Global Policy Watch: Much Ado About De-dollarisation
Reflections on global policy issues
— RSJ
This week, Donald Trump urged Republican lawmakers to let the U.S. default on its debt if the Democrats don’t agree on massive budget cuts. Trump likened the people running the U.S. treasury to ‘drunken sailors’, an epithet I can get behind. Default is not something Janet Yellen, the U.S. Treasury Secretary, can even begin to imagine. As CNBC reported, Yellen chose strong words to express her views if the debt ceiling was not raised by the House:
“The notion of defaulting on our debt is something that would so badly undermine the U.S. and global economy that I think it should be regarded by everyone as unthinkable,” she told reporters. “America should never default.”
When asked about steps the Biden administration could take in the wake of a default, Yellen emphasized that lawmakers must raise the debt ceiling.
“There is no good alternative that will save us from catastrophe. I don’t want to get into ranking which bad alternative is better than others, but the only reasonable thing is to raise the debt ceiling and to avoid the dreadful consequences that will come,” she told reporters, noting that defaulting on debt can be prevented.
There is more than a grain of truth there in some of her apparent hyperbole. The U.S. hegemony in the global financial system runs on trust that they won’t default on their debt. Take that trust out of the equation, and what have you got left? This is somewhat more salient in these times when there’s a talk of de-dollarisation going around. Russia and China have been keen to trade in their own currencies between themselves and other partners who are amenable to this idea. And they have found some traction in this idea from other countries who aren’t exactly bit players in the global economy. In March this year, the yuan overtook the dollar in being the predominant currency used for cross-border transactions in China.
Here’s a quick run-through of what different countries have been doing to reduce their dollar dependence. Russia and Saudi Arabia are using yuan to settle payments for gas and oil trade. Russia offloaded a lot of US dollars in its foreign reserves before the start of the war and replaced it with gold and yuan. It will possibly continue building yuan reserves in future. Brazil is already doing trade settlements in yuan and is also using the CIPS (China’s response to US-dominated SWIFT) for international financial messaging services. Argentina and Thailand seem to be also doing more of their trade with China in yuan. And I’m not including the likes of Pakistan, Bangladesh and other smaller economies that have politically or economically tied themselves up with China and are following suit. And a few weeks back, the French President, Emmanuel Macron, also raised the issue of strategic autonomy of the EU after his visit to Beijing. As Politico reported:
Macron also argued that Europe had increased its dependency on the U.S. for weapons and energy and must now focus on boosting European defense industries. He also suggested Europe should reduce its dependence on the “extraterritoriality of the U.S. dollar,” a key policy objective of both Moscow and Beijing.
“If the tensions between the two superpowers heat up … we won’t have the time nor the resources to finance our strategic autonomy and we will become vassals,” he said.
You get the picture. This idea of de-dollarisation seems to be gaining traction. How real is this possibility? There are possibly three lenses to look at this issue, and we will cover them in this edition.
Why the recent hate for the dollar?
A useful area to start with is to understand where this desire to find alternatives to the dollar is emerging. I mean, it is obvious why Russia and China are doing it and the way the U.S. used its dominance over the financial system to shut out Russia. Companies were barred from trading with Russia, Russian banks couldn’t access SWIFT and networks like Visa and Mastercard stopped their operations. Russia got the message but so did other large economies that didn’t think of themselves firmly in the U.S. camp. ‘What if’ questions began circulating among policymakers there. What if, in future, a somewhat unpredictable U.S. president decides to do this to us? And once you start building these scenarios, you soon realise the extent of dependence the global financial system has on not just the dollar but, beyond it, to the infrastructure and rules of the game developed by the U.S. corporations. There’s been a measured retreat ever since.
In India, a visible example of this has been the push toward Rupay by the regulator and the government in lieu of Visa and Mastercard. But merely looking at the U.S. response to Russia as the reason would be missing the longer-term trend. In his book ‘Bucking the Buck’, Daniel McDowell shows data on the annual number of executive orders that instruct the US Treasury to enforce financial sanctions against specially designated nationals (SDNs). These were rarities in the 70s. By the early 2000s, such annual orders were in their low twenties and in the last few years, they have reached the three-figure mark. It is clear that the U.S. is using its enormous clout as the owner of the global reserve currency and financial infrastructure to punish those who fall out of line. This is war by other means. Interestingly, this ‘sanctions happy’ behaviour in the last decade coincided with a wave of populist leaders coming into power in many countries who would not like to be seen as weak or held to ransom by the U.S. This has meant these states have used strategic autonomy as a plank to pursue their interests to go around the U.S. built system. I don’t see this trend abating any time soon. The future U.S. administrations will continue to use financial coercion as a tool because it appears bloodless, and the larger economies will continue freeing themselves from this hegemony one system at a time.
