Outside Economics

A new form of digital currency has received tremendous media coverage this past year, Bitcoin, which is essentially virtual money that is traded digitally by exchanges. Bitcoins can only be purchased and sold with legitimate currency, such as dollars or euros making it available worldwide. The total estimated value of Bitcoins worldwide is about 9 ½ billion dollars.

Bitcoins exist as software, not physical currency, and are not regulated by any country or banking authority. Even though U.S. Senate hearings disclosed that Bitcoin could be a means of exchange, it gave no assurance that it would actually become an accepted medium of exchange. Government regulations would need to be created and then enforced in order for Bitcoin to become accepted by other government entities. The currency can be traded without being tracked, thus raising the potential for illicit activity, such as involving weapons, drugs, and prostitution. Bitcoins are not illegal, but it is also not legally recognized by governments as a currency. 

In late December, the price of Bitcoins fell more than 50% from recent highs as the world's biggest bit coin exchange, BTC China, said it would stop allowing its customers to use the Chinese currency to buy the virtual currency. This in turn removed a big source of cash that had been fueling Bitcoin prices. At one point in November 2013, the price of one Bitcoin was almost identical to the price of one ounce of gold, both being valued at approximately $1200.

The price appreciation of Bitcoin has been a result of speculation, and hasn’t been used as a store of value or as a medium of exchange to any extent. Some compare Bitcoin to the tulip craze in Holland of 1637, when speculators pushed the price of tulip bulbs to incredible levels, followed then by a collapse in the tulip bulb market.

Bitcoin has surged on speculation that perhaps one day digital money will eventually become a legitimate global currency, and even replacing currencies from certain countries.

Bitcoins are mined by powerful computers that calculate complex, mathematical functions. Total Bitcoin quantity is capped at 21 million, and currently there are about 12 million that exist worldwide. Circulating physical coins only represent Bitcoin, and are not a store of value as is legitimate currency.

The growing mobile payment industry could be a big benefactor to the acceptance of Bitcoin, as new and creative applications are being devised to accept digital currency. Bitcoin transactions are very popular among mobile users, where rather than using a credit card or cash to make a purchase, all you’d need is your phone.

Bitcoins emerged in 2008 designed by a programmer or group of programmers under the name of Nakamoto, whose real identity remains unknown. New Bitcoins can only be created by solving complex math problems embedded in the currency keeping total growth limited.

The value of Bitcoins fell by about fifty percent in mid December following remarks by China and Norway to not recognize the digital currency as legal tender. The government of Norway ruled that Bitcoin does not qualify as real currency, but rather qualifies as an asset, producing taxable capital gains. Norway said that Bitcoins don’t fall under the normal definition of money or currency.

More and more nations have been taking an official stance as the popularity of Bitcoins has evolved. The European Banking Authority has warned about the risks of trading digital money and being subject to losses where consumers are not protected by any government entity or authority.

As digital currency evolves, some believe that it will eventually be accepted as a legitimate currency. But for the time being, others believe that its time hasn’t arrived yet. Various studies have recently emerged with different opinions, such as

a Stern School of Business study conducted by David Yermack, which concluded that Bitcoin behaves more like a speculative investment than a currency, and has no currency attributes at all. For additionall information on bitcoins read Understanding Bitcoin.

Sources: Bloomberg, Reuters

REMEMBER:

"What we plant in our subconscious mind and nourish with repetition and emotion will one day become reality" - Earl Nightningale

The great recession has left its mark on many of us in so many ways it is hard to understand them all - perhaps similar for generations before with the Great Depression. One major mark is in banking. The Great Depression produced the FDIC which insured customer deposits and help provide a level of financial security to the banking system. Now Europe and the E.U. has lead the way with a “bail-in” concept where depositor bank accounts are used to shore up the troubled bank, thus taking the tax payers off the hook for failed banks. 

This week Austria put this to the test. Hypo Alpe Adria (HETA) collapsed under the weight of bad loans. The bank is located in the Province of Carinthia, which has mostly controlled the bank for the past year, when it first started having problems. In taking on the obligation of this bank Carinthia is worried that it may cause the Province to file for bankruptcy as well.

The Austrian Financial Market Authority (FMA) in its role as the resolution authority for failed banks has issued the key features for the steps to resolution. The Bank Recovery and Resolution Act (BaSAG) outlines how the issues surrounding failed banks are to be resolved. The most significant are:

• A 100% bail-in for all subordinated liabilities,
• A 53.98% bail-in, resulting in a 46.02% quota for all eligible preferential liabilities,
• The cancellation of all interest payments from 1 March 2015, when HETA was placed into resolution pursuant to BaSAG
• As well as a harmonization of the maturities of all eligible liabilities to 31 December 2023.

