Central Bank Digital Currencies

Published February 28, 2022

With these pieces of paper they can buy anything and pay for anything.

All these pieces of paper are issued with as much solemnity and authority as if they were of pure gold or silver; and on every piece a variety of officials, whose duty it is, have to write their names, and to put their seals

Marco Polo on seeing paper currency in China

Heat is a great crime movie. The bank heist scene is an epic and a cinematic tour de force. It gives you a visceral jolt: bullets, carnage and gateway cars with bags full of cash feature prominently.

Bank robberies with cash have been an integral part of cinematic zeitgeist and any heist movie worth its salt, be it the modern The Town or classics like The Killing had lucre as center piece.

However, with the onslaught of digitalization the paper currency may be reaching its logical demise. The arguments for its demise have been vociferous.

It is sweetly ironic that the pioneer of paper currency China just like in Marco Polo’s days may also lead its demise.

Both China and Sweden are in advanced stages in terms of conducting tests for Central Bank Digital Currency (“CBDC”). Both countries have seen the use of physical cash rapidly disappear due to the high penetration rate of smart phones and electronic payments.

But why the sudden impetus for CBDCs now? There are two reasons:

1.      The blockchain technology pioneered by Bitcoin has proved its concept and resilience (more about it later).

2.      The second and main reason besides cryptocurrencies going mainstream was the announcement of Facebook to launch a cryptocurrency called Libra in mid-2019.

Libra project was literally the straw that broke the camel’s back. Central Banks hate losing control over their money and the ensuing transmission mechanism of monetary policy. The Libra cryptocurrency was to be backed by a basket of reserve currencies and built on the blockchain. The currency would have been available to billions of Facebook users and though not officially admitted could threaten the national currencies like the US dollar and financial markets.

The Libra project has officially been shelved now after the regulatory pushback.

What is Central Bank Money?

Before we go into the complexity and architecture of CBDCs let’s take a detour to explain what is money and what is precisely meant by Central Bank money.

For a layperson, money conjures images of tangible white paper bills with pictures of dead presidents/prime ministers or other cultural emblems. However, cash or paper currency is one small part of what we technically call money.

Contrary to popular misconception Central Banks do not create money. The actual money in economy is created through intermediaries: we call them “commercial banks”. Money is created when banks create credit through loans, overdrafts etc.

The key take way is that the supply of money is determined primarily by the demand of borrowers to take out bank loans. Banks provide the supply that meets this demand.

Money consists in three forms:

1.      Physical currency i.e.  cash banknotes and coins. This type of money is a Central Bank liability.

2.      Central Bank reserves- reserves held by commercial banks at the Central Bank. Central Bank is a banker to commercial banks, so the latter hold the reserves at Central Bank to facilitate interbank payments. The important thing to note is that this is the only “money” which Central Banks can target directly. They can credit reserves in commercial bank accounts by buying assets (e.g., treasuries) from them. This type of money is also a Central Bank liability.

3.      Commercial bank money – bank deposits created when commercial banks create credit. In creating credit, banks simultaneously create brand new deposits in our bank accounts, which, to all intents and purposes, is money. This money is a liability of the commercial banks.

#1 and #2 are called M0 or base money. On this base money banks create credit and hence money is circulated in the economy.

So far, we have established that Central Banks have no connection with end users of money except via physical cash: everything is intermediated through commercial banks. Individuals do not keep bank accounts at Central Bank-only commercial banks do. The only Central Bank money we as individuals hold is physical currency.

What exactly is CBDC?

Now that we have explained what money is and where does it come from, lets discuss what is supposed to be meant by CBDC.

Our current monetary set up is a digital accounting of money, which is a claim on an intermediary (commercial bank). When we shop online or use our debit card, we are basically using the electronic representation of physical money or money created by commercial banks. A cashless economy can exist without CBDC by making account-based system completely digital.

Sweden is already on its way towards a completely cashless society without CBDC.  China is also pretty much cashless now and Alipay and WeChat dominate the digital payments landscape.

China bypassed the credit card rails enabled by the ubiquitous adoption of Ali Pay and WeChat. They account for 90% of the China’s “digital” payment market.

CBDC will most likely replace cash money i.e., money definition # 1 so there will not be any physical notes with dead presidents/prime ministers.

The more interesting issue is what will happen to reserves and bank deposits i.e., money definition # 2 and #3? That’s where things get interesting and a bit confusing. Bank deposits are a claim on the banks whereas CBDC will be a claim on Central Bank.

There are two broad potential models of CBDC.

