Lessons for Cryptocurrencies from Emerging Markets
By Siddhartha Jha on The Capital
Money is power. This statement is said often in the context of individual wealth, but on a larger scale, currency is an expression of the power of the state. The foundation of a sovereign currency is the directive to accept a printed piece of paper, otherwise known as fiat money. Often this is framed in a benevolent context referencing social trust. We accept the dollar because we trust others will be willing to exchange goods and services for that dollar later on. While superficially trust facilitates acceptance of fiat day to day, the trust is enforced by the coercive power of the state. There is an underlying threat that maintains the demand for fiat currency — you need it to pay your taxes, and if you do not pay tax, you will be jailed. This coercion is not new and has formed the foundation of currency from antiquity when grain taxes were collected by force if necessary, and in turn, the grain, or its exchange in gold, paid for societal projects whether they be irrigation or pyramids. All fiat currency from the Roman coins to the pound sterling to the US dollar relies on this foundation of forcing demand creation by dictating taxes to be paid in that currency. Currency supply is easy to create, but currency demand is created at the barrel of a gun.
These days we are more sophisticated and add layers of obfuscation to crude concepts such as state coercion by creating stories of social trust. Governments borrow extensively against their future tax revenues, trapping everyone in a system that would be painful for all if it failed. This debt against future tax revenue forms the backbone of currency rather than printed notes. Debtors and creditors jostle for power coinciding with long term cycles of inflation and deregulation but with all parties in an overarching bind of forced trust not just due to the need to pay current taxes in the fiat currency but to receive benefits of future tax revenues in the same fiat currency. This increases the loss to all parties for abandoning the currency embedding them further in the system. For example, if demand for US debt disappears, everyone’s dollar becomes nearly worthless, and it is in the interest of all major institutions to make sure the US dollar demand is enforced. Countries where the use of a currency falls apart face rapid societal breakdown as with Venezuela and Zimbabwe in recent decades or Weimar Germany in the 1920s.
To sustain demand for a sovereign currency, the state needs to have sufficient power to extract tax from its citizens both today and in the future. Demand across time is key as the citizens of this country need to be willing to believe in this taxation power in the future, as well as today so that they are willing to lend the government currency in the hopes of getting some greater amount of currency later. This greater amount is represented in a quantified way as the interest rate and reflects faith in the state’s ability to enforce its power in the future. Put another way, part of the interest rate a sovereign has to pay to borrow reflects the trust that people place in the taxation power of the sovereign in the future. The difference between a developed and the emerging market country is a line between countries which can generate enough taxation power domestically, so they do not need to borrow from outsiders. Certainly, a developed country may choose to borrow from foreigners like the US does, but the US is doing so in the US dollar itself for which it controls the printing press. Such foreign borrowing is economically attractive given global capital flows, but there is ample domestic capital to replace that borrowing, which is why US interest rates tend to head lower in times of stress. On the other hand, emerging market countries require external capital to support demand for their currency with a generally higher interest rate reflecting weaker power to tax. Their borrowing from foreigners is often not in their domestic currency where they control the printing press but instead in a foreign currency such as the US dollar. For emerging markets, this lack of control over their currency sharply reduces control over the fate of their economies and beholden to economic conditions in developed markets such as Europe and USA. Volatility Machine by Michael Pettis is an excellent book discussing this effect in more detail.
Cryptocurrencies as Emerging Markets
A cryptocurrency economy is much like an emerging market. A cryptocurrency does not have coercive power to enforce a demand for its currency (for now?), so it relies on external capital flows for demand. As with fiat currency, it is much easier to control supply rather than demand for a currency. Emerging markets offer parallels to the cryptocurrency economy and lessons in the hunt for the ever elusive stablecoin, which would be a safe harbor from the sometimes insane volatility of cryptocurrencies. Emerging markets lack sufficient taxation power due to a combination of internal poverty and insufficient Government power to enforce its writ. Their coins are unstable with dependence on external capital, which is fleeting at the first sign of trouble. Capital flight leads to a sharp drop in currency value, causing further capital flight as the remaining foreign investors rush to protect their holdings from the declining currency. This destructive feedback loop of declining currency value is a fundamental problem with any currency system, whether it is an emerging market currency or a cryptocurrency.
