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August 16, 2021The economics of the Olympics – A golden opportunity or a bronze bust?
Welcome to Finance and Fury. As you might have seen, Brisbane has won the bid for the 2032 Olympics – but is this a good thing for the SEQ economy and the people living in it? in this episode we will have a look at the economics of the Olympics – we will Look at the costs and benefits of hosting the games – to see if firstly Brisbane/QLD is going to benefit – and if there is economic gain for being the host –– Lots to unpack here – lets get into it

Introduction - The Olympics have evolved dramatically over time

From going all the way back to the Ancient Greek times – to the first modern games which were held in 1896

Over time – like many things – Olympics became more commercialised – as over the past 60 years, both the costs of hosting the games and the revenue potentials have grown rapidly – but it seems like the costs have growth at a greater rate than the revenues - sparking controversy over hosting the games – as to whether it is of any benefit to the host city

A growing number of economists argue that both the short- and long-term benefits of hosting the games are at best exaggerated and at worst non-existent, leaving many host countries with large debts and maintenance liabilities – so is this true? And if so, what does this mean for QLD and Australia at large

I've got the data from a few studies – but the main one we will be looking at is – "Going for the Gold: The Economics of the Olympics" – link in the show notes at www.financeandfury.com.au

Costs Incurred When Hosting the Olympics

On the cost side - there are three major categories – 1) general infrastructure such as transportation and housing to accommodate athletes and fans – 2) specific sports infrastructure required for competition venues – 3) and operational costs, including general administration as well as the opening and closing ceremony and security.

General Infrastructure – One of the major expenses is the general infrastructure to accommodate the anticipated wave of tourists and athletes that descend upon the chosen city - cities commonly need to add roads, build or enhance airports, and construct rail lines to accommodate the large influx of people as well as build an Olympic Village to host the athletes

The International Olympic Committee (IOC) requires that the host city for the Summer Games have a minimum of 40,000 hotel rooms available for spectators and an Olympic Village capable of housing 15,000 athletes and officials.

Event Infrastructure - The Olympics also require spending on specialized sports infrastructure. Because of the somewhat obscure nature of many of the events, most cities do not have the facilities in place to host all of the competitions – Think about some of the events, from cycling, needing a velodrome to skateboarding which has been recently added – there are now 41 different sports, of which there are about 340 events all needing different facilities – all of these events and sports need tailored spaces to facilitate the events

Additional Expenses - Once the facilities are in place, the Games require spending for operations including event management, transporting and accommodating the athletes, as well as the opening and closing ceremonies, and security

So, what does this all cost? An accurate financial accounting of Olympic expenditures in various cities is very hard to find

Firstly - It can be difficult to disentangle spending on Olympic building projects from planned infrastructure improvements that might not be attributable directly to the games – such as the Brisbane Airport getting a second runway

Secondly – many of the costs are incurred behind closed doors and never fully disclosed – As an example - Submitting a bid to the IOC to host the Olympics can costs millions of dollars. Cities typically spend $50 million to $100 million in fees for consultants, event organizers, and travel related to hosting duties – as an example - Tokyo lost approximately $150 million on its bid for the 2016 Olympics and spent approximately $75 million on its successful 2020 bid

But these costs are private due to reforms taken by the IOC – The people of a city don't get a say as much anymore as to whether they wish to host the Olympics – the public used to in plebiscites but in many cases, people voted to not host the games – so what the IOC has done in response is to introduce a reform, one of which is putting all the bidding behind closed doors. They're sick and tired of being embarrassed by cities dropping out. So, the process is now secretive.

What are the Benefits of Hosting the Olympics –

There are some major categories of benefits that exist in the short term and long term: the infrastructure and employment in the lead up, benefits of tourist spending during the Games; the long-run benefits or the "Olympic legacy" which might include improvements in infrastructure, foreign investment, or tourism after the Games – but also intangible benefits such as the "feel-good effect" or civic pride

Short run benefits – Employment, Infrastructure and revenues and the intangibles

Employment and spending in pre-Olympics phase - Any large public works project such as the Olympics can lead to a short-run increase in economic activity in the run-up to the opening – but these are dependent on the level of slack in a region's labour and capital markets (i.e. if there is higher levels of unemployment) – and the GDP figures can be inflated by expansionary fiscal policy (i.e. through government expenditure)

Many Government forecasts show that the short-term benefits in revenues are higher than the costs of the games - However - these before-the-Games predictions are rarely matched by reality when economists look back at the data

the studies show actual economic impacts that are either near-zero or a fraction of that predicted prior to the event. Nearly all of the analyses follow the same pattern. Researchers collect any type of regional economic data that is readily available such as employment, personal income, GDP, tax collections, or tourism figures, and then analyze the data before, during, and after the Olympics in search of any changes that occur either during the event or in the preparation stages – their findings are that there is no real changes

I won't go through all the numbers for each of the games – but there can be an initial increase in employment for jobs whilst the construction is going on – but these drop off soon after these works have been completed – so it is a temporary boost at best

But this is only really a benefit when employment conditions are considered 'sack' – the construction and infrastructure industry within Australia is not hurting for work – from clients I speak to in this sector, this is the busiest they have ever been – if things continue then these jobs won't be new jobs – but a re-allocation of existing jobs – therefore little economic benefits will be created – this has been the case in many of the previous games as well – those working on the construction were already employed – the unemployment numbers didn't reduce – due to desire and skills – if you are someone who is unemployed in the hospitality or business sector, are you going to all of a sudden go out and get qualified in contribution and apply for a role in this sector for a few years whilst things are being built for the games? The answer is likely – no!

Also – the economic gains through realised profits are concentrated to the construction, hotels, and hospitality industries – many of these can be international companies – so the money flows out of the nation

The major potential benefits comes in the form that any basic infrastructure improvements have the greater potential to continue benefiting the cities into the future – such as transportation benefits –

Plus - Whatever the bill in the end is - half of the costs are covered by the Federal government and the rest from the state – So if QLD upgrades roads and transportation, the Federal Government covers half the costs

initial revenues during the games – These are broadly classified into Broadcasting rights, tourism, sponsorship, ticketing and licensing

sponsors, media, athletes, and spectators typically visit a host city for six months before and six months after the Olympics, which brings in additional revenue – plus the influx of people that come into the country for the games -

But who gets this revenue? These are split between the IOC and the host city –

television rights have represented nearly half of total revenues of the games, with the IOC sharing around 30% with 70% going to the local Organizing Committees. Revenues from international sponsors are split between the IOC and the Organizing Committees, while ticket revenues, domestic sponsorships, and licensing fees are kept by the host city.

There is no doubt that money is made through hosting the games – but the question is whether these revenues make up the money spent on the games – because otherwise the state is left with larger debts to service as well as potentially unused facilities costing further maintenance costs, meaning more debt – and QLD already has pretty large debts

Another form of economic boon that is advertised is tourism for the economy at large – but is this level of tourism an increase to the normal levels?

Tourism - the "crowding out effect" occurs in relation to cities hosting the Olympics – this is when the crowds and congestion associated with a mega-event dissuades other regular tourists or business travellers from visiting the host region – Every host country has seen a significant drop in tourists in the year that the Olympics are being hosted, nullifying any effects that the influx of people that Olympics may have brought with it – regular tourists avoid the area

This can bring up another major failing of standard before-the-fact economic impact analysis in regards to tourism – this is the assumption of the multiplier for expenditures – Someone going to the Olympics may have less of a multiplier than a regular tourist –

Costs spent on tickets for travel, accommodation and the games are high – accommodation prices increase as well as travel tickets – leaving less to be spent elsewhere

Intangibles - While spending directly associated with the Olympics is typically insufficient to cover the costs of staging the Games, short-run intangible benefits must also be considered. Host cities frequently experience a "feel-good effect" both in the run-up to and in the wake of mega-events

Long run benefits - First, the Games might leave a legacy of sporting facilities that can be used by future generations. Second, investments in general infrastructure can provide long-run returns and improve the liveability of host cities.

A positive legacy of sporting facilities is the least promising of these claims - due to the nature of the sporting events sponsored by the Olympics, host cities are often left with specialized sports infrastructure that has little use beyond the Games, so that in addition to the initial construction costs, cities may be faced with heavy long-term expenses for the maintenance of "white elephants."

Long run issues – Many of these sites are going to be white elephants - The reason why they didn't exist before the Olympics is because there was no economically viable use for them – so once this Olympics ends, this factor doesn't change - Many of the venues from the Athens Games in 2004 have fallen into disrepair. Beijing's iconic "Bird's Nest" Stadium has rarely been used since 2008 and has been partially converted into apartments.

General infrastructure improvements clearly have the potential for better returns if they are implemented well – but there is always the issue of the athletes' villages – in most cases these are converted into another use after the games – I have stayed at the Whistler Olympic Village accommodation as it was converted into a hostel – this has been the case with many Olympic villages, where they are converted into dormitories for universities, hostels or other accommodation sites.

Let's look at the estimates for the Brisbane games and compare this to the previous games –

The Brisbane bid documents forecast most of the Games income – these are all in 2032 Dollars – the revenue will come from ticket sales of around $1.2 billion, domestic sponsorship of $1.5 billion, broadcasting rights of around $800m, and the IOC would contribute another $900 million – Including other Revenues the total is estimated to be $4.5bn AUD

The bid predicts economic benefits of hosting of around $17 billion nationally, with about $8 billion of that for Queensland – This is a pretty staggering estimate – and is likely using some pretty generous assumptions – remember this is against an estimated cost budget of around $5bn

The real issue is the cost estimates - Past Games have shown that the final budget for staging the greatest show on earth is many times more than originally planned- The budget has ballooned to US$15.4 billion, twice its winning bid of US$7.5 billion in 2013. And it could be more – audits by the Japanese government are pinning the figure at more than US$25bn to $30bn – there were additional costs due to the delays, but these are estimated to be around $3bn – the major issue for them is the lack of ticket sales and tourism – leading to one of the biggest losses for hosting the Olympics

Is Tokyo a stand out in overspending? Looking at past games – Athens 2004 – Cost estimate of $3bn, spent $16bn, Beijing 2008 Cost estimate of $20bn and spent $45bn (most ever), London 2012 - Cost estimate of $5bn and spent $18bn, Rio 2016 - Cost estimate of $14bn and cost $20bn (smallest blowout) – Tokyo - Cost estimate of $7.5bn then spent at least $25bn

Minimum blowout of 42%, maximum of 433% - average of around 2.5 times for these games – Going back to Every Olympics since 1960 has run over budget, at an average of 172% in inflation-adjusted terms

Why do we expect the QLD Government to be any different? May see a cost blowout from the original bid to be around the $13bn mark –

The one saving grace is that Brisbane's bid, similar to that of the upcoming Paris and Los Angeles Summer Olympics in 2024 and 2028 respectively, will focus on reusing existing venues, refurbishing existing sites and using temporary venues where possible (i.e. ones to be destroyed or removed after the games are done).

For south-east Queensland, that means using a lot of the venues established for use hosting the Commonwealth Games in 2018 – also instead of the white elephants of Athens and Rio, the hope is that any venue built will also be used down the track – but this is still only a hope – any newly constructed venue is likely to be underutilised

The Bottom Line

Hosting the Olympics tends to result in severe economic deficiencies for cities – there are some exemptions however

If a city already has all of the infrastructure to host a games and doesn't need to outlay any capital – then the costs will be negligible compared to the revenues – however, as has been the trend, cities selected have all needed to increased their infrastructure and facilities to host an Olympics

Therefore - The economic impact of hosting the Olympics tends to be less positive than anticipated - as most cities have ended up falling massively in debt after hosting the games – and many are left with needless facilities that unless they can be repurposed, end up costing the tax payer on an ongoing basis

This begs the question - If the Olympic Games tend to offer only a low chance of providing host cities with positive net benefits, why do cities keep lining up to host these events?

First, even if the overall effect of holding the Games is typically negative, large projects will still create winners and losers - most bid to host the games are spearheaded by leaders in the heavy construction and hospitality industries – which are the two sectors of the economy that stood the most to gain from the city hosting the Olympics.

Second, economic concerns may only play a small role in a country's decision whether or not to stage the Olympics. The desire to host the Games may be driven by the egos of a country's leaders or as a demonstration of a country's political and economic power.

As an example - is difficult to explain Russia's $51 billion expenditure on the 2014 Sochi Winter Olympic Games or China's $45 billion spend in the 2008 Beijing Summer Olympics

Until you look at these are countries where the government is not accountable to voters or taxpayers, it is quite possible for the government to engage in wasteful spending that enriches a small group of private industrialists or government leaders without repercussions

This can also be the case for democratic states that have an disengaged voting base

The best situation for a nation the benefit from hosting the games is that the city is a large developed area with a high demand for sports and already existing facilities and accommodation – therefore the costs can be kept to a minimum and the benefits can be in the form of new revenues –

If a city is relatively small – such as Brisbane – then the games in the long term can be a total waste

Going for the Gold: The Economics of the Olympics - https://pubs.aeaweb.org/doi/pdfplus/10.1257/jep.30.2.201

Thank you for listening to today's episode. If you want to get in contact you can do so here: http://financeandfury.com.au/contact/
26 min
August 09, 2021What affects demand and prices of property in Australia?
Welcome to Finance and Fury. In this week's episode, we will be looking at the demand for property in Australia.

If you haven't listened to last week's episode – it may be worthwhile – discussed supply of property in Australia – this week we will be focusing on demand – which in conjunction with supply = the price of property

When looking at property price movements – there is an equation to crack – low supply and high demand = price gain

e where has limited supply but lots of demand is likely to see some rise in the property price over the medium to long term

the reverse is true – if you have areas with high levels of supply – or the potential for supply to increase over time at a capacity beyond demand – then prices may not rise and at worse, actually fall.

