Electronic currency can potentially take away the ability of central banks to control money

My column on Bitcoins that appeared in the "Poke me" section of economic times.

The unedited version (less dramatic) is below.

The future of money

Have you ever redeemed your credit card loyalty points to purchase a product of your choice? Or converted air-miles received as a frequent flyer to get some free tickets? If you have, you have already been exposed to virtual, electronic money. After all, a key purpose for money to exist is to function as a medium of exchange. These loyalty points serve the purpose of allowing you to exchange them for tangible goods and services.

When we carry out any of the above transactions, we do not see it as an alternative currency. The loyalty points can typically be exchanged for a limited set of goods, and are not universally acceptable. But what if they were? What if they worked as electronic money and were widely accepted?

Fiat money – a promise to pay backed by “confidence”

In a “Fiat Money” system – on which all contemporary economies are based, the notion of money - often represented by currency notes - is based on “confidence” that users have on the issuing authority. With no real assets backing the currency notes, issuers can issue as many notes as they want. However, economic growth cannot be assured by just printing money – it must come from higher production of goods and services. Consequently, if an issuer continues to “print” money, it will fall in value compared to other currencies or commodities.

One way to increase confidence is to back up fiat money by another commodity. Gold served as money for centuries, before it was replaced by “representative money” – where paper (representing the underlying commodity) could still be redeemed for gold. This changed in 1971 – when conversion was disallowed by the USA. Since then fiat money has been the basis of most transactions the world over.

Bitcoin – digital currency

All currency systems so far have required an issuing authority – with the ability to issue or destroy currency. In 2009, a yet unknown programmer using the pseudonym Satoshi Nakamoto published a proof of concept of a crypto-currency called “Bitcoin”. As the website (bitcoin.org) explains “building upon the notion that money is any object, or any sort of record, accepted as payment for goods and services and repayment of debts in a given country or socio-economic context, Bitcoin is designed around the idea of a new form of money that uses cryptography to control its creation and transactions, rather than relying on central authorities.”

Interested readers can study the specifics in detail at the website, but in summary, a user can create an online “wallet” and receive and pay bitcoins from it. All data (including transaction data) is stored in a distributed environment on the web. Since there is no issuing authority, the algorithm for generation of new bitcoins fixes the total number that will ever be in circulation.

Transaction ease is tremendous – there are no transaction charges (or very small ones), payments are easy to make and receive – like sending e-mails. In effect there are no political boundaries, no bank holidays and no one to censor who can receive or make payments and for what.

With reportedly only one breach which was sorted out, the system seems to offer sufficient security for people to have “confidence” in it. Bitcoins can be exchanged for regular currency at an automated price discovered basis transaction history. At present, the bitcoin website reports that daily transactions exceed $1mn per day distributed over 40,000 transactions. 

Why now?

So what makes bitcoins attractive in the current market context – and popular they clearly are (see graph of USD vs bitcoin over the past 1 year).

 

The key driver for popularity of bitcoins is risk that investors face in the current global economic environment, with central banks engaged in competitive devaluation of currency, and large financial institution risk remaining unmanageable.

Imagine if the depositors in Cyprus’ failed banks had, been holding their money in the form of bitcoins instead of holding their deposits in Euro. The Cyprus government, and European “troika” that forcibly took away almost 60% of the deposits would not have been able to get their hands on the money.

Investors have, over the past few years been using Gold and Silver as a portfolio insurance against currency devaluation and systemic risks of financial markets. However, like money, gold and other precious metals too are available to governments to usurp – and therefore, in a Cyprus like situation, are not adequate security. Bitcoins are however not accessible at a single location and, like the internet, cannot easily be controlled.

Bitcoins - the glitches

So long as bitcoins are used as a medium of transaction or as a store of value, it is highly likely that their popularity will grow. Questions arise on how governments would react – will bitcoin transactions be taxed for example?

Bitcoins offer total anonymity. One can have as many accounts as one wants. With smooth transition across borders without the use of banks, bitcoins have the ability to facilitate illegal transfer and transactions. The fact the governments’ are waking up to the emergence of online currencies is affirmed by a new law passed by the US government in mid March. It now requires that transactions more than $10,000 need to be reported.

Lastly, if its popularity rises, it will not take long for markets to start offering derivatives and structured products around it. With no regulatory framework, that would mean risk rise manifold. Despite these obvious road blocks, markets needs to look at this innovation carefully. The challenge that it throws to established order of central bank controlled currencies will, over time, lead to a re-examining of the very concept of money.