The tough and fortuitous road to becoming a reserve currency
But does that mean we will eventually end up with de-dollarisation? Well, there are two things to appreciate here. How does a currency become a reserve currency? How did the dollar become one? And once it does, what keeps it there? If you go back a little over a hundred years, most countries in the world pegged their currencies to gold as a means of facilitating cross-border trade and stabilising currencies. But during World War 1, it became difficult for these countries to fund their war expenses without printing paper money and devaluing their currencies. Britain continued adhering to the gold standard, but it was difficult for it to sustain its war efforts too. It had to borrow to run its expenses during and after WWI. Between the two wars, the U.S. became a huge exporter of goods and armament to the rest of the world, and it took the payment in gold. By the time World War 2 was ending, the U.S. had hoarded most of the world’s gold, which made going back to the gold standard impossible because other countries just didn’t have any gold. When the allied nations met at Bretton Woods to discuss the new financial world order after the war, it became quite clear that the only real option of managing a foreign exchange system was one that would have all other currencies pegged to the dollar, which would then be linked to gold. It is important to understand that there was no specific effort made to replace Pound as the international reserve currency. It just became inevitable, given the mix of circumstances.
Around the same time and for a decade after, the U.S. led the post-war reconstruction efforts in Western Europe and Japan, which gave it a political clout that was unmatched. This political dominance, along with the remnants of the Bretton Woods agreement, is what runs the global currency system in our times, though, in the 70s, the U.S. delinked the dollar from gold as well. That led to the floating exchange rates system that exists today and the dollarisation of the global economy. Over time countries learnt to accumulate their foreign exchange reserves in dollars by buying U.S. treasury bills. Together with the IMF and WB and the associated ecosystem that got built around the U.S. dollar, it became the force that it is today. Now for any currency to replace the U.S. dollar, it has to have the happy coincidence of being a dominant political and economic force, a lack of alternatives for the countries and an alternative to Bretton Wood (or a modification of the same) which can replace the current system. It is very difficult to imagine how something like this can happen unless there is a global crisis of a magnitude where a rebaselining of everything becomes the only way ahead.
That brings us to the other point on what sustains the dollar as a reserve currency. There are multiple factors at play here. There are, of course, the network effects of the dollar being deeply embedded in so many commercial ecosystems that taking it out is rife with friction and pain. Also, the dollar is fully convertible, which makes it convenient for others to use it as a store of value. It has remained stable; its market is deep and liquid, enabling easy conversion of bonds to cash and vice versa; there exists a mature insurance market to cover currency risks and above all, we have an implicit guarantee that the U.S. will not default on its debt. This is a trust that has been built over the last eight decades because the world believes the U.S. will run a rule-based order with a strong legal framework to ensure no single person can override rules or conventions.
Yawn when you hear Yuan as the next reserve currency
So, how does one see the efforts of China or Russia to wean themselves away from this dollar-dominated system? Will the yuan be able to replace the dollar ever? Apart from the points mentioned above, which led to the dollar being in a unique place in the world in the post-war days and which won’t repeat itself any time soon, there are other fundamental issues with the idea of the yuan as a reserve currency. To begin with, it isn’t convertible, and China runs a ‘closed’ capital account system. It is difficult to move money in and out of the country freely. You will need approvals. The opaque legal system, the authoritarian one-party (one-man) rule and the lack of depth in the yuan market mean it is impossible to imagine any prudent central bank risking its entire foreign exchange reserve in yuan. China could turn into an economic giant by exploiting a global trade order without adhering to its associated political expectations. But to think it could do the same in currency exchange order is a pipe dream. Even the numbers of the recent past bear this out. For all the talk of de-dollarisation, there has been a net sell-off of Chinese government bonds by private players in the last year. No one wants to sit on Chinese bonds if things go south in the global political economy. The central banks around the world who have wanted to diversify away from the dollar in their foreign exchange reserve don’t seem to have walked their talk. Even they have been net sellers of Chinese government bonds barring the initial days of the Ukraine war. Lastly, China is still struggling to raise consumption in its economy because, with a closed capital account and surplus capacity, it doesn’t know what to do with the surplus yuan. Without consumption going up, it will make things worse if it starts becoming a reserved or a semi-reserve currency for the world.