As part of this equation – it is important to look at not what is happening now, but what is likely to happen in the future –

If you are looking at what is happening now – then you will be buying into a market based around current dynamics – which may not hold up in the future –

As an example - somewhere with limited supply now, but currently has very high levels of demand is likely to already be very pricey – the issue with buying something that is expensive is the further upside capacity that the property may have can be limited – but let's say that in the future demand stays high, but all of a sudden supply catches up

This is often the case if it is possible – due to developers wanting to get in on the high demand

So, if you have inner city areas with high demand – then developers are incentivised to develop this region and therefore -supply will increase – this can do so at a greater rate then other areas if there are lots of infill or greyfield sites, which we covered in last week's episode

Demand for property – look at what are the drivers of demand, current state of demand and how to identify areas that will be in demand in the future

This comes from people and their wants and need – peoples demand is represented in property in the form of how many dollars someone is willing to purchase a property for – but this one output (of how many dollars people are willing to purchase a property for) has many different inputs –

Desire and demographics – The number of Buyers and where are people demanding property –

The number of buyers comes in two forms – population growth and relocations within a nation

If population growth is high and people are relocating to certain areas – this can manifest in higher demand

Centre for Population still expects Australia's population to grow – but it is likely to be 4% smaller — or 1.1 million fewer people — by 30 June, 2031 due to boarders being closed

Where people want to live can be very subjective – as people have different desires – but often this will be in a close proximity to work, or retirement lifestyle living, as well as facilities like shops, schools and transportation

Desire can also be influenced by emotion – when emotions run hot, in demanded areas – can see FOMO

There has been a shift - Looking at demand through a lense of demographic demand - many people have had a chance to re-evaluate their life circumstances over the past 18 months - Offices were shut and remote working took over – inner city retail and hospitality has been dramatically altered - moving forward people may work from home at a greater rate and not be as drawn into cities

This means gone are the days where our 'home' was simply the place we rest our heads and enjoy some downtime between work and our social lives –

If you can leave your home and be within walking distance of, or a short trip to, a great shopping strip, your favourite coffee shop, amenities, the beach, a great park

That's why choosing the right neighborhood may become even more important – as the saying goes, location, location, location - This is key because it is estimated that 80% of a property's performance is dependent on the location and its neighbourhood.

The more liveable a neighbourhood is – the higher the chance of capital growth – but again, only if supply cannot be replicated

Beyond the demographics of property – another very important component of demand comes in the form of affordability – how much people can actually afford – if the population has no money, or cannot borrow funds to put towards a purchase, then the price demanded will be lower

interest rates are at historic lows – this technically means that housing affordability per $1 is as cheap as it ever has been

Remember that this does not mean that properties are cheap by any sense of any metrics – it simply means that for every $1 that you borrow, it is now the cheapest that it has historically been due to low interest rates

So you can borrow more dollars and you can afford to pay back this balance due to low interest rates – however it isn't really his simple – as the principal component of the loan repayment also increase

The RBA has declared that the interest rate will not increase until unemployment is back to within its preferred range of around 4.5% and inflation is back within a normal band – which may be 2024 based around their forward guidance

Demand in the form of affordability can always be viewed as an aggregate – when talking about demand for property – it is important to look at what is in demand and where – as these areas can hold up better if interest rates were to rise

As an example, lets say, using some hypothetical numbers, that overall demand declined in NSW, QLD and VIC by around 10% – but what does this mean? That is where it is important to break these numbers down

Did demand for apartments and houses decline at the same rate? Or did apartments go down by 20% whilst homes only went down by 5%?

Looking at Sydney as an example - Demand for units has increased the most over the past year, with demand for houses broadly flat – why?

An influx of first-home buyers, as well and investors coming back into the market in 2021, has contributed to the increase in interest for units

When looking at a measure of demand - auction clearance rates are a decent measure to gauge the human emotion

Sydney – 79.1%, Melbourne – 77.6%, Brisbane – 81.6%, Adelaide – 89.9% - these are all good measures – but looking forward –

However - in many areas – apartments will underperform houses – even if they are in slightly higher demand – mainly due to supply as we discussed in last week's episode – A report by the federal government's National Housing Finance and Investment Corporation (NHFIC) predictednew housing supply would exceed new demand by about 127,000 dwellings in 2021, and 68,000 dwellings in 2022, with Sydney and Melbourne to have the largest excess supply of housing stock – mostly coming from apartment developments

Moving forward some areas will strongly outperform others - How do you identify these locations – i.e. What makes some locations more desirable than others?

Physical location – locations that are gentrifying and are expected to become good neighbourhoods due to their lifestyle locations

This means destination suburbs where there is a wide range of amenities that are within walking distance or a short drive are likely to outperform in the future.

At the same time, many of these suburbs will be undergoing gentrification – these will be suburbs where incomes are growing, which translates into people's ability to afford higher levels in prices

A good neighbourhood means different things to different people, but there are some key factors that help to determine which locations have the potential to grow in value faster in the future.

Generally, a good neighbourhood is determined by the physical location, suburb character, and its close proximity to amenities such as a shopping strip, park, coffee shops, education, and even some jobs.

In planning circles, this concept is known as the '20-minute neighbourhood'. Many inner suburbs of Australia's capital cities and parts of their middle suburbs already meet the 20-minute neighbourhood tests, but very few outer suburbs do because there is a lower developmental density, less diversity in its community, and less access to public transport.

So what to watch out for is up and coming neighbourhoods – those that are likely to go through additional population density over the next 10 years – which is the key driver for more amenities being places in – i.e. shopping centres, restaurants, gyms and transportation

Where the overall price comes into it - Supply and demand combined needs to be accounted for

As previously mentioned - Rising property prices are the result of Supply and Demand coming together

When supply is higher than demand – it is considered a buyers' market – sellers must compete by offering lower prices to attract buyers

When demand is higher than supply – it is considered a sellers' market – as buyers now must compete by offering higher buyers

Demand looking forward –

For the last few decades continued strong population growth and declining interest rates has been a key driver of demand

Australia's population has been growing by around 360,000 people each year – this translates into around 180,000 new dwellings needing to be built each year to accommodate all the new households

However - 60% of this growth comes from immigration - so in the short-term population growth will fall with boarders shut

But Australia's planners think that our population will reach 40m people in the next 30 years – so overall population growth will still be one of the highest in the world

Home prices rather hot at the moment – and this may slow down over the next few years – however auction clearance rates remain high and emotions are running high at the moment - with FOMO having become a key driver of property price growth

finance approvals are also are at record levels – showing that more people are looking at getting into property at the moment due to low interest rates – but if rates go back up then these approval levels may start to decline

For Supply – the concentration of 85% of the population in 9-10 cities has helped condense the new supply coming to market

There is no more land supply to add to the most desirable areas to live in as these are currently built out – the only increase in supply in these inner-city suburbs will come in the form of apartments – however – unless you can afford a property for $1.5m + then buying a home in one of these areas may be outside of your price range – therefore you may need to look at outer lying suburbs that are expected to go through high levels of population growth with a limited supply of land – i.e. already built out

Australian house price forecasts - Price movements – for 2022 and 2023 – from core logic and Westpac economics – these are just forecasts – there is very small chance they are going to be exactly accurate

Sydney – 4% then -6%, Melbourne – 6% then -6%, Brisbane – 8% then -1%, Perth – 4% then -1% and Adelaide – 6% then -2% = so for Australia wide – gain 5% in price then see a reduction of prices in 2023 by 5%

It is expected that more expensive areas will outperform – in nominal terms –

The current property cycle was initially characterised by all segments of the market rising – other than inner-city high-rise apartments – but some areas have risen faster than others – as the high end of the market has lead growth in property values

Looking at some of the data from Corelogic – they break property into 3 tiers – high, mid and low - the high tier is the top 25% of property values in any given region, with mid being 50% of dwelling values and low being the lower 25%

Based around these number – the top tier dwelling values are around $1m+

In the recent bull run on property - The top tier saw prices go up by 1.8 times the mid and 2.25 times the low tier property when measures as a percentage – so if the low tier increases by 1%, then the top tier would have increased by 2.25%

This is due to many of the factors previously mentioned – areas already built out and in high demand will be more expensive already – but they can see higher levels of capital growth for houses – not apartments – but also for people wishing to upgrade in housing

Those already in the top tier were likely not looking to upgrade (i.e. trade in property) – so lower supply of these properties – lead to property price gains

Add on the fact that interest rates have been low – allowed for additional increase

Summary – it is impossible to tell exactly what the future of property prices has in store – many variables – but you can get a better idea about price movements by focusing on the supply and demand potentials for property -

If it is a PPR purchase – then a greater level of emotional attachment can occur with this purchase – if it is the right property for you for the long term, you can afford the debt repayments, even if interest rates rise and you have a decent level of equity for the property (20%) – then buying into a market that has seen price gains may be the correct decision

If you are purchasing a property for investment purposes – or to hope for capital growth over the years before trying to upgrade properties – then you can look for properties in areas that you may not want to live due to proximity – but others may

If we are looking at investments – ideally – look for areas which have seen supply cap out but demand yet pick up are potentially areas where prices can rise – this will differ from city to city, suburb to suburb– every city will have different supply and demand characteristics

Also - within cities you will see the breakdown of home versus apartments – as we discussed last week, there are different breakdowns between each of these for what the historical average supply has been and where this supply is likely to come from

What to avoid would be apartments in suburbs surrounding CBDs – i.e. 10kms out from the CBD

Thank you for listening to today's episode. If you want to get in contact you can do so here: http://financeandfury.com.au/contact/
25 min
August 02, 2021The future of property supply in Australia
Welcome to Finance and Fury. In this episode we look at the future of the supply of property in Australia.

We will talk about the availability of land in Australia, look at the population density and supply of developments, as well as what the future supply has in store – assuming that the demand stays constant, then the areas with under supply will see price gains – those with supply abundance will see price stagnation

Australia is a unique country – outside of places like Antarctica, or Greenland with massive land masses but with relativity greater areas of unliveable space – compared to many other nations, we have a high rate of urbanisation with high levels of unused land

Looking at the land use in Australia – Area KM2 and portion of Australia as a %

Land for Intensive uses (mainly urban) 16,822 0.22%

Rural residential 9,491 0.12%

Australia's population is estimated to be 25.5m - of this population around 86% of people are living in urban areas –

This is fairly similar to many other western nations – US is about 83%, UK 84%, France 81% - then you have nations like Singapore or HK – sitting at 100%

What is different is the portion of the land that goes towards housing this urban population – US have 3% of the nations land that houses this urban population, and in the UK it is 5% - remember that Australia is 0.22% - or 13.6 and 22.7 times greater respectively

So in Australia - Using some simple math – Just under 22m people are living in 0.22% of the nations land mass

There are some major reasons for this –

First - Large portions of Australia are rather inhabitable - 18% of the Australian mainland is considered to be desert, but about 35% of the Australian continent receives so little rain that large population centres never sprang up there – Fresh water is always important, but also rainfall for vegetation for food and livestock – apart from Antarctica, Australia is the driest continent on earth – so much of our land has reduced liveability

But when accounting for the inhabitable land – assuming it is 35% of the continent – then this still means that the land use for urban population is 0.34% - or 10 times lower than the US

Secondly - The period of settlement of Australia – focused on the coast and major harbours or river inflows

Over time – major cities sprung up – Sydney, Melbourne, Brisbane, Canberra, Adelaide, Perth – but not in the same manner as other nations that have had hundreds of additional years of development in a different technological era – where the population was given a greater chance to sprawl before technology made urbanisation easier – Urbanisation is only possible in developed countries due to technology

Transportation and infrastructure, as well as water and food supplies used to be the major issues for having large sprawling cities

Transportation and infrastructure – cars, trains, buses, roads – sewage and power – all important to house millions of people in a dense urban area

Water and food – the ability for people to live in cities is a hard logistical task -

this does come back to transportation and infrastructure – how do you produce enough food and provide enough fresh water to people in the millions – but then you need to transport this into city centres – just in time supply chains

Because Australia was starting to grow in population when these problems had mostly been solved – there was no need for population sprawl like in many other nations where the burden needed to be spread out before technology and innovation took over – When comparing Australia to other nations with larger levels of land supply – this starts to become obvious –

Big cities – London makes up 13.5% of the UK population, or New York making up 2.5% of the US population - but Sydney makes up 21% of the population of Australia

This limited supply of land surrounding these major cities when accounting for demand is a large part of why the price of property in London, New York and Sydney is higher relative to many other cities in these respective nations

Where does this leave us as a nation when it comes to property supply in the future –

We have a massive potential to achieve property affordability in Australia when compared to a nation like Singapore – but not in a practical way based around the way that we live, or want to live

If every person living in cities moved to rural areas, we would see more of a normalisation of property prices

i.e. the price of rural properties would rise, whilst CBD prices would decline – on average property could become more affordable -

But as previously mentioned – this is not how many people want to live – most people need to be close to their place of employment or alternatively, wish to have the lifestyle that a bigger city affords – therefore, people wish to live close to cities – hence to help with population growth and demand for property, additional supply needs to become available

When looking at the property supply development – what are the options to increase the supply of land?

more realistic expectations and what town planning is likely to focus on is considered grayfield, greenfield brownfield and infill development –

Grayfield land is economically obsolescent, outdated, failing, or underused real estate assets or land.

name coming from the "sea" of empty asphalt concrete that often accompanies these sites – we all know these types of areas – run down places with lots of older industrial sites/sheds that has seen prices go up

Many of these areas used to be formerly-viable retail and commercial shopping sites but have suffered from lack of reinvestment and have been "outclassed" by larger, better-designed, better-anchored malls or shopping sites - major tenants have vacated the premises leaving behind empty shells – or they are currently rented but the owners offer large prices to buy up these premises

Similar to greyfield – we have Infill development - within an urban community, it is the construction on any undeveloped land that is not to be considered on the urban margin

We all have seen this type of development – a developer buys 2-4 old properties located in an inner-city suburb and puts up 100 units in their place

This development could also be called "land recycling"

Infill has been promoted as an economical use of existing infrastructure and a remedy for urban sprawl

A greenfield is an area of agricultural or forest land, or some other undeveloped site earmarked for commercial development, industrial projects or other construction projects.

