Dollar Reflux - Analyzing Truth vs. Rumors

Some people claim that the Federal Reserve is wielding its sickle and starting to harvest the world, influencing the global economy through the return of the US dollar. This statement seems a bit like conspiracy theory, filled with various conspiracy words, as if claiming that the United States has set a trap and the world has become a leek for the United States, waiting to be cut off. But let's put conspiracy theory aside for the time being and explore the problems with this statement, as well as what a US dollar reflow is, how it affects the world economy, and whether the Federal Reserve's interest rate hikes and balance sheet tightening policies can truly create a US dollar reflow to harm other economies.

Let's clarify that the return of US dollars actually refers to the return of international capital, mainly in US dollars, to the United States, which involves the flow of capital internationally. International capital can be divided into official government capital and private capital. Today, we mainly focus on private capital, which can be further divided into three categories: foreign direct investment (FDI), foreign investment portfolio (FPI), and bank flow.

Foreign direct investment (FDI) is easy to understand, which includes foreign capital directly investing in or controlling domestic companies, such as tesla building factories in China.

Foreign Investment Portfolio (FPI) refers to the purchase of financial Securities assets, such as stocks and bonds, by foreign capital in the form of investment portfolios. Institutional investors such as investment management companies, insurance companies, and hedge funds participate, making this capital more liquid.

Bank flow is a type of loan issued by foreign banks to a target country, usually denominated in US dollars. The final repayment of these loans is also denominated in US dollars; hence, it is referred to as USD foreign debt.

In theory, different types of capital will flow under the influence of different factors, including push factors and pull factors. The driving factors include the monetary policies of developed countries, such as the Federal Reserve's interest rate policy, as well as other factors, such as the monetary policies of the eurozone and Japan. The attractive factors depend on the economic characteristics of different countries, such as China's manufacturing and logistics industries as well as Congo's mining resources.

There is a theoretical model called "portfolio theory" regarding the return of US dollars that believes that the flow of capital depends on changes in interest rates and risks. If US interest rates are low, capital may flow to emerging economies with high interest rates. But even if the United States raises interest rates, their interest rates are usually lower than those of emerging economies, so capital may still flow into these regions despite an increase in liquidity costs.

This model determines the allocation of investment portfolios by balancing interest spreads and risks. For example, if the risk of a country increases, investors may reduce their investment in that country, but this does not mean they will all invest back in the United States; they may choose other countries or assets. Therefore, the return of US dollars does not only refer to the return of capital to the United States but can also flow to other countries or assets.

The Federal Reserve's monetary policy is only one factor that affects international capital flows, and this process is very complex, involving multiple factors such as interest rates, risks, economic characteristics, politics, exchange rates, and international relations. Therefore, simply blaming the return of the US dollar on the Federal Reserve's policies is too simplistic. To fully understand this question, we need to have a deeper understanding of how the Federal Reserve's monetary policy affects international capital flows, which is not an easy question to answer. Capital flow is a complex system, and we need more research and data to fully understand its mechanisms.

Harvest theory claims that the Federal Reserve has created a return of dollars and harmed the economies of other countries through interest rate hikes and balance-sheet tightening policies. Scaling down can be simply understood as the Federal Reserve reducing the supply of money through market means. If QE quantitative easing is the Federal Reserve printing money to release water into the market, then shrinking the table is a reverse operation. The Federal Reserve takes back the money circulating in the market, which is often referred to as "recycling" by the Fed as "recycling dollars into the United States". Benefit the United States and suffer the world. That statement is incorrect. They are implying that the total amount of money remains unchanged, but their geographical location has shifted. The real situation is that the Federal Reserve's scale reduction can cause a decrease in the overall amount of dollars globally, both internationally and domestically in the United States.

So you may ask how the Federal Reserve can do that. He said, Reduce it, then reduce it. Is that how he lost the dollars in my hand? So this actually involves the mechanism of currency creation, especially the partial reserve requirement system of banks. So I will share it with you in future videos. Just remember this: the Federal Reserve will shrink its balance sheet, and the dollars in your hands will not disappear, but it can lead to a decrease in the total amount of money banks lend out. According to this logic, if the money decreases, the amount of money that banks can borrow will decrease. So whether it's lending to the United States Both domestic US dollars and US dollars flowing to other countries around the world will decrease. That's why many people say that shrinking the balance sheet is scary, which could lead to a shortage of dollars, a credit squeeze, and a debt crisis.

So why do banks and companies in emerging economies have to borrow money from foreign investors? Why must I borrow it? So why do we have to expand like foam? Of course, it's simple. When the Federal Reserve lowers interest rates to zero, the money is too much, too cheap, and too easy to borrow. This is not only true internationally but also domestically in the United States. During the period of quantitative easing during the pandemic, the prices of various assets in the United States have skyrocketed; that's the principle. When the Federal Reserve decides to raise interest rates, shrink the balance sheet, or reduce the money supply, theoretically, it will naturally lead to a credit squeeze both domestically and internationally in the United States.

However, there are many factors that lead to international capital flows, and the Federal Reserve's policies are only one of them, so the problem with harvest theory lies in their perception of the Federal Reserve's policies as international capital flows. The most important and decisive force Is that really the case? Let's first look at the examples often used in harvest theory. The 1997 Asian Financial Crisis was the capital inflow statistics of the four most affected Asian countries in the 1990s. So we can see that FDI and foreign direct investment are the same as what we said, but the changes are not very obvious. And the changes in FPI are not so exaggerated, and the biggest one that has caused catastrophic consequences for these countries is the order flow, which represents a large number of bank flows representing foreign loans, which has led to the debt crisis that we explained earlier in these countries.

Is the Federal Reserve's interest rate hike the main culprit causing this bank flow capital flight? These are the statistics of the Federal Reserve's base interest rate during the same period. In 1993, the Federal Reserve issued a rate hike signal. So we can see that there was a brief outflow of capital during this period, but it quickly turned back into a net capital inflow. During the period from 1993 to 1995, the Federal Reserve kept raising interest rates, but this capital not only did not escape but also accelerated its flow into these four Asian countries. Since 1995, the Federal Reserve has made a small number of interest rate cuts and has remained stable in the middle of a certain range without any sudden changes. However, the Asian financial crisis broke out in 1997, and a large amount of this bank flow capital fled, which does not conform to the theory that the Federal Reserve's interest rate hike led to the return of the US dollar to harvest other countries.

In fact, before the crisis, the first significant flight of capital was from the Bank of Japan, and then Soros and other funds began to short the currencies of some countries, further triggering the flight of funds. From the existing data, it can be seen that the Fed's interest rate hike did not play a decisive role in this crisis. In recent years, there has been a lot of research and statistics in the academic community on the impact of the Federal Reserve's policy on emerging economies. Most studies have found that the Federal Reserve's policy has an impact, but it is often short-lived and not a decisive factor. When a country experiences a debt crisis caused by capital flight, it is often directly related to the country's own situation. For example, irregular financial markets, incorrect exchange rate policies, excessive reliance on external debt, unlimited borrowing, and even corruption.

It cannot be denied that US monetary policy will have an impact on capital flows, and some countries are more affected by this. Moreover, when there are systemic risks globally, changes in the Federal Reserve's policies may lead to problems at a vulnerable point, triggering a large-scale financial crisis. The Fed's shrinking balance sheet may not be the most direct factor, but it may become the last straw to crush the camel.

Disclaimer: This material is for general information purposes only and is not intended as (and should not be considered to be) financial, investment or other advice on which reliance should be placed. No opinion given in the material constitutes a recommendation by EBC or the author that any particular investment, security, transaction or investment strategy is suitable for any specific person.