The probability of de-dollarisation seems to be hugely exaggerated at this moment. The alternatives are worse, and for those who complain about the coercive nature of U.S. diplomacy because of their financial clout, wait till you have China with that power. You can check with Sri Lanka for how it feels to be under China’s thumb economically. Also, none of the hype around bitcoin, stablecoin or CBDC is ever going to materialise for them to replace the dollar. The recent events have shown the fairly flimsy ground on which the bitcoin exchanges (banks?) run. It is difficult to see the lack of trust to change in a hurry. But this also doesn’t mean the trend towards diversification of central banks’ reserves will buck soon. The gradual move towards reducing dependence on the dollar and its associated ecosystem will continue. Should the U.S. be worried about this? It shouldn’t, really. It draws enormous privilege for being the reserve currency of the world. It makes its job to borrow or access money very easy. And the fact that it is a safe haven means it benefits from every crisis. But it should also be clear that this privilege has hurt its ability to export because the dollar remains stronger than it should. This, in turn, has led to the financialisation of the U.S. economy, with the rich getting richer and an evisceration of the U.S. manufacturing capabilities. Reserve diversification won’t be such a bad thing for them. But that might mean a reduction of a few hundred basis points in what central banks hold globally in U.S. treasuries.
That won’t de-dollarise the world. For that to happen, something catastrophic will need to happen. Maybe that’s why Yellen used that word about the possibility of the U.S. defaulting on its debt. That’s the kind of self-goal they must avoid.
Matsyanyaaya: The Two Equilibria in India-US Relations
Big fish eating small fish = Foreign Policy in action
— Pranay Kotasthane
There has been a healthy debate over the last couple of weeks on the state of the India-US relationship. In a Foreign Affairs article, Ashley Tellis, a key figure in the 2005 civil nuclear deal, a well-known realist scholar, and a strong proponent of stronger India-US relations, cast some doubt on the burgeoning partnership. The article, provocatively titled ‘America’s bad bet on India’, concludes thus:
The United States should certainly help India to the degree compatible with American interests. But it should harbor no illusions that its support, no matter how generous, will entice India to join it in any military coalition against China. The relationship with India is fundamentally unlike those that the United States enjoys with its allies. The Biden administration should recognize this reality rather than try to alter it.
Tellis reasons that India wants a closer relationship with the US to increase its own national power, not to preserve the liberal international order or to collaborate on mutual defence against China. He further argues that the US ‘generosity’ towards India is unlikely to help achieve its strategic aim of securing meaningful military contributions from India to defeat any Chinese aggression in East Asia or the South China Sea.
As you would imagine, this article put the cat amongst the pigeons. However, I agree with the fundamental argument. Expectation setting is important, and it is true that India is unlikely to behave like a weaker ally; the US-India relationship will most certainly have some shades that the US-China relationship had between 1980 and 2005.
In what seems to be a rejoinder to this article, Ashok Malik—previously a policy advisor in the external affairs ministry—argues that fixating on India’s role in a hypothetical war on Taiwan is a wrong question to ask, an imagined roadblock that even the Biden administration isn’t overly concerned about. Instead, Malik lists the growing relationship in several domains to conclude that the two administrations are far more sanguine, having figured out an approach to work with each other despite key differences.
I agree with this view as well. There’s no doubt that the India-US relationship has grown across sectors despite fundamental differences during an ongoing war in Europe. It is easy to. observe the shift in India-US conversations at the policy execution levels. The talks are no longer about the whys but about the hows. Gone are the days when the India-US partnership conversations began with Pakistan and ended with Russia, with the two sides taking potshots at each other in between. The conversations are about debating realistic projects that India and the US could accomplish together in areas such as space, biotechnology, semiconductors, and defence.
How, then, can I agree with two seemingly opposing views? Because they aren’t mutually exclusive. The India-US relationship is so far behind the production possibility frontier on technology, trade and defence that there are enough low-hanging fruits to pick. And that’s exactly what we are seeing now. But if the US president were to change, or if there were to be an escalation around Taiwan, the India-US relationship would likely hit a ceiling that Tellis warns about.
In edition #165, I proposed a tri-axis framework to look at the India-US relationship: state-to-state relations, state-to-people relations, and people-to-people relations. There has never been a problem on the people-to-people axis. Like Mr Malik, I, too, think that state-to-state relations have turned a corner. However, it is the state-to-people axis which is the problematic axis. Many Indians still seem to harbour a deep frustration with the American State. On the other hand, many Americans also have doubts about the Indian State as a strategic actor.
Finally, it’s only the two administrations that can break this ceiling. The trade-offs aren’t easy, but they are real. Without the Indian government committing itself to do more to counter the Chinese military threat in the seas, the US is unlikely to transfer cutting-edge technologies. Likewise, unless the US quits its stubbornness to give more Indian products preferential access to its markets or delivers on the asymmetric promises under the technology and defence agreements, India is unlikely to revise its stance.