Around 20% of Australia's land is Nature conservation and other protected areas (includes Indigenous uses) – this area is not going to be available for greenfield – but with the right regulations – many other areas of supply could be opened up

When driving outside of cities – you can often see lots of available land – if it has trees on it or is open fields – assuming that it isn't already owned by a private individual – this would be considered greenfield

Many housing estates come into existence through greenfield development – but these can take a number of years longer than to infill - master-planned community such as major housing estates can take between 12 and 14 years to complete – this is from the initial developer purchase of the land, to regulatory planning, all the way to the first person moving in

So, the options will be between green, greyfield and infill development for city areas

Greenfield developments – housing completions – most often in new estates outside of the CBD – in outer lying suburbs – often 30+ minutes' drive to the city centre

Greyfield and Infill developments – multi-unit completions – these will be the supply of property within the CBD radius

Areas around Australia – Stats from Urban Development Institute of Australia

Sydney – Long run average is around 31k p.a. of new residential market supply

Since 2016 – supply has been above the long run average –

But this average is broken down between greenfield housing completions and multi-unit completions – at the last update:

greenfield housing completions – 8k

multi-unit completions – 27k

The supply of units to houses is very different – many more apartments being completed

Melbourne – Long run average is around 38k p.a. of new residential market supply

Since 2016 – supply has been above the long run average –

greenfield housing completions – 18k

multi-unit completions – 24k

Units to houses are closer – more units than houses

Brisbane and SEQ – Long run average is around 19k p.a. of new residential market supply

Since 2015 – supply has been above the long run average –

greenfield housing completions – 11k

multi-unit completions – 11k

Almost a 50/50 ratio between houses and apartments

Adelaide and Perth are similar – both see a fairly even distribution between houses and apartments

Like Sydney – the ACT stands out for apartment completions – but the total completions are vastly lower – the long-term average is around 3.8k – of those 800 are greenfield and 3k are apartments

Looking at these trends and how to apply these to what this means for Property prices –

when demand outstrips supply – prices will rise for property – but when supply outstrips demand – prices will fall

This supply can be broken down into houses (both existing and greenfield) as well as apartments (infill)

The future of housing property – limited supply close to the CBD - and uncertain demand

So in other words - Greenfield and infill will bear the brunt of property availability for major cities moving forward when it comes to homes and apartments

However - The closer to the city you get, the higher the probability that it is either greyfield or infill

As For apartments – greyfield and infill development will be where the supply of these properties come from

For the increase in supply of property in homes, this will come from outer lying suburbs

What to look for and what to avoid – purely looking from a supply perspective –

Available greenfield and greyfield areas need to be paid attention to

For homes – if you are buying a home in an area with a lot of available land surrounding it – then there is a higher chance that you may not see any capital growth for a while until the land is fully developed

For Apartments – if you buy an apartment in an area with either a lot of old run down homes, or commercial sites that are looking a little old – there is a chance that many new apartments can spring up around you

This equation is more detrimental than for residential properties – as a few residential properties or one commercial property can turn into a hundred+ apartments

If you are looking for capital growth – it is best to avoid areas/sites that can be developed with increasing the supply of property – i.e. increasing the residential capacity through multiplying the number of houses from the same land supply

This is mainly relevant to apartments – if you have a block of land in an area (with a house on it or not) that it is hard to increase the supply of land – i.e. everything is already built out on – then this can see capital growth

Suburbs with limited available land and new houses, i.e. not derelict properties – that are closer to the city and do not have the capacity to be built out – these can rise in value – or at least maintain much of their value –

The sector that is unlikely to grow in capital value – assuming demand stays constant – are apartments – the supply can outstrip demand easily compart to greenfield –

For greenfield projects – as time goes on, you need to start looking further and further out from the CBD as the land supply gets soaked up

However – for greyfield or infill projects – you will find this land often within 5-10km of the CBD – the maths for this exchange doesn't bode well for supply versus demand – think about turning 2-4 properties into 100 – this only works if you own one of the properties being turned into the 100 – as you can command a higher price – but if you own an apartment in the area and now this is turned into one of thousands – then the supply can outstrip demand – which means that there are few people who can demand your property

This is just one side to the equation – need to look at demand – which will be covered in next episode

http://udia.com.au/wp-content/uploads/2020/03/State-of-the-Land-2020-Summary-of-Headline-Statistics.pdf

Thank you for listening to today's episode. If you want to get in contact you can do so here: http://financeandfury.com.au/contact/
21 min
July 26, 2021Is the share market at risk of de-risking?
Welcome To Finance and Fury. Is the market at risk of de-risking? Bit of a mouthful – but over the past 12 months the share markets has been going on a run with higher flows of capital going to higher risk shares over those that could be considered defensive shares – those with lower historical risks due to the backing of fundamentals, such are earnings

In this episode – we look at the cycles of share markets – looking at the longer-term trends of periods of risk taking and periods of risk avoidance – in which prices of different segments of shares can move independently from the overall index price movement – index may be going up but segments of the market can decline in prices

As previously mentioned, certain sectors of the market have performed very well over the past 12 months – Tech sectors, financials, commodities and other highly leveraged share sectors have performed well - This has seen segments of the market start to underperform the index in Australia – as a massive chunk of the ASX is made up of the banks and commodity companies – in the US, the upper end of the index is tech companies and financials

In Australia - Under performance has occurred in the historically lower risk segments of the ASX – communication services, industrials, utilities, Health Care, even Gold mining companies – whilst these companies are all incorporated in the ASX index, it means that other companies have outperformed by a larger margin

If the index is 50/50 split between lower risk and higher risks segments, and the index has performed 20% over the past 12 months – in reality any combination of returns could have occurred to get this aggregate outcome – however – let's say that higher risk shares have provided a 40% return, whilst the lower risk segment have provided 0% returns – then this means the index would have performed by 20% over this timeframe – in hindsight, where would you have wanted to be invested? The lower risk shares, the index, or the higher risk segments of the market? Obviously, the high-risk segment

But what about looking forward? Can these higher risk share categories constantly outperform?

Markets have cycles – ups and downs – the nature of market volatility –

But these ups and downs of the market are viewed as an aggregate of all shares in all sectors when viewed as an index – but what makes up the index? Thousands of individual shares

When separating out the underperforming companies to the over performing companies, the ASX has had an incredible return – especially over the past 18 months

Growth/Risk companies have returned 70% over 18 months

Value shares have returned only 8% over this same time period – this by itself is a below average return, but when compared to growth companies, it is a significant underperformance

The prices of shares is based upon the behaviours of the investors in the market –

The price responds to inputs – the number of buyers and sellers in the market – which can be broken down further into economic human action which is actuated to what is anticipated

Praxeology - is the theory of human action, based on the notion that humans engage in purposeful behaviour, as opposed to reflexive behaviour (like increasing saliva in your mouth when you see food and are hungry) and other unintentional behaviours (like slipping over on ice)

People want to make as much money in markets as possible – so when economic dynamics are present – the market is anticipated to respond in a certain manner – therefore, people change their investment positions around this, and the price of these shares change – how much of this is a self-fulfilling prophecy is anyone's guess – regardless, the historical numbers don't lie

When it comes to investing – whilst emotions can be the catalyst to your response, which may not be rational or in your best interest, people believe that they are responding with purposeful behaviours when investing – that is to make the most money possible – or to avoid losing money – even if the end result does not work out in this manner – i.e. you end up losing money – you still are acting in a purposeful manner – even though it may not be rational or work out for us in the long term - we have myopic risk aversion built into us epigenetically

There is no such thing as perfection – a humans we will always get things wrong – but our behaviours to help avoid further losses in markets is to follow crowds – if everyone is selling and we aren't is there something wrong with us? Do we not know something that they do? Our brains then think that obviously, they know more than us, then this means we also need to sell – which locks in potential losses in the portfolios

This is the issue with human behaviours in the market – because the market is millions, if not hundreds of millions of investors participating in the selling and purchasing of securities which are publicly available to anyone

So in the end the price of any share comes down to the sentiment of the market – supply and demand –

When markets are hot, they are hot – when they are cold, they are cold – this cycle follows human responses to the inputs provided to the market – i.e. all publicly available information which translates into market sentiment

But this behaviour translates into both rational and irrational investment behaviours – when greed is prevalent in the market, fundamentals are thrown out the window – therefore risky companies do well – but when sentiment turns, then investors can have the realisation of their precarious positions – want to exist these and seek other unloved investment opportunities

Average cycle from 1955 for the S&P500 index – full cycle is around 70 months or just under 6 years – this is the average, some go for 50 months, some for 100 months

The share market can be broken down into two share segments – PE expansion companies and EPS Growth companies

Remember - When I talk about the market – I am talking about the millions of buyers and sellers that exist – who each are making their own decisions on whether to purchase a security or not

Phases of the market cycle – four phases, despair, hope, fundamental and optimism

Despair – this is the stage where the market sentiment is basically in despair - investors which make up the market are worried about losing money on their investments, so they are selling – this creates a situation where prices on listed securities decline – when you have an excess in supply of sales orders, the prices will decline – often quickly when not money people are willing to purchase in this period of despair – this cycle normally lasts around 13 months

Drawdowns – historically the market has declined by 26%

PE Expansion companies have declined by 23% and EPS focused companies declined by 3%

So the brunt of the market decline has been due to Growth companies, with value companies seeing lower declines

Hope – this is the next phase that the market enters into after the initial despair – that is hope that market returns will become positive once again – but there is little fundamental reasoning for this – lasts on average for around 11 months

Therefore the shares that do the best in this period are those that investors are investing in our of hope – i.e. those that do not have much basis in regards to logical reasoning why people should be purchasing them

As an example – let's say that a company is expected to grow their earnings 20% p.a. for the next 10 years, this would sound like a great investment – but what if they are starting off at a point of a negative $200m of net earnings – then after costs they are expected to break even in 10 years' time

The price of this share going up massively in this period is an example of hope – the hope that the projections of this company become manifest – these is a chance they do not, there is a chance that they do, but investing in a company today that is losing money to see potentially bigger earnings growth in 10+ years is an example of hope – investing out of hope that a company will do well in the future even though it is losing money today – the issue with this is that anything can happen in the market – this company could be out competed and replaced by a competitor – or their costs go up, or revenue growth is now what was estimated – therefore, the investment into this is purely based on hopes of major returns in the future –

The more people invest in their period, the greater the overall returns to companies will be – i.e. the more hope there is in the market that we are out of the worst, the better the overall returns because more investors are willing to sink their money into the share market

PE expansion companies do really well in this period compared to the market returns – the market returns have been 32% - whilst the PE companies have been 42% - which means the fundamental companies are sitting at a negative 10% returns

This creates a situation where if you were investing for fundamentals, you would have been sorely disappointed

Fundamental – this is where the market starts to regain some sense of pricing and focus on what matters – earnings and underlying performance of companies

Risk is attractive in periods of high hope – but the fundamentals begin to matter more when hope in the market has gone

When market fundamentals matter and clearer heads prevail, then the focus on fundamentals become more prevalent in markets

The market is still up in this period – at a total level of 34% - but Value companies account for a return of 54%, whilst growth companies are at a -14%

This cycle of the market is the longest – at 32 months

Optimism – when the market is getting into the late stage of the cycle – when the price gains of the fundamentals companies outstrip the reality, people think that the tough times are over, and that things are looking up for the future -

In this cycle – the market tends to move by 25% and last for around 14 months

The PE companies grow by 23% of this and the EPS companies grow by only 2% - fundamental companies no longer justify the prices based around their cashflows and the previously unloved PE companies are back in favour

Optimism prevails for around a year – before the cycle repeats

Then the despair kicks back in and PE companies crash whilst value companies decline as well, but not by the same extent – important to point out that these timeframe have been the average over the past 66 years, doesn't meant that every cycle is the same – some may see much longer periods of despair, like in the GFC, or shorter periods such as at the start of 2020, where despair only lasted 3-4 months instead of 13 –

But what is important is understanding the cycles – every cycles timeframe will be different – every returns for each segment will be different in absolute terms – but what will be the same is that when thing are in despair, value companies do better than growth, when hope is present, growth companies do better than value, when fundamentals are important, value companies do best and then in the final stage of optimism, growth companies do well again

Certain shares do well in certain cycles – In only two stage of the cycle do fundamentals do well – so 2/4, or 50/50 are fundamental shares outperforming - but it is for the longest period of time that they do so, which makes up around 64% of the cycle

Risk and High beta shares do well due to emotions in the market – not realities – they also suffer at the extreme ends –

The largest downturn for fundamental companies is -10% during the hope period whilst the market is at an overall positive return – however growth companies lost 23% and 14% in the despair and fundamental period respectively, which underperform the index significantly

Where does the market currently stand? It appears that we are still in the hope period – but we may be nearing the end of this stage in the cycle – This means we may be soon be entering into the fundamentals period – timelines are off – but the return comparisons in magnitudes and market cycles are still on point

There was a despair period back in march and April of 2020 – hope soon took over, which has lasted for the last 12-18 months – now things are starting to calm down and due to economic realities like inflation and potential interest rate increases, fundamentals are now more in focus

When fundamentals become important – however, the timeline will likely be off this time – the growth companies may continue to shoot the lights out – but if the market starts to turn, the things to look out for

Value – Assess the expected cash flows and earnings, dividend payments

Enterprise value and book value

Intangible elements – management and brand

Quality – prefer higher quality companies with proven business models (not start ups with no market share or proof of concept for their product)

Resilient and financially robust – and have higher operating efficiency

Sentiment - An improvement in the expectations

Can this relate into higher expected flow through into better earnings and cash flow, dividends – leading to capital growth

Risk – are they lower volatility

Lower sensitivity to the market (measured by Beta)

Or a purchase that allows additional portfolio diversification

Summary –

Whilst growth companies have outperformed value companies in two of these periods including the current one we are in, not only do value companies have a greater time period being positive, they also avoid the long term declining trends when markets have a downturn

From here – there is a high chance that fundamentals, value companies will become in favour with the market

What could drive the risk rally further from here is a lowering of the cash rate and a general optimism in markets that the economic reality doesn't match – however this is totally possible –

But at some point this trend of hope will fall flat – leaving the currently in vouge share susceptible to a decline

The risk rally can continue – but the better place to be in risky assets based around historical data is the non-hope assets – those that have earning backing them, and can provide some basic utility to society

Thank you for listening to today's episode. If you want to get in contact you can do so here: http://financeandfury.com.au/contact/
21 min
July 19, 2021The freedom in financial freedom
Welcome to Finance and Fury. What does your future have in store for you? It is hard to say exactly – so instead, what does your ideal future look like? You might be thinking about next year, the year after that, or 20 to 40 years in the future – Let's say that in regards to this question – think about once you have achieved financial independence – i.e. finished your working life and are retired – where are you, how are you living, what are you doing and how are your funding this? Have you become a grey nomad, are you living by the beach, spending your time playing golf?

