Vijay Kumar Gaba

One of the several global trends that have been developing in the past decade, in particular, is the dissipation of the US dominance in the game of Lawn Tennis. The game that was dominated by US players for several decades does not have any commonly recognizable US players. The list of top 10 rank players in the ATP Men ranking has only two US names – Taylor Fritz (9) and Frances Tiafoe (10); while the rest eight are all European players. In women ranking also only two US names – Jessica Pegula (4) and Coco Gauff (7) – appear in the top 10 lists. Within Europe also, players from Eastern Europe are dominating the court, versus Germany, the UK, and France which had a significant presence in the game for decades.

It would be interesting to study if there is a correlation between losing dominance on the Tennis court and losing dominance on the mint streets (economic muscle) and battlefields (strategic power).

In the past decade, the US has ceded significant economic power to China. For example, consider the following three data points:

·         The share of Yuan in global cross-border payments is inching closer to 3%.

·         The share of the USD in global reserves has declined below 60% from a high of 72%, two decades ago.

·        China has become the largest trade partner of almost 75% of the countries globally, within two decades of its admission to WTO.

On the technology front also, the US has been steadily losing its edge over China in the past couple of decades. In 2020, China filed 2.5x more patents than the US and was granted 50% more patents than the US. In particular, China led the patents in the field of Biotechnology and Energy. (see here)

Maybe equity investors are taking cognizance of these trends and are de-rating the US stocks. The current risk premium for US equities is the lowest since 2004.

On an unrelated note, the pattern of rains in Rajasthan has been changing noticeably for the past decade or so. As per the IMD statistics, the normal level of average rainfall in western Rajasthan has increased by 32 percent since 2010, while in eastern Rajasthan, it has increased by 14 percent. There have been frequent instances of floods in Rajasthan over the past decade.

“A 2013 research by the Max Planck Institute tried to explain and define the effects of climate change in recent years with the help of high-resolution multimodality. The average level of rainfall in west Rajasthan will increase by 20-35 percent and east Rajasthan will increase by 5-20 percent in 2020-2049, compared with 1970-1999 data.” (see more details here)

If this trend sustains, we shall see some dramatic changes in the economy, demography, and ecology of the state. Real Estate enthusiasts might want to further explore this trend.

This summer Americans drove less than the summer of 2020 when many office goers were working from home and the economy was partially shut down. The situation is no better in Europe. Higher fuel and food cost is driving the cost of living higher in most of the world, significantly disturbing the household budgets.

Many emerging and underdeveloped markets were struggling with higher inflation even before the pandemic. But pandemic and adverse weather conditions in the past two and half years have made the situation worse.

Whereas many emerging markets, especially in Africa and Latin America, have been struggling with higher inflation and rise in the cost of living for a couple of decades, it is a relatively new phenomenon for the post 1980s developed western economies. The present generation in these economies had gotten used to cheap and easily available money and marginal food and fuel inflation in the past two decades. For them this sudden and sharp rise in basic cost of living is nothing less than a major shock. Most of them may not be financially sufficient, economically trained, socially skilled and/or mentally prepared to deal with this problem.

On the other hand, the modern asset pricing models may also not be suitable to the situation where interest rates are rising at record pace. Many valuation models used for making investments in "startups" - having very long payback period in terms of conventional asset pricing techniques; not differentiating between revenue and capital cashflows for operating purposes; usually funded by professional private equity investors with little own skin in the game; and having high leverage debt as the ultimate source of funding – may not work at all in a scenario where USD is depreciating and cost of USD borrowing is running in excess of 6%.

The current spike and persistence of inflation has been attributed to the logistic constraints due to the pandemic; adverse weather conditions; Russia-Ukraine war and fiscal support extended by various governments to mitigate the hardships faced by the citizens. Initially most central bankers believed that the inflation is transitory and will wane as these conditions change. However, in the past six months a realization seems to be dawning upon them that the trillions of dollars in new money, printed over the course of the past 2yrs, may also have a key role to play in this episode of high inflation. Apparently, it took 215yrs for the US government debt to reach US$7trn. It has added the same amount in just the past 27months.

