Central Banks in a Fragmenting World
Please consider a speech by Christine Lagarde, President of the ECB, on Central Banks in a Fragmenting World
The global economy has been undergoing a period of transformative change. Following the pandemic, Russia’s unjustified war against Ukraine, the weaponization of energy, the sudden acceleration of inflation, as well as a growing rivalry between the United States and China, the tectonic plates of geopolitics are shifting faster.
We are witnessing a fragmentation of the global economy into competing blocs, with each bloc trying to pull as much of the rest of the world closer to its respective strategic interests and shared values. And this fragmentation may well coalesce around two blocs led respectively by the two largest economies in the world.
All this could have far-reaching implications across many domains of policymaking. And today in my remarks, I would like to explore what the implications might be for central banks.
In short, we could see two profound effects on the policy environment for central banks: first, we may see more instability as global supply elasticity wanes; and second, we could see more multipolarity as geopolitical tensions continue to mount.
Today the United States is completely dependent on imports for at least 14 critical minerals. And Europe depends on China for 98% of its rare earth supply. Supply disruptions on these fronts could affect critical sectors in the economy, such as the automobile industry and its transition to electric vehicle production.
In response, governments are legislating to increase supply security, notably through the Inflation Reduction Act in the United States and the strategic autonomy agenda in Europe. But that could, in turn, accelerate fragmentation as firms also adjust in anticipation. Indeed, in the wake of the Russian invasion of Ukraine, the share of global firms planning to regionalize their supply chain almost doubled – to around 45% – compared with a year earlier
This “new global map” – as I have called these changes elsewhere – is likely to have first-order implications for central banks.
One recent study based on data since 1900 finds that geopolitical risks led to high inflation, lower economic activity and a fall in international trade. And ECB analysis suggests similar outcomes may be expected for the future. If global value chains fragment along geopolitical lines, the increase in the global level of consumer prices could range between around 5% in the short run and roughly 1% in the long run.
These changes also suggest that a second shift in the central bank landscape is taking place: we may see the world becoming more multipolar.
During the Pax Americana after 1945, the US dollar became firmly ensconced as the global reserve and transaction currency, and more recently, the euro has risen to second place. This had a range of − mostly beneficial − implications for central banks.
But new trade patterns may have ramifications for payments and international currency reserves.
In recent decades China has already increased over 130-fold its bilateral trade in goods with emerging markets and developing economies, with the country also becoming the world’s top exporter. And recent research indicates there is a significant correlation between a country’s trade with China and its holdings of renminbi as reserves. New trade patterns may also lead to new alliances. One study finds that alliances can increase the share of a currency in the partner’s reserve holdings by roughly 30 percentage points.
All this could create an opportunity for certain countries seeking to reduce their dependency on Western payment systems and currency frameworks – be that for reasons of political preference, financial dependencies, or because of the use of financial sanctions in the past decade.
Anecdotal evidence, including official statements, suggests that some countries intend to increase their use of alternatives to major traditional currencies for invoicing international trade, such as the Chinese renminbi or the Indian rupee. We are also seeing increased accumulation of gold as an alternative reserve asset, possibly driven by countries with closer geopolitical ties to China and Russia.
There are also attempts to create alternatives to SWIFT. Since 2014, Russia has developed such a system for domestic and cross-border use, with over 50 banks across a dozen countries using it last year. And since 2015 China has established its own system to clear payments in renminbi.
These developments do not point to any imminent loss of dominance for the US dollar or the euro. So far, the data do not show substantial changes in the use of international currencies. But they do suggest that international currency status should no longer be taken for granted.
10 Major Points With No Disagreement
- Weaponization of energy
- Fragmentation of the global economy into competing blocs
- More multipolarity as geopolitical tensions continue to mount
- [Historically] geopolitical risks led to high inflation, lower economic activity and a fall in international trade
- Significant correlation between a country’s trade with China and its holdings of renminbi as reserves
- Countries intend to increase their use of alternatives to major traditional currencies for invoicing international trade, such as the Chinese renminbi or the Indian rupee.
- Increased accumulation of gold as an alternative reserve asset, possibly driven by countries with closer geopolitical ties to China and Russia.
- Attempts to create alternatives to SWIFT. Since 2014, Russia has developed such a system for domestic and cross-border use, with over 50 banks across a dozen countries using it last year. And since 2015 China has established its own system to clear payments in renminbi.
- These developments do not point to any imminent loss of dominance for the US dollar or the euro.
- So far, the data do not show substantial changes in the use of international currencies. But they do suggest that international currency status should no longer be taken for granted.
Amazed if Not Shocked
There is not a single thing above that I disagree with, with plenty of things to cover. I am amazed that any central bank president sees things as I do.
Regarding point 8, the EU attempted to create an alternative to SWIFT to facilitate more cooperation with Iran, but failed.
So it’s not just the BRICs (Brazil, Russia, India, and China) attempting to get around US sanction madness.
Brazil’s President Calls for End to US Dollar Trade Dominance, So What?
Point 9 is also worthy of discussion. I wrote about that on April 14, in Brazil’s President Calls for End to US Dollar Trade Dominance, So What?
The reason for US dollar dominance is simple. Trade is between individuals and corporations, not between nations.
