Dollar circulation mechanism and pricing system

(1) Dollar circulation mechanism

Let’s start with the circulation mechanism of the global US dollar. Specifically, if the US dollar maintains its status as the global central currency, then other countries will inevitably need to hoard US dollars. Regardless of the need to maintain economic and financial security, or from the perspective of economic development, many countries are likely to have trade surpluses or current account surpluses with the United States in the end. Conversely, if other countries have trade surpluses, the United States will inevitably run trade deficits.

So from this perspective, the United States, as the engine of the global economy, is actually largely achieved through its own trade deficit. When the U.S. has a trade deficit, there will inevitably be an outflow of dollars. At this time, U.S. dollar funds flow to other countries along with the U.S. trade deficit. For other countries, although holding a lot of U.S. dollars is helpful to their own financial security, they need to find investment channels for the U.S. dollars they hold.

In reality, these U.S. dollar funds will eventually flow back to U.S. dollar assets. U.S. dollar assets are generally divided into the US onshore market and offshore market, but the most active pricing center for US dollar assets is still in the United States, that is, the US stock and bond markets. In fact, through such a global circulation mechanism of the US dollar, the United States has achieved self-balancing of the balance of payments.

For the United States, it does not need to use its own foreign exchange reserves to adjust the imbalance in the balance of payments, because theoretically, the deficit under the current account can be made up for through the surplus under the capital account, which is why the US dollar has become the global center A huge advantage of the currency.

Of course, in such a process, the external debt of the United States will continue to increase, and other countries will accumulate claims on the United States. These claims are often realized by holding US stocks and bonds, including investing in some US assets. This involves a concept, the international investment position, which refers to the stock of all financial assets and liabilities of a country or region to other countries or regions in the world at a specific point in time.

The international investment position is a bit different from the balance of payments we talked about above. Balance of payments is a concept of flow, which refers to the overall inflow and outflow of funds within a period of time, while the international investment position is a concept of stock, which reflects the sum of assets and liabilities at a point in time.

How to understand the financial assets and financial liabilities in the international investment position? For example, if a country invests in the United States, we record it as the country's financial assets in the United States, but from the perspective of the United States, it is a financial liability. Similarly, if a country invests in U.S. bonds or stocks, it will be recorded as external financial liabilities by the U.S.

The United States is a country with huge debts. What is the current financial debt situation of the United States? The net international investment position of the United States has turned negative since the end of the 1970s, and the overall debt situation has grown exponentially in the past few decades. Currently, the net external debt of the United States is about 45% of GDP.

The increase in debt naturally leads to a depreciation of the dollar. From the perspective of the United States itself, with the increase in debt, the United States also hopes to promote the depreciation of the dollar to a certain extent. will change. The depreciation of the US dollar is actually equivalent to the decline in the actual purchasing power of the US dollar received by the creditor countries, which is beneficial to the United States and does not cause any harm.

Historically, the United States has repeatedly devalued its currency to reduce its actual debt burden. The most famous is the Plaza Accord that the United States asked Japan and West Germany to sign in 1985. At that time, the United States also believed that its current account deficit was too large, and hoped to increase exports by devaluing its own currency, thereby reducing the current account deficit.

However, after the signing of the Plaza Accord, the overall debt of the United States has not shown any signs of slowing down. In 1987, the United States asked the major developed countries to sign a new agreement, the Louvre Agreement. The core of this agreement is that the United States hopes that everyone can maintain the basic stability of the exchange rate, which means that the United States does not want the dollar to depreciate. Why?

Because with the continuous depreciation of the dollar, the international market at that time had begun to lose confidence in the dollar, but the United States wanted to maintain the status of the dollar as an international central currency, so I hope everyone can help him maintain the stability of the dollar exchange rate. Therefore, in general, the exchange rate policy is largely a reflection of the will of the state. 

(2) Global Asset Pricing System

This also has a big impact on the exchange rate. Generally speaking, if the US dollar center system exists, a very serious reality will emerge. The world's major financial assets are actually priced in US dollars. The pricing here is a relatively broad concept.

For example, some international investment funds generally use the US dollar as their benchmark currency. When they invest in some non-dollar assets, there will naturally be an exchange rate problem. For example, if a fund invests in South Korean stocks, even though it buys stocks in Korean won, it must reflect its Korean won assets in US dollars at the end of the year. One of the purposes of this is industry consistency and comparability, but fundamentally it also reflects the dominance of the US dollar in the asset pricing system.

Going back to the example itself, when the fund bought Korean won assets, it actually exchanged its U.S. dollars into Korean won, which naturally resulted in a depreciation of the U.S. dollar against the Korean won.

So we can often see such a situation, when the entire emerging market economy improves, the market will sing more stocks in emerging markets, accompanied by the appreciation of emerging market currencies. In fact, behind it reflects the current situation of the global asset pricing dollar centralization. Even if the funds are in South Korea, once the U.S. dollar is used to buy Korean won to invest in the Korean stock market, it will have an impact on the Korean won exchange rate.

From this perspective, we will find that there is pressure to depreciate the U.S. dollar, because for international investment funds, asset valuation will eventually return to the U.S. dollar, so any investment in non-U.S. assets will bring depreciation pressure on the U.S. dollar . Taking a closer look, we will find an interesting phenomenon: when the stock market plummets, the dollar tends to strengthen; when the stock market rises sharply, the dollar tends to weaken. Because of this, many people regard the dollar as a safe-haven asset.

From the perspective of global dollar capital flows and the global asset pricing system, there is pressure on the dollar to depreciate. This is in contrast to the fact that the U.S. economy is basically boosted by the dollar. This is what market analysts are most concerned about. a place.

The fundamentals of the economy will affect the performance of the exchange rate in the medium and long term, but market factors will increase this short-term volatility. Therefore, to understand the disturbance of market factors on the exchange rate, one must have a basic coordinate in mind, that is to say, the performance of the exchange rate is ultimately determined by the fundamentals of the economy.