USD, SDR, Economic Collapse, Sovereign Debt, China, Russia, SWIFT, and SAP
The fear of an economic collapse is a constant emotion which spans across financial demographics and business news cycles. Everything from sovereign debt pressures to currency wars, with trade wars sprinkled in for good measure, are leveraged as potential sparks for the next crisis.
Over the last five years, I have made a reasonable case that central bank monetary policies around Quantitative Easing (QE), and the subsequent Quantitative Tightening (QT), or normalization of monetary policy, would not lead to the dollar collapse and economic turmoil that so many had been predicting. There has been much written about the QE response to the financial crisis of 2008 and the inevitable normalization of those policies which would follow. So let’s just focus on the basic economics to help us understand the broader impact of these policies and the direction the world now appears to be taking as a response to the last crisis.
Economist Robert Triffin developed an economic theory around the inherent conflict which develops when a national, or political credit-based currency, such as the US dollar, is used in an international reserve function. The domestic and international responsibilities of such a currency are in opposition to one another and create an ever-escalating monetary imbalance which has an impact on the entire global structure. Triffin stated that America would have to carry a current account deficit in order to maintain the dollars de facto global reserve position. When we consider that America went from having the world’s largest trade surplus at the end of WW2 to now having the world’s largest trade deficit, we can’t help but follow Robert Triffin’s reasoning to the same conclusion.
There could be more to the story though, and Triffin’s theory may have been flawed. On a base fundamental level, the theory is stable and proven accurate when correlated with real-world events. But on a more complex level, the theory may not be as applicable. We will explore this later in the article when we consider the re-alignment on trade deals being mandated under the Trump Doctrine.
The Triffin Paradox, as it became known, has been one of the most widely cited bodies of economic theory in the last half-century. Triffin accurately predicted that a widening international use of the USD, along with a gold shortage, would eventually lead to a run on US gold holdings. The fact that this indeed happened in the 1960’s and eventually led to President Nixon closing the “gold window” in 1971, gave the Triffin Paradox foundational support with most economists.
The original Bretton Woods agreement was a partial gold standard (non-domestic convertibility) and in essence, ended in 1971, but the international role of the USD only increased further as OPEC agreed to transact all global energy sales in American dollars. The International Monetary Fund (one of the institutions created at Bretton Woods in 1944, alongside the World Bank (WB) and World Trade Organization (WTO), created a supra-sovereign asset called Special Drawing Right (SDR) in 1969. The SDR was developed as an alternative measure to provide financial assistance, or liquidity, to nations who found themselves on the wrong end of the growing global imbalances.
The Bretton Woods institutions and the monetary and financial policies which followed were purposed with the task of managing the USD centered framework. The institutions worked hand-in-hand with the Federal Reserve and other central banks around the world to ensure the imbalances were managed through exchange rate arrangements and domestic interest rate policies which more served the international objectives as opposed to the domestic needs of any specific nation.
The SDR from inception was built as a value-composition of the top global reserve currencies. This is an important distinction. The SDR is not supported by a basket of currencies. It is, in fact, the basket. No basket - no SDR. It is an alternative reserve asset which is not a currency, but it does serve as a claim on currency held by IMF members. We will come back to the SDR further down.
On December 11, 2001, China was admitted to the World Trade Organization (WTO). America’s growing trade deficit with China began to increase at a faster pace from this point. Outside of the Federal Reserve itself, China is the largest holder of US debt. Most economists and financial analysts consider this to be an advantage which China holds over America, but such is not the case. This widely misunderstood dynamic between both extreme spectrums within the global system of imbalances has caused the People’s Bank of China to explode a domestic credit market which could implode under a strengthening USD.
The best method of understanding this situation is to use a simple example. If I owe you $100 dollars, that is my problem. But if I owe you over a trillion, that is your problem. China has a huge problem which is straining its domestic capital markets and preventing it from fully opening those capital markets to international investors. The internationalization of the renminbi (RMB), or yuan, needs to progress in order for China to strengthen the foundations of its huge economic growth. The continuation of the “Chinese miracle” is not a guarantee, and the domestic economy could implode and cause a revolution within the country.
