Brad Setser on the War in Iran and the Future of the US Dollar

27:26And that's probably typical because most private equity funds are going to be mostly pretty dollar heavy. A typical global reserve portfolio is now at 57%. So the notion that reserves are the source of inflows into dollars is a bit dated. A reserve portfolio will typically have a lower dollar share than a standard return-seeking equities fund, which just because of the outperformance of the U.S. large caps will be more overweight dollars. Joe, mildly annoyed Brad is the best Brad, I think. We should ask a question about the IMF report on global imbalances. No, no, we have a lot to talk about. Well, I mean, actually, Can you just expand on this further?

28:10So we look around the world and we see that actually reserve portfolios are arguably or all things equal, maybe underweight dollars. Was that always the case? Is there a structural reason for that? Like what's the story behind this mismatch? I didn't actually realize that. Well, reserves can be managed for safety and liquidity and not for return. I see. And so the pressure to get the most returns is weaker. So you don't have to chase the tech stocks. You don't have to match an index. And if you don't have the tech stocks, you're underperforming the index. You're underperforming your benchmark.

28:47Your benchmark as a reserve manager will be more bespoke. Higher priority on safety and liquidity. That's observation one. Observation two, and this is where things get funky. A quarter of global reserves to the first approximation are in China. Now, China still manages its currency against the dollar. But China, as a matter of policy, brought its reserves, formal reserve dollar reserve share down, last disclosed number, down to 55 % from 79 % in 2005. They did not like the optics of financing their strategic rival and holding a lot of treasuries in visible ways. Now, that's a bit misleading because the dollar share of the portfolios of the state banks, which now have a very large share of the total state portfolio, is much higher, 70%.

29:41And if you actually net out the offshore liabilities of the state banks and just look at the net, the euro offshore portfolio is matched by euro offshore liabilities. So that nets out. The dollar offshore are matched by dollars onshore. So in a sense, the BOP flow through the state banks was almost – setting aside some of the CNY lending, which has gone up, was like 100 percent dollars. Like a Taiwanese lifer portfolio, one of my other favorite topics, would be 95 percent dollars. Remember, central banks are holding reserves as an asset against liabilities, money that don't pay interest. Some have to sterilize.

30:24So they don't have the same pressure to generate returns. And so therefore, they can hold lower yielding, safer assets. And a couple of big players, China and Russia, just didn't want to be too heavy dollars. God, there are so many things now that I'm thinking about. We could like different avenues I want to ask Brad about. But just since you mentioned Taiwanese life insurance companies, it got me thinking about East Asia a little bit. But I'm just curious, like, have you ever seen anything like what's going on with South Korea right now? No. I only think because East Asia, where it's just like this insane.

31:00I mean, this is a real, obviously, like a big, generally rich, developed economy by and large. And it's just having this insane growth spurt, both in the stock market and actually the real economy, because of how the incredible margins and sales it's getting on essentially memory chips right now. Like, is there any analogy that comes to mind for what we're witnessing here right now? I'm not that comes to immediately to mind. I mean, a huge growth in exports. Yeah. Very rapid real growth, particularly in Taiwan, actually, but narrow one sector expanding. Right. And then weakening currency. You know, you have growth outperformance.

31:38You have a terms of trade positive shock from the semiconductor prices. And then you have a weak currency. And then you have an economy – like last year, all of the outflow from Korea that matched the current account surplus was into equities. A third of that was from their national pension fund, so a policy flow. Two-thirds of it was just retail and retail decided, even though Samsung is making money hand over fist, that they preferred to hold US sex socks. So, no, I haven't seen anything like it. I mean what is also interesting right now is that Korea is a very petroleum-intensive economy, a lot of petrochems.

32:16energy intensive industries in addition to the memory chips and so and it's uh energy poor fossil fuel poor so it is on the one hand benefiting from this giant positive shock memory chip surge in price surge in demand ai is helping samsung print money hand over fist and then the economy's on the receiving end of a pretty big negative shock because of the loss of oil flow. And so, you know, we've sort of stayed in a, that mix has kept the won weak. The interesting thing to me is that the Koreans are now starting to complain that the won is too weak, despite being a country that historically likes a weak currency for exports.

