Rethinking reserve strategies: Will Central Banks dump the dollar?

The Trump administration unveiled the tariff rates on its trade partners and sent shockwaves through the global financial system. Tariff rates threatened to disrupt established global trade flows and supply chains.

The markets, though, heaved a sigh of relief on Wednesday as Trump announced a 90-day pause on tariffs for all countries, except China. The reason for the 90-day pause could have been the turmoil in bond and stock markets.

There were two options for the trade partners once reciprocal tariffs were announced. Either to approach the Trump administration for negotiation or resort to retaliatory measures.

China chose to take the latter option and was punished with additional tariffs. The intent of the Trump administration seems clear. It wants to strike trade deals i.e., quick wins, to even out the terms of trade.

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In the process, it risks compromising the supremacy and exceptionalism that the US has enjoyed for decades. Countries can no longer rely on the US as a guardian of the global geopolitical order or even consider it a reliable trade partner or defence ally.Most countries would have to cut out bilateral deals with the US to prevent the most favored nation (MFN) clause of the WTO agreement from kicking in.Theoretically, imposition of tariffs brings down efficiency. The US economy would not be able to produce all the goods efficiently indigenously. It is therefore difficult for the supply curve to adjust over the short term. Even over the longer run, the indigenous production could be inefficient, resulting in deadweight loss.

Therefore, in the short term, the prices of essential commodities (food and clothing) can go higher, and as consumers rationalize spending budgets, discretionary spending, such as on consumer durables, could be curtailed. Therefore, the impact on inflation can be difficult to predict. It is important to track the US breakevens i.e. inflation expectations

Over the longer term, we could see trends like De-Dollarization play out. Central banks globally would look to diversify their Reserve holdings. Demand for US treasuries could come off. Countries would look to strike more bilateral trade deals or focused regional trade deals.

Also important to track are high yield spreads and CDS spreads, as these provide early warning signs of a recession or slowdown. Certain countries that have relatively lower tariff rates could see their export share to the US increase.

Trends in global freight rates on key shipping routes would give important clues. Also, countries will have to protect their domestic economies from dumping by manufacturing powerhouses. They will either need to erect trade barriers of their own or keep their currencies undervalued.

As far as India is concerned, our tariff rates are relatively low, which would help us increase our export share. Our diplomatic ties with the US are fine as well. The RBI will have to manage the currency smartly as it would not want the Rupee to strengthen too much in relative terms to avoid dumping, and also not too weak to get on the US Treasury‘s currency manipulation watchlist.

Despite the Trump administration’s recent decision to hit a 90-day pause (except on China), we believe countries will be cautious and look to have safeguards in place.

Diplomats will be working overtime to negotiate and/or strategize and plan safeguards by planning tariffs of their own, FX management strategy, etc. It is, after all, a case of once bitten, twice shy. Markets and risk sentiment, meanwhile, will continue to yo-yo.

(The author is Founder and CEO IFA Global)

(Disclaimer: Recommendations, suggestions, views, and opinions given by experts are their own. These do not represent the views of the Economic Times)