10 May 2024

Global Financial Trends

VARIOUS NIXON SHOCKS

Freya Beamish / Christopher Granville / Global Team

◼ The US and Chinese growth models cannot continue to coexist within the current
international monetary system
◼ Both currencies are too strong, and FX shocks could trigger a fragmentation of the
system, or a shift to something new
◼ More optimistically, CBDC networks could be a useful release valve for an exorbitant
privilege that has become a burden

Summary
The US and Chinese growth models are fundamentally at odds. Rapid US inflation has rendered
that tension latent, but it will not remain so for long. In the extreme, this re-emergence of the zero-
sum games between middle-income US and China could fragment the international monetary
system leaving behind a weaker dollar, and higher average inflation. Currency shocks seem likely,
given the extent of diverging aims. But a muddle-through path also still seems possible, where the
US accepts some undermining of its exorbitant privilege, which from a popular standpoint, has
become an exorbitant burden. Ultimately, we favour returns on US asset over Chinese over the
secular term, and this is the secular underpinning to the dollar. But China’s RMB
internationalisation efforts are receiving support from the deterioration of the geopolitical
environment as people search for dollar alternatives. We investigate the broad architecture that
China has built, both on the level of counterparts to existing international monetary technologies,
and on the level of new technologies, which China has been developing for over a decade, with
international institutions also treading into new technology.

FX shocks
The Chinese authorities are very cautious about their currency, particularly since the 2015
debacle. And RMB internationalisation and strength have the all-important backing of Xi Jinping.
That is all very well, but China’s “new” growth model, in which it directs funds in large quantities
towards green sectors, may involve new sectors, but it is simply the same old model of excess
production and therefore supply far in excess of domestic needs. The RMB is plagued by
opposing forces arising from the integration of a fundamentally Communist country into a would-
be Capitalist system. The pressure on the currency from trade flows is towards strength, but the
RMB remains under depreciation pressure because excess production is depressive of returns,
subsequently keeping Chinese capital fleeing and keeping Chinese households for deriving the full
currency appreciation and wealth they deserve. In turn, this keeps excess savings in place as
people endeavour to save their way to wealth.
 China cannot have its cake and eat it all in one go. We have always been sceptical of RMB
internationalisation because the Chinese economy lacks the backstop of voracious consumers
amid a deep financial market. But innovation can open up new options, and shocks, such as
those hitting the global economy in recent years, war among them, are just the thing to catalyse
change.

China’s economic need, in order to get onto a path of private consumption-led growth, is to allow
failures to fail, issue a lot of government bonds to recapitalise the banks, issue a lot of RMB to
provide the liquidity to buy those bonds and in so doing devalue the RMB.

Currently, it purports to be focusing on forging agreements, tacitly or behind closed doors or

otherwise, for the RMB to take a more international role, and stockpiling of commodities, not least
gold, but also more broadly. Internationalisation requires stability, which would be rocked by a
maxi-deval. But the longer-term aims of generating demand for the RMB through pricing of
commodities and desire to circumvent US surveillance, could provide a handy backstop,
differentiating the RMB from the yen at its concurrent peaks in private sector debt ratios and the
REER.

The two poles of the global economy are uncompetitive

Source: GlobalData TS Lombard, OECD

Of course, a maxi deval would be a seismic shocks rippling through the global real and financial
economy incurring all sorts of unexpected results. Not least, it would invoke the wrath of any US
president let alone Trump. We would have to throw in the additional elements of how the EA,
which is currently “enjoying” undervaluation against both the RMB and the dollar, would respond.
It has to be said, however, that lingering US inflation might make the US a little more amenable
now than at the point where they have already tackled the inflation problem. Granted, we think
inflation will anyway settle in the 3% range rather than the 4% range and that 3% is ultimately
acceptable to the Fed, against the backdrop of any electable administration. But this last mile of
above-target inflation would be the least disruptive time for China to unleash its deflationary
devaluation.

China would then have every incentive to try to stabilise and support its currency going forward,
with the political aims of RMB internationalisation but also from an economic standpoint, in that
China’s key imbalance is one of paucity of income in the household sector, while currency
appreciation tends to re-orient income flows at the margin away from corporates and towards
households. A strong RMB, therefore, makes sense, but only if the debts are first cleared through
some combination of default and devaluation, rather than the slowburn demand deflation of

Global Watch| 10 May 2024 2

 wage compression endemic in trying to repair balance sheets through running internal surpluses,
requiring an ever-larger surplus with the rest of the world.

How might it all go horribly pear shaped?

In any number of ways. Most obviously, Trump, were he to gain office might initially exacerbate
RMB weakness with tariffs but then respond with cries of manipulation, in the most seismic case,
responding with a devaluation of his own. Globally, it is both the dollar and the RMB that look
overvalued on a Unit Labour Cost basis. A true currency war would be the path in which 1970s
inflation problems really might stage a comeback.

The US benefits from being the world’s reserve currency with inflows keeping borrowing costs
low, greater possibility of seigniorage, simplified global trade and expanded economic and
financial influence. This ‘exorbitant privilege’ also comes at a cost, as the US found in 2008, when
it turned out that low interest rates also generate unsustainable borrowing patterns. Sustained
dollar strength and the lack of currency depreciation in times of weakness – the dollar rallies in a
global recession – has likely been partly responsible for the hollowing out of the middle-income
section of the distribution, though bad management of China’s entrance into the WTO at very
undervalued rates is largely to blame, alongside technological developments. The global reserve
currency, simplistically, tends to operate on a current account deficit, where low interest rates
facilitate borrowing from the rest of the world, with foreign entities willing to lend into deep capital
markets, though the gross flows that are masked by the netted balance are a much bigger part of
the overall use of the currency. In short, that current account deficit which comes hand-in-hand
with the dollar standard since the Nixon shock in 1971, has become a symbol of popular
discontent.