Inarguably, the problem of inflation has many more dimensions. Hiking rates and withdrawing quantitative tightening will take more than 25yrs to reach a sustainable level of debt. Manufacturing a recession by sharp hikes will only destroy demand for various commodities and weaken the inflation. However, the inflationary forces will keep coming back, much stronger than now, as and when the growth begins to revive.

A sharp USD and EUR devaluation could perhaps be one of the more viable solutions left to (i) reduce the public debt materially in a short period of time; (ii) complete restructuring of the global terms of trade; (iii) rationalization of the global commodity prices especially energy; (iv) catalyze a new investment cycle led by US and European exports.

The investors in USD denominated assets would obviously suffer tremendous losses. No wonder large investors like the Chinese government have materially reduced their holdings of US treasury and USD. India is also trying hard to diversify its trade to include other currencies like Ruble, Riyal and Yuan, to contain its exposure to USD.

The questions that beg answer are:

(a)   What shall be the safe haven in case of a sudden USD decline. Whether it would be the traditional asset like Gold; a new age asset like digital currencies or traditional safe havens like CHF, CNY, SGD etc.?

(b)   Is there any actionable for a small investor, if this speculation does come true?

 On 29^th June 2022, Reuters reported a trade deal that could have material and far reaching implications for India’s external trade in particular and the global trade in general as well. As per the agency, it has accessed documents from the Indian Custom department showing that Ultratech, the largest cement manufacturer in India, has imported 1,57,000 tonnes of coal, worth USD25.81million (appx INR2000cr), from Russia. The consignment is invoiced in Chinese currency Yuan (CNY), implying that the payment will be made in CNY, without using the global payment network like SWIFT. The agency also reported that other companies have also placed orders for Russian coal using CNY payments. (see here)

This could be the first instance of an Indian company using CNY to make international payments. Apparently, this time the transaction could be to circumvent the international sanctions on Russia. Ultratech would be using USD to buy CNY in China or Hong Kong to pay the Russian coal producer SUEK. But the success of this transaction may encourage companies to explore INR-CNY and INR-JPY routes of payment in future. It is pertinent to note that Russia and China are successfully conducting CNY-RUB trade for many years.

In the fiscal year FY22, India had a trade deficit of USD79.55bn with China (including Hong Kong) and a trade surplus of USD32.8bn with the US. These two countries are India’s largest trade partners, accounting for 26% of India’s total foreign trade. Notwithstanding the persistence of geopolitical conflict and political rhetoric, China’s (including Hong Kong) share in our foreign trade has risen to 14.4% in FY22. China accounted for 18% of India’s total imports in FY22, against 7.6% for the USA. An INR-CNY payment system in bilateral trade could be extremely beneficial for India, as it may help in bridging the trade deficit with China by making our exports to China more competitive.

Besides, India runs a trade deficit of USD28bn (FY22) with Saudi Arabia, mostly on account of oil imports. Saudi Arabia in turn runs a trade deficit of similar magnitude with China. Successful INR-CNY trade with China and Russia could open doors for non USD settlements with other trade partners also. This could potentially reduce dependence on USD for payment settlement.

It may be argued, CNY could not be as reliable a currency as USD, given the reputation of the Chinese political system and authoritative government. The US has always accused China of manipulating its currency. However, so far not much irrefutable evidence is available to conclude that PoBC has unduly manipulated CNY or exploited its trade partners. On the other hand if we compare the strength in USD considering the amount of USD printed by the US Fed in the past one decade, reasonable doubts emerge over sustainability of USD’s present strength.

The Indian Express highlighted in its 17^th March editorial (see here), “The weaponization of trade, the imposition of sanctions and the exclusion from SWIFT (Society for Worldwide Interbank Financial Telecommunication) by the US could trigger a faster de-dollarisation as countries displaying diplomatic and economic autonomy will be wary of using US-dominated global banking systems.

The US dollar, which is the world’s reserve currency, can see a steady fall in the current context as leading central banks may look to diversify their reserves away from it to other assets or currencies like the Euro, Renminbi or gold.

The notion of de-dollarisation sits well in the thought experiment of a multipolar world where each country will look to enjoy economic autonomy in the sphere of monetary policy.”

