Letter # 26

The Counterfeiters, a 1940 German film, opens with a concentration camp survivor Solomon Sorowitsch sitting on a beach holding a suitcase full of dollars. The war has just ended and he intends to put that currency, of questionable provenance, to work at the tables of Monte Carlo. You see, it was a bag full of US dollars (not Francs or Lira) that made the scene authentic. Fast forward to City of Ghosts in 2002 set in Cambodia. A crooked insurance salesman uses a suitcase full of dollars to ransom his kidnapped partner and mentor.

The stories are half a century apart and the cinematic setting has moved to emerging Asia, but the currency stays the US dollar, not Euro, nor Yen or Renminbi. No self-respecting kidnapper would accept anything other than the dollar! ⁽¹⁾ Over 80% of the USD100 bills circulate outside the United States, attesting to the dominance of the US Dollar ⁽²⁾. Let us take a brief detour before we return to this topic.

In the past one week, the US Treasury secretary nominee Janet Yellen made two seemingly unrelated comments. One, she said that the US needs to “act big” to revive the flagging economy as she sought to counter criticisms from Republicans that the USD1.9tn stimulus was unaffordable given the 15% fiscal deficit and over 100% national debt to GDP ⁽³⁾.

Second, she called for curtailing the use of Bitcoin as they were “mainly used for terrorist financing” (emphasis mine) ⁽⁴⁾ . She is not alone; ECB President Christine Lagarde also wants “global regulation of Bitcoin due to money laundering concerns.” ⁽⁵⁾ I am sure they are made aware of the many reports that indicate that crypto currency accounts for sub-1% of all money laundering and illicit transactions ⁽⁶⁾.

In the first reading, the two comments may not seem related, but humour me for a moment. Unholy trinity is a pesky macroeconomic problem that all “economists” are aware of, but the “politician” in them believes they can talk their way out of it! What it suggests is that any country can choose among: (a) capital mobility; (b) exchange-rate management; and (c) sovereign monetary policy. A country may choose two, but cannot have all three.

With capital fully convertible in the US and it choosing to have an expansionary fiscal and monetary policy of historic proportions, in theory, the exchange rate should be out of their control. The second comment by Yellen then, was the politician in her, trying to control the hitherto uncontrollable unholy trinity.

The implications of a weaker dollar on international markets (including India) are fascinating, but I would be remiss if I don’t mention the exceptional book Exorbitant Privilege by Barry Eichengreen. As the Federal Reserve’s balance sheet crosses USD7tn (it was still below USD4tn during the taper tantrum in 2013) and US debt to GDP decisively crosses 100%, the last time it happened (mid 1940s) assumes a lot of significance.

The book details the journey of the US dollar to becoming the world’s reserve currency. Prior to WW1, the pecking order of the greenback was much behind Sterling, Mark, Franc, Guilder and Lira. Despite the size and strength of the US economy, the US had no central bank and its currency was a hodge-podge of bond-backed notes by commercial banks. Post the setting up of the Federal Reserve in 1913 and during the WW1, the prominence of the dollar increased dramatically as the Fed did well to create a market for trade credits, smoothed interest rate spikes, reduced financial volatility and solidified management of the gold standard. Europe was floundering at the time, and by 1920, the dollar had become one of the world’s major international currencies. The book then goes on to explain the Bretton Woods era (1945 to 1970), the history of international monetary system (1970s through 1990s), the official adoption of Euro (1999), recent GFC (2008 onwards) and what the future might possibly hold.

Lastly then, onto the impact of a weak dollar on Emerging Markets. Over the past four months, FIIs have invested USD21bn into the Indian equity market (previous best was USD16bn in 2012 for the full year!). Although this has stretched market valuations dramatically, we note that such behaviour is not unprecedented–a US dollar depreciation has been intricately linked to higher Emerging Market returns (see chart below). Between 2002 and 2008, the dollar index fell by 40% (from 120 to 72) and Emerging Markets returned 205% over the period. Then, between 2008 and 2017 (nearly 9 years) the dollar index rose from 72 to 102 (up 40%) and Emerging Markets returned a cumulative -12%. Since 2017, however, the dollar index has been falling again, briefly breaching 90 this month.

For every time then that “market experts” point to markets trading over 2 standard deviations above mean and central bank governor suggesting that “stretched valuations threaten stability” ⁽⁷⁾, by historical precedent, it is quite plausible that foreign investors will keep pouring money into Emerging Markets and India as well. When liquidity becomes more important than fundamentals, it might behoove us to track liquidity at least with half the zeal as closely as we track fundamentals.

Note:
(1) Stories adapted from the book: The exorbitant privilege
(2) There are more $100 bills in circulation than $1 bills, and it makes no cents – The Washington Post
(3) Janet Yellen says US must ‘act big’ to revive flagging economy | US economy | The Guardian
(4) Janet Yellen suggests ‘curtailing’ cryptocurrencies such as Bitcoin, saying they are mainly used for illegal financing | Business Insider India
(5) ECB President Christine Lagarde Wants Global Regulation of Bitcoin Due to Money Laundering Concerns, FATF Plans Update on Implementation of VASP Rules (crowdfundinsider.com)
(6) The False Narrative Of Bitcoin’s Role In Illicit Activity (forbes.com)
(7) Stretched valuations threaten stability: Shaktikanta Das – The Hindu

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