Some say it was Bertrand Russell who gave a public lecture on astronomy describing how the Earth orbits the Sun and how the Sun, in turn, orbits around the centre of a vast collection of stars called our galaxy.
At the end of the lecture, a little old lady got up and said, “… what you have told us is rubbish. The world is really a flat plate supported on the back of a giant tortoise.” The mathematician gave a superior smile before replying, “What is the tortoise standing on?” Said the old lady, “You’re very clever, young man, very clever. But it’s turtles all the way down!”
Had Russell been talking about the global economy, I would have been on the side of the little old lady… only the tortoise would have been the US dollar and all those turtles underneath it, US Federal Debt.
The recently fudged deal between the Biden administration and the Republican-controlled House of Representatives to raise the US Federal Debt limit resulted in an enormous sigh of relief across nearly all capital markets worldwide: the full faith and credit of the United States would continue to be honoured. Dollarworld would not – at least not this time – be knocked off its axis.
Few commentators were churlish enough to note that the net result was yet again to raise the water temperature in that jacuzzi that is today’s US economy. And the froggie wallowing in it will live to bask another day. Yes, over time he will likely become ever more soporific. But most of the financial commentariat dare not let the poor amphibian know that he is a degree or two closer to his day of reckoning. For now, the perverse logic of boiling frog economics remains intact.
In the 15 years since just before the Global Financial Crisis in 2008, US Federal Debt has quadrupled from $8-trillion to $32-trillion today. This Federal Debt increase is the result of the detritus from wars abroad (Afghanistan), “wars” at home (on Covid-19), unfunded Trump tax cuts and much more overspending besides… yes, even President Biden’s ballyhooed Inflation Reduction Act.
In the next decade, the bipartisan Congressional Budget Office expects that Federal Debt total to rise by another $20-trillion to $52-trillion. Though the increase will not be “straight line” – this year’s deficit is forecast to be “only” $1.4-trillion, over half of which will again be financed by foreigners – the coming increase translates into an average of $2-trillion growth in Federal Debt for each year during the next decade.
And most of that increase will be funded via those “turtles”: US dollar bond market debt (BMD) issued by way of Treasury Bonds, Bills and their like.
At the risk of getting financially geeky, it is important to understand the truly axiomatic role played by Treasury Bonds in the Dollarworld of capital. Quite simply, they determine the price of risk and so – theoretically – the value of pretty much every financial instrument that can be traded internationally. (Not cryptos, of course: but then is that one further reason why the SEC is now going after digital currencies?)
As any student of the first level of the CFA programme focusing on the cornerstones of modern corporate finance will tell you, in the end – and indeed from the very beginning – it is the yield on the 10-year US Treasury Bond (USTB) that theoretically determines the price of every other security in the US dollar atmosphere, be they an equity or debt instrument. Those assets outside that atmosphere are few, but yes, their number is growing and yes, their benchmarks are different… but I will come to that below.
Back in Dollarworld, that USTB 10-year yield is the gimbal at the heart of the gyroscope of capital: the sun at the centre of the solar system of finance.
And if something were to knock that gimbal off its spin axis, the financial consequences would be “catastrophic”… which is the precise term used by Janet Yellen ahead of that recent US Federal Debt limit deal: for nearly all in the US and many beyond, it just had to be done.
Why then is this seemingly esoteric measure so important? Because it is assumed to be the “risk-free rate”… only it is patently no longer “risk-free” and, in all truth, it never was. Still valuation methodologies had to start somewhere, and this linchpin was that somewhere. What it defines – theoretically – is the risk-free opportunity cost of capital. If you dare to invest anywhere else, you had better be duly rewarded for taking that extra risk above and beyond this “guaranteed” return.
(That today’s US 10-year Treasury yield [3.75%] remains below US CPI [4.0%] and has done so for much of the past five years only makes matters worse for capital. But I will not open that Pandora’s Box here.)
The net result of this is that much of the world of finance has come to be built upon Treasuries, this bale of turtles that is the pool of issued US Federal BMD. (Yes, I had to look it up: it is a “bale” of turtles!) The borrowing instruments underpinning Federal Debt anchor the wider universe of BMD issued within the United States.
39% of global BMD
And according to the Bank of International Settlements, in 2022, the US share of total BMD outstanding worldwide was $51.3-trillion out of the global total of $133-trillion, some 39%. (Note that this 39% share is carried on the shoulders of 4.3% of the world’s population. At the lesser $32-trillion, each US citizen is now weighed down by nearly $95,000 of today’s Federal Debt, each taxpayer by $245,000.)
Though not umbilically linked, this 39% share comes close to matching the global share of government deficits the US ran in 2021: 42% or $2.7-trillion out of a global government deficit total of $6.4-trillion. It is also worth noting that all the 2021 budget surpluses run by the few like Norway and the UAE totalled a mere $244-billion, meaning over $6-trillion of all those 2021 government deficits most of the world created were unfunded; to repeat: not covered by income but by BMD.
Granted, this means the US is not alone in its overspending, merely the Granddaddy of them all when it comes to the gargantuan scale of its fiscal profligacy.
The influence of that Treasury Bond yield does not stop with that American share of 39%: the amount of BMD globally keyed off that USTB 10-year yield is larger than just that $51.3-trillion rooted inside the US. Again, according to the BIS, the rest of the West (Japan and Korea included) accounted for a further $43.4-trillion worth of government BMD securities; note that this aggregate is less than that of the US alone.
