Central Banks Digital Currencies are coming; here’s why they are a game-changer for investors.
Central banks have no other option but to accelerate the introduction of digital currencies (“CBDCs”). China’s platform is already “live” in selected provinces and the ECB, the Fed and the BOE are all moving forward with their respective plans. Granted it will take years to fully deploy, CBDCs represent the biggest transformation in financial markets since Bretton Woods and the implications for global investors are profound.
The world economy already had a debt problem before Covid-19 and the virus only exacerbated the issue. As the measures to contain the pandemic reduce economic activity, governments have no other choice but to increase deficit spending to avoid economic dislocation and political unrest. In less than a year debt to gdp ratios in the most advanced economies, already high by historical standards, have increased to unprecedented peace-time levels (see IMF data below). As the C19 situation is still far from resolved and the damage to the economy likely to be structural, all major economies will continue to run high budget deficits for years adding to the already gigantic stock of debt.
Debt defaults have severe political consequences, domestically and internationally. That is why policymakers typically resort to devaluing or inflating the currency as a way to reduce debt. Economic history shows that, almost with no exception, whenever debt/Gdp ratio in a country exceeds 130%, a devaluation in the form of inflation ensues as a way to reset the system and write the debt down. The problem is that for years all major central banks have tried to create inflation to no results. Not only the policies available have failed to reflate the economy, but they also have inflated financial asset prices which, in turn, aggravated income inequality and generated more political instability. The chart below shows how core inflation in the G10 economies has lagged below 2% level for the last decade.
Enter CBDCs. Using some of the same technology behind crypto currencies, central banks can bypass financial institutions and issue money directly to families and businesses. Using a digital wallet/app (think “Venmo” or “PayPal”), the issuer can directly credit (or debit) money to the recipient’s account. The technology doesn’t simply enable “digital money”, it allows for the money to be “programmed” as well. Imagine the ability to grant a subsidy only to certain families based on specific criteria. Money that can only be spent on certain goods & services, say grocery and education, and that has to be used within a month before the unspent balance is debited away. CBDCs is a dream come true for policymakers as it enables the instant deployment of narrowly targeted policy and the measurement of results in real time. As a bonus CBDCs allow for the eventual phasing out of paper money, long considered the root cause of tax evasion and illegal activities.
Differently from Bitcoin, whose supply is strictly metered by encrypted software, policy makers can create or destroy CBDCs as they see fit. They are ultimately designed to enable an absolute control of monetary supply and to create inflation. The latter is critical to dilute the value of debt in real terms, de-zombify economies, reset the global balance sheet and, ultimately, reignite economic growth. Furthermore, history shows that inflation is also key to reducing income inequality, the other major political problem of our age. In fact, last century’s most inflationary decades, 1940s and 1970s, both also marked a significant redistribution of wealth (see chart below).
There is however a dark side to CBDCs. They mark the fusion of monetary and fiscal policy and the end to any pretense of central bank’s political independence as these become de facto government agents. They also endanger privacy as every economic transaction can be tracked by the government. A serious issue as we witness an increased fragility of democratic institutions globally. However, while the issue of civil and economic liberties is ultimately a function of the specific country, the harm to savers and investors is assured as inflation destroys the savings’s purchasing power. In addition to creating inflation at will, CBCDs also afford the option to roll out any tax progressively. VAT for example is very effective but also has the downside of being “regressive” as it taxes in the same way, i.e. at the same rate, both the wealthy and the less affluent. With CBDCs, the policy maker would have, with a few lines of software, the option to deploy an “ad hoc” tax rate based on the taxpayer’s specific income, wealth or other factors. In summary, the reason for the introduction of CBDCs is the need to roll out redistributive policies aimed to tax, explicitly or implicitly, wealth and income.
