Rabobank: A New "Berlin Wall" Is Going Up And The Shock Of This Decoupling Is Only Just Beginning To Be Felt

By Michael Every of Rabobank

When I lived in Russia in 1994, the only two places that sold affordable food to go in the entire metropolis were McDonalds and a sandwich chain called ‘Combis’. I learned to say “a BigMac and fries, please” in Russian just as fast as I learned to understand “Attention, the doors are closing” on the long metro journey from the burbs where I lived so get some hot food. McDonalds had opened in Moscow on 31 January 1990, before the USSR was dissolved, and the enormous crowds it drew were taken as emblematic of the power of Western capitalism and the dawning of a new age of its global supremacy.

Yesterday, McDonalds stopped operations in Russia, joining other major Western firms in doing so – and the symbolism is again telling.

Ignore the stupid Thomas Friedman “world is flat” meme that no two countries with branches of the golden arches have ever fought a war: this particular microwaved Norman Angell argument has been proved hubristic for many years already. What matters far more is that the closure is a symbol of a rapid global decoupling based around geopolitics, logistics, and physical commodities – and food is again caught in the middle. Every day brings fresh escalation, and just the last 24 hours have seen:

• The US ban all Russian energy (except uranium), which the White House had kept resisting until the last minute
• The EU announce it will diversify from Russian energy as soon as possible, which will apparently take around a year, and will involve rejuggling global energy supply chains
• The EU plan the launch of a massive new Eurobond to pay for both its new energy security and its new defence spending – which crosses a fiscal Rubicon in that defence spending is going to be a multi-decade commitment, not a one-off package. The EU is also flagging potential outright price interventions in energy markets.
• Italy considering possible energy rationing – indeed, the serious discussion of the inevitability of some form of Western rationing other than just by price underway in serious circles
• China announce it is considering buying into the Russian energy and commodity sector, with firms like Gazprom and Rusal likely targets, which will infuriate the West
• Shell say it will no longer deal in any Russian energy at all
• The US Commerce Secretary say Chinese companies that defy sanctions against Russia may be “essentially shut”, e.g. China’s semiconductor sector
• K-Street lobbyists finally learn to reject some sources of money – in this case Russia, but who next?
• Russia announce it will restrict some raw material exports, with the details of to whom and of what to be made clear in two days – but we can already guess it will be those sanctioning it.
• Russia suspended access to FX for its citizens until 9 September, further underlining the squeeze in a market where RUB closed at 130 after having hit 175 briefly on Monday
• Wild trading on the Hong Kong-owned LME ‘undone’ by the 145-year old exchange: after Nickel soared 250% Tuesday, it ‘cancelled’ trading, allowing the Chinese players caught in a short squeeze to close out huge loss-making positions at the prevailing end-of-Monday price.
• Global commodities trading houses suddenly raising debt

Meanwhile in the war, military observers see Russia is slowly resolving the enormous problems in its military supply-chains and is grinding on through sheer force of numbers – exactly as it has done many times historically: Kyiv is still in its sights. Poland made a formal offer to Ukraine of its MiG-29 jets – which the Pentagon immediately struck down. However, the White House seems to lag, not leads on war responses, so don’t rule out some planes arriving at some point. The US is also to send Patriot missiles to Poland as a defensive measure. In short, escalation is certain, and then so is an escalated Western –and eastern– economic response.

At this point, one must surely notice that a new ‘Berlin Wall’ is going up. (I wish I had not lost the piece I chiselled out of the old one.) The issue is that this time the economies on the other side of it have vast amounts of both physical commodities that we need, and the manufacturing supply chains we also need. The shock and pain of this decoupling, which both sides are driving, is therefore only just beginning to be felt. As regular readers will know, this is hardly new territory for us. Indeed, we have done a lot of past work looking at who wins and loses in these kinds of scenarios.