Subordinated liabilities is simply another term for depositor’s money in the bank. In the typical banking arrangement the bank’s assets are the loans on the books, while their creditors are all the depositors. The exact opposite of personal or business finance, where loans are liabilities and cash deposits are part of their assets. 

This sort of “bail-in” can cause a lot of panic in finance world, simply because people losing their deposits can demonstrate some serious concerns about how well a bank is operated. Clearly an uncharted path. Some concerns exist over the legal as well as the practical aspects of the “bail-in” concept. This makes the creditors of the bank more responsible for how the bank is run. If there appears to be any problems creditors simply will not lend money to a bank or if they do they will demand a much higher risk premium. This will of course raise interest rates for everyone.

Corinthia attempted to remove the guarantees by purchasing the bonds at a discount from the bond holders, primarily Commerzbank, AG and Pacific Investment Management Co., (PIMCO), who rejected this offer last month. The creditors are demanding that Austria pay up if Carinthia cannot pay. In either case the depositor’s monies are gone.

This rule was put into place after the Great Recession to help relieve the burden on the tax payers for bailing out banks. The results are yet to be determined, but like every regulation there are unintended consequences. Some of those consequences maybe, higher interest rates, depositors being extra cautious where they deposit their paychecks, fewer loans made to small or medium size businesses, bankers will be unwilling to take risks with business owners on such loans. 

In The United States

You maybe asking yourself why does this bank in Austria matter to me? Here is the short answer; the United States banking regulators have adopted a similar rule. When a bank fails the regulators can force a bail-in of depositors monies to right the ship. Many people do not realize or understand that this can and most likely will wash up on the shores of America as soon as we have another major financial melt-down. Watching how this precedent action plays out may be an example of how it will work here in the States. 

I am clearly not suggesting that you take your money out of the banking system and hide it under your mattress, that would be foolish. Also I think that U.S. banks operate with safety and soundness regulations that help protect depositors money. This maybe one reason why gold and silver has shot up in price this past week. People still perceive precious metals as a safe haven for currency problems. 

When smaller, less developed countries from around the world need to exchange their currencies into a more utilized and liquid currency, they utilize SDRs (Special Drawing Rights), essentially a basket of currencies. Created by the IMF in 1969 to supplement a shortfall of preferred foreign exchange reserve assets, namely gold and the U.S. dollar, SDRs have evolved to over $200 billion in value.

The SDRs are currently made up of four currencies, the U.S. dollar, the euro, the yen, and the pound. Over the past few years, China has been aggressively bargaining to have its currency, the yuan, included in the SDRs. Such an inclusion is considered a validation by the IMF that a country’s currency is internationally recognized and accepted.

In an effort to strengthen the world’s recognition of its currency, China has entered into currency swap agreements with other countries, bypassing the U.S. dollar as the reserve currency. Currently there are fourteen nations that have signed currency swap agreements with China allowing them to clear their trades using the yuan as the main currency. Those countries include: Argentina, Belarus, Brazil, Canada, ECB, Hong Kong, Iceland, Indonesia, Malaysia, Singapore, South Korea, Thailand, the United Kingdom, and Uzbekistan.

Monday, November 30^th

The IMF announced that the Chinese yuan will be included in the SDRs basket of currencies. It is expected that the demand for the yuan will not increase much considering the currency controls of the Chinese government. Central banks have begun acquiring the yuan but they don’t expect to have a major increase in demand.

Central banks don’t use the SDR as a yardstick for determining the composition of their foreign-currency reserves. These are much more heavily influenced by cross-border trade, said Karthik Sankaran, a director of global strategy at Eurasia Group.

Before the currency swap agreements all trading with these countries and China were conducted with U.S. dollars as the reserve currency. While many policy makers don’t believe that the yuan will supplant the U.S. dollar anytime soon, no one thought the Chinese economy would grow to become as big as the U.S. economy anytime soon either.

The inclusion of the yuan in the SDRs Basket is a big deal to China, they view it as placing their currency value equal to that of the other currencies in the Basket. It’s a bit like letting the camel poke its head in the tent! Soon enough the entire camel is in the tent.

In our competitive world economy, China will continue to work at becoming the world’s largest economy and they will compete to become the world’s reserve currency. As the country with the largest population, they want to be a super-power on the world stage and set world economic standards. (Remember they are still a communist nation with limited human rights.)

With the fall of Bretton Woods system and increasing availability of credit through international banking institutions, SDR’s are not used as much as they were when they were first developed. After all we have left the gold standard back in the early 1970’s, which in essence changed precious metals (gold and silver) from a common median of exchange (controlled currency) to a commodity, greatly increasing their value and volatility, particularly as the currencies have been devalued over time.

What are your thoughts of this new development in the world’s economy?

Sources: IMF

Remember

"Peace and contentment come into our hearts when we save a portion of our earnings and avoid unnecessary debt."  - Ezra Taft Benson