1.      Direct retail CBDC: Every citizen will have an account with Central bank, which will process every transaction between the counterparties. To be honest this is impractical. Central Banks will not want to be turned into retail banks. Furthermore, this model will disintermediate the entire banking sector.

2.      Wholesale CBDC: In this model, some select account holders (most likely banks and may be other counterparties) will have accounts at Central Banks.

Both these models can be turned from “account based” to “token based”. To understand we need to delve into the blockchain technology.

CBDCs are beholden to the underlying blockchain technology but in spirit they are totally different. The currency will be tokenized via UTXO, whereby the Central Bank no longer has to monitor accounts for every individual. Once tokens are issued, the tokens themselves pass between market participants, and the Central Bank’s responsibility is limited to running the blockchain system that issues, redeems, and follows the flow. With tokenization implementation, the overhead to maintain extensive database and IT infrastructure will be minimized.

In short, CBDC will be based on blockchain technology, but it will not be decentralized like Bitcoin.

All blockchain technologies face a trilemma. Any blockchain needs to balance competing demands of decentralization, scalability, and security. For example, Bitcoin is decentralized and secure but not scalable (There are efforts underway to scale it up via Lightning Network but that’s another discussion altogether).

CBDC will be most likely based on a centralized blockchain.

CBDC could theoretically be transferred between counterparties via an “approved” digital wallet.

So, the banks who have always intermediated between end users and central banks could face more competition like what happened in China.

For instance, in China both Alipay and WeChat are payment channels and will continue to use digital Renminbi when it comes into play. Though they might have a competition from other “approved Central Bank wallets”.

In essence new digital wallet application may be created which will be linked to the CBDC account through APIs.

With CBDCs, we can make direct digital payments without our data passing through a long chain of financial intermediaries.

Why are Central Banks keen on CBDC?

Central Banks are keen on CBDC because it will give them more control than what the current monetary system allows:

1.      Control of monetary policy: The monetary policy is transmitted via a complex web of intermediaries and is more of an art than science. CBDC will enable central banks to literally drop money via helicopter. Imagine having US$100 instantly credited in your account.

2.      Prevention of tax evasions and illegal usage:  Physical cash is one of the main sources of tax evasion. It is also one of the preferred instruments to hide illicit gains. CBDC will make it extremely difficult (not impossible since humans have ingenious capability to come up with counter schemes) to pull a Walter White act.

3.      Financial inclusion:  A lot of people in developing countries do not have access to banking facilities. All you need for CBDC is a mobile phone and not even an internet connection if it has NFC facility. During Covid even a developed country like USA had to send stimulus payments via cheques. CBDC will make any payments to citizens instantaneous and targeted.

What are the potential risks?

Privacy is one of the main issues cited. But I think the ultimate design will differ from country to country. Without privacy, I am not sure CBDC could gain traction. There might be some top-down pressure in countries like China but in Western democratic system, a CBDC without privacy guardrails will not fly.

In fact, US Federal Reserve has explicitly stated its CBDC to be “privacy-protected, intermediated, widely transferable, and identity-verified”.

Who will be the winners and losers?

The winners besides Central Banks will paradoxically be cryptocurrencies. They will gain additional respectability and Bitcoin might become boring and mainstream.

The losers will be banks. They have already been losing to Alipays, WeChats etc. They are increasingly becoming dumb pipes over which other parties are building APIs via open banking regime. However, as mentioned above most central banks will be keen for CBDC to complement the current money system.

Credit card like Visa and Master Card companies could be vulnerable to disruption by CBDCs. Their debit card products will be more vulnerable.

The topic of CBDCs is evolving rapidly and we hope to see many interesting developments in the future. The essay is just a first attempt to capture the big discussions.

Author: Ali Asad, CFA | Strategic Advisor, Alpha Capital

SBP is indicating that the interest rates have peaked

Published January 25, 2022

In line with the forward guidance provided in the last monetary policy, SBP kept the policy rate unchanged at 9.75% in its Jan-22 Monetary Policy Statement (MPS), after consecutive hikes in last four meetings totaling 275bps.

