducing the map of China trade – the biggest trading partner with 124 countries, versus the US at 56 – that we put in the March Market Thinking.
This trade, especially with what is known as ‘The Global South’ is increasingly wary of the $ for the reasons outlined above and also because their suppliers are going to be asked to be paid in ‘local currency’. With Russia prepared to buy gold at a fixed price in Rubles and those Rubles being available to buy Oil and Gas, an arbitrage will effectively restore the value of the Ruble close to pre invasion levels. In effect Gold is acting as the ‘currency transformation’ vehicle instead of the $.
Already, the latest demands from Russia that Oil is now paid in Rubles has led to the realisation that Russia can effectively counteract the ‘sanctions’ from the EU by using the same arguments that the EU itself used when justifying EU companies breaking contracts back in 2014. The EU (successfully) argued that sanctions meant that sovereigns could force companies to break contracts and that sovereigns had sovereign immunity. Russia, using that precedent is arguing that companies such as Gazprom should only accept payment in Rubles. But it should hardly have been a surprise.
“They shut down the correspondent accounts for our commercial banks, made settlements in dollars and euros impossible and disconnected the banks on the sanctions list from SWIFT, at least some of them. What did they think we were going to do?”
The realty is that European companies simply have to open Ruble accounts with non-sanctioned banks and transact in Rubles. Prior to this announcement, 80% of $/Euro revenues from resource sales had to be converted into Rubles anyway, so this is not going to massively increase demand for Rubles, as explained in this detailed an informative article from Naked Capitalism. Also worth noting that the Ruble/Yuan exchange rate, having spiked 80% from its January level is now ‘only’ 21% above its previous (recently highly stable) rate, similar to the 22% spike in the Euro/Swiss rate in early 2015 when the Swiss ‘unpegged’ the currency.
The bigger question, beyond the Petro-Dollar is the Reserve Currency status of the $. One of the problems with being the Reserve Currency of course is that the country in question is obliged to provide their currency to the rest of the world by running an (ultimately unsustainable) current account deficit – something identified by economist Robert Triffin in the 1960s and subsequently named after him as the Triffin Dilemma. This issue received renewed prominence after the GFC in 2008/9 and, importantly for current considerations, was mentioned by PBOC governor Zhou Xiaochuan, in the context of using the SDR, the currency basket of reserve assets managed by the IMF as a potential replacement for the $ as a modern equivalent of the Bancor. This has a number of appealing aspects to it, while also challenging the conventional wisdom on the unshakable position of the $. Firstly, it is not creating a new Reserve currency, in effect it is already in existence, rather it is utilising something already in place and which is seen by the rest of the world (RoW) as less structurally in favour of the US.
Could the SDR become the new Bancor?
The basket weights are reviewed every 5 years (next due this summer) but , most obviously, unlike in Keynes’ time, they include the Yuan.
This was something we discussed back in 2019 (watch out for the peg…to the SDR) in the wake of a fascinating article about pegging the Hong Kong Dollar to the SDR. At the time, the usual suspects (Kyle Bass, George Soros etc) were banging their drum about the Hong Kong peg, but we chose to stick with the HK authorities, who were supporting this proposal and had previously easily seen off attempts by US hedge funds to undermine the currency. No surprise, to us at least, that the $200m, 200x leveraged fund launched by Kyle Bass betting on the collapse of the HK peg by December 2021 went the same way as all his other ‘bets’ on China.
This article was a follow up to an earlier paper published by the same academics at Peking University and HK Institute for International FInance, Matthew Harrison and Geng Xiao, which looked more broadly at the idea of the SDR as Bancor. At the time of the GFC, the notion of the SDR briefly found favour with then Treasury Secretary Tim Geithner, but after a sharp drop in the $, the view was quickly rescinded. The point of this history, is that a move as dramatic as replacing the $ with the Bancor/SDR needs a crisis, and we may be having exactly the crisis needed to make this change.
Knock on Effects
As noted before, if we now find the Bancor/SDR being used for financing international trade, or even if we simply see more bilateral swap lines as are starting to be used between Russia and India, then the amount of physical trade in $ is going to shrink. The fact is that the $6trn of global trade a year is dwarfed by the $6trn of FX turnover every day. As the BIS tri-annual report shows, this is almost 90% structured around the $.
Take down the use of the dollar in the real world and you need to collapse the 300x leveraged activity of the speculative FX market that trades off the back of it. This market is dominated by the big banks, who effectively are punting their balance sheets around the underlying flows and are a significant contributor to profits, especially as last year, when volatility picks up.
Just as the responses to Covid accelerated changes already underway, so will the responses to the Russian invasion. A deleveraging of leveraged markets trading in $s was already underway thanks to the shift in Fed policy, but the emergence of trading outside of the $ cross in FX and even the prospects of a new market for supra-national debt may well have serious repercussions across the FICC desks that they are only just beginning to realise.