This is a big question – if you have never really thought about this before then you probably can't form a good mental image of this without taking the time to think about it – In this case, it may be worthwhile to stop listening now and spend some time to figure this out – if you need help, or some templates, we have some at the website – financeandfury.com.au – register to the members section for free and get all the handouts and tools

But if you do have your ideal picture of what your financial independence looks like - Everyone listening to this will be different in what they are picturing – having a different idea about what they want to do in retirement, how much this will cost them, and how they are going to fund this – some people will want $300k p.a. and other will want $50k p.a – I see this in my daily life in advising clients – everyone has different wants and capacities to achieve this

This difference is great – everyone has different desires, dreams, things that make them happy – as well as financial recourses to turn their goals into a reality – as an individual, you have the right to choose how you live your life, both now and in retirement

But as an individual, your ability to achieve your desired outcome really comes down to your freedom of choice – which comes from the freedom that society allows the individual to have – where the laws of a society are dictated to us by Governmental powers

Your freedom to choose what you want to do – your ability to choose where you live, how you travel, what you do with your money are all incredibly important when it comes to determining your own financial freedom

You also have the freedom to choose how you will fund this – though business, personal investments, superannuation, property – but all of these are subject to legislative risks – if the government that you live under doesn't allow property rights, or you to own anything, like North Korea, then you are out of luck – you will never have a retirement as the state isn't going to fund your retirement, and you have no capacity to accumulate wealth towards your retirement – as private ownership is outlawed – you work until you die, scraping by every single day in an effort just to feed yourself

This is where Freedom is important – if you had no freedom of choice and had to rely on a centralised entity deciding for you, where if the state has the power to give you everything, they also have the power to take everything away from you

But this is why we are lucky to live in this country – we have one of the most generous social security schemes in the world – but on top of this we still do have incredibly high levels of investment and financial independence freedoms – this makes me very appreciative when looking around at what is happening in other countries around the world - look around at most other nations in the world –

Cubans are protesting in the streets for their freedom – they have been living under communism for decades and want their own self-liberty

South Africa turning inwards on itself through rioting which is destroying economic infrastructure which will further exacerbate their economic decline with supply issues of the basics, like food, medicines and energy

Or North Korea as previously mentioned, or Venezuela – where 90% of the population lives under severe food shortages – the average population lost around 11kg in 2017 alone – but those at the top live very well – not like an economically free nation, it is purely the politically connected and politicians themselves that live well – due to the centralised nature of the state

What is happening in these countries is a stark reminder that no matter how free or economically powerful a nation once was – there is always the ability for it to slide into decline with governmental central planning – but also how lucky we are to not be living under a completely centrally planned economy

There is one simple test to determine where the best countries to live are – look at where people want to move – nobody is trying to emigrate to nations with highly centralised governments – people are trying to flee these nations

There has been a common trend through history – the only walls communist/socialist nations have ever had to build are those that are stopping people from leaving – which again limits freedom of movements

Freedom to choose is the most important thing for you to be able to achieve your financial independence – But the more power the state is given, the less your freedom of choice inevitably becomes

I love freedom – but I have to work within reality – there is no free society – that is basically anarchy where there is no government and no centralised laws – in which case society would fall back onto the non-aggression principle

There has never really been a society with no government system – even small tribes acted as mini-monarchy's – with a tribal leader –

Based around the current government systems of democracies in most of the developed world – There is a score of the Economic freedom index – done by Heritage.org

Australia is one of the highest-ranking countries on this list

Property rights are cornerstone of any economic freedom in my POV – i.e. you legal right to own assets

This comes down to having a strong legal framework that protect property rights, and a robust rule of law mitigates corruption - When the enforcement of your rights is high, expropriation is highly unusual, and enforcement of contracts is reliable

Compared to other third world nations - The judicial system needs to operates independently and impartially and can enforces laws against bribery and corruption effectively when they are discovered

Sadly – Australia has been declining in property rights since 2015 – we were at 90 out of 100, but we have dropped down to 81 out of 100 – still very good when compared to many other countries – but this declining trend if it continues means that in 30-40 years, we may be no better off than many other nations currently experiencing economic worries

Under a democracy - Your freedom isn't normally reduced significantly overnight – it is done through one piece of legislation by another over years – every new law introduced technically mitigates the individuals' rights – remember there are around 180 new laws and amendments to laws in Australia that occur every year

Negative rights, or as the US constitution states, God Given rights – actually date back to the natural rights based around the Greek philosophers works – in the US constitution it is stated as "Life, Liberty and the pursuit of Happiness" – which are seen as inalienable rights which all humans are born with, and which governments are created to protect

Instead – the thing that many people are worried about is that it is the governments that are infringing on these rights as opposed to protecting our rights

When it comes to your own inalienable rights – I believe that anyone who works and puts the resources needed into themselves should have the right to retire exactly how they wish – if they work towards this then you should be able to achieve your desired goals, but based on your own economic reality

This isn't to say that someone who has never work or never invested has the right to retire to a multi-million dollar property on the coast and get $250k p.a. in passive income at the tax payers expenses – but based on my experience, more people have pretty achievable retirement goals -

But if someone has done everything right, through planning for this and directing the necessary financial resources to this goal then they should have every right in aching this

This boils down to the real issue - getting off the system is almost impossible unless you work at it – if you never worry about where you will be financially in 20-30 years then you may have a problem – where the state determines what you are entitled to

But using the system that is in place to better your life through using our economic freedoms shouldn't be taken for granted – it should be something that is taken advantage of and used on a daily basis -

My only concern for people being able to achieve that goals over the long term is that property rights are taken away – such as a communist system

for anyone to achieve their desired outcome in relation to retirement – they need to own something – otherwise they are living off the state and hence living the lifestyle subscribed to them by the powers that be

The issue is that under any state where people aren't allowed to own anything, there is no funding mechanisms for social security – i.e. taxation or a government that can print money without hyperinflation the economy – in other words, not living in a centrally planned economy

However – where we currently sit - As long as property rights are retained – there is still a lot of freedom that you can take advantage of –

When comparing Australia to countries like Cuba or South Africa, Venezuela, North Korea – is much better off – better take advantage of it and not take it for granted – not taking this for granted is one of the most important points of this whole episode –

When people think that they are hard done by, or deserve more – they turn to the entity that can provide them with what they want – in private employment – this is your boss – you ask them for a raise and if you are producing more than your output then you deserve this – however, in a democracy then for those who are not working or willing to allocate a portion of their income towards their futures can turn to the government as the solution to their problems

The issue is that the more people rely on the government – the more they give away their own individual freedoms and ability of choice – the more this happens the less freedom the population is given when it comes to achieving their desired goals

This episode isn't meant to be as pessimistic as it sounds – because there is a way out of this at the individual levels

At the societal level – I have no idea if there is a way around the slow reduction of economic freedoms – democracy is always going to shift towards a system of having greater government controls – the more a government control the more they can promise – governments have something that people want, so they vote them more authority to provide this – it is a cycle of all nations/empires through history – they rise and they fall – this is something that is outside of our individual control

But as individuals – we need to come up with our own gameplan – we cannot rely on the government to determine what we need in our daily lives – they have never met us, and as we opened the episode on, everyone's needs are different – hence no one policy or level of social welfare can provide what is needed for the population at large – as this is made up of millions of individuals

One of the greatest quotes which hammers home this fact is by Thomas Sowell - "No one will really understand politics until they understand that politicians are not trying to solve our problems. They are trying to solve their own problems - of which getting elected and re-elected are No. 1 and No. 2. Whatever is No. 3 is far behind"

This is where everything comes back to Creating your own freedom – within the legal framework provided to you by the government - This comes in many forms depending on how you go about this – your ability to gain financial independence, do what you want, is reliant on you -

The first step is to Find out how you wish to spend your time – and how much this will cost – if your current lifestyle is what you are comfortable living with, then great – if not, what would it cost you to do what you want?

The rest of the planning is centralised around this point of reference – the end target to achieve your retirement goal

Then - Focus on what you have property rights over and Get into the game –

To break this down further - Look at your goals – lifestyle requirements and passive income requirements

Lifestyle – Everyone needs somewhere to live – which comes back to owning a property –

This is a big one – property prices are high – the only thing that can bring these down if you don't own property is a major increase in interest rates, but central banks/Governments don't want this to occur – so getting into property has priced many people out of the market – but getting in is still important – if you don't currently own property, set goals to achieve this -

Mainly for Self-sufficiency –

Passive income – investments and retirement assets – this helps to build your own self-sufficiency to become independent from needing to work or requiring government assistance

Financial independence is great – but there are two major issues with this – price inflation and shortages – These go hand in hand in a way – shortages create price inflation, but price inflation creates shortages in what you can afford – which means your passive income and investments don't provide the same level of consumption as they would in today's dollars – normal inflation of 2.5% p.a. should be accounted for anyway – there are tools on the website to help with this – but if inflation is 5% p.a. instead, or there are a few years where inflation reaches 10%+, this can reduce your purchasing power

I aim to keep my expenses down to a minimum through becoming food, water and energy independent over the next 5-10 years – this means that we can be less reliant on my financial resources in the worse case event that we suffer a severe economic downturn

The end game – what to do in your own life -

Focus on high-value priorities and goals – then work out how to get there

But the most important part is don't take for granted the freedoms we currently have to build wealth – there is no financial freedom without having freedom in a society

Seeing people currently trying to escape nations where there are no economic freedoms is a reminder that we have things pretty good – and that they have a view that they are entitled to the basic freedoms we take for granted – as opposed to thinking that we are entitled to other people's money – which over 50 years could lead to a system where governments are given the power to strip all economic freedoms away from people

Thank you for listening to today's episode. If you want to get in contact you can do so here: http://financeandfury.com.au/contact/
20 min
July 12, 2021Can investing using environmental, social and governance scores help to outperform the market?
Welcome to Finance and Fury - Is ESG investing the way of the future and good for your portfolio?

Within the last few years, large publicly listed companies and investment managers investment are really paying attention to what is known as an ESG score – which stands for environmental, social and governance – it is meant to be used as a determinant on the sustainability of investments – the concept of sustainability it is growing in prominence in every sector of the economy, but particularly within institutional investments and publicly listed companies

In this episode – I want to look at what is ESG, how it is determined and scored, and can following this trend and only investing in ESG companies help your bottom line when it comes to long term returns?

To take a step back – society has been moving towards greater levels of sustainability and environmentalism – with this shift – Publicly listed Companies are becoming concerned with where they fit into this – as well as investment managers wishing to purchase these companies

if you are a fund manager investing in a weapons manufacturing company, is this an ethical investment based around ESG metrics? If it doesn't score well and your mandate determines that you cannot invest in low scoring companies then this would have to be excluded from your portfolio – even if the world is going to war and Raytheon is about to make a lot of money

But from Raytheon's point of view – you want to be considered by professional investment managers to be an ESG company so that that institutional money can flow your way – because if you are cut off from that market, your share prices will suffer and you would be failing your duty as a board member to maximise shareholder value – i.e. providing returns to shareholders

So major corporations are becoming very engaged with the parties that provide ESG scores to help not only incentives further investment in their business – but also to help determine from an outside/institutional perspective if the company is worth investing in – as public investors have shown an interest in putting their money where their values are –

This has also seen the rise of many managed funds, brokerage firms, and ETF providers offering products that employ ESG criteria as the sole determinant for investment decision making – people want these products so the market is providing to meet this demand – but does following ESG scores as a criteria for an investment strategy actually work for a long term investment strategy?

What is ESG - Environmental, social, and governance criteria are a set of standards for a company's operations

Environmental criteria consider how a company performs as a steward of nature - can include a company's energy use, waste and pollution, natural resource conservation, or treatment of animals

criteria can also be used in evaluating any environmental risks a company might face and how the company is managing those risks - For example, there may be issues related to a company's ownership of contaminated land, or its disposal of hazardous waste and management of toxic emissions, or its compliance with government environmental regulations

Social criteria examines how it manages relationships with employees, suppliers, customers and communities

Does it work with suppliers that hold the same values as it claims to hold? Does the company donate a percentage of its profits to the local community or encourage employees to perform volunteer work there? Do the company's working conditions show high regard for its employees' health and safety? Are other stakeholders' interests taken into account?

Governance deals with a company's leadership, executive pay, audits, internal controls, and shareholder rights.

A big one I have seen is ethics of the company, board composition and transparency – does the company uses accurate and transparent accounting methods and that stockholders are given an opportunity to vote on important issues? Do they have a diverse board, or is it all old white males? Are there any conflicts of interest in their choice of board members, do they use political contributions to obtain unduly favourable treatment, or do they engage in illegal practices?

ESG investing is sometimes referred to as sustainable investing, responsible investing, impact investing, or socially responsible investing – however – this is very similar to CSR - Corporate social responsibility

Based around these criteria - an ESG score is calculated –

An organisation's ESG score is a numerical measure of how it is perceived to be performing on each of these criteria – Each of the Environmental, social, and governance criteria are given an individual score then it is combined into one

The key word in this score is 'perceived' - An ESG score is calculated based on how an organisation is seen to be performing – that is, how its behaviour relating to ESG issues is reported – not what it is actually doing behind closed doors

Just as with the building of corporate reputation, there is a gap between reality and perception. While a business may have a strong policy around carbon emissions and waste reduction, or a system of transparent, performance-based promotion, if that information is not in the public domain, it won't impact its ESG score.

Alternatively – if a business has a face value of supporting every social movement whilst enacting policy behind the scenes that is antithetical to these values, then this is not picked up in these scores - ESG scores don't necessarily reflect the internal reality of a company - as ESG scores only measure how corporate behaviours are reported and the face that they put on to the public

Therefore, a reality gap exists – and poses a risk – as if you are basing investment decisions purely around an ESG score, then this not meet your investment desires if you are trying to invest in a socially responsible way

Let's have a look at a few examples – when comparing the ESG risk scores

Disney – they have a wonderful public perception – and own a massive chunk of media and merchandising rights – theme parks, movies with the rights to Marvel, Star Wars, media as well, like ABC in the US – they also have merchandising rights, so many toys are marketed and made – where are they made? Well, it has become apparent that it may be slave labour – through internment camps in China –

So – based around the issues with the use of Chinese free labour – how would they rank? Pretty poor you would think - ESG Risk rating is Low based around the official metrics – 14.9 – Actually a lower risk than Netflix – they are given a ranking of 87% by CSRHUB – which is an ESG rating agency

Another example – Tesla – Most people would consider this company as very environmentally friendly – good social governance – and is great for society at large – on a score of 0-50 – where 0 is no ESG risks, meaning it is the cleanest company on earth with the best contribution to society and lots of diversity in the board and management – where would you place Tesla – 10? 20? – well it is 31.3 – which is high risk – CSRHUB gives them 38% out of 100%

But good news – BWM, or Daimler are all lower – 27.7 and 25.2 - CSRHUB gives Daimler 87%

To put this in perspective – BHP has an ESG risk rating of 30.1 – with a 75% rating - so Tesla is a lot lower – even BP Oil got 64%

How are these risk scores calculated? Because does it make sense that these companies rank where they do?