Does that sound far-fetched? Consider that the Chinese people have a regular history of rising up and overthrowing dynasties and incompetent rulers. The centralized government in Beijing is aware of this and has built its socioeconomic model around the need to develop its vast rural population into a middle class which can consume material goods. The expansive “ghost cities” of China which have been built around the country were meant to house 100 million rural peasants as the new middle class. This could still happen but it will depend on the outcome of the trade re-alignment taking place with America. More on that soon.
On March 23, 2009, as a response to the financial crisis, the Governor of the People’s Bank of China Zhou Xiaochuan published a paper titled “Reform the International Monetary System”. Zhou Xiaochuan was putting forward the idea of reforming the IMF and SDR as an alternative to the Bretton Woods USD based framework. From the paper:
“The desirable goal of reforming the international monetary system, therefore, is to create an international reserve currency that is disconnected from individual nations and is able to remain stable in the long run, thus removing the inherent deficiencies caused by using credit-based national currencies.”
“Though the super-sovereign reserve currency has long since been proposed, yet no substantive progress has been achieved to date. Back in the 1940s, Keynes had already proposed to introduce an international currency unit named “Bancor”, based on the value of 30 representative commodities. Unfortunately, the proposal was not accepted. The collapse of the Bretton Woods system, which was based on the White approach, indicates that the Keynesian approach may have been more farsighted. (Readers can reference the POM article The Geopolitics of XRP for additional information on ”the White approach”. - JC) The IMF also created the SDR in 1969, when the defects of the Bretton Woods system initially emerged, to mitigate the inherent risks sovereign reserve currencies caused. Yet, the role of the SDR has not been put into full play due to limitations on its allocation and the scope of its uses. However, it serves as the light in the tunnel for the reform of the international monetary system.”
“A super-sovereign reserve currency not only eliminates the inherent risks of credit- based sovereign currency, but also makes it possible to manage global liquidity. A super-sovereign reserve currency managed by a global institution could be used to both create and control the global liquidity. And when a country’s currency is no longer used as the yardstick for global trade and as the benchmark for other currencies, the exchange rate policy of the country would be far more effective in adjusting economic imbalances. This will significantly reduce the risks of a future crisis and enhance crisis management capability.”
The better part of POM’s history has been spent understanding these proposed reforms, as most of the major players, including some within the US Treasury Department, were promoting the same. The major challenges with elevating the SDR to a true global currency status involved structural changes to the IMF governance framework. These changes would have reduced American influence over IMF governance, which some within the American establishment disagreed with.
As a response to the 2009 paper by Zhou Xiaochuan the members of the IMF developed the 2010 Governance and Quota Reforms. Though the Obama administration agreed on the reforms at the beginning, America stalled on implementing the changes. A version of these reforms was finally enacted in 2016 around the same time that the Chinese renminbi was added to the SDR composition. The addition of the RMB to the basket was controversial as some felt that the Chinese currency had not yet reached a level of internationalization which would provide it the necessary reserve status of other member currencies. The addition should be considered a political move by the IMF against American interests.
China desperately needs to diversify its foreign exchange reserve holdings of USD denominated debt. The development of RMB denominated financial securities and assets is a strategy to move forward this de-dollarization and internationalization. The on-shore and off-shore RMB serve as a barrier to protect China’s domestic financial markets from speculation while it promotes international expansion.
The New Silk Road Initiative serves as a vehicle for China to expand its influence across the Eurasian Continent (See The Great War for Eurasia while building corridors for RMB liquidity. But the New Silk Road Initiative, like the continuation of China’s domestic growth, is not a guarantee. Emerging nations who have signed on with the New Silk Road Initiative have been burdened with debt to China, and as the USD strengthens under the Trump Doctrine, it’s not just China which is under risk of experiencing a major credit crisis. A strong US dollar can unravel the whole Eurasian geopolitical strategy which China and Russia have been engineering for years. It is unlikely that Russia is unaware of this.
One of the largest challenges with unwinding the dollar standard, or the Bretton Woods framework, involves the existing exchange rate arrangements. For the most part, it is these very arrangements which have been the biggest contributors to the global imbalances which have developed. The Bretton Woods institutions have structured the exchange rates around the world to accommodate and promote a stable USD. As the international supply of USD increased it was the currencies of the emerging markets which carried the bulk of the inflation. This imbalance became so large that American made goods became expensive to other nations. American companies moved factories overseas and shifted the whole global supply chain management framework to the emerging nations.