V. Ganpathy, a global expert in international trade and technology transfer, also opined (see here) that “India operates a huge trade deficit in excess of $150billion. One of the best way to counter this trade deficit is by introducing Rupee trade for major imports.” Ganpathy believes that the benefits of Rupee trade substantially outweigh losses. He believes, “An aggressive international trade lobbying is required to actively promote Rupee trade with dominant economies.” If India wants to become a global trade player, “the local currency should be the preferred trading instrument.”

The Ultratech deal could just be a small beginning for a major change in India’s foreign trade paradigm.

Recently, some RBI officials reportedly told the parliamentary standing committee on Finance that RBI fears increased “dollarization” of the Indian economy due to popularization of cryptocurrencies. The representatives of the central bank reportedly testified before the committee that “…almost all cryptocurrencies are dollar-denominated and issued by foreign private entities, which may eventually dollarize a segment of the Indian economy. The cryptocurrencies could be a medium of exchange and replace the rupee in financial transactions, both in domestic and cross-border transactions, affecting the monetary system and undermining the RBI’s capacity to regulate capital flow.”

In this context it is pertinent to note that—

(a)   As per the latest available World Bank data, foreign trade accounts for ~38% of India's GDP. A substantial part (~86%) of this trade is invoiced and settled in USD; whereas only 5% of India’s imports are from and 15% of India’s exports to US.

(b)   It is estimated that approximately 60 to 65% of India’s foreign currency reserves are held in US dollar assets.

(c)    At the end of FY21, India had about ~US$570bn of external debt; about 21% of GDP. Out of this ~18% was short term debt (due for repayment in 12months). Though the composition of this debt is not readily available it is safe to assume that a significant part of this debt is denominated either in USD or currencies that are pegged to USD or are closely linked to USD, e.g., CNY, AED, SAR, SGD etc.

(d)   In the recent consumer price inflation (CPI) data (April 2022), about 20% of the total CPI inflation was imported inflation, caused by rise in global prices and depreciation of INR against USD.

This implies that a substantial part of the Indian economy is already “dollarized”. To that extent, the concerns of the RBI are valid and understandable. This also explains the “go slow” policy on rupee convertibility and stricter control over capital account.

As per Gita Gopinath, renowned economist and Deputy Director IMF—

“The greater the fraction of a country's imports invoiced in a foreign currency the greater its inflation sensitivity to exchange rate fluctuations at both short (1 quarter) and long (2 year) horizons. For the U.S. with 93% of its imports invoiced in dollars the consequences are far more muted than for a country like India that has 97% of its imports invoiced in foreign currency (mainly dollars).

When a country's currency depreciates the expectation is that it will stimulate demand for the country's products as it lowers the relative price of its goods in world markets. This is unlikely to be the case for many countries that rely on foreign currency invoicing for their exports. This does not imply that exporters in non-dominant currency countries do not benefit from a weaker exchange rate. They do, but it mainly works through increases in mark-ups and profits even while the quantity exported does not change significantly. The benefits of higher profits in a world with financial frictions can of course be large and raise production and export capacity in the longer run.”

The question is what India should do to avoid dollarization of the economy. Obviously, banning cryptocurrencies and controlling foreign currency transactions may not be sufficient. We would need to materially increase the invoicing of our exports in INR.

The Nobel laureate Robert Mundell propounded the Mundell-Fleming paradigm in 1999 to address this issue. As per this paradigm, to gain from the weakness in local currency (vs other currencies), the exports must be invoiced in local currency.

For example, if Indian exporters invoice their products/services in INR, their prices do not fluctuate often. In this case, depreciation of INR against the importers’ currency will immediately result in cheaper cost for the importer and therefore lead to demand shift towards Indian products/services. However, if Indian exporters price their products/services in USD (as is the case presently) the shift to Indian producers will depend upon the equation between USD and Importer’s currency.

The key for India therefore is to develop more bilateral relations where the trade could be conducted in local currencies, e.g., India exporting in INR and importing in the currency of suppliers. The bilateral FTA route being adopted by India in the recent past is perhaps the best way to achieve this goal.

The most interesting part of this changing paradigm would be how the bilateral trade relationship between India and China develops. China is one of our largest trade partners. Trade relations with China are obviously critical for India’s overall economic growth and development. The ideal outcome would be if we can reduce our trade deficit with China through mutual agreements, e.g., by increasing export of services, food etc.