It comes down to who is doing the scoring - Analysis companies use various calculation processes – but these scores are done at the behest of these companies – If you are a major company, you go to a rating provider, hand over all your information and they come up with a score – some of those scores I mentioned come from Sustainalytics – a subsidiary of Morningstar – one of the worlds top rating agencies - the others come from CSRHUB

Due to the individual companies' methodologies – it is actually harder to determine what contributes to an individual score – as these will vary depending on which analytics they employ. Research by State Street showed only a 0.53 correlation between ESG scores for the same subjects between another provider, MSCI's ESG ratings and Subanalytics – therefore there is about a 50% relation between a score on their board, or their environmentalism – so one company that may seem to be an ESG champion on one site, may not be on another

This is all due to the fact that ESG scoring is the measurement of perception rather than reality - so ESG data systems can be largely subjective and vary dependent on which company is doing the rating

so how does anyone make an accurate investment decision based around these wildly varying metrics?

The answer is that you really can't under their current form ESG ratings and scores are often based on voluntary company self-disclosure and partial data.

The issue is that most ESG scoring systems from some companies include an analysis from publicly available print and social media content – so if a companies social media profile supports social movements domestically, whilst using slave labour abroad which is not incorporated into the metrics – this company will appear to be a higher rating on ESG than a company that doesn't participate in the same practices, but isn't as active in changing their twitter profile

How does an ESG investing approach help with portfolio returns –

Looking at a few examples –

Australian iShares ESG fund – Holdings, CBA, CSL, WES, MQG – but then FMG, Transurban, Newcrest, James Hardie – and Xero – so in the top 10, three are mining companies – performance wise this was only created this month – so no data

Other Funds – BetaShares has an Australian Sustainability Leaders ETF – 1 year is 17.79%, 3 years is 10.80%

The benchmark index of the Nasdaq Future Australian Sustainability Leaders Index – which the BetaShares fund has underperformed by 0.5% at every stage

Another Australian Fund is Van Eck - 1 year is 25.02%, 3 years is 10.17% or 5 years of 7.59%

In comparison – the ASX300 provided 28% over 1 year, 9.74% over 3 years and 11.2% over 5 years

iShares Core MSCI World ex Australia ESG Leaders ETF – Returns of 30% over 1 year, 14% over 3 years and 14.5% over 5 years

International index - 28% over 1 year, 14.8% over 3 years and 15% over 5 years

There is no clear winner – The indexes have slightly outperformed in the long term

Can this be a good investment for the long term – as more people start ESG investing?

There could always be the issues of "Bad" companies performing very well and missing out on this –

However – due to public perception – A company with a higher ESG score may start to gain more traction in regards to investment inflows – especially from financial services companies such as JPMorgan Chase, Wells Fargo, and Goldman Sachs – and ETF providers in Australia

The very nature of more money flowing into highly rated ESG companies could be a long-term investment – not for the actual performance of the companies themselves in fundamental terms – but from a perspective of more money flowing into these companies and hence the prices go up

Even for one of the largest investment sectors within Australia - Superannuation funds – Their mandates may limit or eliminate non-socially responsible investing

We have seen the divestment from Coal within superannuation funds over the past 12 months – coal companies on the ASX are not faring well – most have seen a decline in prices over the past few years – many saw a loss in EPS recently with coal prices plummeting to $50USD a tonne in July 2020 – but it is back to all time highs at $136USD a tonne – so coal companies may actually rebound quite a bit – but this component of return may not be included in the ESG investing

Brings up interesting issues – as a super fund their fiduciary duty is to provide long term returns for the sole purpose of their members retirement - choosing investment strategies based entirely on investments classified under ESG and socially responsible investing score could start to lag markets depending on the score allocated to companies

Remember – score can be subjective – large companies with a good social presence and the ability to have great PR

In summary –

If you are going to be investing only in Large cap companies and using ESG metrics – probably nothing to be gained here – they will all have great ESG scoring based around the metrics and how companies determine these scores –

Mid and Small cap companies – these may be left unloved by these types of funds – but this is where a large chunk of capital growth comes from the market –

Companies at the top that have a large portion of the market shares have limited capital growth when compared to new companies coming in

If you are going to invest – then invest – if you are looking for ESG – don't rely on metrics from companies providing these – decide if a company meets your ethical criteria

Thank you for listening to today's episode. If you want to get in contact you can do so here: http://financeandfury.com.au/contact/
21 min
July 06, 2021Is high inflation here to stay?
Welcome to Finance and Fury - The big question on many investors minds at the moment is if inflation is going to be transitionary, or something that is going to set into the economic framework for the long haul – maybe not for the next decade, but for the next few years at least – if you listen to Central Bankers, the inflation within the economy is transitionary i.e. going to last a few quarters then revert back to normal, if you listen to investment pundits, it is something that could set into the economy for the long haul – i.e. the next few years – so who is right?

In this episode – we will look at inflation – an often-misunderstood concept – because when talking about higher inflation it is important to focus on what type of inflation is occurring – as well as what is important to the economy – so we will look at the core concept and types of inflation, the current causes of inflationary pressures and try to see if this is something that is just going to be a momentary shock to the economy and your purchasing power, or if it is going to be persistent for the next few years and something that could really affect not only your own wallet – but also financial markets due to an increase in interest rates, and potentially a dramatic one at that if central banks need to combat inflationary effects similar to that of the 1980s.

To start with - It is important to define inflation – as many people have different definitions of inflation and what price increases are actually important to them – I talk to many people about this, it is interesting as people see inflation as something different

Now - the very definition of inflation as per the government's measurement of statistics is based around price increases of a basket of goods and services – measured by the consumer price index (CPI) – IMO this is not a great representation – the collection of these statistics can be very biased, based on what is included in the basket and how it is collected – there are 10 baskets in Australia - food, alcohol & tobacco, furnishings, health, transport, recreation, insurance & financial services, housing, education and communication – each of these go through trimming (normalising outliers) as well as hedonics (adjusting for quality increases) – so it is a pure measurement of a price increase and is often an underrepresentation to the actual price increases seen

An important point is that housing doesn't represent the costs of your mortgage or the price of buying a home – we will come back to this later – but as an example, the CPI for housing is a negative 0.9% over the past quarter – whilst the price of timber and construction has increase massively over this time period – so take this with a grain of salt

What are these price increases, being measured by CPI representing? Goods and services we buy from private companies – which aim to be competitive – a company in a competitive environment won't increase their prices just because money supply has increased – if they do, they will lose business to other competitors – assuming the market is competitive

But what creates price increases? Does a company want to charge as much as possible and make a profit? Sure – but what creates a situation where this is not possible? Competition – the more supply on the market allows for competition between distributors, so monopolistic prices cannot be charged (which are always higher than that of a free market economy)

Market prices of supply and demand – Particularly at the moment, looking back over the past 18 months – coming from Supply shortages –

What have we seen over the past 18 months – small business being shut down – small business has always provided some form of competition in supply – remove this you are left with only an oligopoly of suppliers, especially in the distribution services – on top of this there has also been the issue of direct suppliers, those producing the goods, like farms which have seen shut down – this creates a situation where less competition is present in both the production of goods as well as the supply chains which distribute these goods

Also, you have Increase cost to businesses – labour costs of employment have been a major point of contention over the past year since government unemployment benefits kicked in – the best example of this I have seen has been in the US where there is no federally mandated minimum wage – Unemployment benefits equate to around $15USD per hour – so if a business is going to hire someone for $15USD to fill a role, would you take this role if you had to work 9-5, 5 days per week? Do nothing or work full time for the same salary? This brings up the economic cost of your time – say a role was advertising for $17 per hour, would you then work for a benefit of $2 per hour? When compared to not working - probably not – it is the equivalent of trading your time for $2 per hour – a business would need to offer well above market rates to employ people to get the people they need to operate a business – this increases the cost to the business – which leads to an increase in prices being passed through – I have seen some stories from the US where hospitality services like MacDonald's cannot find anyone to work – so they need to offer higher salaries – which results in higher prices of goods provided

This beings up the concept of Productivity – for every dollar invested, what is the return in business – if you are spending $1 then as a business owner you hope to see at least $1.01 in return – however with additional costs of labour over the current economic cycle, this reduced this capacity for business owners to turn a profit – due to a situation where businesses were shut down for large chunks of the year, hurting their supply potential, but then when they are allowed to re-open, they are now competing with the government in the form of unemployment benefits – this further compounds the effects of a restricted supply – so assuming demand stays the same, this allows those remaining companies to increases their prices – not only to compensate for the loss of revenues (if they have had any, because large companies have not seen this) – but also to account for the increase costs to the business -

On the other hand – you have monetary theory of inflation - which states that the increase in the money supply will lead to an increase in inflation through reducing the purchasing power – the more money there is, the less valuable each dollar is

This is true –when the money supply has a limiting factor, such as under the gold standard – i.e. where the increase in the gold supply would lead to inflation through a reduction in the purchasing power of the population directly – as you used to be able to convert your paper money for gold – but also when the monetary supply increase is distributed equally to the population

The trouble is that this monetarist theory goes back to monetary systems like the gold standard – where monetary increases which were backed by something decreased the relative value of each dollar, or even ounce of gold – and the financial system wasn't the major recipient of any increase in the monetary supply – then an increase in the money supply would represent a reduction in the purchasing power of the population –

take Spain as an example after the gold rush that occurred after looting the Aztecs (and other tribes of south America) – they say that due to their over supply of gold, that prices of things started to increase – well this was due to this gold being distributed amongst the population eventually, first through repayments of debt that the Spanish crown had – which was then siphoned through the hands of the monarch, to nobles to the everyday individuals – so due to the abundance of gold in Spain, the purchasing power of one ounce was now lower – so it did lower their purchasing power – however when looking at today, most of the money supply increase does not end up in our hands and due to the fiat nature of the financial system, an increase in the monetary supply doesn't correlate to an increase inflation rate as it did in the past – especially due to the way it is measured by monetary officials

To look at this point further – there has been a massive increase in the money supply occurring since the 1970s – but this got ramped up to a new level from 2009 onwards – the introduction of un-conventual monetary policies like QE increase the base money supply – US saw an increase of their monetary base by 10.58% p.a. for the decade from 2010 to 2020 – did inflation rise by this level the way it is measured? No, it averaged 2% p.a.

This shows that the inflation effects were contained through the nature of credit growth – i.e. the increase in lending increasing the price of property and other assets, such as shares

This brings up another major point – in particular when it comes to Australia - If inflation is considered to be the reduction in purchasing power of your dollar – then no area of the economy is more prevalent then the property market

If you could buy a property 20 years ago for $100,000 and today the same property is selling for over $600,000 with no improvements or renovations – then this is an average inflation rate of 9.4% p.a. over this time period

The government statistics do no consider the effects of the monetary expansion through credit growth on inflation of asset prices – this has really hurt the Australia dream – owning a property to get into the game and start to see some equity growth

Hence – the inflation to reach this dream has been eroded by almost 9.5% per annum, well beyond the average household's capacity to save – which due to the current ZIRP environment is actually a disincentive to save – i.e. you get 0% interest whilst seeing inflation eat away the real value, let alone the fact that you potentially need to save a further 9.5% p.a. each year for a deposit that you wait

If people are looking for correlation of anything when it comes to monetary expansion and increases of prices, it isn't CPI, but credit growth and hence property price increases which have been the most correlated

This brings up the biggest question of all – what inflation really matters to you and how is this created?

is inflation caused by the money supply increase, devaluing your purchasing power?

is inflation the measurement of prices charged by businesses on goods and services, caused by supply and demand?

or it is the price increase of assets – essentially devaluing your purchasing power over time?

the truth is, that it is a muddied version of all three when it comes to what is important to you and I – they all matter

Inflation caused by the money supply increase is seen where this money goes – which over the past 20-30 years has been asset pricing – particularly property but also shares to a lesser extent

This has been great if you have been in the game for the past 10-20 years – but if you a new entrant, then you are buying in at the top of the markets in the hope that the same monetary policies continue - but in essence this has created a large barrier to entry – especially for housing

But over the past 20 years - Inflation from business price changes have been seen as both deflationary and inflationary –

Sectors that have seen less direct government involvement have seen deflation in prices – electronics – but only from non-monopolistic supplies – TVs, fridges, and other electronic goods, clothing, cars – all seen in real terms lower prices – think about buying any of these goods 50 years ago – it was very expensive and you got a worse product – today you get a great product for less in real terms

Other sectors that are highly regulated – energy, health, education, housing, insurances – have seen a large increase in prices – but the two have managed to offset each other – so CPI in the way the government measures it hasn't been particularly noticeable

In this essence – inflation – the way it is measured and what monetary officials focus on hasn't come from the massive flood of the monetary expansion – the CPI measurements we have seen have come from issues with supply chains – when compared to demand

This is why I think the major issue with inflation at the moment has come from supply issues –

Many companies being shut down over the past 18 months and not allowed to operate – labour costs increasing – so this needs to be passed on to consumers through price increases

Therefore – if lockdowns and the limiting of supply continues – then prices definitely have the capacity to increase further, increasing the inflation measurements – In addition, if governmental support payments like unemployment benefits continue to be generous o the point they are anticompetitive to the free market with other businesses – this will also lead to an increase in the costs of goods due to increased costs of labour – being passed on in the form of an increased price of a good or service – if the world returns back to normal – not the new normal – then the inflation currently seen should subside – even if it does have the capacity to still increase costs in the long term

As an example - one high year of inflation is still bad – it is due to the compounding nature of returns – Start with $1 – if inflation is 2.5% p.a – that good will cost $1.28

Now say that inflation of 10% for 1 year leads to that good costing $1.10 – then it reverts back to 2.5% p.a. – in 10 years' time it costs $1.37, which is a reduction of purchasing power by 33% in 10 years' time when compared to inflation just going up by 2.5% p.a.