The coercive threat of violence for collection of taxes that forms the foundation of the power of the state functions primarily to prevent the feedback loop of a capital flight. Your capital cannot fly away if you are forced to live in the nation and pay taxes in that currency. For a country or a cryptocurrency system without sufficient internal resources or power to enforce demand, they are continuously exposed to the turbulence of outside capital flows.
To understand how a stablecoin may come around then, we need to look to emerging markets for lessons on their efforts to do the same. Much blood and energy have been spilt on expanding the coercive power of the state to ensure demand for the currency, but only a few countries at a time can manage such feats, and they do not fall into the “emerging” category. To maintain a stable value for their currency, emerging markets follow, or at least need to, follow a few strategies:
- Interest rates on the debt help modulate supply and demand
- A large set of reserve of foreign currencies to maintain confidence in the value of the local currency
- Net export balance that is not volatile and uncorrelated or anti-correlated to the interest rate above
Flexible interest rates help to modulate the external demand for the currency with rising rates encouraging stronger demand for the currency. For many emerging markets, their central banks modulate short term interest rates in response to currency movements, and longer maturity debt has active markets determining interest rates. However, flexibility of interest rates alone does not guarantee immunity from destructive feedback loops of capital flights. Higher interest rates to encourage demand for the currency can instead increase the country’s interest payments on existing debt. The worsening fiscal situation and resulting fear can lead panicking foreign investors to flee further pushing up interest rates in a vicious loop. For cryptocurrency stablecoin candidates which have algorithmically determined interest rates, this vulnerability familiar to emerging markets is still applicable. Longer maturity debt can alleviate this, but most of the time, most emerging markets and cryptocurrencies do not have sufficient demand to lock up long term capital (want to lend Argentina or the Ripple economy for 30 years?).
To keep the interest rate feedback loop at bay, countries maintain reserves of foreign, developed market currencies to keep confidence levels at high levels. East Asian economies are the clearest example of large foreign reserve chests with trillions in USD held to protect currency values. For a stablecoin candidate, a large set of reserves seems likely to be necessary in the current state where confidence is essential to maintain demand.
Reserves cannot be accumulated without a long period of positive net exports whereby the country sells a higher value of goods to the outside world versus spending on goods purchased from the outside world. Accumulated net exports help build reserves, and it is no coincidence that in the “emerging” phase, few countries without long term positive net exports have been able to maintain a stable currency. Many emerging markets go through short bursts of rapid accumulation of export capital, but end up adding excessive debt during these boom periods as consumption outstrips savings. When the inevitable economic slowdown arrives, there are not enough reserves to last through the shock, much like a startup that excessively spends its capital raise chasing growth.
Just having large surpluses are not an antidote from a currency crisis. The export vs import balance of a country should be uncorrelated or anti-correlated to the interest rate it pays on its debt. Volatility Machine by Michael Pettis once again discusses this concept in considerably more detail than can be outlined here. As an example that should clarify the concept, if your country imports oil and oil prices start rising, the resulting pressure on the currency makes further oil imports even more expensive, thus pressuring the currency further. Additionally, the deteriorating trade balance leads foreign investors to sell the country’s debt driving up interest rates further reinforcing yet another feedback loop. All these effects are in clear display with the Turkish Lira, a coin that has gone from being stable to decidedly non-stable.
Currencies such as the Hong Kong Dollar and Singapore Dollar have maintained stable values for decades without being reserve currencies by maintaining large reserves and a diverse array of exports such as electronics and financial services, which are not prone to sudden collapse in price as with commodity exports. At the other end of the spectrum, economies such as Venezuela and Zimbabwe have seen a spiral of destructive feedback loops stemming from poor policies that led to their respective currencies becoming worthless. In the middle of these extreme scenarios are a host of emerging market economies where currencies have been stable for long periods followed by sharp devaluations that can spawn mini-crises without forceful interventions. Examples include Mexico in the mid-1990s, Brazil a few years ago, and Turkey recently.