It is this global supply chain management framework which Trump is now attempting to bring back to America through the re-negotiation of trade agreements.
Over the years I have stated that the answer to correcting the global imbalances would be to devalue the USD to make American made goods more affordable to the rest of the world. This would increase US exports and lead to an overall improvement in GDP. While many focus on the amount of the debt, the larger challenge is debt management. As an example, at the end of WW2, the American debt-to-GDP ratio was substantially higher than it is today. The chart below from the Congressional Budget Office projects the debt-to-GDP ratio out to 2047 but does not consider the substantial increases to GDP under the Trump Doctrine. We should anticipate that this ratio will begin to trend downward in the coming years, which will put America in a stronger position against China.
The flip side of this argument is that the Chinese renminbi would have to appreciate to reduce exports and decrease its trade surplus. America decreases its trade deficit and China decreases its trade surplus through depreciation and appreciation of domestic currencies. Eventually, the imbalances adjust to a level which accommodates global growth and the expansion of liquidity. But that is only part of the issue.
The largest problem in the existing monetary structure is the accumulation of foreign exchange reserves. In particular, it is the large accumulation of USD in the foreign exchange reserve accounts of central banks around the world, with China being the largest. Everything written above is a symptom of this one aspect of the existing dollar standard. These reserves are used to support the USD monetary standard and provide the asset off-set for a central banks liabilities.
The composition of these FX reserves vary from nation to nation, but the largest percentage of accounts around the world is made up of USD. Over the last few years some nations, such as Russia, have been dramatically reducing their holdings of USD. China, for its part, needs to be careful how fast it diversifies its reserves while maintaining a parallel momentum with RMB internationalization. The Trump strategists know this and just about have China in a checkmate position on trade. Beijing will make a deal to prevent a domestic credit implosion and unrest amongst the population.
Under the IMF Sovereign Debt Restructuring Mechanism (SDRM) there are multiple paths forward which can be taken. Nations such as Greece have taken loans from the IMF which have riddled the country with more restrictions on domestic policies and growth potential. The allocation of SDR quota amounts from member nations was one of the items on the table for reforms back in 2010, as suggested by China and Zhou Xiaochuan.
The alternative to the SDRM is Collective Action Clauses, or CAC’s. Both the SDRM and CAC are highly debated by monetary and financial policymakers around the world. The laws governing CAC’s differ from New York to London, with no agreeable alignment on the application of those laws. While CAC’s would benefit the USD standard and American interests, the SDRM would serve the interests of the IMF (and in turn China) and a broader use of the SDR. (See Global Debt Consolidation Under New York Law
Before moving on we need to have a clear understanding of a reserve currency. A domestic currency, as an opposing example, is used for banking and commerce within the economic framework of a nation. It serves the needs of the that domestic economy and interest rate adjustments can be used to expand or contract the money supply as needed to maintain inflation and a sustainable level of growth.
Reserve currencies, with the USD being the dominant and primary reserve asset, need to meet those domestic accountabilities while also maintaining international responsibilities. As we’ve discussed, this is where the problem begins. These international responsibilities include the following:
Serve as a cross-border payment settlement system.
Provide global liquidity through financial assets and investment products.
Provide a pricing benchmark for raw commodities.
Establish an exchange rate pegging mechanism for global trade and commerce.
Each of these can be broken into more detailed aspects, but for our purposes here this simple overview will suffice.
The USD standard has served all four since the Bretton Woods agreement of 1944. The institutions built around the agreement have developed and enacted policies to support the framework, including admitting China into the WTO. Even the SWIFT system of international payments was created to facilitate the dollar standard and its cross-border payment settlement requirements.
Evolving the SDR to replace the USD standard was always a possibility, but the widespread agreements required to get all the major players moving in the same direction is extremely difficult and will continue to slow the reforms needed to prevent another financial crisis. As we can still see today, the strengthening USD is putting extreme pressure on the currencies of the emerging nations, and another Asian currency crisis like in 1998 could be developing.