One much newer view doing the rounds this week has been that ‘China is a big winner because it will sell its holdings of US Treasuries, forcing US yields higher, and then buy Russia commodities, setting itself up as an alternative to the US dollar globally’. Really? No. There are the usual, sound arguments of a closed capital account, no rule of law, and no trusted, deep pool of financial assets. But that overlooks more fundamental problems for China.

Let’s imagine Beijing sells all its Treasuries. That makes sense now Russia shows that if China misbehaves geopolitically then its FX reserves can be ‘turned off’. But China will sell its Treasuries to whom, and at what price, and what cost to itself? Maybe the PBOC takes the hit and monetizes the loss. But in these hyper-political times, the Fed would notice this happening and step in to buy the US debt with QE, keeping US yields low. China would then get (more) printed money for all the goods it has sold the US rather than (low) interest-yielding US debt. So, China would still have US dollars. It would have to use those dollars to buy the Russian commodities that will apparently back CNY. Except Russia doesn’t want dollars because it can’t use them. So China would have to sell them to someone else for RUB – which is not possible either because of the scale involved and the risk of sanctions.

Let’s assume China buys Russian commodities somehow: how does this ‘back CNY’? China is massively SHORT all commodities due to its geography and demography. Its backing for CNY, which *is* strong, comes from manufactured goods, not commodities. Is it going to put $1 trillion of grain, which rots, or oil or nickel or palladium, which it needs to use daily, into a vault as an anchor for the currency, like a gold standard? If so, consider gold standards need tight monetary and fiscal policy while China has expanded its debt and broad money supply to war-economy dimensions already: the IMF says it ran an augmented fiscal deficit of -19.9% of GDP in 2020. How is this dynamic stable? Only with the capital controls to stop that debt/money flooding out that mean CNY cannot be a true global reserve currency like the US dollar.

If China takes a big stake in Russian commodity exporters, the latter will want to be paid in RUB unless Russia is prepared to become a de facto empire of resources for it to extract. (Trust me, Russians know this – and the move risks Western secondary sanctions, as we have flagged.)

If Russia accepts CNY, China still faces the problem of what it does with the exports it builds with them – because it sells those goods to the rest of the world for US dollars or Euros! The only way not to do that is to sell less to the US and Europe – which may now happen more quickly than some expect, if not imminently, if the West sees China as supporting Russia. In other words, Russia switches from Western to Chinse technology supply chains – and the West decouples from Chin as a result. That would undermine the Chinese trade surplus which also keeps its currency stable.

That is, unless China can find a new set of major importers willing to buy in CNY and run vast trade deficits with it: that used to be called an empire. Or China could consume more locally so it doesn’t need to export so much to others. Yet that involves changing its entire political economy towards more private sector and private consumption, and less state sector and mercantilism. Regrettably, it seems far easier for China to try to change the global economy than to do that, because it also undermines the Chinese trade surplus and political control of the key levers of the economy.

The simple message then is this: yes, this is a metacrisis, as we flagged before it started. Yes, a new ‘Berlin Wall’ is going back up. Yes, this time lots of things the West needs are stuck on the other side of it: commodities are one – including both energy and the agri goods needed by nearly a billion people; a multiplicity of Chinese manufactured goods are another. Yes, working out how to restructure into a new model/pattern will shake the world, as we already see it is shaking commodity markets, debt markets, equity markets, and some FX markets – with far more to come if/when the ‘China’ shoe drops. So, there is no ‘easy win’ for anyone here – and certainly no launchpad for a plug ‘n’ play ‘new global financial hegemon’ backed by commodities to simply replace the US as the US replaced the UK.

And now back to the mundane world of central bank speak and data: the RBA governor now says a rate hike this year is “plausible”. After all, he too has Ukraine as an excuse for having been wrong on inflation. Chinese inflation data today saw CPI 0.9% y/y, in line with expectations, and PPI down to 8.8% vs. 8.6% consensus. Can this downtrend last with global commodity prices heading into the stratosphere? How much subsidy can China afford? One asks as the EU itself moves towards energy subsidies and potential price controls. But having such things in common actually makes decoupling all the easier.