Lessons from emerging markets for cryptocurrency stable coins
- A flexible exchange rate has a better chance of maintaining long term stability. Hard pegs such as those attempted by countries such as Argentina or by cryptocurrencies introduce rigidity that builds up imbalances only to lead to sharp declines in value later. Even if not perfectly efficient, prices are great processors of information, and forcing a fixed price allows imbalances to build up without any warning. The hard peg that Argentina maintained in the 1990s worked great while the economy was doing well but the same peg led to excessive imbalances of debt to build up. When the economy inevitably slowed, it was too late, and the break of the peg was a sharp, painful crash making up for the forced stability of all the previous years.
- The degree of flexibility of a currency can have a meaningful effect on its stability. A purely free market-driven currency may not be suitable for emerging markets. Rigid free market believers often forget to check if the assumptions that go into a free market being successful are valid — the theory is not applicable if it’s resting axioms are not valid. In the case of emerging markets, the feedback loops discussed above along with asymmetric power available to a few international institutions certainly do not satisfy the requirement of perfect competition amongst homogeneous participants. For a country such as Singapore, the currency is a managed float with a certain band of inside which the currency is allowed to fluctuate in. Furthermore, the sensitivity of the currency’s moves is also managed with respect to a basket of outside currencies. Such float management in an algorithmic way would be an option to maintain a relatively stable cryptocurrency without forcing the rigidity of a peg.
- The coin economy needs to save up reserves during times of robust demand and capital inflow with transparency into the size and changes of those reserves. This last part has been an issue with coins like Tether, but given the levels of technology used in the blockchain ecosystem, a near real-time auditing system for a pile of USD is not difficult and inexcusable not to set up. With reserve amounts being public and viewable at any time, there should be minimal guessing as to the viability of the system. In conjunction, if reserves drop below certain thresholds, the network would react by increasing transaction fees and invoking some of the measures in the next couple points.
- The coin should pay out interest adjusted in a dynamic manner to modulate supply and demand of the coin. The problem is certainly not symmetric as it is much easier to regulate too much demand by lowering the interest rate than it is to invite demand with increasing interest rates. As with any emerging market currency, maintaining confidence in the system is key to prevent a bank run situation. The interest rate should be based on market forces with rates rising to the level needed to ensure sufficient holders of the coin emerge. Certainly there does not need to be a single interest rate as in real markets. Coin holders can be separated into different tiers with higher tier holders having longer tenor holding lock-ups or higher costs for selling their holdings with their compensation being higher interest rates for holding the coins. The interest rates for these different tiers of holders would be dynamic as they are in large, healthy bond markets for a range of tenors and credit risks.
- Since higher interest rates are unlikely to be enough to prevent a spiral in the currency during stress periods, further layers of checks are needed against a capital flight feedback loop. First, the transaction fees of the network can be structured to rise the more the currency value falls. This would lead to a slower volume of selling in panics as well as adding to network reserves as the value of the currency falls helping to offset some of the perceived negative fundamentals. Second, some holders could be locked-in to their holdings for certain periods of time with heavy penalties to sell early or often, adding a layer of holders beyond the differential interest rates discussed above to add confidence for the market. These holders would presumably receive a significantly higher interest rate as compensation for their inflexibility. Finally, a group of liquidity providers would be tasked to be ready to buy or sell the currency of the network while also being highly incentivized to keep the network functioning well. Liquidity providers outside the system can vanish at the first sign of trouble as can happen with say a bank in London making markets in an emerging market bond.
No set of rules is ever going to be enough to sustain an economy dependent on external capital, such as a cryptocurrency one. Perhaps the most consistent lesson from emerging market crises is avoiding an obsession with near-term stability. Forcing artificial stability causes imbalances to build up causing abrupt crashes that are much more destabilizing than a slower, more orderly devaluation. In 1998, Russia attempted to maintain the Ruble’s exchange rate at the cost of its dwindling foreign reserves, which eventually led to default. Over 15 years later, during a renewed bout of economic stress from a sharp decline in oil prices, the ruble was allowed to devalue and find it’s new equilibrium without causing widespread defaults and economic collapse. For cryptocurrencies, being comfortable with some instability and allowing fluctuations in dynamic bands is a better long term solution than forcing pegs.