Rebuilding middle income, probably does require that efforts to run a high pressure economy are
not continuously thwarted by pressure leaking abroad due to an overvalued dollar, such that
resilient domestic demand is met by foreign supply. The two direct policy reponses are tariffs,
which would probably be the first impact, were Trump to be re-elected, and devaluation, which
might then follow. Tariffs are an immediate threat to the RMB in particular, but as we suggested
above, Trump’s response to previous rounds of tariff-generated currency weakness would be to
point to manipulation. We refrain here from speculating how far he might go in pushing back
against that, but we note that Trump’s advisers have not been idle during his time out of office.

Four new Bretton woods moments?

The “dollar standard” has had its pros and cons. As my colleague, Dario Perkins, highlighted in
2020, the system has many flaws, including:

1 A dangerous feedback loop between low interest rates and rising debt levels, since leverage
makes the system more unstable, increasing demand for safe assets and keeping rates low

2 An amplifier of macro divergences between the US and the rest of the world

3 A coordination problem by which the Fed has only a domestic mandate, but the dollar has
global implications – “It’s our currency but your problem.”

4 US financial dominance goes hand in hand with current account deficits, but these are
associated with hollowing out middle income and generating populism

Global Watch| 10 May 2024 3

 These problems have been known for years, but the dollar system was another that appeared to
be the worst “apart from all the rest”. It takes a major catalyst to disrupt a convenient status quo.
Generally, currencies rise and fall with empires. The transfer of reserve currency status tends to
be triggered by wars or major shocks. As it happens, the events of the past few years could fall
into that category, and EM central banks are hard at work devising new technologies to bypass
the dollar system.

Underlying drivers of dollar discontent from both sides

In 2020, even the IMF itself suggested that a new Bretton Woods moment may be upon us.
Struggles and shocks create change and the past several years has been full of such drivers and
catalyst.

1 The main underlying driver, as we see it, is that the two poles of the global economy, the US
and China, operate divergent economic growth models. The US model is a profit-oriented
model, whereas China is a market-share-driven model. The RMB is continuously pulled in
different directions, therefore, as excess production swells the trade balance but also
depresses returns, dissolving the interest differential finally into complete reversal. Far from
being able to transition to an international currency by natural means, even the Chinese do
not want to hold RMB, hence the newfound penchant for gold beans. China growth model
has left it with a pile of debt which can be escaped either by demand deflation – the current
method, involving wage compression and attempted real effective depreciation – default, or
devaluation, which are intimately linked. In short, escaping a debt pile implies real effective
devaluation of some kind. At the same time, the US has been left with a hollowed-out
manufacturing sector and a severely aggravated middle-income section of the distribution.
Hence the rise of populism and the increasing pressure on the Chinese Communist Party.
What cannot last, does not last. A world in which the US and China are battling to depreciate
would give rise to a new international monetary system, not least because export lobbies in
the rest of the world would have something to say about such actions.

2 The pandemic was a catalyst for many of the secular drivers we have been writing about. It
has exposed the fragility of global supply chains and re-ordering and duplicating supply
chains may well speed the development of parallel payments systems. Brad Setser asserts
that “Financial friendshoring isn’t an option”. While supply chains may be re-drawn, the
current profile of current account balances leaves the surpluses in one block – let’s call it the
China block – and the deficits in the other – let’s call it the democratic block. Europe used to
be in the surplus block but the new energy map has deteriorated the surplus, while the
changed relationship with China, in which it has become a competitor rather than an export
destination, also implies structural deterioration in the EA current account balance.

3 The classic catalyst of new currency regimes is war. Russia’s invasion of Ukraine, therefore,
is right on queue, with rising Middle Eastern tensions serving as an acute reminder of the
ongoing incentives. The “Western” response taking the form of financial sanctions is a clear
catalyst of fragmentation of the international monetary system.

4 The major real economic effort of the next decade will be the greening of the economy. This
includes a shift away from fossil fuels that will redraw the map of the dollar demand,
ultimately undermining the petrodollar flows. New ubiquitous commodities are emerging,
from copper to semiconductors, to batteries. The battle to price these all-important
commodities in dollars or RMB has long-since begun but it will only become hotter from here.

Global Watch| 10 May 2024 4

 Triggers
Beyond the drivers and the catalysts, there are the triggers. Beyond those discussed in the US and
Chinese case, the yen’s 40% depreciation, if it continues, could be another cat among the pigeons,
precipitating change.

Options – new technology and geopolitics

War and technology, like it or not, occupy an symbiotic relationship. Technological develop is
always ongoing but war and shocks such as the pandemic spur the process along as resources
become focused on meeting a universal threat.

The technology of the tally sticks

Money is a technology, which changes over time. A clear example of the roots of modern money
is found in the innovation of tally sticks. These were literal sticks, often hazel or willow, divided in
half lengthways. The stick formed a record of a debt owed, with the debtor retaining the “foil” half
and the creditor retaining the “stock” half. Due to the grain in the wood, the two halves would
match. Kings used these sticks to pay for goods and services and then required taxes to be paid
in them. The sticks would then circulate as money because anybody could pay their taxes in
them. The King’s representative would come to the village, “spread the cloth on the ground, and
[match] the stock and the stub.”

The requirement to pay taxes and the acceptance of the state’s own liabilities in payment for tax
liabilities (the liabilities cancel) is the basis of money. A tally stick is a simple but smart
technology for achieving that. Because it is simple, it facilitated trade that otherwise might not
have happened due to a lack in a double coincidence of wants.