So even transitionary, or one or two years of inflation can be damaging – especially as monetary policy is trying to combat deflationary environments through having low interest rates

So, in conclusion - Is inflation transitionary? – there are indications that broad-based inflation indicators are rising, but nothing is conclusive at this stage if this is going to be anything more than a transitionary effect – but this could always change in the coming months

The case for looking at inflation being a long-term trend is usually based around a broad-based phenomenon – where the price of everything is increasing across the board – It is not just one or two sectors of the basket are going up in price – but that the whole economic environment shows a general price increase

Think about inflationary episodes in economies around the world in the past and present – Weimar Germany always comes to mind – where the cost of everything was elevated – or today with Venezuela and other south American countries, like Argentina which have struggled with inflation for years – most of this occurred in a different economic environment but also with extreme government controls on supply

I would go out on a limb and say that we won't end up in this sort of situation if the economy is allowed to go back to work – the only thing that could lead to this is a massive shock to supply due to further lockdowns or restrictions of business, as well as extensions of the above market rate unemployment benefits

Looking at what happened in 2020 - For the first time in decades central banks actually increased money supply well above demand – due to the forced shutdown of economic activity - the economy did not collapse due to lack of liquidity or a credit crunch, but due to the lockdowns and restrictions of supply – this created the major area of inflation we are seeing playing out now:

a disproportionate amount of money flowing to risky assets joined by more flows to take overweight positions in scarce assets – in other words - the excess money made investors move from being underweight in commodities to overweight, as commodities are scares resources – creating an abrupt rally

So what is the risk? - The history of the economy points to a similar pattern playing out - when money is aggressively printed and with this comes the excuse that there is no inflation – then when inflation rises, central banks and governments tell us that it is transitionary and to not worry – then this transitionary inflationary inflation turns out to be a longer term trend – then government/central banks present themselves as the solution to the problem –

From the Government perspective – this involved imposing price controls and restrictive measures on exports – this would be the worst-case scenario – as it would further compound supply shortages due to prices being capped below the costs of production and sale

The risk has always been the government responses – a free market can see inflation for periods of time, but this if often corrected as additional supply comes onto the market to soak up the demand

But the real risks to markets – Central Bank policy – If inflation is overly persistent in the way that central banks measure this – will they then increase interest rates?

This has massive flow throughs to the economy – not only in financial markets by reducing the present value of cash flow valuations of equities – but also increasing the financing costs of property, reducing the price capacity of credit growth, and with this price increases

So the major question is: Will central banks tighten policy when government deficits are soaring and even a small increase in sovereign yields can generate a debt crisis?

In summary - My thoughts are that inflation, the way it is measured by the government and what influences CB policy responses - shough only be temporary if things are allowed to go back to normal economic activity – but this is the real issue – many small businesses may not come back – which does increase the risk of inflation running away –

Inflation in the context of asset price increases through credit growth is likely to continue – but then at some point if interest rates do go back up – it would slow

This doesn't mean that the areas that see the monetary expansion effects should be ignored – for example - property has been inflationary –this isn't measured by statisticians and is hence ignored by monetary officials – whilst it is ignored by them, it is still important to you

The issue with this is that CBs will let CPI run wild beyond the point of control before responding – but CPI will only run wild if government continue their absolute control over the economy through further economic shutdowns and reduction productivity through unemployment benefits

The irony of this is if we actually viewed inflation as the increase of credit growth – rather than the increase of prices selectively edited by central banks – there would have been an increase in interest rates –

Due to the largest spending components of most households being property, this could then lead to deflationary pressures as less people are willing to spend in the economy

Thank you for listening to today's episode. If you want to get in contact you can do so here: http://financeandfury.com.au/contact/
26 min
June 28, 2021Central Bank Digital Currencies – coming to a wallet near you.
Welcome to Finance and Fury. This episode is to look at Central bank digital currencies - Central banks releasing digital currencies is an inevitability at this stage - proof-of-concept programmes are currently in the works across the globe - with more than 80% of central banks looking at digital currencies – The RBA is one of them

There is a lot of cover in this topic – we will define a central bank digital currency and go through why central banks are looking at pure digital currencies as an option – We will also look at what is happening in China with their plans for the distribution of the digital yuan – but also look at the alternatives the RBA is looking at

Defining the different forms of currencies in the modern monetary economy – physical and digital

Physical money is easy - Think of cash in your wallet – either in notes or coins – this is physical money – when you log into your bank account and see digits on a screen – this could be considered a digital currency – but you can still convert these digits into physical money

Digital currency is the name given to the electronic equivalent of physical money or cash when it is issued in a purely digital form

Digital currency is managed, stored or exchanged on digital computer systems over the internet.

Types of digital currencies include cryptocurrency, virtual currencyand central bank digital currency

Under current legislation – you can still convert your digital currency into fiat currency, hence physical – you can withdraw digital forms of money – i.e. exchange BTC for AUD, then withdraw this AUD

Currently – the digital representation of your physical money can be used via payments technologies such as online banking and electronic financial transaction point of sale – EFTPOS for short

These payment methods are linked to commercial bank accounts in your own name, as well as deposit-taking mobile wallets, and gift, credit or debit cards – most people listening would have most likely used this form of payment – transferring the right to a physical currency digitally

A CBDC is different to cryptocurrency – or cryptoassets based around the terminology used in legislative frameworks

these are government sanctioned and centralised in their production – exactly like physical money - a cryptocurrency such as BTC or ETH does not – it is decentralised

A CBDC would still have a ledger – but this would be centrally controlled and fully integrated into the financial payments system

Currently - Every single day - Central banks are issuing conventional digital money to commercial banks that can then be exchanged with cash at par value – you go to an ATM to withdraw digital representations of your dollars for physical ones – the internet revolutionised this in the financial system

banks used to have to store more physical currency – or at least a paper entitlement to this – to meet the demand of consumer payments - digital was never a consideration – with the decline in physical currency demand – less economic activity is conducted in this manner – so banks need to hold less physical cash - I remember going to Coles with my grandparents when I was a kid – they would take out cash for their weekly spending and pay in cash for everything – because this was how things were done in their day – today – credit and debit cards have mostly replaced cash payments

In the current monetary economy - the RBA actually does issue digital currency to commercial banks through the provision of money into each bank's account within the exchange settlement account (ESA) system — However – there is no major central bank that purely issues digital currency directly to the public

Whilst most currency that exists is digitised – it can still be transferred into physical currency

Plus – you don't get your digital cash from a central bank – you get it through commercial banks

The transfer of the monetary system from a physical currency to a digital one would be a form of a monetary reset - Let's take a step back and look at the previous monetary reset that occurred –

Under the gold backed currencies – you could convert your paper money for gold at the equivalent pegged value – until this was banned by Governments on the population – in the US from 1933 – but other Central banks could still convert currency for gold under the Brenton woods system – until 1971 when any form of gold standard was abandoned

Think of a Central Bank Digital Currency as a similar process of reducing your financial freedoms – you can currently convert your digital money into physical money – but when the nation adopts a pure digital currency policy, this is no longer possible – no more physical cash – everything is digitised – the same as when the population was no longer allowed to convert the currency for the asset backing it – i.e. gold

This brings us to a core component of this episode – the People's Bank of China (PBoC) – which is one of the most prominent central banks globally, aims to be the first major central bank to issue digital currency for use by the general public and business – replacing physical cash

This digital yuan will be fully produced and backed directly by the Chinese central government

The underlying technology for this is different to the blockchain ledger, and will be controlled by the Chinese government and not distributed across the Chinese financial system - or any other nodes – like a decentralised ledger that crypto operates on

Why do Central Banks – particularly China's want a digital currency?

Based around the released papers - it is suggested that the Digital Currency electronic payment system will alleviate the risks to the financial system that are present with both physical money or cryptocurrency transactions – these are anonymous counterfeiting, money laundering and illegal financing

This sounds like a great argument if you are a monetary official – on the surface - because under a purely digital currency, monetary regulators can completely monitor digital currency transactions – for them this is a major plus as they will greatly increase their financial and monetary supervision capabilities – but what about for the individual in the economy – who makes up the economy

So, Governments and Central Banks want to track every transaction that someone makes – this is firstly in an aim to reduce the black market economy

Black market economies emerge to fill in the gaps of an imperfectly legislated economic environment – with tradies in Australia – the 10% discount to pay in cash to avoid GST

In other nations that are highly regulated through central planning – black markets emerge to provide goods as well as currencies to fill in a gap – because of limitations of government controls – these sorts of economies exist mostly in communist/socialist economies like Venezuela and North Korea

Where there is demand – people will find a way to fill this through providing the supply – whether it be food or drugs – if people want it and the government wont allow it – it will likely find its way onto a black market

The black market fills a hole to reduce the inefficiency of the government – allows the economy to function at a greater capacity than it would under a complete governmental control – hence, the introduction of a pure digital CB currency removes this natural phenomenon to help right any wrongs that central planning creates

This is particularly relevant in nations which complete central planning – socialist/communist countries like Venezuela and North Korea, or the USSR, China and Cuba in the past – the only way for people to get an allocation of food was often through the black market – but at imperfect prices due to market disruption

All of these operate on cash – which cannot be tracked and measured by the government - It actually creates a completely centralised and controlled economy – the monetary authorities may view this as a win – but for the every day individual, this limits their ability to maximise their economic output – the greater limitations occur in situations where economic transactions are limited by government – countries like Australia are relatively free – but in countries like China – this could really reduce the individuals living standards if they are both cut off from cash payments and restricted in the digital payments –

The most alarming factor of all of this – especially for China – this relates to their social credit score system – monitoring what you spend your money on – allows them to allocate you a score

If you spend too much on alcohol, or if you are hoarding too much cash and not being a productive member of society through investing or spending this, well – you will see your score lower – even if you are friends with an alcoholic – your score will lower – then you save, spending money, cannot travel, find accommodation to live and you become homeless quickly as you are completely cut off – you can also not beg for money

This digital Cb currency from China has the added element of being able to piggy back onto what is already an incredibly authoritarian system of control of its population – where if you score is also too low – now you no longer have the right to access this currency and you are shut off – with no method of redemption

From an Economic perspective – monetary officials want to create the perfect world – where they can measure spending down to the exact dollar and manipulate the economy through making adjustments to the money supply and interest rates – they can also get a measure on inflation

They have been trying to do this for decades but with little effect – think about monetary policy for a minute – the control over interest rates is aiming to control behaviours of individuals that make up the economy – if there are lower interest rates, this based on the rational models that entities like the RBA have, which theorises that a lower interest rate should decrease the incentive to save cash and instead people will spend it – this should then increase inflation and then interest rates can increase over time – but these models aren't perfect – as unintended consequences occur – what happened in practicality is that the lowering of interest rates to help increase inflation resulted in credit growth – i.e. mortgage sizes – where people were borrowing more money – whilst interest rate payments were lower per dollar borrowed, people now had more borrowed dollars – so total interest rates did decrease, but loan repayments for principal increased – resulting in more money flowing into debt repayment – hence less being spent in the economy – therefore the inflation never materialised as hoped

Monetary officials think that these models aren't perfect because they don't have complete data – they don't know how much exactly each individual is spending and where they are spending this – plus, inflation is currently measured by around 0.8% of households keeping a manual diary and reporting this back to the ABS – would be much easier to have a direct line to every transaction you make and measure the relative price increases – this equals a completely centralised and controlled monetary system

What they never understand is that there I no way to control a complex system like the economy – any model is never going to work as the economy is non-linear – i.e. if you put in $100 to the economy expecting a multiplier of 2 under a linear system – you would get $200 – under a non-linear system you could get $20, -$50, $100 – who knows – inputs do not equal outputs

In addition – thin about Welfare payment that governments and central banks can make – a recent proposal was made in limiting spending and transactions to a card where it could only be spent on food or other essential goods – no alcohol or withdrawn as cash to spend on who knows what – this would fulfill this if CB digital currencies came into existence

But also – Digital currencies in their pure form are only from CBs to commercial banks – the invention of digital CB currencies allows for the expansion of helicopter monetary policies

The payment directly from a CB to your bank account – this is the basis for economic policies such as UBI based around modern monetary theory – MMT

So these CB digital currencies allows for a circumvention of fiscal policy – no longer goes a government decide on welfare payments – CBs can directly pay individuals as the commercial banks would no longer be required as a financial intermediary

The end result of this is Central Banks increasing their Control over the economy –

We already do don't have a free market economy – money is the life blood of any economy – it is what facilitates the exchange system of the economy – but the control of the supply of money and the interest rate control affecting incentives to save or spend has completely destroyed the natural state of the economic and business cycle

What is even more telling about the potential implications for us – is when looking at a speech given by the Bank of England's chief economist in 2015 – where CBDC would be the ideal mechanism to implement negative interest rate policies – if you get charged to save, then you would withdraw your cash savings and put it under your mattress – but if this is not possible, you would have no options to either spend or invest the cash

Increase spending – from both the population but from a central bank through just issuing more digital currency – as well as economic transfer payments directly to the population – if this doesn't come from a government, and from the creation of the money supply – it isn't technically debt represented on a balance sheet anywhere

Under the current economic environment – for governments to spend money they don't have, they get into a deficit and fund this through issuing a bond – with digital currencies directly issued from a CB – no government debt

From a central bank's point of view – a digital currency can also reduce the costs involved in handling, maintaining and recycling banknotes and coins throughout financial systems and economies

It is true that it does cost money to print dollars and produce coins – There can also be currency shortages - Coin shortage in the US at the moment – the costs go up over time to produce these assets, whilst inflation reduces the real value of the currency

I did some maths for Australia – looking at the 20c coin – it weighs 11.3g – and constitutes 75% copper and 25% nickel – well at current market prices this represents around 7c of nickel and 11c of copper – so even the raw materials are worth around 18c – let alone the manufacturing costs – so in producing a 20c coin, the RBA may actually be losing money if commodity prices continue to rise

China is serious about this – they are rolling it out -

It will initially be distributed to all commercial banks affiliated with the Chinese central bank such as the Agricultural Bank of China

First phase - it is designed as a replacement for China's Reserve Money (M0) – this is the monetary reference to central bank notes and coins – it is essentially the base money supply on which banks can extend the money supply to commercial banks

Second Phase - it will be distributed to large fintech companies such as China's Tencent and Alibaba to be used alongside their WeChat Pay and Alipay inhouse payments respectively

The first public testing is already going on - in October 2020 - China's central bank issued 10 million yuan ($2 million AUD) of digital currency to 50,000 randomly selected consumers

This digital currency is available for transactions across 3,389 retail outlets in Shenzhen

Next phases of testing - 4 key cities are going to be the first cities to test the use of the DCEP

These cities will be closed economies – where pilot tests and this is testament of digital currencies - Beyond this first stage of domestic integration – China is thinking of internationalising the RMB by offshoring the yuan into Hong Kong and Singapore

Multinational foreign firms – companies such as McDonalds and Starbucks will also take part in the DCEP testing alongside local hotels, supermarkets, postal lockers, bakeries, bookstores, gyms

Does this relate to Australia and why would cash disappear?