Inflation has been very low for decades and its reappearance will take most by surprise. It will ravage savings and no major currency will be spared. The US dollar, the most widely used store of value, will also probably meet its demise as the global means of exchange. Bonds, the largest of all financial assets and where the bulk of the debt exists, will also suffer as inflation decimates the value of principal in real terms and wipes out yields. Yet, after the initial trauma, investors will take cover and kick off a new phase of economic history. A massive shift from “fiat” to “real”, or “hard”, assets will ensue. Unable to protect the value of savings using money or other traditional financial instruments, investors will migrate to assets that cannot be as easily devalued due to their inherent scarcity. “Hard” assets include property, art, commodities or anything else that satisfy at least two criteria; it has to be inherently scarce and has to be considered a store of value by a critical mass of participants. Venerable reserve assets such as gold and fine art will come back into fashion together with new instruments such as Bitcoin.
Technology will also come to play a major role in this paradigm shift. The same technology that enables CBDCs also provides new tools to store and transfer “hard” assets. Anything of “value” (a property, gold or an art piece) can be digitized (“tokenized”) and securely stored, transacted or even used as a collateral to receive or lend credit. Such “tokens” effectively operate the assets and can be used in any economic transaction. Imagine paying for a cup of coffee with a tiny fraction of a condo you own or borrowing to buy a new car providing as a collateral tokenized Amazon shares. This technology is also poised to democratize the access to those asset classes and massively increase their liquidity. No longer requiring intermediaries, terms and governance are guaranteed by encrypted software making the system “trustless” and transactions virtually instantaneous. Assets such as vintage cars or farmland become, for the first time, immensely liquid and, as they can be also be purchased on a fractional basis, accessible to the widest number of participants.
The implications are mind-numbing. Consider that only money/M3 and bonds represent approximately $353 trillion while the combined value of Gold, Art and Bitcoin is only about $13 trillion. Even assuming just 10% of M3 & bonds “stampedes” into those “hard” assets, we would see a three-fold increase of the latter relative to their current valuations. Some of the wealth may also shift into real estate and commodities, also traditionally effective inflation-hedges. Yet opportunities in those sectors may diverge dramatically. Some valuations in both residential and commercial real estate are already questionable, e.g. shopping malls and student-accommodation, while others, perhaps farm land, may end up benefiting the most as food demand continues to grow. After a decade-long slump, commodities may also start to rise. Also in this sector selection will be key as technological advancement may wreak havoc on some categories while buoying others. Think; “long lithium, short oil”.
Even if an investor can successfully front-run inflation and take cover into real assets, an equally important issue will be protecting wealth from ever-more rapacious sovereigns. As Gresham’s Law takes hold, governments will need “real” tax revenues to fund policies and replenish reserves. For the first time in generations, investors will have to put jurisdictional risk front and center of their considerations. The asset’s and the investor’s residence will make all the difference and, regardless of how foresighted their investment strategy was, the jurisdictional arbitrage will make the difference in wealth protection.
The digitalization of wealth is one of the great themes of our age and Covid-19 is simply accelerating it. Already in 2015 the World Economic Forum was anticipating that by 2027, 10% of the global Gdp would be digitized and stored on encrypted decentralized ledgers. The need to reduce debt and the inefficiency of the current system is forcing policy makers to embrace CBDCs. Therefore cognizant investors will be forced out of traditional financial assets by the need to protect their wealth from inflation and over taxation. The second-order consequences of CBDCs go well beyond wealth management. CBDCs also usher the end of the “fiat” money system started on August 15th 1971 with the closing of the US’ gold window. History can be defined as a long sequence of sovereign defaults but this time may really be different. As economic participants no longer trust (or need to) a centralized monetary system we may see for the first time the rise of totally decentralized platforms to store and transfer value. As A. Einstein put it; “The measure of intelligence is the ability to change’’.
The information on this document should not be interpreted as or deemed to be a recommendation to any investor or category of investors to purchase, sell, or hold any security, currency, or cryptocurrency. Any investment decisions must in all cases be made by the reader or by his or her investment adviser. The views expressed in this article are solely those of the writer.