Tally sticks were the height of monetary technology in medieval times

Source: GlobalData TS Lombard, Wikimedia Commons

Tally sticks had their flaws, though. They don’t look particularly easy to carry so one might be out
in a field and come across a traveller but not have any “money” on one. They also had the
unfortunate drawback of being a fire hazard. Similarly, coins, are heavy, and easily stolen.

The flaws of a currency are tolerated due to the opportunity cost of spending time developing and
establishing something new. But when a shock comes along, the incentives can suddenly
change.

Global Watch| 10 May 2024 5

 Fiat currencies and dollar hegemony
Skipping a few years of monetary history, the dollar standard started with 1944, with the decision
to put the currency at the centre of international trade. The dollar because the world’s reserve
currency under the Bretton Woods system, with fixed exchange rates and full convertibility into
gold. At the time, the US was running a trade surplus, creating a “shortage” of USD. The solution
was generous grants to fund reconstruction in the 1947 Marshal Plan. By the 60s, however, some
economists, notably Robert Triffin, after whom the ‘Triffin Dilemma’ is named, saw the writing on
the wall. Triffin suggested that the US would eventually need to run persistent current-account
deficits to provide dollars to meet global demand. Stubborn dollar strength made the Bretton
Woods system unsustainable, with European countries draining US gold reserves. President
Nixon ended the system with a unilateral decision to suspend convertibility of the dollar into gold.
The US trade deficit continued to grow, however, and the world moved to a pure dollar standard,
though commodities remained intimately linked into the picture.

Blockchain and de-fi

Blockchain technology offers new monetary technology. What does blockchain do that
“traditional” money does not? Supporters emphasize that it allows for non-reversable transactions
getting rid of the need to pay someone for trust, with which economic rents are associated. It
provides a “solution to the double-spending problem using a peer-to-peer distributed timestamp
server to generate computational proof of the chronological order of transactions.” ‘Old’ money
technology requires a trusted central authority or mint that “checks every transaction for double
spending. After each transaction, the coin must be returned to the mint to issue a new coin, and
only coins issued directly from the mint are trusted not to be double-spent”, though policymakers
argue that a trusted central authority is still useful. More broadly, these technologies could
significantly reduce transaction costs.

The technology allows for the unification of messaging and settlement, alongside opening up
potential for smart contracts, such as those built on the Ethereum platform or Neo, the Chinese
counterpart. For example, in trade finance, payments could be made dependent on GPS data,
tracking the delivery of goods, where the interest rate declines, the close the goods are to the
destination. Lower interest rates facilitated by technological advance could conceivably support
trend growth rates in the real economy.

It is still not clear that de-centralised crypto currencies really have the potential to circulate as
money. As we saw with the tally sticks. Money is not just based on trust that a greater fool will
take it from you, or even to put it more positively, that someone else will have a greater demand
for money than you in future. The value of money is found in its ultimately backstop, which is the
creditworthiness of the borrower being so incontrovertible that anyone is willing to hold it
because they will be able to find someone else willing to hold it but also that the borrower is
someone to whom the vast majority of people owe a separate liability – in this case tax – and
that this liability is payable in the currency. The point is that there is a very large pool of people
that will always need the currency for this specific reason of clearing their own liability. The
central authority’s liability – the circulating money - can then be cancelled with the tax liability
using that currency. This is the importance of the centralisation. Commercial banks are given the
authority to print money in this currency, but their money also derives its value from the backing
of the requirement to pay taxes in that currency.

Nevertheless, these new technologies offer the potential to improve the existing centralised
monetary systems through for instance programmable Know Your Customer; see Project Agora
below. Insight could be gleaned here from technologies surrounding XRP on Ripple – a real time

Global Watch| 10 May 2024 6

 network for global payments, across multiple currencies or even assets, recording transactions
orders in a distributed ledger technology used by banks - and Stellar – an offshoot of Ripple, for
transactions between people instead of banks. The benefit of XRP technologies being that it
works between banks, as policymakers are adamant that these developments should not
undermine the global banking system.

Problems with the new de-centralised technology

Beyond questions about their use as a circulating currency, de-centralised technologies still have
their flaws. It is not abundantly clear that the system is secure, though we know we are liable to
be cancelled in certain quarters for such a statement. From an individual standpoint, it seems
strange that one might be responsible for the security of one’s private key, which at the very least
seems inconvenient if not catastrophic. Equally, if a public key somehow becomes known then
one’s entire transaction history is also known. Even the concept of blockchain itself depends
upon more than 50% of node being honest. Developers are working on making this feature
quantum-proof, but advancements in quantum computing, for example, must at least be
acknowledged as a known unknown. Finally, the entire project is built upon dubious foundations
from an environmental standpoint. Raising a tally may have required cutting some willow trees
back, but data storage issues are on a whole different scale in terms of environmental impact.

From dollar smile to smirk, with CBDC undermining

While the dollar and government-back fiat currency has its own special place in circulation, the
development of network of non-dollar CBDCs would undermine a part of transactions demand for
the dollar. Bear in mind, however, that demand for settlement of cross border trade is just one
part of the overall demand for the dollar. Whether countries want to hold reserves in a currency
depends upon its use as a store of value. The dollar holds a special place in that it rallies both
when the US outperforms, but also when global recession risks rise. Again, taking the GFC as an
extreme, despite the fact that souring assets in subprime were at the centre of the crisis, because
global financial institutions had funded their purchases of these assets in dollars, the primary
concern, in the moment of crisis was to close down dollar debts.