Elections & Banking - Red Light Ahead

My last month's column for Wealth Insight:

While private banks are part of any investor’s portfolio, PSU banks have to remain a trading play 
While private banks are part of any investor’s portfolio, PSU banks have to remain a trading play

By Anand Tandon | Nov 24, 2012

The year 2012 has been and continues to be an election-heavy year – with 7 state assemblies completing their terms. Elections are a time when politicians are at their “promising best” – often promising voters rewards in the form of lower power tariffs, waiver of farm loans, and nowadays computers, TVs and other goodies. It is common knowledge that elections spoil rural credit culture: farmers wait for elections for waiver of overdue credit, and are too often rewarded with it. I recently came across a working paper published by Harvard Business School which offers some interesting insights. Authored by Shawn Cole (http://www.hbs.edu/research/pdf/09-001.pdf), the paper establishes some important points which have implications for investing in bank stocks.

Higher credit, but no increase in production
Using data for 32 elections conducted across 19 states over 8 years, Cole establishes that in an election year, agri-credit portfolio of state owned banks (PSU banks) increases 5-10 per cent. Private sector banks, on the other hand, do not reveal any such increase. This increase cannot be attributed to rainfall, population or any productivity-linked variable. Importantly, the paper establishes that increased credit does not result in increased output.

Higher defaults, and write-offs
Another related observation is that while the average increase in credit is 8 per cent, the increase (peak to trough) in defaults increases 16 per cent. While it should be expected that an increase in credit will lead to higher bad loans, the increase of 16 per cent is too high to be explained by just the rise in credit.
Data also reveals that post the election, the bad-loan percentage falls quickly. This is not because recoveries increase – the author suggests that the drop is a result of write-offs that the banks undertake to live up to the pre-election promises made by the politicians.

Higher benefits to areas where election results are uncertain
The areas that seem to get the largest bump up in credit are those that are viewed as being at the margin with regard to the ability of the ruling party to win elections. The study revealed that areas where the ruling party/coalition won by a margin of 15 per cent or more, received almost 5-6 per cent lower credit than those areas where the voting was closer. In other words, bank loans were being used as a means to “buy” votes in “swing” districts.

The “committed” voter received a different reward: he had his loans written off! Where the margin of victory exceeds 15 per cent, “forgiven” loans increase, leading to an almost 27 per cent drop in figures of delayed loans. Other areas, where the ruling party lost, do not witness such largess. The formula seems to be inducement before and reward after.

Implications for investing in banks
The paper re-establishes the notion that politicians will use whatever resources they can to win elections. It also explains why government of the day does not wish to reduce its investment in state owned banks to lower than 51 per cent, despite facing the daunting prospect of having to invest between Rs 1 trillion and Rs 2.5 trillion over the next ten years. This, despite the investment yielding poor returns – dividends to shareholders are lower than borrowing cost; capital gains are notional since policy does not allow equity to be sold since government holding is already near the 51 per cent threshold in many cases. After all, who would voluntarily wish to give up the means of “purchasing” voter goodwill.

Without going into the moral or ethical dilemma that this poses, what does this imply for the average investor?
It has long been known that whenever a new chairman takes charge, there is a sudden jump in the non-performing assets of banks. This is particularly true for state owned banks. SBI offered a great example at the last change of guard. Consequently, investing just after a new chairman takes over is hazardous for investors. Better to wait a couple of quarters for the “clean-up” to be visible.

To this, we now add another tool – whenever an election is due, state owned banks operating in that state will likely witness a sharp increase in agricultural credit in the year prior to the election, followed by increased write-offs. Consequently, investment in such banks is best avoided till atleast 6 months after the elections to enable the write-offs to work through the system.

The current year has seen a revival in the stock market. However, state owned banks have significantly underperformed. A combination of inadequate capital, larger exposure to poorly performing sectors, and consequently, higher re-structured loans have driven valuations to below stated book in most cases. In addition, it is possible that the market is already factoring in the decline that is likely in agri-credit portfolio for reasons stated earlier.

Inefficient capital allocation increase societal costs in many ways. Taxes have to increase to pay for government spend; including the capital required to be infused in banks. This is an indirect transfer from urban to rural India since farmers are not directly taxed. Another impact is lack of accountability of state owned banks for their performance resulting in below par customer experience and higher cost ratios. In a perverse way, the private banks benefit, since they gain a greater share of the market due to better product and service, despite having to work harder to raise capital which is “freely” available to their state owned competitors.

While private banks will form part of any investor’s portfolio, state owned banks have to remain a trading play. Consistent performance for state owned banks will have to wait till the level of government ownership and control falls to lower levels. However, given that politicians across the world attempt to use public institutions for private ends, it will be a long time coming.