The global imbalances of the USD standard framework have contributed to a sovereign debt crisis in many nations around the world. Interestingly enough, Russia is one of the few nations with no sovereign debt concerns and is leveraged to replace China as the dominant economic powerhouse on the Eurasian continent. It’s early, but we could be witnessing the transition of primary Eurasian economic and geopolitical power from China to Russia. The Anglo-American establishment (remnants of the British Empire aligned with American business and banking interests - reference The Anglo-American Establishment and Tragedy and Hope by Prof. Carroll Quigley), which Trump has politically overthrown in America, has invested considerable capital and assets in the rise of a dominant China. The reversal of this strategy would be devastating to the long-term interests of this establishment. The Brexit process and separation of Britain from Europe (a Eurasian peninsula) should also be considered a reversal of this strategy. But that’s a story for another time.
As we can see from the above four points regarding the functions of a reserve currency, there isn’t a single asset today that effectively and efficiently meet all of those accountabilities without causing further imbalances. China, itself has stated that it does not want to replace the role of the USD for the same reasons that have negatively impacted the American domestic economy.
The SDR can evolve to accommodate some of the reserve functions but would not be able to provide the level of liquidity needed to meet global growth needs. This is where the emerging new crypto asset class will integrate with, and eventually surpass, the traditional monetary system built around the central bank model.
The central bank model began with the Bank of Amsterdam in 1603 and continued with the Bank of England in 1693. The new central bank liquidity funded the Industrial Revolution and spurred economic growth for centuries. This model is built around the expansion and contraction of credit based money supplies, or fiat currencies. The last reiteration of this model can be found in the Bretton Woods dollar standard, and as multiple crises over the decades attest, the model is no longer capable of providing the liquidity required to drive global growth in the 21st Century.
The four functions of a reserve currency should be segregated and given to different supra-sovereign assets. As an example, the function of providing a cross-border payment settlement standard is now incrementally being shifted towards a more effective and efficient model developed by the company Ripple. Ripple has built a blockchain distributed ledger technology which can leverage its native digital asset XRP to facilitate a cost-effective and almost immediate transaction of cross-border payment settlement. Central banks, large commercial banks, global institutions, and cross-border payment service providers are all beginning the transition to the Ripple technology.
The broad integration of XRP into the cross-border payment settlements function would remove a tremendous amount of international pressure from the USD. This would allow for an increased reduction of USD denominated foreign exchange reserves and begin the process of correcting the monetary imbalances. The moment I grasped what Ripple was building with XRP and the Interledger Protocol was the moment I understood how it would fit into the international monetary system, and why its ascension was inevitable.
But this still leaves three other reserve currency functions which need to be considered. Providing global liquidity through financial assets and investment products is still likely to remain with political credit-based currencies, as each nation will continue to promote financial products denominated in its own domestic asset. This is how it should remain for the foreseeable future, as a nation's growth and interaction with the international system will be the largest contributor to both global growth and liquidity.
Neither the SDR or XRP, by themselves, or with each other, would be able to provide the gigantic amount of global liquidity which will be required to drive 21st Century growth. National currencies, presumably in a new digital version, will interact seamlessly within the new decentralized crypto-based monetary and financial systems. XRP and Interledger will provide the bridge to transfer value from asset to asset within the system.
The SDR could be used to provide the other reserve currency functions which are currently the responsibility of the USD. Providing a benchmark for raw commodities and serving as an exchange rate pegging mechanism to handle the accounting function of global trade and commerce is something which a broader and more reformed SDR could accommodate. Managing Director of the IMF Christine Lagarde has even suggested that a digital version of the SDR could provide greater benefits to the global economy, and for sure, she is right. Based on what we have broken out above, a digital SDR would be the natural evolution for the multi-currency value composition and would integrate within the new crypto-based framework, but its function would be separate from that of XRP. SDR, like other digital assets, would also use XRP and Interledger to transfer value.
It should be noted that the architecture for this new crypto-based monetary and financial standard is being built now as I type these words. Large commercial banks, stock exchanges, central banks, global institutions, amongst others, are all developing crypto-based extensions of their existing services and products. It’s no longer a question of maybe, or hopefully, it is just a matter of developing, validating, and implementing the services and products. With each passing week and month, the world is moving that much closer to the moment of the greatest fulcrum. With the development and validation of the central bank model throughout the 17th Century, few of the average mass population knew what was happening, or could even have understood it. A similar pattern is taking place today, as over 90% of the population either does not understand what is taking place or has never even heard of the things we have just reviewed. That should stand as a statement on our failure as a civilization to educate the mass population on the fundamental and structural components which sustain our shared world. The computer and smartphone are the new printing presses. With so much information available and shared, its troubling that we find ourselves in such a position of educational deficit.
