The Dollar Reserve Standard and the Interconnectedness of Fiat Currencies
Here, I explore some of the implications of the dollar reserve standard. What do I really mean by ‘dollar reserve standard’? I mean that a significant proportion of minor central banks own dollars and dollar-denominated assets. In short, the renminbi, the taiwan dollar, the korean won, etc. are all ‘good for’ dollars. Meaning; these currencies are liabilities of their respective central banks, that – in turn – own dollars (and dollar-denominated assets).
I seek to briefly answer the questions: what does this mean for the world? What does this mean for prices? How can a contrarian investor wield this understanding to his/her advantage?
The dollar is mainly ‘good for’ government bonds, mortgage-back securities, and gold. That is, dollars (which are liabilities of the Fed) are backed by the Fed’s assets. A chart of the Fed’s balance sheet with some commentary is shown here. As I have discussed previously, there should always be a profit-motive in owning a currency, for it to be a functioning currency. Put simply, I mean this: a dollar is a claim on some collection of assets. For there to be a profit-motive in owning a dollar, the amount paid for a dollar – in trade – should be less than what the dollar is ‘good for’. For example, if a dollar was backed by only 1 ounce of gold, who in their right mind would swap more than 1 ounce of gold for that dollar?
So now getting on to foreign fiat currencies; the same applies, only they are – themselves – (mostly) backed by dollars (and dollar-denominated assets). That is, the reserves held against foreign fiat currencies are dollars and dollar-denominated assets. If – say – a 100 RMB note were ‘good for’ $15, then who in their right mind would pay more than $15 for a 100 RMB note?
How does this help in the endeavor of speculation?
Ask yourself the following questions; if all of the above is true, what does a scarcity of dollars entail for foreign fiat currencies? And, what would an abundance of dollars entail for foreign fiat currencies?
I hope the profound interconnectedness of fiat currencies is becoming apparent to you. Changes in the value of the dollar can have the effect of increasing or decreasing the burden of debts (and other currency liabilities) globally! This is particularly true for those currencies that are either outrightly pegged to the dollar, or – to a significant degree – backed by dollars. Therefore, it should be no surprise to see that emerging market stock indices behave as levered S&P 500s:
When the Fed increases the size of it’s balance sheet, it has the result of diluting the dollar. Since foreign fiat currencies are backed by dollar reserves, those currencies tend to fall in value (vs things). As this occurs, people in ‘short currency long things’ positions tend to gain, and that trade gets progressively more crowded. [Note, this also applies to businesses, who go 'long' capital machinery, wages, and rent via debt]. When the tables turn and the dollar becomes scarce, suddenly, the effects are felt globally (and particularly in dollar-pegged countries). The dollar squeeze entails a mass liquidation in emerging markets that is perhaps more gut-wrenching for EM businessmen than for their developed counterparts. The typical policy is for foreign central banks to devalue their currencies. Meaning, each currency unit becomes backed by less dollars to compensate for their rise in value. And then the cycle starts again…
The long-term bullish case for Asian currencies is that this process – at some point – will become completely intolerable and unpalatable for their respective masses. As central banks change the compositions of their assets away from dollars (and dollar assets), they could appreciate against the long-term sinking dollar.
Russell Napier describes this process very well. I recommend watching the video of this year’s Russia Forum. There are also some great remarks by Marc Faber, Nassim Taleb and Hugh Hendry in it. For similar emerging markets related stuff, see my comparison of the emerging market boom with the 1830s.
Recommended: Charting the Federal Reserve's Assets - 1915 to 2012