  • SBP now has a more comfortable posture on the existing monetary setting, mainly due to the contractionary stance of the fiscal policy after the recently passed Finance Supplementary Act 2022 which will help in containing the country’s budget deficit and slowdown demand growth.
  • While SBP expects YoY CPI inflation to remain close to the upper end of its forecast range of 9% to 11% in the next few months, it believes that sequential momentum of inflation and inflation expectations have fallen significantly.
  • The SBP has reiterated that current real interest rates are mildly positive on a forward-looking basis and that the current monetary policy stance is sufficient to guide inflation to the target range of 5-7% during FY23; but at a quicker pace than previously expected.
  • This effectively implies that as per current assessment of SBP, the interest rates have peaked, with SBP expecting small adjustments of policy rate on either side, depending upon the subsequent data outturns. This could be a key trigger for the stock market.
  • Despite recent rally in global oil prices, SPB maintained its Current Account Deficit (CAD) target in the range of USD13-14bn during FY22, as CAD appears to have stopped growing since Nov-21, and non-oil Current Account balance is expected to be in a small surplus during FY22.
  • The SBP has lowered its GDP growth rate target to 4.5% from previous estimates of 5% due to upward revision of FY21 growth and expectation of a slowdown in demand owing to a blend of monetary and fiscal tightening.
  • Farmers expect wheat yields to rise by ~5-10% in CY22

    Published January 25, 2022

  • Considering the recent news flow regarding concerns on 2022 wheat crop due to low availability / application of fertilizer, we conducted several interviews in the agricultural value chain to understand where things stand.
  • To give some background DAP offtake during Oct-Nov CY21 fell 5.6% YoY due to record high prices approaching PKR~10,000/bag. While Urea offtake rose 15%, actual urea availability to farmers is likely to have been much lower due to alleged smuggling, resulting from local urea prices being at an 80% discount to international prices. Resultantly, urea prices in the black market also surged to PKR~3,000/bag against official rates of PKR1,770/bag.
  • Farmers’ view

  • Farmers in Punjab and Sindh are optimistic about 2022 wheat crop. While they confirm less-than-optimal DAP and urea application to the wheat crop, they believe that the unexpected rains during the ongoing Rabi season and resulting increase in moisture have more than compensated for the low fertilizer application.
  • The current state of wheat crop is healthier than last year. As such, farmers expect 2022 wheat yield to rise by ~5-10% YoY. This would mean that the government will comfortably achieve its wheat production target of 28.9mn tons.
  • Fertilizer dealers’ view

  • Fertilizer dealers suggest that farmers initially reduced DAP application and planned to replace it with higher urea application. However, with urea shortage in Dec-21, urea application also fell short of the desired quantum.
  • As such fertilizer dealers expect wheat yield to decline by 10-15%. In Sindh, wheat is trading at PKR 2,700/40kg against the government notified price of PKR 2,200/40kg.
  • Pakistan Market Strategy: Ideal Entry Opportunity

    Published January 18, 2022

    • 5 years of weak KSE-100 performance has magnified the return potential for the next 5 years as earnings have bounced back strongly making valuations highly attractive

    ‒KSE-100 closed CY21 at 44,596 points and yielded 2% for the year in PKR terms. Dec-21 closing for KSE-100 was 5.0% below Dec-16 closing. In USD terms, KSE-100 has yielded a cumulative negative return of -44% between CY17-21 (-11% annualized)

    ‒Long term (5 year) forward returns at PSX are negatively correlated with trailing returns. We, thus, believe that weak KSE-100 performance between CY17-21 has substantially enhanced return potential during the next 5 years.

    ‒KSE-100 earnings virtually stagnated between CY16-19 but have risen sharply during CY20-21. Share prices have yet to reflect this turnaround, making valuations highly attractive. Trailing PE ratio is at 5.0x; 10-year low. Trailing PBV at 1.0x is also at a 10-year low. Our Dec-22 KSE-100 target of 56,200 offers an upside of 26% from Dec-21 closing.

    • PSX has been missing a market mover as FIIs, mutual funds, banks & DFIs have been net sellers

    ‒Since CY15, foreign investors have sold USD2.6bn worth of Pakistan stocks. Mutual funds have sold USD178mn worth of stocks since CY18 whereas banks/DFIs have also sold USD125mn. While Insurance Co.s have been net buyers (USD 474mn) their participation as buyers is concentrated at market bottoms. In this backdrop, bulk of the liquidity since CY18 has been provided by Individuals (USD 784mn) and Corporates (USD 363mn).

    • Return of FIIs post resumption of the IMF program could be the potential liquidity trigger as Pakistan’s valuations are at a steep discount to frontier market peers

    ‒Pakistan offers one of the lowest PE despite higher EPS growth, highest dividend yield, and a unique blend of low PBV & one of the highest ROEs.

    ‒While frontier funds’ aggregate Pakistan allocation stands at 2.2% vs MSCI FM weight of 1.3%, some funds are substantially overweight on Pakistan, while others have zero / negligible allocation. A strong run at PSX post resumption of IMF program may lead frontier funds with no existing Pakistan allocations to become overweight as Pakistan trades at a steep discount to FM peers. This could be a key source of liquidity infusion in CY22.