Manipulation by design

My take on central banking as it appears in Wealth Insight here. The article is reproduced below:

Barclay’s CEO, Bob Diamond, recently lost his job. In the aftermath of the financial crisis in 2008, Tucker, Deputy Governor of the Bank of England (BoE), telephoned Diamond. Tucker, apparently, indicated that Barclay’s Libor rate “did not always need to be as high as (they) have (been) recently”. Diamond passed on the message to his team — who took this as indication from the BoE to report lower rates — which they proceeded to do. Investigations of this “rigging” have so far led to resignations of the Chairman, CEO and COO of Barclays. Barclays has been fined £290 million for this attempted “manipulation”.

Can’t “fix” rates on your own
The Libor is calculated (fixed) by Thomson Reuters on behalf of the British Bankers’ Association by taking a poll of a panel of banks (16 banks for pound, 18 for USD) just prior to 11 AM. The survey asks banks the rates at which they “think” they can borrow. No actual transaction takes place. It is at best an “oligopolistic” rate — a “survey” rate. The four lowest and four highest rates are then eliminated and the Libor is calculated by taking an average of the rest. If Barclays was consistently reporting higher rates than the rest, it would have been eliminated. Even an “in sample” bank will have a weight of about 10 per cent. Overall, any single bank can skew the rate only by a few basis points (1/100th of a per cent) at best.

In markets where money moves freely across borders, rates in one currency cannot dramatically differ across borders. One way to check if the Libor was completely out of whack is to check its correlation with the T-bills rate in the US — the rate at which the US government borrows. The US T-bill rate in turn tracks the Fed Fund rate — a rate which the US Federal Reserve “manages” by intervention in the money markets (which includes printing dollars when needed). As the graph on the next page shows, barring the spike in 2008 (caused more by liquidity tightening post Lehman), there seems to be no systematic drift in the value of Libor vs T-bills.

The elephant in the room
Policy statements of Central Banks are watched carefully — for one primary reason. As the monopolistic printer of money, the Central Bank in any economy is in the business of managing (manipulating) interest rates. It is what they do. It is their mandate.

In 2008, a sharp fall in housing prices — caused in no small measure by the US Fed allowing an asset price bubble to be formed, led central banks the world over to lower interest rates. This increased asset prices, thereby shoring up the balance sheets of banks. This was manipulation — as is all policy “intervention” by Central Banks. In that context, Barclays executives cannot be faulted for doing what they thought their regulator wanted them to do. It seems strange logic that the bank is being penalised for working on the directions of the Bank of England.

Banks — more equal than others
In a recent interview to Business Line, Dr YV Reddy, the former Governor of the Reserve Bank of India, is quoted as having said, “The government licenses banks to accept non-collateralised deposits — virtually telling people that your deposits are safe. The banks, in turn, agree to lend to government whenever the government wants. This is a compact. In some sense, it is the biggest con game going on”. The implied sovereign guarantee allows banks to leverage their balance sheet 10 times, magnifying the return on equity. The heightened risk is mitigated by the back-stop of the central bank. This sets up moral hazards. Bankers get incentivised for taking risks — if the risks materialise, the Central Bank steps in. Else, bankers receive outsize bonuses on profits from highly leveraged transactions.

Shared area indicate US recessions 2012 research.stlouisfed.org

Central Banks were set up with the objective to bring stability to the monetary system. In reality however, their intervention has led to increased volatility and boom and bust cycles. When the banks involved are “too big to fail”, the problem becomes that of the tax payers.

Unintended consequences
The power to manipulate markets is not easily controlled. Borrowers — corporations and consumers (home loans and consumption loans) — lobby central banks for lower rates irrespective of the economic situation. When was the last you heard a demand for higher interest rates when the economy was over-heating?
However, when growth slows, the clamour for lower rates rapidly rises.

Lobbying also ensures that shareholders are not penalised. In 2008 public money was liberally used to bail out banks in the US — directly through investment, and indirectly through monetary policy. The ownership of stressed banks and financial institutions remains with the original owners — a situation where profits are private and losses are public! Central planning for the economy has failed. Will centrally-planned monetary systems follow?

From "too big to fail" - to "too big, will fail"

The recent banking crisis has brought to the fore the argument against letting banks become too big. For far too long, regulators and politicians (including the erstwhile finance minister - Chidambaram) have argued for the merger of government owned banks. For some strange reason (atleast strange to me) - this is supposed to increase the ability of the banks to compete. With capital adequacy requirements unchanged, why a merger will allow greater competitiveness - especially since in the Indian context the merged banks will typically not be allowed to restructure either branches or staff - has always mystified me. At last, I see a serious academic Prof. Jayanth Varma argue for smaller banks. Hope someone is listening.