32:58And the National Pension Service has just announced they're going to expand their hedging program. I hope they succeed. The world economy does not benefit from won at 1 ,500 and an even bigger Korean surplus over time. Well, we'll have to bring back former Odd Lots guest, Hyun Sung Shin, to talk about all of this. Good luck. I mean, he's got a promotion. He does a good job these days. I just refer to him as former Odd Lots guest from now on and forever.

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36:29Just going back to the de-dollarization idea, as you point out, there's a lot of nuance with reserve portfolios. And then one of the things you always see when a headline comes out saying that foreign countries reduce their share of U.S. treasuries is this idea of the custodial accounts. And maybe we're not getting a full picture of exactly what they're buying. When it comes to gauging de-dollarization, I'm doing air quotes. No one can see me because this is a podcast. But like, what are you actually looking at to score and gauge whether that's a real trend and whether or not it's accelerating over the past five weeks or so?

37:05It's hard to track in real time. I mean, the obvious indicator is if the world is de-dollarizing, they're going to be buying fewer dollars and the dollar should be falling in value, which in general is not. So, I mean, I think that's the simple high frequency metric. To me, it is very difficult to have a credible story around de-dollarization, when the dollar is strong, not weak relative to history, and when the total dollar claims on the US, including dollar-dominated equity claims, have continued to increase. And so in 2025, the world was longer dollars than it was in 2024, despite all the hot air spent talking about de-dollarization.

37:49Function of the fact that we have a current account deficit of over a trillion dollars, so we have to sell a trillion of financial assets, and we are not selling euro or yen or yuan-denominated claims to the world. So last year was sort of financed 50-50 with dollar debt and U.S. equities, which implicitly settle in dollars. So in that sense, I find it a silly discussion. In order to de-dollarize, the world has to stop funding the U.S. in dollars. Now, there's a whole bunch of other things that can happen around the world. And there is a small subtrend where some emerging market borrowers are borrowing in yuan to save money.

38:25And so I think that is an interesting cross-current, but it is a modest cross-current. The sanctioned countries, of course, don't use dollars or euros to settle payments because they cannot. Now, in general, they seem to want to get rid of the sanctions. They're not saying, oh, this has been great. We are so lucky that we have to settle payment in yuan and sell our oil to China at a discount. They generally would like to say, well, we would love to be unsanctioned to sell in dollars and to have a competitive market for our oil, not just a monopsony buyer in China. But look, you look for indicators of changes in hedge ratios.

39:06You look for individual countries or individual institutions that have changed their portfolio allocation in a meaningful way. And I think over the past nine months, there was decent evidence that some of the Scandinavian pension funds, institutional investors, hedged or reduced their dollar bond holdings, partially in response to some overheated rhetoric around Greenland. On the other hand, unambiguous evidence because of some silly changes in regulation that had a big impact that the Taiwanese lifers reduced their hedge ratio by a really big number. And the Japanese lifers continue to see – like they let their hedge ratios slip because hedging is costly in Taiwan.

39:54It's costly in Japan. And you haven't been rewarded for hedging because the currencies have stayed weak. And in fact, in Taiwan, when you reduce the hedge ratio, that works as a bid for the dollar and it pushes the dollar back up and pushes the Taiwan dollar down. So it becomes self-reinforcing circular Soros reflexivity. So you see parts of the global economy that are hedging. You see parts of the global economy that have really reduced their hedge ratio, just gone all in long dollar fixed income. And you see parts of the global economy that are less comfortable holding dollar fixed income, but they are absolutely unwilling to be underweight U.S.

40:33equities. And so what you really end up seeing is not de-dollarization. It's just more a little bit of a rotation towards holding U.S. equities and a little less bonds. Going back to sovereign wealth funds and just thinking about them abstractly, you know, countries, particularly big commodity exporters, have various good reasons to have sovereign wealth funds. Their revenues are going to be very volatile and cyclical. And so you want to smooth them out. In some instances, though, one factor is that you have these countries that get incredible dollar inflows, but don't really have big domestic industries, and so you can't spend it all domestically without creating a lot of inflation.

41:14But now we see in the Gulf countries in particular that there is just a lot more domestic economic activity happening, period. We know that sort of Abu Dhabi and Dubai are just growing, bustling cities in their own right. And so there is actually opportunity. There might be domestic capacity. We know that Saudi, you know, they're trying all kinds of stuff from we've talked about this in the past, from soccer teams to mile long, multi mile long cities in a vertical in a horizontal line or whatever. But just generally, does the growth of some of these countries, just in terms of domestic economic activity, change the calculus about how some of these revenues are used?