    • Macro landscape is challenging but likely IMF program resumption in Jan-Feb’22 will lower uncertainty

    ‒GoP’s target of 4.8% GDP growth during FY22 is higher than Pakistan’s ICOR implied growth potential (4.4%) and the external account has already witnessed weakness. During the last two decades; surge in GDP growth beyond ICOR implied GDP growth potential have led to substantial weaknesses in external account; requiring painful adjustments and sharp decline in growth.

    ‒Current Account Deficit will likely rise to 3.8% of GDP in FY22 versus 0.6% in FY21. PKR/USD to move in the range of 172-182 during FY22.

    ‒With FY22 CPI inflation likely to average 10.2%, we expect SBP to further increase policy rate by another 125bps in CY22 to 11.0% by Nov-22.

    ‒Pakistan is tightening its fiscal stance post Covid spending spree. Tax Laws Supplementary Bill and PSDP cuts as per IMF preconditions will partially achieve this with further belt tightening likely in FY23 budget.

    • Sector and stock picks

    ‒OVERWEIGHT in Banks, E&Ps, Cements, OMCs; MARKETWEIGHT in Flat Steel, IPPs, Fertilizer; UNDERWEIGHT in Chemicals.


    Mini Budget FY22: Rationalization of taxes to help contain fiscal slippages

    Published December 31, 2021

    • The government has finally announced the Mini Budget – FY22, after getting SBP autonomy bill approved by the cabinet, paving the way for the resumption of IMF the program. The 6th review will be presented to the IMF Board on 12th Jan-22.
    • The finance Minister Shaukat tarin introduced amendments in the income tax, sales tax and federal excise laws in which the government withdrew PKR 343bn worth exemptions. Though these measures will lead to higher inflation, however, will support in containing imports and resultantly the burgeoning trade and current account deficit.
    • The mini budget will also raise the tax collection, meeting one of the IMF conditions of expanding the tax horizon. During 5MFY22, the government tax collection stood at PKR 2.3tn, up 37% YoY.
    • The current account deficit has already swelled to USD 7.1bn in 5MFY22 and is expected to reach USD 14bn (4% of GDP) during FY22, which we expect to settle around 3.5% of GDP post implementation of the new tax regime.
    • On the expenditure side, the government has hinted to lower its public sector development expenditure by PKR 200bn and hence the net positive impact on fiscal space will be around PKR 543bn.
    • The new taxes are also levied on the undocumented sectors and at the input stage, in order to bring them under tax net.
    • Amongst the listed sectors we view the budget to be negative for Autos and IT & Telecom, neutral to negative for Food & personal care and pharmaceutical, while positive for E&Ps and refinery.

    E&P: Government is finally showing some interest in resolving E&Ps circular debt

    Published December 6, 2021

    E&P: Government is finally showing some interest in resolving E&Ps circular debt

    • Recently, the Advisor to Prime Minister on Finance and Revenue stated that listed state owned E&Ps can reduce their circular debt by declaring large dividends, use the dividend payable to the GoP to offset its receivables and stop charging penal interest on their circular debt stock.
    • This proposal is slightly different from the previous proposals, which would have required an injection / fiscal cost of PKR 117bn based on Sep-21 accounts of the E&P companies.
    • The proposal means that the government is not willing to incur any fiscal cost, local E&Ps would not get any liquidity injection and would in fact have to use their cash balances to pay dividends to private sector shareholders. On the flipside, the listed state-owned E&Ps are more interested in further beefing up their cash reserves, which are up by PKR 62bn since FY18.
    • Any large dividends from E&P companies would be contingent upon either E&P companies setting aside their conservative mindset or the GoP agreeing to incur a fiscal cost through a cash injection. We believe the latter will be a better approach.
    • OGDC’s and PPL’s overdue receivables stood at PKR 589bn as of Sep 30, 2021. For OGDC, an additional PKR 131bn are stuck in quasi GoP TFCs and related accrued markup. This takes the total stock of E&Ps circular debt to PKR 720bn, equivalent to 46% of the total asset base of these companies.