Studies by the Reserve Bank of New Zealand (RBNZ) suggest there are two main reasons why cash could disappear

Cost - The relative cost of its use of physical cash compared to digital methods – as we went through earlier in the episode – the major reason to get rid of a fiat cash is if it is worth more than what the value you attribute to it is – i.e. why spend 0.21c to produce a 0.2c coin?

Undesirable outcomes – Central banks think that physical cash has a socially undesirable outcome – i.e. the attractiveness for tax evasion, money laundering and illegal transactions

In Australia - large-scale cash transactions have been deemed such a social risk that in 2019 the Currency (Restrictions on the Use of Cash) Bill 2019 was introduced in Federal Parliament to ban cash transactions over $10,000 – this is a step to limit cash

How the RBA views this topic on alternative digital payment methods

Australia's digital version of the Australian dollar (AUD) will be some way off

In 2020 - The Reserve Bank today announced that it is partnering with Commonwealth Bank, National Australia Bank, Perpetual and ConsenSys Software, a blockchain technology company, on a collaborative project to explore the potential use and implications of a wholesale form of central bank digital currency (CBDC) using distributed ledger technology (DLT). This is part of ongoing research at the Reserve Bank on wholesale CBDC.

From a central bank/governmental perspective - The benefits have been acknowledged to include

improved financial tracking

cost reductions from reduced production and general handling of coins and banknotes.

In China, Australia and elsewhere, the cashless trend is seen to be strong with both business and consumer habits seen as key drivers in the likely seamless adoption of a DCEP.

China is the first mover – where they are cracking down on crypto assets – as they are implementing their own digital currency - China wants complete control – any nation that implements this also likely wants complete control

Be prepared for the next decade of change – as central banks adopt digital money – replacing physical currency

Thank you for listening to today's episode. If you want to get in contact you can do so here: http://financeandfury.com.au/contact/
28 min
June 21, 2021Banks and cryptoassets – the first introduction of a regulatory framework.
Welcome to Finance and Fury. This episode we will continue looking at the crypto markets. In particular, we focus on the regulatory frameworks that have been released by the Bank for international settlements, BIS for short.

One division of the BIS - the Basel Committee on Banking Supervision - released a consultation paper this month to provide a framework to every nation's regulator of financial institutions on how to treat cryptocurrencies -

Now – the Basel Committee on Banking Supervision is the world's most powerful regulator of banking standards and rules – it gets to decide what capital adequacy banks should focus on, as well as what assets should be classified as capital – if you have been listening for a while, you would have heard me mention this group – they are who APRA, who regulates superfunds and banks in Aus take their directions from

So this recent release is meant to provide the framework for banks on how to treat different forms of cryptocurrency on their balance sheets - if they wish to start purchasing crypto

The big question of this episode is if this is a major win for cryptocurrencies, as it was initially treated as purely based around market price reactions, or is this something that could actually damage the crypto markets through a financial system takeover?

Firstly, it is important to note that this paper does not refer to crypto as a currency – such as the name cryptocurrency would imply – instead, they call them cryptoassets – implying that these are assets for banks or for the financial system to hold or trade these as assets – this off the bat could be viewed as an implied intent, where in the BIS's view, existing cryptos will never be treated as a currency in the mainstream – but I wanted to mention this as I will be using the term cryptoasset throughout most of this episode when it is in relation to this prudential paper – please forgive me in advance as cryptoassets will be mentioned a lot

Another important point is that this report specifically states that central bank digital currencies will not fall under this legislative framework – which also implies that this is a serious option that they are looking at and will fall under a different legislative framework – as an actual currency, not a crypto asset – which we will come back to next week

Start with the introduction to the BIS report –

The BIS have noted that over the past few years, they have seen rapid growth in cryptoassets – with market capitalisation of these assets rising – sitting at an estimated $1.5 trillion

But while the cryptoasset market remains small relative to the size of the global financial system – there continues to be rapid developments, with increased attention from a broad range of stakeholders – these stakeholders are some investment banks, since banks like JPM, Goldman and Citi have already launched their own crypto-focused businesses – I find it hard to believe that the BIS would view individuals as stakeholders

In this report the BIS brings up the normal rage of concerns with Cryptoassets – including consumer protection, money laundering and terrorist financing, as well as their carbon footprint from the electricity usage

But the big point of concern they focus on is that, quote: "The Committee is of the view that the growth of cryptoassets and related services has the potential to raise financial stability concerns and increase risks faced by banks."

In other words, crypto can be destabilising on the financial system – anything that provides some potential competition is destabilising if you are used to monopoly controls – this happens in all aspects of commerce – if you have a monopoly business operating who can fix prices and provide poor services, then a competitor appears, this is destabilising for your business practices, you will lose customers – so what to do? In most cases they simply buy out the competitor or have them shut down

If banks were to start trading crypto using derivatives, then this could also pose a risk to the financial system

The report also mentions that certain cryptoassets have exhibited a high degree of volatility, and could present risks for banks as exposures increases – these risks include liquidity risk; credit risk; market risk; operational risk (which include fraud and cyber risks); money laundering / terrorist financing risk; and legal and reputation risks – this basically ticks all the risk boxes beyond political/legislative risk – but to the BIS this isn't a concern, as they impose these risks on the market

To that end, the BIS Committee has taken steps to address these risks through producing this legislative framework – and they first started looking at this over two years ago, back in March 2019 – where the Committee published an article on the risks associated with cryptoassets – then in December 2019, the Committee published a discussion paper seeking views of stakeholders on a range of issues related to the prudential treatment of cryptoassets – remember stakeholders are entities with direct connections to the BIS – i.e. Central Banks and megabanks

It is important to note that mega banks like JPM, Goldman and Citi group are very interest in securitising crypto – anything that can be securities to make a profit off is a bonus in their eyes – remember in the mid-2000s they were creating synthetic contracts off collateral debt obligations – i.e. peoples mortgages to try and made more money than simply what the interest payments could provide to a commercial bank

How does this legislative framework treat cryptocurrencies – or cryptoassets as the BIS refers to them – I won't be covering the minute details for the sake of time, as this report is 20 something pages long – but if you are interested the links will be in the show notes at financeandfury.com – or you can look up Prudential treatment of cryptoasset exposures – but I will be covering the higher level implications of this framework

Cryptoassets are defined as private digital assets that depend primarily on cryptography and distributed ledger or similar technology – these digital assets are a digital representation of value, which can be used for payment or investment purposes

The prudential treatment of cryptoassets has been guided by three general principles:

Same risk, same activity, same treatment: a cryptoasset that provides equivalent economic functions and poses the same risks compared with a "traditional asset" should be subject to the same capital, liquidity and other requirements as the traditional asset. The prudential treatment should, however, account for any additional risks arising from cryptoasset exposures relative to traditional assets.

Simplicity: The design of the prudential treatment of cryptoassets should be simple. Cryptoassets are currently a relatively small asset class for banks. As the market, technologies and related services of cryptoassets are still evolving, there is merit in starting with a simple and cautious treatment that could, in principle, be revisited in the future depending on the evolution of cryptoassets.

Minimum standards: Any Committee-specified prudential treatment of cryptoassets would constitute a minimum standard for internationally active banks. Jurisdictions would be free to apply additional and/or more conservative measures if warranted. As such, jurisdictions that prohibit their banks from having any exposures to cryptoassets would be deemed compliant with a global prudential standard

This is an important point – as the framework is the minimum standards that need to be applied – if a regulator wishes to go above and beyond, or even ban banks for holding crypto, that is well within their rights and would be deemed compliant

In essence – what these principles do – assuming a bank is allowed to trade crypto - is break it down into groups of assets – Group 1 (broken down into A and B) and then Group 2

Group 1 cryptoassets – these fulfil a set of classification conditions and as such are eligible for treatment under the existing Basel Framework (with some modifications and additional guidance). These include certain tokenised traditional assets and stablecoins

Group 1 cryptoassets will be subject to at least equivalent risk-based capital requirements based on the risk weights of underlying exposures as set out in the existing Basel capital framework.

The cryptoasset either is a tokenised traditional asset or has a stabilisation mechanism that is effective at all times in linking its value to an underlying traditional asset or a pool of traditional assets. In the case of underlying physical assets, they must verify that these assets are stored and managed appropriately

All cryptoasset arrangements must ensure full transferability and settlement finality at all times. In addition, cryptoassets with stabilisation mechanisms must ensure full redeemability (ie the ability to exchange cryptoassets for cash, bonds, commodities, equities or other traditional assets) at all times.

Group 2 cryptoassets – are those, such as bitcoin, that do not fulfil the classification conditions. Since these pose additional and higher risks, they would be subject to a new conservative prudential treatment

These coins are the ones that people would be more familiar with – such as BTC, ETH, ripple, really any coin that isn't a stable coin or a tokenized version of an asset like a share, bond, commodity or currency

Each of these groups therefore have different Capital requirements for each banks reserve requirement - Similar to activities related to traditional assets that the banks hold, such as loans, bank activity related to cryptoassets will increase the operational risk charge to a bank within the Basel framework – due to cryptoassets being new and rapidly evolving, there is potentially an increased likelihood that they pose unanticipated operational risks in most cases to the banking system – this is basically saying that they don't know the true risks to the financial system if banks start trading crypto

Group 1 cryptoassets will be subject to the requirements set out in the Basel Framework for a normal asset that the banks hold – group 1 is broken up into two categories depending on the classification of the asset

Group 1a cryptoassets: tokenised traditional assets – i.e Tokenised traditional assets use an alternative way of recording ownership of traditional assets through the use of cryptography - may be treated as equivalent to a traditional asset for the purpose of calculating minimum capital requirements for credit and market risk - In practice this means that a tokenised cryptoasset is treated the same as - Bonds, loans, commodities, deposits and equities in regards to capital adequacy requirements

This is because this form of cryptoasset must confer the same level of legal rights as ownership of these traditional forms of financing, eg rights to cash flows, claims in insolvency etc.

For example, a tokenised corporate bond held in the banking book will be subject to the same risk weight as the non-tokenised corporate bond held in the banking book. Similarly, if a bank holds a derivative on a tokenised asset, it will be reflected in the market risk charge in the same way as a derivative on the non-tokenised asset – so in the banks eyes there is no difference in holding a bond or a tokenised version of the bond

so – a tokenised cyptoasset can be recognised as collateral for the purposes of credit risk mitigation if it falls within the framework

Group 1b cryptoassets: cryptoassets with stabilisation mechanisms that seek to link the value of a cryptoasset to the value of a traditional asset or a pool of traditional assets through a stabilisation mechanism.

Cryptoassets under this category must be redeemable for underlying traditional asset(s) (eg cash, bonds, commodities, equities) – things like a stablecoin – so whilst not a tokenised version of the asset, its value is linked to the underlying asset, therefore it is treated relatively similar – however

Group 2 cryptoassets – are those that pose unique risks compared with Group 1 - as such are subject to the newly prescribed capital requirement – these are coins like BTC and ETH – anything that doesn't have a tether to the value

A risk weight of 1250% is applied to the greater of the absolute value of the aggregate long positions and the absolute value of the aggregate short positions to which the bank is exposed.

A 1250 percent risk-weight is the equivalent in banking terminology to a 100% capital requirement

So for bitcoin and Ethereum - this would require banks to hold $1 dollar for every $1 in "exposure" to those assets

This is in line with the toughest standards for banks' exposures on riskier assets, such as illiquid shares or junk bonds - So if the bank has a $100 exposure in bitcoin this would result in a minimum capital requirement of $100

This also applies to cryptoasset derivatives positions with the potential maximum loss value under a RWA formula – This can be a bit of an issue for the derivative markets – as the RWA is often not the total loss based around the value of the trade, but the cost of the derivative contract – which is often many times smaller – as you are paying for a premium

So in summary – if the assets are a tokenised version of an asset, or use an asset as an anchor for their value, then the banks can hold these and it can be treated as part of their capital requirements under the existing Basel III requirements – so banks can use this as part of CAR to against their RWA – under Basel III – you need to hold 8% of your RWA – which in Aus is calculated as 35% of your loans

My take on all of this

This could be good news for crypto markets, as they now may see greater recognition by the most powerful financial institution on earth when it comes to providing direction on regulatory frameworks

Or, it could be that the financial system sees another way to make some money – so why not take the plunge?