41:58It's like, oh, we can actually deploy this domestically in a productive way, maybe by building data centers and so forth, that it won't just be we're going to add to inflation. Well, we can debate about whether yet another data center is going to truly prove productive. Our AI tech barons certainly believe it to be. But there is a scenario where they've kind of drunk their own Kool-Aid and are overbuilding data centers. You know, Saudi Arabia is a great example. The line looks like it's not going to be a line at scale back. The desert ski resort with artificial snow is no more. That's been canceled.

42:34Everything was sort of getting pulled back in. Well, not everything. The big cube in Riyadh, I guess, is still going forward. But yes, it did fundamentally change Saudi Arabia when MBS came and said, I am going to throw a ton of money into domestic development, basically real estate, but also sports, entertainment, da-da-da-da, combined with some social liberalization around women's role in society. Huge change. And what it in practical terms meant, some people use the fiscal break even. I think fiscal spending, some things can be kept off budget. I prefer to just look at the good old-fashioned balance of payments.

43:18The balance of payments break even of Saudi went from 60 to 90 to 100. So in order to have a current account surplus that needs to be invested abroad, the Saudis now need an oil price of roughly 95. They did not get that last year. So they were running budget deficits. They are running a current account deficit, which was financed by borrowing from the world. And since MBS not only wanted to do all these domestic economic developments, he wanted to play in the big boy league with the Emiratis and do big investments in the US and be chums with Donald Trump. The Saudis, in order to do all that, buy equities, as well as build all the domestic projects, they borrowed$100 billion last year.

44:05They were the biggest borrower in the emerging world. So if you don't have the level of wealth that the Emiratis or the Qataris have, you will find yourself in a position where you are no longer a source of petrodollars. You're a drain on the world's euro dollar system. And the Saudis have flipped and become a drain on euro dollars. The Emiratis can do whatever the hell they want. I mean, the Emiratis just have so much money and so few people. So few people as in Emirati-born residents who have a claim on the oil surplus, not the high-end. I know, Tracy, you were a high-end guest worker when you were in Dubai.

44:45And the low-end guest workers who don't have a claim on the oil. And so the Emiratis are just in a position. In some sense, the Emiratis can – they are like the Rockefellers if they had not given their money away. They wouldn't actually need to run an oil field in order to invest in all sorts of things just because they'd made so much money from oil over the past 50 years that they can just become investors. The Rockefellers, if they hadn't donated to the Council on Foreign Relations, right? Spent all the money. I'm very happy that they gave some money. We all are very happy. Okay. So I realize in this conversation we haven't talked at all about Europe yet.

45:26Yeah. And it feels like lately, whenever we do talk about Europe, the only certainty is always that it's going to come out in a worse position than it was before. If you're looking at Europe right now with the additional burden of higher energy, with all the focus on AI, with China's export boom, is Europe just inevitably in a structurally weaker place than it was before? Not enormously. At the margin, losing Qatari gas means they're going to become more dependent on American gas. They're not thrilled with that. They're, of course, not thrilled with any increase in oil price. But where we are now, this is a manageable shock.

46:06This is a much, much smaller shock than the loss of Russian pipeline gas in 22, which I think we underestimate how big of a shock that was to the European economy. So I don't know that this particular shock is enormously negative to Europe. It is modestly negative because Europe's a net importer of 12 million barrels of oil. So, you know, every$10, lose 40 billion on the current account. Europe is wealthy enough. It can afford that. It's not going to impinge them. It causes political problems when gas prices go up. The Germans want to cut fuel taxes to offset that, like, you know, as rich countries sometimes do.

46:47I don't think it fundamentally changes much about Europe. It does highlight fossil fuel dependence because Europe is fossil fuel light. It does add to pressure to do more nukes, to be more serious about renewables. And it certainly doesn't help Europe figure out how to respond to the China shock, which I think is a much bigger shock to Europe than at least this kind of petroleum shock. And then the other baseline problem, which we'll see if it's solvable or not solvable, is that we're going to be in a world where missile interceptors are constrained and there's going to be a scramble to make missile interceptors.

47:27And the US is going to be even less willing to provide missile interceptors to Ukraine. So we're in a world where Europe, its missile defense, will have to come from its own production to a much greater degree, which is arguably a positive for long-term development. But it does create a near term sense of vulnerability. But I think I think the the central shock in this case is going to be much more heavily felt in oil importing Asia. Yeah. So, you know, you talked about the high bar that would have to clear for some meaningful change and, you know, the dollar's role in the global economy or, you know, the dollar's dominance, et cetera.