    Universal Network Systems Limited: Benefiting from pandemic-induced consumer shift

    Published November 17, 2021

    Expensive at FY21 numbers, fairly valued at FY22 management guidance

    • Universal Network Systems Limited (UNSL) is offering 6.85mn shares or 25% of post-issue capital to raise PKR 446 mn (USD 2.5mn) through getting listed on GEM (Growth Enterprise Market) board of PSX It is the second listing on the board after Pak Agro Packaging in the small business space. UNSL will be the first fully integrated e-commerce logistics company going for the listing.
    • The offer price is fixed at PKR 65/share, with a premium of PKR 55/share to par value of PKR 10/ share. We believe the company is in a high growth phase with exponential revenue generation in international freight and e-commerce during FY21. We expect the trend to continue post IPO funds utilization which justifies the higher offer price. Our fair value of UNSL comes at PKR 45/share based on FY21 numbers, however, using management’s guidance for FY22 the fair value goes up to PKR 72/ share.
    • Investment Thesis: The stock is attractive based on:
      • Pandemic led new consumer buying pattern,  with more online orders and UNSL being the only technology-enabled logistics company to capture the opportunity.
      • Expansion in all business segments (e-commerce, last-mile delivery, and software solutions) to increase the company’s footprint in Pakistan.
      • Ongoing technology revolution in the country under Pakistan vision 2025 and Digital Policy 2018, which plans to increase ICT market size to USD 20bn by 2025, and e-commerce to USD 10bn.
    • Key risks to investment thesis are;
      • Sponsors under litigation.
      • Increasing fuel prices and company’s inability to pass on cost due to fixed price nature of customer contracts,
      • Slowdown in the economy may lead to loss of business, and
      • Currency devaluation affecting margins of the company due to international payments.

    Economy: What to expect post resumption of the IMF program?

    Published November 11, 2021

    IMF – EFF resumption around the corner

    • The Sixth review of the IMF’ Extended Funding Facility (EFF) is ongoing, and the recent news flow indicates that the government has agreed with the IMF on some fiscal measures including:
        • Increasing power tariff to help contain the circular debt
        • Ending of some of sales tax exemptions to keep the revenue collection target intact for FY22
        • Giving full autonomy to the SBP
    • It appears that the finer details on structural adjustments are still being ironed out (Primarily new draft of SBP autonomy bill). IMF completed combined 2nd through 5th reviews in Feb-21 with disbursement of only USD 500mn due to govt’s failure to meet the quantitative and some of structural benchmarks.
    • The resumption of the IMF program would likely be paralleled by unwinding of the fiscal and monetary stimulus post COVID-19. Amid rising inflation, policy rate is likely to increase in order to achieve positive interest rates. The government will likely have to reverse part of its expansionary fiscal stance and aim for a more sustainable growth plan alongside increased focus on structural reforms, which have been on the backburner since the onset of COVID-19.

    GDP growth rebounded in FY21, but there are question marks on future sustainability

    • FY21 GDP growth of 3.9% was broad based; driven by a combination of low base effect, and Govt stimulus led rise in local consumption. With falling investment during the last two decades, ICOR implied GDP growth potential has fallen by 70bps from 5.1% in 2000s to 4.4% in 2010s.
    • During the last two decades; surge in GDP growth beyond ICOR implied GDP growth potential have led to substantial weaknesses in external account; requiring painful adjustments and sharp decline in growth. GoP’s target of 4.8% GDP growth looks aggressive.

    Current Account Deficit will likely rise to 3.5% of GDP or USD 11.2bn in FY22; a sub 100 REER is likely to persist

    • We expect CAD to rise to 3.5% of GDP in FY22 versus 0.6% in FY21, as imports growth is outpacing exports growth.
    • Imports are likely to grow 30% in FY22, exports are expected to increase by 20% and remittance by 9% YoY.
    • For the SBP to continue to build reserve buffer, the current BoP situation needs to be managed urgently. This would require a sub 100 REER. For FY22, we estimate PKR/USD to depreciate by 7%-13% and expect it to move in the range of 168.2-177.0 assuming a REER of 100-95.

    CPI likely to surpass SBP’s targeted range (7-9%); Policy rate to rise until mildly positive interest rates are achieved

    • We expect FY22 CPI inflation to average 9.3%, surpassing SBP’s targeted range of 7-9% (GoP forecast of 8.2%). There are substantial upside risks from 1) Global commodity price surge, especially food. 2) Domestic demand revival, 3) Weakness in PKR.
    • We believe the era of accommodative monetary policy is behind us. We expect the central bank to undertake cumulative hikes of 225 bps, taking policy rate to 8.5% by May-22 and 9.5% by Nov-22. IMF may require a more aggressive rate hike.

    Fiscal policy is expansionary; needs to be reigned in

    • GoP announced an expansionary FY22 budget with targeted net federal development spending up 36% YoY and subsidies up 59% YoY in FY22. ~44% of budgeted PSDP has already been released in 2MFY22. Continuation of this momentum will likely be inflationary.
    • There are risks to nontax revenue collection target; especially Petroleum Levy (PKR 610bn). 4MFY22 collection is likely to have been 4% of annual target. Nov-21 collection (net of subsidy) would likely be negative.