There is nothing inheritably wrong with making money – but the way that banks do this, especially in the US is different from you or I purchasing crypto

The issue with this is the structure of the financial system – as these banks are TBTF

If you buy one BTC for $50k and it drops down to $10k, you have lost $40k which sucks – you will likely feel bad – but you can hold onto this and hope the price recovers

But the way a bank like JPM or Goldmans make these trading positions is normally though the use of derivatives on these assets – they only put up a fraction of the funds and cannot simply hold if the prices decline – because of counter party risk – as each bank tries to get out of a position at one point of time – this can create major issues -financial system collapse –

If you go bankrupt – then too bad – if a bank goes bankrupt – this becomes your problem – as banks will get bailed out – remember, they are Too big to fail

The BIS notes that the extreme price volatility of some of these assets – particularly those in group 2 – have unproven track record of liquidity will make it challenging to hedge positions when providing derivative instruments or when manufacturing investment products that reference crypto assets

There are any number of ways that this can explode in the future – here are just three I can think of off the top of my head

One – Requirements for additional dollars or bonds to be printed to absorb the increase in the RWA for any bank holding category 2 of the crypto assets – Say BTC does go to $500k - Banks need to increase cash they hold if prices rise – banks don't hold much cash relative to their overall asset and liability position – the balance sheet of banks is basically neutral – they have the same amount of liabilities as assets – so if the price of cryptos increases massively, then banks would need to have central banks expand the money supply further for them to maintain their CAR requirements

Reminds me a little bit of the Mississippi bubble – the price of assets increases to the point that people want to cash out – but not for a worthless form of conversion such as the paper money being issued – if cash like the USD continues to be expanded at its current pace – people could request alternative assets destabilising the financial system - could create a major issue down the road

Two – asset bubble through bank speculation and derivative practices – The GFC period was bad enough when you have banks speculating on newly created assets – whilst mortgages have been around for hundreds of years, the CDOs were relatively new –

Through entering into crypto – banks are entering into a new territory of pure speculation – the buying and selling of cryptoassets by itself isn't the issue – but the speculative practice of derivates and who knows what else they come up with in the years to come could become a major issue for the stability of the financial system – could both collapse crypto markets as well as shares and bonds if economic confidence gets hit

Three – Additional risks, such as AML issues – if the banks do not act in good faith, because to be honest they do not have a good history of this – there could be a call by regulators for additional crack downs on crypto

So in summary – this legislation Creates a two tiered system for Cryptos – and opens the door for the largest financial entities to begin speculating on what is already a volatile asset

For the two tiers - one is seen as good as the assets underlying it - The other – is seen as a very risky asset class

So we may also see the rise of tokenised assets and a new wave of how the economy works

In addition – it means that you will now be competing with the most sophisticated traders on earth – complex computer algorithms dictating market prices could see larger swings in volatility

It goes without say that governments are increasingly focused on issues surrounding cryptocurrencies – especially with some central banks exploring digital currencies – this even came up in the recent G7 meetings this month

So we will finish off the crypto series next episode looking at China's Central bank digital currency

Thank you for listening to today's episode. If you want to get in contact you can do so here: http://financeandfury.com.au/contact/

https://www.bis.org/bcbs/publ/d519.pdf
28 min
June 14, 2021El Salvador and Bitcoin - a match made in heaven?
Welcome to Finance and Fury. This episode we will continue to look at what is happening in crypto markets. After last episode, we are starting a bit of a mini-series on crypto and digital currencies. This wasn't originally intended but I have been doing more of a deep dive into this topic and there has been some timely news articles that I want to cover.

In this series, we will look at a few factors in relation to the crypto markets. Mainly governmental and financial institutional adoption of mainstream cryptocurrencies, like BTC. This series will cover the topics of firstly, el Salvador and other potential Latin American countries accepting BTC as legal tender, then Basel Regulations updates on banks/financial institutions accepting cryptos as assets and the implications this has on markets, and then to finish things off, China rolling out a digital currency that has been in the works since 2014. This may change over the weeks if I uncover any more interesting topics, but at this stage, this is the gameplan.

But in today's episode – we will be following on from last week's episode where I give my personal thoughts on crypto currencies

I mentioned last week that a few small nations may accept and adopt BTC – good timing – on the same day the episode was released - news that El Salvador was proposing the acceptance of BTC as legal tender came out – in the meantime, this has passed into legislation – so we will start the mini-series looking at this development

Now - El Salvador has become the first nation to formally adopt a cryptocurrency as legal tender

and a handful of other Latin American leaders have indicated that they would follow suit – such as Paraguay and Panama

Does this really mark a change in bitcoin's reputation and acceptance on the global stage? Yes and no – Yes for developing/3rd world nations reliant on the US dollar and remittance, but no for any major economy who are standing firm on their own domestic fiat currencies or proposed central bank digital currencies

Why has El Salvador made this decision? It isn't as simple as them being the first adopter in a global trend - Let's look at why – as it comes down to the make up of these economies as well as their reliance on not only remittances –

El Salvador – small Latin American country wedged between Guatemala and Honduras – the last time there was this much buzz around this region was the football war of 1969, which was fought over a few issues but was accelerated by the FIFA 1970 qualifying matches – but it is a small country with around 7m people living in it

But it is considered 3rd world – GDP per capita of $4k v Aus at $55k

They are also heavily reliant on the USD – which is another legal tender in the country

This is a problem for them as they are a net importer of goods – which means they can run out of USD – in other countries, you can just print more money – but El Salvador cannot do this

Like many other Latin American nations - El Salvador's economy is heavily dependent upon remittances – this is a term for funds sent home by citizens working abroad – i.e., an El Salvadorian works in the US and sends money home to family members – then this is remittance

Remittances totalled over 20% of their GDP output in 2019 – and had only been growing over time –

the economy in El Salvador has been struggling for years – their domestic economic output has struggled due to their internal economic issues, so they have become more reliant on external factors, such as the reliance on inflows of USD into the country to spend – they have also had some major political issues as well which we will come back to later in the episode

The Governments move to adopt BTC is a very smart one from their president – when it comes to trying to maximise the remittance levels as well as potentially increase the crypto mining in the country – it works to achieve both ends

Currently, remittances are delivered by money transfer services companies like Western Union – these are centralised and highly regulated under financial service regulations – this can be complicated between boarders – some nations disallow the transfer between boarders due to money laundering and counter terrorism financing laws

Then to actually make the transfer happen through a money transfer service when it is permitted, it requires an in-person visit to an office and proof of identity for both the sender and receiver

In El Salvador - there are around 500 Western Union offices across the country – but most of these are located in populated areas – so some of the poorer individuals living in rural areas of the nation can have limited access

Let's have a look at the current state of financial services in El Salvador - around 70% of the population is considered to be unbanked – this means that they lack access to a basic bank account – which is an issue for anyone wishing to save or conduct online commerce – this is why physical cash transactions are facilitated through money transfer services – who needs a bank account when your withdrawals are coming from these services?

In addition – due to the governmental history and political risk of the country – many people don't trust financial institutions – let alone have the capabilities to establish a bank account

Now – lets contrast this to say a BTC transfer – these allow anyone with a mobile phone and internet access to send or receive funds -

Also - BTC could be spent directly on goods and services, just as the US dollar is in El Salvador – all can be done though a wallet – so rather than someone going to Western Union and getting acceptance of the USD transferred to them, then withdraw the cash and then go spend this at their local store, they can simply be transferred BTC and then spend this on goods and services directly at a vendor

it does sound a lot easier, doesn't it? – but this is from a first world western perspective – which we will come back to in a minute

But first – let's have a look at how this could be great for El Salvador in the interim –

If BTC prices continue to rise over time – and the population continue to accumulate more BTC in their wallets – then the prices of goods and services will become deflationary for them – i.e. they can afford to purchase more goods or services for the same amount of BTC

As many crypto analysts suggest the price of bitcoin will rise over time – and let's assume that it does – anyone in El Salvador that has BTC stored in their wallets can now afford more goods and services, especially whilst other goods and services are being pegged to the USD –

This could potentially create an increase in wealth a consumption power by any lucky Salvadorians who has acquired and holds bitcoin if prices continue to rise

If you invest 3 BTC in the country, you can also become a citizen

So additional wealth and investment may come into the country

Mitigation of environmental concerns around the electricity consumption of cryptocurrency – El Salvador has a large geothermal capacity – Geothermalpower in El Salvador represents 25% of the country's total electricity production and is one of the top ten geothermal energy producers in the world

However – they are currently an energy net importer – and it isn't cheap electricity prices

So, if the government, or private energy providers invests in further geothermal capacity, then the Government invites mining syndicates to set up in the country to mine crypto at a low electricity cost – could provide a cost-effective method of accumulating coins – plus they can tax it – to help generate more government revenues – this could be a major plus to their economy – but this would take years to implement

This all sounds great – and any market innovations and adaptions in my book is something in the right direction – but is that what is going on here?

Important to take a step back and think about the functional economy within El Salvador and the use of BTC – as a 3rd world economy - for those of us in the 1st world – we cannot really appreciate what daily life is like to operate in an economy like El Salvador

For a functional BTC exchange to emerge – it requires the internet - Recipients of bitcoin realise their funds by connecting to the internet

Does El Salvador have wide spread internet access in the country and is this the major method of transaction between consumer and vendor? – World Bank has the data on this –as of 3 years ago, only 34% of the country was using the internet or had access to the internet

This right away may seem to be a problem – unless this government program is to give all of the rural or poor population a phone with internet capabilities – how are they going to function under BTC as a monetary exchange? Would be different if this was done in Aus – where around 95% have regular use to the internet – but in a nation without the very infrastructure to help facilitate this adoption, there is a major bottleneck

Another major issue is that is appears that businesses are being forced to accept BTC – I am not a fan of this – I personally think it goes against the very core concept of crypto – that is should be voluntarily adopted and based around individual liberty – i.e. to get away from government control and oppression that the monetary system has paced on the population – now a government policy forces all vendors/suppliers in the country to accept BTC

Based around the legislation translations I have seen – relying on translation, I cannot speak Spanish – but the government acceptance of BTC as a legal tender requires every single commerce transaction to have to option to be conducted in BTC

If they breach this – they are now breaching the nations commerce regulations and suffer consequences

It is essentially the equivalent of you going to the farmers markets and wanting to pay in BTC – but they don't have the capabilities to accept this form of payment –

I go to a farmers market and around half of the vendors only accept cash – rather than me paying on bank card or credit card – but this is okay – as it is all still AUD – it is just the method of payment which differs –

With BTC – there is currently no physical widespread payment mechanism for this – if a merchant doesn't have internet, how does this affect their business?

It is a big question – and one that the economy of El Salvador has been given very little time to adjust to – remember – we are not talking about a first world nation – that has the capacity to access internet and sign up to wallets if need be overnight

I personally have never been to El Salvador – but I have been to many other 3rd world nations –and the cultural acceptance of certain technologies and pace of adaption that first world nations have shown shouldn't be projected on any other nation

Many of these nations do thing in their own time – and the approach of 'if it isn't broke don't fix it' can apply to many situation – so the very fact that the government may try to force your local street side vendor in El Salvador, who may not have access to the internet themselves to adopt and accept BTC overnight, let alone within the next 5 years may be a big challenge

May put additional stressors on the population and hence the economy

Another major issue is the volatility of BTC – I mentioned earlier in the episode that if BTC can continue to appreciate in value, then the price effect will be deflationary, assuming goods and services continue to be prices relative to USD

This is where Adopting bitcoin as legal tender is not without its downsides – what is BTC all of a sudden decline in value by a substantial margin – this would have the opposite effect – through reducing the purchasing power of those holding BTC – creating an inflationary pressure

BTC can be rather volatile – as an example – at the time of putting this episode together – the price of one BTC if $46k AUD, or $35.7k USD – this represents a decline of roughly 45% from the April high this year

Volatility in purchasing power can be an issue – as it affects the individual's ability to make consumption decisions – if you purchasing power can easily change by 10% +/- per day then this can create major uncertainty when it comes to make purchasing decisions, as well as selling decision – Now imagine that someone in El Salvador had received all their savings through remittance in the form of BTC – then over a month the price declined by 45% - this means they have almost half the ability to spend – so what do they do?

Can create economic cycles within El Salvador – if BTC crashes – then purchasing power is less – so people won't spend anything for a month or two – and wait and hope until prices rise - if the price does, then you may see a massive spike in consumption, with which supply cannot keep pace, then you get inflationary pressures in USD terms, then if this cycle continues, you may start to see the purchasing power of the BTC decline even further

So there are some untested areas of the economy with this case study for a small nation adopting a crypto currency

My personal views – I may be completely off – but BTC being accepted as legal tender by the government may simply be a policy that benefits the upper classes of El Salvador more so than many of the poorer individuals who rely on remittance – those with money who are politically connected and already have internet access – such as cartels and political officials, corrupt or not – rather than the poor farmer trying to sell their goods on the street – this take may be cynical of me and I may be missing a major factor of this policy here – but based around the historical behaviour of the El Salvadorian government, as well as the capacity for the average population to accept BTC as a method of payment due to limited internet access, it makes sense to me at lease

When you look at El Salvador or many other tiny Latin American nations – historically many of these countries are run as either a banana republic or as a narco-state – where there is an embedded relationship of corruption

Who does this policy help? When you look at the fact that the majority of the poor don't have access to the internet and will still be reliant on remittance from money exchange services – it may not be them

The very lack of an internet connection in the nation stifles the adoption of the policy – plus puts a major political risk on businesses who are now required to fund to cost of getting a device and internet access to accept BTC payments

But from my 1,000 foot view – take this with a grain of salt – as I am providing an analytical assessment without ever setting foot in the country or talking to the population – but the majority of the poor who cannot afford internet connections or smart phones may be left in the dust

But those who have internet connections and have large amounts of capital to move can really benefit - Look at the current president and his actions – this is based on news stories, so no idea if they are true or not -

The President wanted to secure a $109m loan from the US to militarise their police -the plan was opposed by both opposition parties who had the majority – game over right? Well - he ordered soldiers into the Legislative Assembly to help incentivise legislators to approve the loan until it passed in his favour

He has also been accused of negotiating a deal with MS13, the most powerful gang in the country to provide less strict prison conditions if they can lower the number of public murders

Gang presence is huge – MS13 and MS 18 are the largest crime syndicates in the country who are responsible for drug and human trafficking trades

Who has the most money to flow into El Salvador – a group of local farmers, or a massive criminal network like MS13

This isn't a justification to ban crypto like BTC, as no other currency on earth has seen more criminal deal committed in it than the USD –

In summary –

If this was a move where all major governments/monetary authorities were going to look at the same process, then this would be great news – but it is in reality a minor occurrence – as the capability to directly accept BTC for commence is lacking in the country, beyond those wealthy elite or drug cartels already set up for this

but I hope it just helps to show a different side to the title that most people have read, showing that BTC is being accepted by El Salvador – as there is more to the story once you dig a little deeper

I may be wrong, the internet connection and adoption by the local population may occur overnight, but time will tell –

Next week – we will look at the evolution of the banking system in relation to crypto – in particular the Basel Committee views on the subject and their recently released guidance to banks around the world on how to treat crypto

Thank you for listening to today's episode. If you want to get in contact you can do so here: http://financeandfury.com.au/contact/
24 min