NICHOLAS SHUBITZ: Stagflationary banking crisis could accelerate de-dollarisation

As central banks continue raising interest rates to fight inflation equity markets have come under pressure, and we have already witnessed the collapse of several large Western banks.

As inflation, interest rates and banking sector instability continue to rise in the US and Europe, investors may look to emerging markets to achieve real returns on their investments. Central banks are injecting liquidity into the banking sector in response to the crisis, but this risks accelerating de-dollarisation.  

Even if the major developed market central banks bail out failing banks and pause their interest rate hiking cycles, highly indebted businesses, and households, which have spent over a decade borrowing at near zero interest rates, may remain under pressure. Facing energy shortages in the EU and with low unemployment supporting wage growth in the US, inflation is likely to remain sticky in the West. This could prolong the stagflation we are witnessing in developed markets, which decreases the real rate of return on investments in these economies.  

China has already decreased the share of US debt in its reserve holdings due to the falling market value of long-dated US Treasuries, resulting from a rise in short term interest rates, which is what caused the collapse of Silicon Valley Bank. Meanwhile, Chinese banks are seeing a reduction in their capital requirements as the government seeks to stimulate the economy. China’s prudent fiscal discipline in response to the coronavirus has allowed the country to target a 5% growth rate this year, with inflation at 2%. On paper, this makes China a better investment destination than the US, which is expected to grow at 0.4% with inflation at 6%.   

Western central banks may be hamstrung, unable to raise rates without precipitating a full-blown crisis and unable to cut rates without worsening the inflation outlook. Maintaining interest rates at their current levels (which are still negative in real terms, unlike the Brics countries), is forecast to only produce gradual disinflation, while exposing highly leveraged developed market economies to unaffordable debt servicing costs during an economic slowdown. This could lead investors to favour emerging markets over developed ones, and may eventually result in a return to hard currencies like gold or other US dollar alternatives such as the Chinese yuan.     

High inflation has typically made emerging markets a riskier bet compared with developed market economies because it leads to higher debt servicing costs and an increased risk of default. But now that inflation among the Brics countries is lower than in Europe and the US, this could see investments in Brics bond and equity markets offer better real returns.

This thesis is also supported by the Brics generally enjoying higher economic growth rates and tend to gain more from higher commodity prices. The attractive combination of positive real interest rates, oversold currencies, higher growth rates, lower levels of inflation, and stable banks, all suggest emerging markets could outperform.  

While a stagflationary banking crisis can be expected to have effects on portfolio allocations, recent events also produce a strong political motivation for de-dollarisation. It is not only ordinary Europeans and American who are fed up with wealthy depositors getting bailed out by central banks while small businesses and households are left to fend for themselves as central banks try to correct their own policy failures with aggressive rates hikes. Foreign governments are becoming increasingly concerned about the West playing fast and loose with fiscal and monetary policy too.  

If the Western central banks continue to fund big government deficits and rescue failing institutions such as Silicon Valley Bank and Credit Suisse, this could encourage the continued misallocation of capital, undermine productivity and ultimately call the very foundation of Western capitalism into question. It will also accelerate the political motivations for de-dollarisation, with consequences for the value of the US dollar, making investments in US assets even less attractive. China is already dumping US debt and buying record amounts of gold, and if others follow suit the dollar could weaken considerably.   

This is a particularly acute risk if the US Federal Reserve is forced to pivot from its rate hiking cycle in response to the banking crisis. The Fed’s balance sheet is already increasing (signalling an early end to quantitative tightening) and its plan to offer struggling banks loans against the face value of their bond portfolios as collateral (which could see trillions of dollars of liquidity injected into the US economy) is another example of using easy money to resolve a crisis. Not only does this threaten to undermine attempts at reigning in inflation, it also motivates de-dollarisation for those who do not enjoy this extraordinary privilege.   

The US may be better served by letting mismanaged banks fail. In this scenario there would be a brief crisis and US assets would be repriced lower. But this would allow interest rates to be cut to near zero again, stimulating the kind of bull market that has sustained an increasingly financialised US economy in recent decades, as seen following the 2008 crash, which attracted large amounts of foreign capital to US equities. The alternative, persistent stagflation and markets trading choppy and sideways, like in the 1970s, could produce a similar decline in the dollar seen in that decade.   

That said, maintaining low interest rates and boom bust market cycles is not a sustainable economic strategy and the US will have to tackle its budget and trade deficits at some point. Japan managed to avert a currency crisis by using its foreign reserves to defend the yen. If the US is forced to sell gold to support the dollar while China continues to buy record volumes of the yellow metal, this could precipitate a loss of confidence in the dollar and produce a shift to gold or the Chinese currency. 

The banking crisis may not be over. As small banks come under pressure this could concentrate the Western banking sector further, creating even more systemic risk, and perhaps one day the world’s biggest bank, the Fed, could face a crisis of its own. If the Fed’s solution to every problem is to simply create more dollars, foreign buyers could lose faith in the utility of holding and trading US bonds, equities and currency. Similarly, if the US keeps transferring shocks to the global economy other nations may be further incentivised to favour alternatives to the dollar.   

• Shubitz is an independent Brics analyst