Trade Example
- A Brazilian soybean producer sells soybeans to a merchant in China.
- A Brazilian scooter manufacturer buys Lithium batteries from a Chinese merchant.
- The soybean producer buys nothing from Chinese merchants.
- The Chinese battery producer buys nothing from Brazilian merchants.
Why would the Brazilian soybean producer want to hold yuan, especially given that the yuan doesn’t even float?
Why would the Chinese battery producer want to hold the Brazilian Real?
No one is forcing the soybean producer or the battery producer to do anything. By choice they prefer to trade in dollars, which by the way is instantly convertible to any currency the producers may wish to hedge in.
Need for Cooperation
Lagarde did go on about the need for cooperation. And that discussion was mostly fluff although cooperation is certainly needed.
G20 was functionally broken as a mechanism for most forms of international cooperation well before Russia invaded Ukraine. Rifts between US and China, Canada/ EU/ US and Russia all too big.
Remains useful as a venue for talks, but real cooperation shifted back to the G7
— Brad Setser (@Brad_Setser) April 17, 2023
“Every G20 meeting since the invasion has concluded with no communique.”
“Cooperation has shifted back to the G7”
Really? What Cooperation?
The coordinated immobilization of Russia’s fx reserves was done through the G-7, as were the banking and energy sanctions.
no secret that full US-EU convergence on China has been a bit more difficult
— Brad Setser (@Brad_Setser) April 17, 2023
Weaponizing the US Dollar
The only cooperation we have had was in weaponizing the US dollar. That’s something Lagarde failed to mention. So did Setser.
It is the US weaponizing the US dollar that directly led to many of the key points that Lagarde made.
What Does China Do With a Dollar That’s No Longer Risk Free? Buy Gold?
On March 18, 2022, I asked What Does China Do With a Dollar That’s No Longer Risk Free? Buy Gold?
The reason for this topic has to do with the Fed’s unprecedented decision co confiscate Russia’s foreign currency reserves. Not only was the action unprecedented, it was illegal.
The Federal Reserve Act mandates that the Federal Reserve conduct monetary policy “so as to promote effectively the goals of maximum employment, stable prices, and moderate long-term interest rates.”
Nowhere does the act give the Fed the right or power to confiscate the reserves of sovereign nations. But that is exactly what the Fed did.
If the Fed can do this to Russia, who else?
Q&A With Michael Pettis
Mish: Will China now hold more commodities and fewer dollars despite the pro-cyclical nature of it? More Euros or Yen over dollars? More gold?
Michael Pettis:
- “Given that so much of China’s “reserves” are now indirect and held by state-owned banks (all the increase since 2017) it’s hard to say what the currency composition of China’s reserves are.
- “Officially the US dollar is still by far the biggest component, but it is slowly declining.
- “I expect that this will continue as far as the official reserves go but, as you know, the hard part of reducing the US dollar component of your reserves is figuring out what the alternative should be, and with such high and growing reserves (once you include the indirect reserves at the state-owned banks) that is a very difficult question to resolve.”
Yuan Will Not Replace the Dollar
The Yuan Will Not Replace the US Dollar, Nor Will It Be Backed by Commodities
Don’t confuse a diminishing role for the US dollar with it’s demise as the global reserve currency. It’s far too early for that. For further discussion, please see the above link.
Also note my above trade example regarding Brazil’s desire to end dollar dominance. Wishin’ and hopin’ and beggin’ and prayin’ doesn’t do it because trade is not between nations.
Cooperation is Nonexistent or Failed
The imbalances mount. What cooperation there has been, mainly Russia, has failed. It has driven much closer cooperation between China and Russia with Brazil struggling to join that party.
Three Conflicting Goals of Cooperation
- Reduce dependence on China
- Avoid protectionism
- Appease the Greens
Impossible Requirements
1 + 2 is difficult if not impossible. 2 + 3 is difficult if not impossible. 1 + 3 is difficult is not impossible.
1 + 2 + 3 is 100% guaranteed impossible.
As an added bonus, please factor in Taiwan.
Then factor in China’s control of rare earth elements and permanent magnets. The permanent magnets and other rare earth elements are used in cell phones, missiles, wind turbines, and electric vehicles.
Brad Setzer
“The coordinated immobilization of Russia’s fx reserves was done through the G-7, as were the banking and energy sanctions. no secret that full US-EU convergence on China has been a bit more difficult.”
A bit more difficult or impossible given the three conflicting goals and weaponization of the dollar?
The US and G-7 Allies Are Torn Over Dependence on China
This morning, I wrote The US and G-7 Allies Are Torn Over Dependence on China
At the time, I was unaware of Lagarde’s speech.
I am still amazed that she actually seems to understand most of the actual risks although she failed to discuss weaponization of the dollar.
This post originated at MishTalk.Com
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Mish
Fragmentation of the global economy into competing blockold choo choo started moving., ain’t gonna stop. and who was LEFT ON TRAIN STATION? EUROPE was !!!old , over populated, divided as always, and w/out natural resources europe!!good luck, europe will need one.!
Surprise, surprise! I never expected the spineless vassals of the American empire to fail at anything! 😉
Well, individuals and corporations are bound by the rules of the nations that they are based in.