48:07But look, there's a widespread view around the world that the U.S. has become a very reckless nation, right? I mean, there's these complaints. Why does global policy, the prospect of a war being started by the U.S., depend on what 10 ,000 voters in Michigan and Wisconsin? This is some quote from some European, how they view things every four years. We have been extremely hostile to formal allies for reasons that most people around the world can't comprehend. The Greenland example. Joe, you were not on board with Canada becoming our 51st state. I'm disappointed. Canada is a great example. Didn't you grow up on the border?

48:50Didn't you see? These things just pile up, right? And so even setting aside—and then, of course, now there is this current war, which most countries are clearly not on board with. Hard to understand. Most countries don't really understand what the goal was. It may end up being a huge own goal if it permanently gives Iran. It's unclear what's going to happen. Could these things pile up in such a way such that, look, setting aside these flows, the U.S. ends up being kind of a trend more towards a global pariah. We know that polls about the U.S.'s favorability continue to decline throughout much of the world, et cetera.

49:34How sustainable is it to have the dollar as a reserve global currency, the thing that everything priced in, if so much of the world essentially views the U.S. as a rogue state? When it's framed in those rhetorical terms, it almost feels like, you know, the only possible answer is that the dollar will become less dominant in global transactions. And as I mentioned, as a share of cross-border financial assets, the equity share is bigger than the reserve share. It's not no longer just the flows. The flows coming from holding safe reserves are nowhere near big enough to have a net international investment position of negative 100 or even a net debt position of negative 50.

50:19So you can certainly make that argument. I can also make an argument that before the Iran war, China, because it was unwilling to let its currency adjust, was intervening in the foreign exchange market to the tune of$100 billion a month. And that$100 billion was flowing into dollars. So unless China changes how it manages its currency, and this is a much bigger flow than anything around petrodollars. And it was hard to track flows. going into bank funding markets, so forth and so on. But in some sense, until China, which didn't love the U.S. before, decides that it is willing to change how it manages its currency and how it manages its economy, it is compelled to go into the market and buy if its exporters want to convert dollars for yuan.

51:14And when its exporters are not converting dollars for yuan, they are still holding dollars. Now, they could hold euros. But if they hold euros, you know, they get less interest. So it hinges on a little bit more than just global perceptions of the U.S. The Chinese have not loved the U.S. for a long time. The Chinese have not found a way to really extricate themselves from a world where they often need to really buy a lot of dollars and add dollars to their system. Like the world doesn't love China. I think China can be a coercive power. You know, President Trump basically had a theory around last year's trade negotiations, which in the—to put it in this year's terms, he wanted other countries to pay a toll for access to the U.S.

52:01consumer market. They should be giving us things because, you know, this is our world's greatest market. The Chinese have wanted people to pay a political toll, treating China or the great nation with respect, not criticizing the CCP, various other things, to have access to certain industrial products, rare earths. And it sometimes have suggested, well, you cannot criticize us on trade. You know, show us respect because otherwise those permanent magnet licenses won't come. So they extract a toll. They are, can be coercive. Think of how they treated Australia after the Australians said some impolite things about China's handling of COVID.

52:47Yet it is very, very difficult for most countries around the world to respond by not trading with China. So I think in the foreseeable future, countries may not respect the US. They may believe the US is a reckless and a rogue power. But you can still use our dollar to transact between Africa and Latin America efficiently. And that will not be viewed as a political statement. It'll just be viewed as the most efficient way of getting something done. So that's kind of how I would expect things. Now, I do think we are in a world where an enormous share of the world's financial wealth, Both people looking for safety, the reserve assets, people looking for a bit more yield than you can get out of a safe G10 government bond, the private credit, CLO world, and then people wanting the equity home runs.

53:46All those investors globally are now quite overweight U.S. assets. And as a result, the dollar is quite strong. And so to me, the core question is not really whether the geopolitics will change things. assuming we don't get into a full-on blow-up with Europe, which would, I think, accelerate some shifts. I think the real question is, is this intense overweight in the dollar sustainable when we have fairly reckless policies? And the answer so far has been yes. Brad Setzer, thank you so much for coming back on the show. Really appreciate it. Thanks for having me again. Thanks, Brad. That was fantastic.