Dollar smile already undermined … even without CBDC networks

Dollar smile distribution

Global Traditional smile:
New dollar smirk distribution
recessionary US growth
outperforms, USD
50
USD performance

Strong US growth is
now not necessarily 40

RoW growth 30
outpaces
US: USD 20
declines 10
Swap lines
0
cap risk-off
-6.0% -4.0% -2.0% 0.0% 2.0% 4.0% 6.0%
USD
appreciation US economic data performance DXY w/w change

Source: GlobalData TS Lombard Strategy team Source: GlobalData TS Lombard Strategy team

Global Watch| 10 May 2024 7

 Depth of capital-raising abilities in a currency, therefore, are critical to its attractiveness in times
of crisis and as a reserve currency. And that depth and willingness to borrow in a currency is
related in part to the question of what is going to be bought with the proceeds. If there is plenty
priced in dollars that borrowing entities might want to buy, both in the real and financial
investment economies, then borrowing in that currency is a naturally hedged position. The result
is that we are left with the underlying driver being strong final demand and good prospects for
assets in that currency. Beyond that, borrowing in a currency may come down to availability,
which again depends on what currency the lenders themselves want transact in.

The smile, however, is fraying at the edges, even before we approach the question of CBDC, with
the Fed gradually diluting from exorbitant-privilege policy. On the left side, the immediate
provision of dollars in risk-off events through the Fed swap lines caps the dollar squeeze, where
previously, entities would have been scrabbling for the dollar to pay down short-term debts. The
promise of Average Inflation Targeting somewhat weakens the right side of the smile, as US
policymakers would be accepting, at least initially, the prospect of higher inflation versus interest
rates, though we believe the resultant high-pressure economy would then also lift growth. In the
first instance, however, this dollar smirk could come back into play if and when US inflation
comes back into range of the 2% target in a sustainable fashion, even without contemplating
lower transactions demand for the dollar, for cross border trade. To be clear, we think 3% inflation
would be acceptable in the US, and eventually modestly higher inflation may be tolerated out of
necessity in Europe, but the shift in that direction will be more gradual, with central banks lacking
a dual mandate. Any productivity growth gains from high pressure policymaking, in real time,
would be contested as cyclical rather than structural, keeping markets guessing about the longer-
term strength of the dollar.

China’s optionality
Replicating the old system but outside of the dollar
China and the rest of the BRICS have busy at work sounding out non-dollar systems and
measures that might support the gravitas of such a system for years. The BRIC nations began to
take the costs of the dollar system in the wake of the Global Financial Crisis, and also looked with
envy upon the appreciation of the dollar despite the fact that the crisis appeared to be centred in
the US.

These various developments remain small in their dollar amounts but the networks are diverse,
and building them has allowed these nations enhance expertise.

China has made various developments within the old/current international and monetary system
as well as what are coming to be seen as the “canar[ies] in the coal mine” in de-dollarisation,
drawing upon the phrase used by Zongyuan Zeo Liu and Mihaela Papa Can BRICS de-dollarize the
global financial system.

Bank of Kunlun

The firewalled Chinese bank is owned by the Chinese state energy group CNPC and used for
transactions with Iran, though these are not necessarily RMB payments, and the bank suspended
payments in 2017. Payments starting in 2019 were reportedly in RMB.

Global Watch| 10 May 2024 8

 China International Payments System vs SWIFT/Fedwire/CHIPS

A payments system, with an associated messaging system, supervised by the PBoC, allowing
gross cross-border transactions in RMB. The concern for various EMs is that SWIFT data can be
accessed by the US authorities, while CHIPS/Fedwire is under the supervision of the Fed. SWIFT
yielded its proprietary data to the US authorities after 9/11, when Congress threatened to
sanction the society, while two of its data centres are based in US territory. It is a cooperative and
banks can be excluded by a shareholder vote compelling the board to take action. For now, China
continues to use SWIFT for cross border messaging, even within its own banks to foreign
branches, and SWIFT now supports Chinese characters. Barry Eichengreen describes China’s
endeavours to build an alternative as a “field of dreams” problem. If you build it… they won’t
necessarily come. Equally, willingness to hold in RMB is necessary for a Chinese rival to the
CHIPS system (clearing of large-value payments either directly among the 50 or so participants or
directly). Would Saudi Arabia, for instance, see value in diversifying a large portion of its reserves
to Chinese bonds? At current hedging rates, why not. But over time, the likelihood is for RMB
depreciation, and a devaluation would rock confidence.

Nevertheless, China’s direct participants, who must be incorporated in China, number in the same
range as that of CHIPS, though indirect participants and transaction volumes in the latter are
much more numerous. They are mainly overseas branches of Chinese banks, and the geographic
reach is global excepting Latin America. Reportedly, participants include several major global
banks. In short, it is more than well on its way to being “built”. As of 2022, however, 80% of
payments through CIPS still use SWIFT messaging, seemingly because many non-Chinese
institutions simply do not have the translating capacity for CIPS messaging. The growth rate of
CIPS reportedly is rapid though we found it hard to corroborate sources.

CBDC, however, eliminates the need for all of these processes, reducing the frictions to entry for
China, though it is not clear what CBDC offers in respect of circumventing sanctions over the
CIPS. The PBoC is the sole viewer of transactions in either eCNY, for example, or CIPS.
Eichengreen suggests that a transaction through eCNY might make possible a more limited
retaliation, against a Chinese bank as opposed to the Chinese government.

The US and euro form the vast bulk of SWIFT payments

USD EUR GBP JPY CNY

60%

50%

40%

30%

20%

10%

0%
Nov 10 Nov 12 Nov 14 Nov 16 Nov 18 Nov 20 Nov 22

Source: GlobalData TS Lombard, BBG

Global Watch| 10 May 2024 9

 New Development Bank –

The NDB was formed in the early 2010s by the BRICS. Presidents are elected on a rotational basis
from one of the founding members, with four vice presidents, one from each of the other four.
Membership has since expanded to include, the UAE, Bangladesh and Egypt, with Uruguay listed
as a prospective member. All new transactions with Russia were put on hold owing to the
requirement of “sound banking principles”, though ratings agencies still chose to downgrade the
bank on long-term issuer default scales.