We have covered a lot of ground in this article. It is difficult to make a reasonable argument without building context and a functional understanding of the basics behind the contributing factors. There is one last important piece we must cover before closing the article, and this is around the sovereign debt challenges and the potential use of IMF substitution accounts to address those challenges.
An aspect of the SDRM (Sovereign Debt Restructuring Mechanism) is the use of SDR denominated substitution accounts to reduce the pressures related to sovereign debt. The basic principle is that a nation would exchange its large holdings of foreign exchange reserves for an allocation of SDR. Considering that America holds the largest amount of debt in foreign accounts, the use of substitution accounts would consolidate America’s debt within the IMF itself. This is the core reason why American policymakers, and legal experts, prefer the use of Collective Action Clauses (CACs) over the SDRM. But that is not to say that there couldn’t be a combined use of both strategies.
Trump recently made a statement that America could provide loans to other nations. This is a substantial statement and provides an indication of the direction America may be going on sovereign debt restructuring. Like with the shift from trade surplus to trade deficit, America went from being the worlds largest creditor nation at the end of the war to being the worlds largest debtor nation. The Trump doctrine is attempting to unwind that as well, and once again put America in the lead as a stable nation making loans to others.
The parallel consideration of this strategy is that America may want to keep the dollar strong and retain all reserve functions outside of the cross-border payment settlement standard. To be sure, it is the cross-border function which puts the most strain on the dollar as it contributes to the large expansion of the dollar money supply within the global system and the ever-increasing accumulation in the foreign exchange reserve accounts.
This is where the theory of Robert Triffin breaks down. How applicable can the deficiencies as defined in the Triffin Paradox be when the functions of the reserve currency are segregated? As a whole, the theory is sound, as we described at the beginning, but when considered under the premise of everything we have covered above, aspects of the theory are not as accommodating.
As such, I see a continuation of the back and forth between America and the IMF on reforming the SDR and the governance and quota systems. While the expectation was that America would depreciate the USD to increase exports and grow its GDP, the Trump doctrine has started to achieve the same under trade re-negotiations. Dollar depreciation is Trump’s greatest card, and he will be unlikely to play it until the last moment. A strong dollar gives America a lot of negotiating leverage as the strain on China and other nations is immense. Played strategically and at the right time, dollar depreciation, which in essence would be a re-negotiation of the exchange rate arrangements, could spur the American economy to even greater heights of economic growth. Increasing GDP means a more manageable debt-to-GDP ratio, which means a reduction in America’s debt challenges. No need for fear, an economic crisis is not around the corner. At least not for America.
Unproven claims around developing integrations between Ripple and Swift, the existing cross-border settlements service, provide a logical path forward on the transition components of global settlement. We should anticipate that Swift will become just one of the thousands of Ripple customers who use XRP and the Interledger Protocol to improve efficiencies and lower costs. Eventually, Swift may find itself redundant and losing its own customers, but by that time the whole crypto architecture itself will be functioning at a much larger volume than it is now. The normalization of monetary policy around the existing traditional system, being Quantitative Tightening (QT), or the incremental increase of interest rates and the reduction of central bank balance sheets, will facilitate a contraction of the traditional money supply while the new crypto money supply expands.
Another unproven claim which has come about recently, and actually began back in 2016, is a possible integration between corporate enterprise giant SAP and Ripple. The world’s supply chain management system functions on the SAP platform. Consider that Trump is attempting to shift the world's supply chain management function back to America, alongside reducing the role of the USD in the cross-border settlements, and we can begin to see a larger strategy coming into focus around a new standard built on XRP and Interledger. We can speculate with our broad understanding and education, but we will need to wait for further confirmations before making additional connections. Though there is no denying a clear pattern is unfolding around both the unwinding of Bretton Woods and the development of an expansive XRP architecture. One not being the replacement of the other of course, as both are very much different beasts serving very different purposes. - JC