Understanding Trade and Capital Flows: Part 3

The Impact of the US Dollar as the Reserve Currency

In Part 1, I explained how the US Dollar’s status as the reserve currency creates strong demand for the dollar, enabling the US economy to run a sustained trade deficit without facing currency devaluation. The dollars sent abroad through the trade deficit are recycled back into the US through foreign investments in assets like our equity markets, real estate, and by purchasing US debt, effectively loaning dollars back to the US. This results in a large capital account surplus for the US.

However, I believe the tariff war is not primarily about reindustrializing America or bringing jobs back, but about restoring US monetary sovereignty over the US dollar. While reindustrialization and job growth would certainly be beneficial, I argue that this is not the central objective. Let me explain.

When foreign companies are paid in US dollars for their goods and services, they deposit these dollars in foreign banks. These dollars are then considered “Eurodollars” (i.e., US dollars held outside of the US, such as in Indian banks). Eurodollar deposits in foreign banks can be used by those banks or other lenders to issue USD loans. The key difference between these loans and domestic dollar loans is that Eurodollar loans are governed by the local banking regulations in the country where the deposit is held. This means they can be less regulated than domestic dollar loans, which must comply with US government oversight.

For example, imagine going to a bank in India and asking for a loan of 90 million Indian rupees. If the banker agrees, they may offer you a loan at 20% interest. However, with Eurodollar deposits, the same banker could offer you 1 million USD at a lower 7% interest rate (assuming a conversion rate of 1 USD = 90 rupees). You, as the borrower, would likely prefer the Eurodollar loan due to the lower interest rate. The borrowed Eurodollars would be spent or invested, and eventually end up in another Indian bank, where they may be loaned out again. These dollars can be rehypothecated indefinitely, with the only restriction being local banking regulations.

The Problem with Offshore USD Creation

The issue arises when USD is generated offshore through the issuance of Eurodollar loans, which directly undermines the US’s control over its currency. For example, if India faces difficulties repaying its USD loans, it could put significant strain on the entire dollar system (similar to the scenario we discussed with the Eurozone in Part 1). The Indian government and central bank would need to intervene to help the country obtain the necessary dollars (e.g., through swap lines), or it could cause substantial market disruptions.

If the US does not intervene, India, having accumulated large holdings of US assets and debt, might be forced to sell these assets to acquire the necessary dollars. This could lead to a crash in US asset markets and an increase in interest rates.

LIBOR and the Transition to SOFR

Both Eurodollar loans and US loans need to have a benchmark of rate that reflects short-term borrowing of USD. This is so that the lender can protect themselves from exposure relating to USD liquidity—passing that on to the borrower. In the past, this benchmark instrument was called LIBOR (London Interbank Offered Rate). LIBOR was the quoted rate for unsecured (meaning non-collateralized) USD borrowing among 16 banks—6 US banks and 10 foreign banks.

For example, a loan might look like this:

• Loan Terms: 1 million USD at 7% + LIBOR

When dollar liquidity dried up, LIBOR rates would rise, putting stress on all LIBOR-based loans, both domestic and international. After 40 years of LIBOR use, it was phased out and replaced by SOFR (Secured Overnight Financing Rate) in 2022. In 2012, a LIBOR manipulation scandal surfaced, where banks were found artificially inflating LIBOR quotes to increase the cost of LIBOR-based loans, exerting pressure on the US Central Bank to lower interest rates.

Why SOFR is a Better Benchmark

SOFR is harder to manipulate than LIBOR because it is based on real borrowing rates in the repo market. In the repo market, banks borrow USD against US Treasury securities with agreements to repurchase those Treasury securities at slightly higher prices. SOFR reflects the actual cost of secured lending, unlike LIBOR, which was based on unsecured loans.

It’s important to note that the collateral is not exclusively US Treasuries, but it can also be other highly liquid and high-quality assets that meet a certain criterion. This makes SOFR more robust and harder to manipulate, as it is tied to actual transactions in the market.

Key Differences Between LIBOR and SOFR

• LIBOR: A quote for unsecured USD borrowing from 16 banks (6 US, 10 foreign)
• SOFR: A real rate based on secured borrowing of USD collateralized by US Treasury securities or other highly liquid and high-quality assets

Starting in 2022, all new contracts had to be benchmarked to SOFR, meaning that foreign banks could no longer manipulate the rates to influence US monetary policy. SOFR’s shift to being based on US Treasuries also means that borrowers now need to own US Treasury securities or other highly liquid and high-quality assets. If they did not have these, then they would require access to borrow these securities.