In other words, the stage is set for the Indian PM’s official state visit to the US next month.
India Policy Watch #1: Generalists vs General Equilibrium
Insights on issues relevant to India
— Pranay Kotasthane
Non-civil services folks who have worked in governments are almost always extremely insightful. Perhaps, their experience working with the bureaucracy gives them a filter to reject impractical ideas, while their breadth of knowledge allows them to take a long-term view of policy ideas. These "scholar-warriors" are often able to get to the root of issues.
One such person is Montek Singh Ahluwalia, who was a guest on this week's Ideas of India podcast. Among the many insights he delivers, one that switched a lightbulb on for me was the segment on "generalists vs specialists" in government. While this is an old debate, one that civil service "mains" exam takers would not so fondly recall, this conversation made me think somewhat differently.
Responding to a question on the HR problems in government, Ahluwalia says:
There’s big bias within the government against people wanting to specialize. The IAS’ view of itself is, it’s a generalist service. This I think is a bit of a colonial hangover. You come from England to rule the country; expertise is looked down upon. But in this day and age, we ought to be encouraging the people who are really into IT—there’s no point putting someone who’s really made up his mind that he wants to be in IT to have a stint in education and health and road transport and that sort of stuff.
At another point in the episode, he begins the journey of a policy reform as follows:
In the Indian system, and maybe it’s true in all systems, every area is assigned to a ministry, and changes of policy that belong (in a narrow sense) to that area are the responsibility of the ministry. There are two problems here. One is, the functioning of a system as a whole requires you to do more than just add up what needs to be done in each area, because you want to look at what the economist would call a general equilibrium approach. If you want to reach a particular result, you’ve got to do A over here, B over there, C over there.
I think there's a deeper insight at the intersection of these two dimensions. The “generalists vs specialists” debate masks another important dimension of effectiveness—whether the person approaches a problem with general equilibrium thinking or is limited to partial equilibrium analysis.
General equilibrium analysis takes into account the long-term interactions of a large number of economic agents. In mathematical terms, it is based on the assumption that several variables can change at once in response to a policy change. Partial equilibrium analysis, on the other hand, focuses narrowly on one sector and a handful of variables.
Ahluwalia explains that generalist civil service officers can default to partial equilibrium analysis because they are blinkered by their ministry mandates and interests. For example, few bureaucrats from the Ministry of Commerce will advocate that a unilateral lowering of tariffs will be beneficial to India, even though a general equilibrium analysis says so.
However, many specialists also fall into this same trap, albeit for different reasons. An urban planner is likely to hate mixed-use neighbourhoods, while an environmentalist might argue that all mining is evil. These partial equilibria arise from the failure to see the interlinkages across the economy, a crucial aspect of general equilibrium analysis.
So, irrespective of whether you are a generalist or a specialist, what matters is whether the bureaucrats are able to approach problems with a general equilibrium mindset. The current government mechanism to move career bureaucrats across ministries through deputations is probably a sub-optimal way to achieve competence in this dimension. The second mechanism is to have intra-ministerial committees or expert committees. Organisations such as the Planning Commission, Niti Aayog, or the PMO are supposed to bring in a general equilibrium mindset as well. The question is which of these bodies is best equipped to do this in this way. Probably, another way to push towards this equilibrium is to have economists and behavioural sociologists in many ministries so that their internal recommendations take a broader view beyond the self-protection of ministerial turfs.
PS: There’s a nice chapter on “Trace the general equilibrium effects” in In Service of the Republic by Shah & Kelkar.
HomeWork
Reading and listening recommendations on public policy matters
A Twitter friend asked for book recommendations to understand post-independence Indian economic history. These are the ones that came to mind:
India's Long Road: The Search for Prosperity by Vijay Joshi
India: the Emerging Giant by Arvind Panagariya
India's Tryst with Destiny by Arvind Panagariya and Jagdish Bhagwati
Backstage: The Story Behind India’s High Growth Years by Montek Singh Ahluwalia &
Changing India volume, this set is a compilation of Manmohan Singh’s papers (reading level: advanced)
[Podcast] This Grand Tamasha episode is a great introduction to internal security in India, backed by the latest research and data on a crucial yet under-discussed topic.
[Podcast] Should there be a caste census? Here’s a Puliyabaazi on this topic that’s sure to gain more traction as the national election draws near. We present two opposing perspectives, one by Yogendra Yadav and the other by Pratap Bhanu Mehta, before reaching our own divergent conclusions. Listen in and tell us what you think.
#210 Metastability