Links will commodity-producing economies are especially important. Articles were circulating
around summer of 2023, with a big focus on Saudi Arabia joining BRICS, and the NDB. Officially,
Saudi are expected to join the BRICS as an observer, but no further comments were made about
officially joining the NDB. However, although we know countries like Egypt and the UAE are
involved, Saudi's involvement is as straightforward as simply becoming a member - a recent
news press release from NDB shows the creation of a joint working group to develop cooperation
between the Islamic Development Bank (IsDB) and NDB. The Islamic development bank is based
in Jeddah, Saudi Arabia, and is a AAA rated Saudi bank, established 50 years ago as a multi-
lateral development bank of the global south. The partnership between NDB and IsDB gives the
BRICS access to various more Arabic/Islamic economies involved with the IsDB, and provides
those countries with an Islamic Banking framework to carry out projects.

Initial subscribed capital in NDB was $50B, equally distributed among the founding members and
initial authorised capital of $100B. Each member cannot increase share of capital without
unanimous agreement from the other four, and while new members can join, the BRICS’ share
must be at least 55%. By way of comparison, the WB and EIB at the time of NDB set up had
capital bases five to six times larger, with the African Development Bank also twice the size.
World bank financial reserves come from several funds raised in the financial markets, from
earnings on investments, and fees paid in by member countries, and contributions made by
particularly by members.

Once again, the overall scale of projects is relatively small. NDB annual reports reveal 14 projects
approved in 2022, for a total value of $2.71B, with 85 projects in the portfolio at the end of the
year, with the amount of financing approved for projects in the portfolio at end-22 equalling
$30.23B. 4/5th were sovereign loans in 2022, with nearly 90% are sovereign loans in the overall
portfolio.

NDB bond issuance is relatively small Project approvals also find it hard to avoid USD

10,000 25,000
Millions

9,000
Total bonds outstanding $M in Total project approvals
8,000 different currencies 20,000
outstanding $M in different
7,000
currencies
6,000 15,000
5,000
4,000
10,000
3,000
2,000
1,000 5,000
0
USD CNY HKD ZAR AUD GBP 0
USD CNY EUR ZAR CHF INR

Source: GlobalData TS Lombard, Bloomberg Source: GlobalData TS Lombard, Bloomberg

Global Watch| 10 May 2024 10

 While small, this once again sets up architecture for controlled channels out of China as the NDB
issues bonds – green bonds and in the Chinese interbank bond market - in Chinese onshore
markets with proceeds used for infrastructure and sustainable development projects in member
countries. The projects are undertaken on the insistence on using local FX finance rather than
relying on solely on the dollar.

Similarly Belt and Road projects are strongly encouraged to invoice in RMB, though similarly the
Asian Infrastructure Investment Bank’s capital is relatively small compared to the Asia
Development Bank and World Bank.

Contingent Reserve Arrangement and PBOC swaps –

This architecture was formed shortly after taper tantrum, by the BRICS, when the Fed raised
interest rates and EM currencies were destabilised, partly due to large dollar debts. It was set up
with $100B of currency swaps, with China contributing $41B.

While the Fed has its network of CB swaps, so too does the PBoC. Zoltan Poszar that this
network is geographically far more diverse than that of the Fed, including mostly EMs though also
including the ECB, BoJ and BoE. At the same time, these channels go beyond merely aiming to
deal with plumbing issues as the dollar system creaks and also aim to foster trade and real
economic activity.

Once again, in terms of the (ironically) dollar amount, use of these swap lines are constrained by
willingness to hold the RMB, but they have become sizeable, at above RMB3.5T in total.

New systems - BRICS CBDCs and DM responses

Writers such as Zoltan Pozsar of Ex uno plures fear that CBDCs are bringing together BRICS
central banks in a replication of the correspondent banking system on which the dollar standard
runs. Others have claimed it will end monetary privacy and destroy the traditional banking system
by eliminating their middle-man rents. Policymakers hope it will unlock new methods of
policymaking, allowing them to differentiate between borrowers and savers and fine tune interest
rates for different sectors. Detractors worry that it would enable central banks to push policy
rates deeply negative. Again, policymakers may be enticed by the ability fully to integrate parts of
monetary and fiscal policy, allowing, for instance, ‘helicopter’ transfers, bypassing the financial
sector and providing money directly to the real economy in times of economic weakness.

What appears really to have spurred on development in the past few years, however, is
deterioration in the geopolitical environment and the idea of a replacement for the
SWIFT/Fedwire/CHAPS nexus, allowing countries worried about US sanctions to bypass the
dollar system altogether. A firm in one EM, for instance could obtain money in the currency of
another, without having to touch the dollar system, merely running transactions from one
corporate wallet directly through the central banks to another corporate, though policymakers
may choose to set up systems that preserve the two tiers of central and commercial banks.

CBDC do not solve the problems with fiat currency identified by the decentralised crypto crowd.
Governments would still control the printing presses and if anything, are more able to generate
inflation, as they can bypass the banking system to provide funds, directly generating “money”.
Often in episodes of QE the impact on prices is muted because the bonds are purchased simply
from financial institutions, with narrow onward channels into the real economy, or within that,
banks, meaning that “money”, known as deposit liabilities, does not change at all.