This effectively limits Eurodollar loan generation by foreign banks, as they can no longer circumvent the need for high-quality USD collateral. Eurodollar loans are now constrained by access to this collateral, no matter what the local banking regulations are.

US Domestic Lending and SOFR Impact

US domestic lending offers USD loans in forms such as fixed-rate mortgages, car loans, business loans, municipal bonds, and commercial paper. These loans are unaffected by SOFR and are governed by domestic lending conditions. Their rates are more directly influenced by factors like inflation, the Federal Reserve’s policy, and economic growth within the US.

In contrast, most Eurodollar loans use the SOFR rate, which ties them to the cost of borrowing US dollars in the repo market. A reduction in USD liquidity abroad, coupled with an increasing SOFR rate, will make SOFR loans more expensive over time. This could lead borrowers to avoid USD loans, particularly from foreign banks, and instead seek loans in their local currencies. The borrowing rate of USD reflects the cost of borrowing USD in the US. Therefore, having USD loans issued abroad undermines the central bank’s policy in other nations, while also encouraging excessive borrowing in countries that may not yet have the productive capacity to meet debt servicing requirements (as discussed in Part 2).

Additionally, in the US, the local currency is USD, so dollars are readily available. In contrast, USD abroad depend on the US providing those dollars, creating a distinct dynamic in foreign borrowing.

The Tariffs and the Need for US Dollar Supply

Returning to the tariff issue: While Americans may be “addicted” to cheap foreign goods, the larger concern is that foreign economies are “addicted” to US dollars. Due to the widespread issuance of Eurodollar loans, foreign economies depend on the US running a trade deficit to supply the dollars necessary for servicing these loans.

Reducing the trade deficit will also reduce the capital account surplus, which in turn decreases the accumulation of high-quality USD collateral required to hedge SOFR loans. This will increase the cost of these loans and further discourage foreign countries from lending in USD.

Foreign Countries and the Struggle for High-Quality USD Collateral

Foreign countries with Eurodollar loans face a challenging situation. They need to hold high-quality USD collateral to hedge their exposure to SOFR. As a result, they cannot aggressively sell the US assets and debt they’ve accumulated over years of trade deficits. Instead, their best strategy is to roll over speculative investments in the US into high-quality USD collateral, thereby reducing their issuance of Eurodollars.

The demand for dollars may also drive a shift in investment from equities with little or no earnings to those generating tangible profits for shareholders. This shift could lead to a decrease in the value of speculative assets that lack a proven market fit.

By limiting—and eventually ending—Eurodollar loan generation, the US gains greater control over its currency and trade balance.

The Link Between Tariffs and Reindustrialization

Tariffs help restore US control over its currency and trade balance while promoting reindustrialization. By reducing the trade deficit and bringing production back to the US, tariffs can rejuvenate the manufacturing sector, boost jobs, and reduce reliance on imports, contributing to long-term economic stability.

Tariffs aren’t just protectionist—they’re about building economic resilience. By fostering US manufacturing and reducing dependence on foreign production, the US can achieve greater self-sufficiency in key industries like steel, technology, and automotive production.

Conclusion

Offshore Eurodollar loans can weaken US monetary sovereignty by increasing foreign dependence on US dollars to service debt. If foreign economies struggle to secure dollars, the US may need to intervene, causing financial instability and pressuring the Federal Reserve to lower interest rates. Limiting Eurodollar loan creation via tariffs and reducing the trade deficit allows the US to regain control over dollar flow and reduce systemic risks.

Tariffs not only restore US monetary sovereignty but also help rebalance the global financial system. By reducing the trade deficit, the US can encourage other countries to focus more on domestic consumption and less on exports. This shift would create a more balanced global financial system, with the US positioned as a stronger economic power.

The US tariff strategy is aimed at restoring control over monetary policy and sovereignty, not just reducing trade imbalances or reshoring jobs. Limiting Eurodollar creation and encouraging domestic manufacturing will foster economic growth, strengthen the trade balance, and improve the US’s position in the global economy. While disruptive in the short term, these measures aim to create a more self-sufficient and stable US economy.

I want to thank Tom Luongo for explaining the importance of the shift from LIBOR to SOFR. You can visit his page through the following link.