To a greater (UK) or lesser (Germany) degree, valuation metrics of these Western turtles are mathematically and mechanically linked to that US BMD bale. Beyond the West’s total of $94.7-trillion, the rest – broadly what is sometimes called the Global South – accounted for the balance of $38.3-trillion, with China alone accounting for $20.8-trillion of that residual.
And, as all South African market operators know, even some of the Global South’s $38.3-trillion dances in time to the T-Bond tango.
Nor does the influence of the Treasury Bond yield on fixed income securities stop at bonds: the even larger-in-size tradable credit market is also keyed off this linchpin. As a London colleague noted, it really is “one rate to rule them all”.
I realise that I may have overwhelmed the reader with big numbers… but that was deliberate. In going into the specifics of the US BMD bale, I sought to shock as to how utterly ginormous it has become, and as such, just how precarious is the foundation upon which the world of finance now stands. And it is not just the US BMD pile – that turtle bale – that is precarious: by definition, it is the status of that bale’s currency of denomination, the tortoise that is the US dollar.
Different atmospheres for trade and capital flows
No wonder much of the Global South – led by the BRICS Club – are now looking to breathe another, non-US dollar atmosphere for their trade and capital flows!
One consequence of global decoupling between the US and China – or de-risking if you use the less provocative term – will be that it will move to create two (and maybe more) different atmospheres for trade and capital flows. One remains all too familiar: it is centred on that of the US dollar tortoise and its supporting Federal Debt turtles.
The only other atmosphere of consequence (at least for now) is far less familiar and much harder to define as it has only recently started to take shape. As yet, there is no dominant currency within it, though the growing assumption is that the Chinese renminbi will at least be “primus inter pares”, though I expect the Indian rupee also to feature heavily.
Were this to happen, the yields on the Chinese and Indian 10-year Government Bonds might yet become valuation linchpins in those alternative atmospheres.
There is evidence of this growing bifurcation of trade and capital atmospheres everywhere. Take, for example, the total funding raised by China-focused venture capital and private equity funds outside of China. In 2021, it reached $48.6-billion. In 2022, it fell to $16.5-billion. Thus far for 2023, it has totalled only $1.15-billion.
At the global level, only those countries with exchange controls – notably on the free flow of capital into and out of their economies – can hope to insulate themselves from the atmospheric pressure of Dollarworld. This is far easier to do if they also run a current account surplus as well as have significant levels of foreign exchange reserves.
In normal times, South Africa has neither, making us very dependent on the rising and falling of the barometer readings of Dollarworld. By contrast, China is largely insulated from these Dollarworld atmospheric fluctuations: it always runs a current account surplus and has the ample foreign exchange reserves needed to maintain an “air-lock” between its own atmosphere and that of Dollarworld.
Though there will be much else besides to discuss at the upcoming BRICS Summit in August – whether it takes place in Johannesburg or another more Putin-friendly location – one priority will be to start mapping out the architecture for alternative atmospheres: my hunch is that, short term, the initial focus will be on de-dollarising trade flows before moving on to de-dollarising capital flows, although the BRICS Bank is already considering the latter.
The new path will not be easy to map out: global finance’s network dependency on the US dollar for trade and capital flows is probably more pervasive than our computers’ dependency on the Windows operating system! But expect a start to be made in August.
Its success will likely depend on which other current account surplus runners join the BRICS Club in the coming years. China will be the anchor tenant of course, while Russia is unavoidably and enthusiastically a member too; both run current account surpluses.
Watch for the positions taken by the leading oil exporters and other surplus runners, led by Saudi Arabia and the UAE. Collectively, the unspent export earnings of these countries could provide an extra degree of cover for the three existing members of the BRICS Club – India, Brazil and South Africa – that traditionally run current account deficits.
South Africa exposed
South Africa is even more exposed than India and Brazil: our foreign exchange reserves only cover 4.6 months of imports. Our bond and equity markets are so integrated with that Dollarworld that any premature move to another atmosphere would be incredibly disruptive. The South African Reserve Bank has already warned as much.
My sense is other nations will need to take the lead in constructing alternative atmospheres before the likes of South Africa would consider diversifying away from Dollarworld.
Furthermore, these alternate atmospheres will need to be more defined and robust than they are today before nations that habitually run external deficits would consider making such a risky migration, even partially and even then, initially concentrating on trade flows before adding capital flows.
But there are signs that this migration is – very tentatively – starting to happen, predictably within the trade transactions of other BRICS nations.
India is buying gas from the UAE and using dirhams to settle their import bill; India obtained those dirhams by accepting them as payment for its exports to the UAE. Brazil is starting to settle trade with China using both reais and renminbi. For now, the amounts involved are not large.
But the mechanical channels are being put in place to grow these volumes and so to bypass the US dollar and in particular to disintermediate the US dollar clearing-house mechanism located in New York’s banking system.
Meanwhile, the turtle population of US BMD upon which today’s Dollarworld of finance rests continues to breed at an almost uncontrolled rate. And, as the Bible did not say, but even Bertrand Russell would have doubtless agreed: “It would be a foolish nation that built its financial house on the back of a tortoise itself riding upon the backs of a fast-growing bale of turtles.”
Awkwardly, unsurprisingly and perhaps even understandably, for now South Africa prefers being trapped in the known realm of the foolish rather than venturing forth into that unknown unknown. This means South Africa is choosing the Devil of Ballooning US Dollar Debt over the Deep Blue Sea. But for how long? DM