Global Watch| 10 May 2024 11

 eCNY and mBridge

The PBoC began researching CBDC as far back as 2014. eCNY was launched as a pilot in 2020. It
is fully backed by the PBoC and treated as cash in circulation. The PBoC operates a two tiered
system, probably wary of undermining its banking system, where it issues eCNY and the large
state-owned banks and internet banks operate wallets, while other banks and payment service
providers then manage services to businesses and consumers, who are able to undertake peer-
to-peer transfers.

For now, eCNY does not offer interest payments, the idea being that it should replace cash but
not bank deposits. Indeed, the banks responsible for customer privacy, and Know Your Customer
duties – providing a line of defence between sanctions and the PBoC itself – and are also
responsible for creating the retail infrastructure. The benefit of taking on those costs is that these
banks are given a slice of the payments business, which typically is dominated by internet
companies.

Beyond the potential lures for DM central banks, a CBDC provides special benefits to
policymakers in a system such as China’s. It could potentially allow for controlled capital account
opening, where the PBoC could create a closed loop under its surveillance. For China, a CBDC
critically also offers a sanctions hedge, and begins to create demand for its currency from other
EMs looking to do the same. eCNY, at this stage, is officially targeted at domestic retail payments
rather than cross border payments.

In any case, mBridge already provides an experiment with a multi-CBDC common platform for
wholesale cross-border payments, built upon a “custom-built distributed ledger technology”. The
Digital currency institute of the PBoC is among the five founding members, which also include the
HKMA, Central bank of the UAE, and the Bank of Thailand. Note that the UAE also has a separate
project with Saudi Arabia, known as Project Aber; see below.

Russia-spurred CBDCs for cross-border trade

“Necessity is the mother of invention.” Russia, having invaded Ukraine, being cut out of the US
dollar system has proved a de-dollarization catalyst in the specific area of international trade
settlement. During the first year of the war, this effect became apparent in the switch from the
USD and EUR to RUB and CNY denomination of most settlement of Russia’s external trade
transactions. This is shown in the chart below, which is also shows the dip in the CNY share at
the start of this year. This latest development reflects the power of the US Treasury even over
non-US transactions, as these still involve banks in China and Russia’s other trading partners (led
by India and Turkey), virtually all of which need to make use of the dollar in their international
operations make no use of the dollar. Being sanctioned by the US would therefore undermine
their business.

Global Watch| 10 May 2024 12

 Currencies' shares in Russian imports since the invasion of Ukraine
USD EUR RUB CNY Other CNY share (RHS)

60 45%
40%
50
35%
40 30%
USD bn

25%
30
20%
20 15%
10%
10
5%
0 0%
Feb-22

Dec-22

Feb-23

Oct-23

Dec-23

Feb-24
Jan-22

Apr-22
May-22
Jun-22

Aug-22
Sep-22
Oct-22

Jan-23

Apr-23
May-23
Jun-23

Aug-23
Sep-23

Jan-24
Mar-22

Nov-22

Nov-23
Jul-22

Mar-23

Jul-23
Source: CBR

A Biden Executive Order last December widened this sanctions net by authorizing the Treasury to
sanction financial institutions in any country not only for dealing with Russian sanctioned
persons/entities but also for “conducting or facilitating any significant transaction or providing
any service involving Russia’s military industrial base”. This second sanctions criterion may have
been kept intentionally vague and would appear to have had the desired effect. The fall-off in CNY
payments has been mirrored by Russian companies’ reports of payments interruptions with
Turkish and Indian banks.

Russia and its trading partners plan to counter this sanctions threat by resort to CBDCs for
direct settlement of commercial invoices and FX trades on a peer-to-peer basis – i.e. avoiding
banks and their correspondent accounts. The blockchain ledger will mask the transactions and
counterparties involved from US scrutiny. To the extent that formidable American intelligence
capabilities enable the US authorities to identify some counterparties, the fact that these will no
longer be banks weakens the impact of any new sanctions. It is simpler and quicker to replace a
sanctioned commercial (non-financial) counterparty than a newly sanctioned bank.

The Russian foreign minister Sergey Lavrov indicated in an interview last month that this will
be Russia’s top priority when it hosts the annual summit of the (now expanded) BRICS grouping
next October – that is, agreement on activating what the Russian director in the New
Development Bank describes as “a multilateral clearing and settlement system in national
currencies that participating countries’ CBDC platforms could plug into.” While uniquely urgent for
Russia, this US-insulated CBDC-based cross-border trade payment system should also suit China
and major ‘Global South’ players. This interest starts with the value of trade with Russia, import of
needed commodities (with a discount bonus) and export of manufactures, but the clinching
factor may be the attraction of a pre-emptive hedge against being on the receiving end in the
future of the kind of US sanctions now imposed on Russia.

Global Watch| 10 May 2024 13

 Dollar dominance: Less impregnable in international payments

USD RMB

90%
80% Quickest change
coming here
70%
60%
50%
40%
30%
20%
10%
0%
Share of trade finance Share of international payments Share of FX reserves
(ex Eurozone)

Source: IMF, SWIFT, GlobalData TS Lombard

Here, then, we have what may be the world’s first clear-cut use case for CBDCs – as a
defensive mechanism against US sanctions impairing trade. As and when this initiative gathers
steam (and there will surely be ‘teething problems’ even assuming political agreement is reached
later this year), this will remain a far cry from radical de-dollarization. Cross-border trade
settlements are arguably less importance for global dollar dominance than its accounting for the
bulk of countries’ international reserves and its use as the currency of international lending and
capital raising. On the other hand, the emergence of a non-dollar ‘global current account’ –
analogous to the original post-war Bretton Woods set-up with currencies convertible on the
current account of the balance of payments but not the capital account – will boost the status
and, at the margin, the relative value of the RMB. For it seems reasonable to suppose that the
RMB will be the most popular choice for participating counterparties to hold in their digital wallets
held in their national central banks

Gold and commodity-based currencies

While the world left the gold standard in 1971, the commodity has experienced a resurgence
recently, with the PBoC seemingly in the vanguard. Alongside apparent stockpiling of industrial
commodities, this has led to speculation that something is afoot in China, with the prospect of a
devaluation. While this makes sense from a longer-term perspective, we note, however, that gold
remains tiny as a percentage of China’s total central bank reserve holdings, not to mention the
unofficial reserves held in State-owned banks. Bringing in commodities is undoubtedly part of the
overall plan but this part of the plan seems likely to take years and gold prices would need to rise
massively to form a substantial part of overall reserves.