54:28This is like, you know, now every episode is going to get ranked. And I was like, yeah, that was probably one of his worst three. We should all have the community. Nothing like, and I know I'm never going to hit Taiwan Life. Yeah, no, this was a good one. This was a good one. Excellent.

54:53Joe, always good talking to Brad. Always good. You know, one thing that struck me in that last answer, he mentioned the word toll quite a lot. You know, the idea of China trying to extract a political toll, now potential tolls in the Strait of Hormuz. And I've been thinking about that a lot because, you know, if we think about the, back in 2022, I wrote a piece called Chokepoint Capitalism. And it was the idea that governments around the world were waking up to the importance of strategic supply and this idea that because of COVID, you have to have a certain independency in important things. And I think like we're starting to see that kind of translate into the geopolitical sphere in terms of like power nowadays is basically being able to control those choke points.

55:41And so a lot of diplomacy, a lot of geopolitics is now focused on, you know, Trump is going to affect a choke point in semiconductors or a choke point in the world's oil supply. Yeah. I don't know if I'm saying that right, but like there's something there. Yeah. Well, I mean, I thought it was interesting. So Brad talking about, you know, Europe is going to have to spend more money on missile defense, for example. The U.S. is going to be less reliable. Stocks are being depleted, etc. This is like the phenomenon of our time, which is that every region, every country or at least every region feels it has to spend on its own.

56:17Right. The capacity of another nation that it may have assumed it could trade with will not necessarily be reliable. The other thing I was thinking that I've been thinking a lot about is, OK, Chinese manufacturing dominance is a very thoroughly discussed issue in the U.S. and Europe. Right. But it's not it doesn't really get as much attention in the rest of the world. So, you know, you don't hear about, for example, the effect of Chinese exports in undermining Mexican exporters nearly as much or Brazilian exporters, etc. These are also countries that are trying to. You might if we were in Mexico or Brazil.

56:57Right. I agree. But the upshot is, I think because we are in a sort of U.S.-Europe dominated media landscape, we mostly hear about China as a sort of pressure point to rich countries. is that we are not discussing the fact that also there is going to be this domestic stress that will emerge from manufacturers in these countries. In other words, what I'm saying is you look at the rest of the world and you say, well, they're going to pivot to China because the U.S. is this reckless rogue state, et cetera, except that they're all going to be facing the same - The same issue. The same issues as the U.S.

57:33and Europe are. We're just not talking about them because Because that's not the center of our conversation. But the idea of like, OK, it's very obvious for Mexico or Brazil or any or Kazakhstan or whoever else to, quote, pivot to China, whatever that means. They're facing all of these same issues in many cases as well. Yeah. I think the middle power theory gets really interesting in that context. Anyway, shall we leave it there? Let's leave it there. This has been another episode of the All Thoughts podcast. I'm Tracey Alloway. You can follow me at Tracey Alloway. And I'm Joe Weisenthal. You can follow me at The Stalwart.

58:07Follow our guest Brad Setzer at Brad underscore Setzer. Follow our producers, Carmen Rodriguez at Carmen Armand, Dash O 'Bennett at Dashbot, and Kale Brooks at Kale Brooks. And for more Odd Lots content, go to Bloomberg.com slash Odd Lots. We have a daily newsletter and all of our episodes. You can chat about all these topics 24-7 in our Discord, discord.gg slash Odd Lots. And if you enjoy Odd Lots, if you like it when we have mildly annoyed Brad Setzer on the podcast, then please leave us a positive review on your favorite podcast platform. And remember, if you are a Bloomberg subscriber, you can listen to all of our episodes absolutely ad free.

58:43All you need to do is find the Bloomberg channel on Apple Podcasts and follow the instructions there. Thanks for listening.

58:59Thank you.

59:29Brad Setser:Expectations around masculinity can quietly wear men down, often without clear warning signs. In Season 3 of The Visibility Gap, Dr. Guy Winch and his guests explore how these pressures show up, how to spot them earlier, and how men can access meaningful support. Listen to the new season of The Visibility Gap, a podcast presented by Cigna Healthcare. This Mother's Day, celebrate all the women who make life brighter with a gift from Pandora Jewelry. Choose jewelry that reflects what she means to you and the moments you share. Make it even more meaningful by personalizing your piece with an engraving in your own handwriting, something no one else has.

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