Nevertheless, PBoC gold purchases have formed a useful bailout, helping support the price of the
commodity for which Chinese people are dumping RMB. At the same time, we note fringe
developments that show further cracks appearing in the dollar system, with Russia directly
swapping oil for gold with Ghana.

Global Watch| 10 May 2024 14

Gold bugs in China Xi Jinping says buy gold

120 $/t oz Gold price metric ton

Shanghai Premium USD/troy oz 2300
100
3200 China Official Gold Reserves (rhs)
80 2200
60
2700
40 20th Party Congress 2100
20 2200
2000
0
-20 1700 1900
-40
-60 1200 1800
-80
-100 700 1700
Apr/08 Apr/12 Apr/16 Apr/20 Apr/24 2016 2018 2020 2022 2024

Sources: BBG, TS Lombard. Sources: BBG, PBoC, TS Lombard.

But Gold is still a small percentage for PBOC Though consumption has shot up
Gold as a percentage of total central Bullion consumption tons
bank reserve holdings China India
China
Saudi Arabia
Thailand 2023
Switzerland
India
Phillipines
Poland
Russia
Turkey
Netherlands
Italy
France 2022
Germany
USA
Portugal
0% 20% 40% 60% 80% 0 100 200 300
Source: World Gold Council, IMF, JP Morgan Source: GlobalData TS Lombard, BBG

The ubiquitous commodity

The interaction between fiat currencies and commodities, whether they be precious industrial
metals, energy, or commoditizable goods is an intricate one. Part of the shift in the dollar
standard away from gold involved agreements to invoice oil in dollars, providing a constant
demand, tied to real economy demand, for dollar reserves to purchase oil. We may not know
about the intricacies of these deals for years. Details on the 1974, deal allowing Saudi Arabia to
but UST outside of public auctions by creating “add-ons”, thus masking Saudi purchases of USTs,
took decades to surface. The deal involved a promise from Saudi Arabia to price oil in dollars, in
return for security support.

Chinese aims to entice various economies into pricing their commodities in RMB are not a new
thing, but, given the new voracious appetite for copper in the greening of the economy and
China’s ongoing need for an outlet for excess savings in exports, the economy seems likely to

Global Watch| 10 May 2024 15

 stay near the heart of the global commodity trade. Once again, writers such as Zoltan Pozsar
suggest that a new commodity-oriented system could develop, with a shift from “It’s our currency
but your problem” to “It’s our commodity but your problem”. Once again, however, this relies on
the overall end demand for RMB and willingness to accept the currency.

Similarly, the race for semiconuctor self-sufficiency and battery supremacy is not just about
securing supply chains but about raising the ability to price such a ubiquitous good/commodity in
RMB. China has developed dominant positions all along the supply chain for the components
necessary for the green revolution.

In the meantime, Russian oil sales to China also have increased invoicing in RMB.

PetroCBDC

Project Aber is a joint initiative between the Saudi and Emirati central banks, commencing in
2019, to develop and test the usage of CBDCs for cross border instant, block chain payment
systems. Initial reports touted high levels of technical advancements and success in initial
testing, with positive conclusions being drawn from the digital currency experiment between the
Saudi's and Emarati's, who have seen a wide adoption of block chain currency and technology in
the region. The media coverage for this has dwindled down with official communications stating
the project is now undergoing further testing phases with commercial banks in Saudi Arabia and
the UAE to test efficiency of cross border payments for consumer spending as well as B2B
transactions, and the project seems to continue running and testing, in preparation for the launch
of a CBDC project.

How far can the RMB get?

Inter-BRICSpanded trade is becoming a significant chunk of the global share. The figures in the
chart below from my colleague Jon Harrison, however, are plumped up by the legacy of
overinvestment and fresh overinvestment in green goods, for much of which, the final demand is
in DMs, where politicians are starting to fight back against dumping. Similarly, the massive
expansion of China’s current account surplus and bilateral trade in the pandemic reflects
abnormal circumstances, where China was the only economy able to respond at scale to a major
re-orientation in the composition of demand towards goods, as well as US cyclical overheating
and Chinese secular demand deflation. More broadly, as China is now debt saturated, it will be
looking for final demand abroad rather than supporting EMs to through rapid infrastructure
growth.

The additional demand for a non-dollar currency, circumventing US surveillance, however, is an

unknown quantity and will rise with geopolitical deterioration and global fragmentation.

Global Watch| 10 May 2024 16

 Inter-BRICS trade has is sizeable but interlinked with DM demand and overinvestment

12 Exports to US Exports to China Imports from China

10
8
6
4
2
0
-2
-4 Change in exports to US & China and imports from China as a
-6 share of exports/imports since 2017 (ppt)
-8

Source: GlobalData TS Lombard, CEIC

DM central bank response: Agora

How are DMs and global institutions responding? Initially, the plan seemed to be to ignore CBDC,
which was not the worst idea in the world for the US, given that CBDC networks pose a threat to
US dollar dominance and one shouldn’t look a gift horse in the mouth. But, whether because of
fear of being left behind on genuine technological improvements, or through endeavours to
provide these technologies on a platform to rival that between the BRICS, or perhaps even
because the US is done with the burdens associated with the exorbitant privilege, the US appears
now at least to be making a more serious attempt to investigate the options. Not least with the
recently announced Agora project.

This project is presented by the BIS as an endeavour to reduce transactions costs, while keeping
banks in the loop. It is another two-tiered system but brings together central banks and
commercial banks on one platform, with programmable KYC and the possibility of advances in
smart contracts. Rather than stable coins, the process is one of tokenisation, representing claims
digitally on a programmable platform. The stated aim here is to gain the benefits of technological
advancements, in particular, to lower the burden on banks, assuming that KYC checks against
money laundering and sanctions violations have created a low return high risk environment for
banks, limiting transactions in the real economy.

This type of technology aims to take the best of the old system, and bring in the benefits of new
technologies, without rocking the entire banking system and potentially also raising concerns
about policy over-reach. The BIS emphasises the singleness of money, coming back to the idea of
why money circulates. The singleness of money holds because of the settlement function of the
central bank. Private entities acquire claims their own bank, not the sender’s bank and the central
bank sits between, the point being that transactions are settled at par even if different forms of
privately and publicly issued money are used. In contrast, stable coins, are always tagged with the
name of the issuer.

Having tokenised deposits and tokenised central bank money on a unified ledger cuts out all sorts
of transaction costs and hopefully allows all sorts of new types of transactions to take place.
Payment chains can be very long, running through multiple time zones and legal systems.
Tokenisation combines messaging and settlement into one unified transaction, with the payment

Global Watch| 10 May 2024 17

 path mapped on a unified ledger. The goal is to address the decline of correspondent banking in
all but the largest corridors.

It is impossible to know what innovations might occur, otherwise they wouldn’t be innovations.
We do, however, continue to think that this type of platform, facilitating transactions directly
between currencies and bypassing the dollar, must reduce transactions demand for the dollar.
But as we suggested, outside of the current inflation battle, most US administrations would
probably accept that.

Velocity?

A future topic of investigation for us, given the high priority we place on analysing money trends,
is what effect this will have on velocity. If it generates a new wave of financialisation, it could
result in downward pressure on velocity.

Bottom line
Ultimately, the outlook for the current international monetary system seems increasingly perilous.
De-globalisation and deteriorating geopolitics suggest a more fragmented currency system,
where the RMB could start to gain traction at the margin due to demand for a non-dollar currency,
though would be hobbled by the low likelihood of active transition to private consumption-led
growth. Optimistically, the US and China could learn to live with each other in this environment,
with the US rebuilding middle income by escaping the extremes of the exorbitant burden. What is
harder to square is that China’s own currency policy and aspirations to internationalisation run
counter to their plans to continue relying on excess production of green goods. The path of FX
shocks from the dollar and the RMB, both of which are overvalued compared with the rest of the
world is not so far into the tais of the distribution.

Reserves allocated to CNY have grown but remain very small

Allocated reserve claims

USD Share CNY Share (RHS)

70% 0.03
60% 0.025
50%
0.02
40%
0.015
30%
0.01
20%
10% 0.005
0% 0
Q1 1999 Q1 2002 Q1 2005 Q1 2008 Q1 2011 Q1 2014 Q1 2017 Q1 2020 Q1 2023

Source: GlobalData TS Lombard, Datastream

Global Watch| 10 May 2024 18

 Disclaimer
This report has been issued by TSL Research Group Limited in conjunction with its subsidiaries Lombard
Street Research Limited, Lombard Street Research Financial Services Limited, and Trusted Sources UK
Limited (together “TSL Research Group”). This report is intended to be viewed by clients of the TSL
Research Group only. The contents of this report, either in whole or in part, shall not be reproduced, stored in
a data retrieval system or transmitted in any form or by any means, electronic, mechanical, photocopying,
recording or otherwise without written permission of TSL Research Group.
The information and opinions expressed in this report have been compiled from publicly available sources
believed to be reliable but are not intended to be treated as advice or relied upon as fact. Neither TSL
Research Group, nor any of its directors, employees or agents accepts liability for and, to the maximum
extent permitted by applicable law, shall not be responsible for any loss or damage arising from the use of
this report including as a result of decisions made or actions taken in reliance upon or in connection with the
information contained in this report. TSL Research Group does not warrant or represent that this report is
accurate, complete, or reliable and does not provide any assurance whatsoever in relation to the information
contained in this report. Any opinions, forecasts or estimates herein constitute a judgement as at the date of
this report based on the information available.
There can be no assurance that future results or events will be consistent with any such opinions, forecasts,
or estimates. Past performance should not be taken as an indication or guarantee of future performance,
and no representation or warranty, express or implied is made regarding future performance. This
information is subject to change without notice, its accuracy is not guaranteed, it may be incomplete or
condensed and it may not contain all material information concerning the company and its subsidiaries. The
value of any securities or financial instruments or types of securities or financial instruments mentioned in
this report can fall as well as rise. Foreign currency denominated securities and financial instruments are
subject to fluctuations in exchange rates that may have a positive or adverse effect on the value, price or
income of such securities or financial instruments. This is a generic research report and as such does not
have regard to the specific instrument objectives, financial situation, and the particular needs of a client.
Clients should seek independent financial advice regarding the appropriateness of investing in any of the
types of financial instrument or investment strategies discussed in this report.
By reading this report you accept TS Lombard’s terms and conditions.
Registered Office: John Carpenter House, John Carpenter Street, London, England, EC4Y 0AN. Registered in
England No. 10232483

Global Watch| 10 May 2024 19