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In recent engagements with our investors, the topic that has come up most frequently is fears of higher inflation.

Concerns on inflation are valid. We have essentially had an entire generation of consumers never having had to live through a high-inflation period. Historically, inflation peaked in the early '80s in the US, meaning that a person would have to be in their mid-to-late 40's (at the very least) to even remember it, and more likely in their 60's to have felt the experience of seeing their purchasing power erode at double-digit rates year-over-year. As such, the risk of inflation is top of mind for us as an investment team, and has been since last year.

We think a number of topics around the potential effects of inflation (both near term and long term) on the Fund are worth highlighting, not the least of which is what we as your investment team are doing about it.

Firstly, we distinguish between what could be called 'transitory' inflation (which is affecting near-term sentiment and making news headlines on an almost-daily basis) and potential 'structural' inflation (i.e. where prices go up, and then keep going higher).

If we go back 15 months to when the COVID outbreak began to materially impact economic data, demand for goods and services were artificially depressed, as many consumers were confined to their homes for long periods of time. What we are seeing now is that the reopening of the global economy and the related pent-up demand for goods and services (i.e. the demand-side of the inflation equation) has to an extent overwhelmed the pace at which the supply-side can respond and normalise by producing/delivering a sufficient quantity of goods/services. This demand/supply imbalance has resulted in temporarily higher inflation as there are relatively more people chasing the same (or fewer) amount of goods and services. We expect that as supply chains work through the disconnections (typically it takes several months to ramp up production capacity) and the imbalances normalise, this type of 'demand-pull' inflation will moderate. At present, the combination of 'demand-pull' inflation and a relatively weak comparative base for the period March to July 2020 is pushing up the reported inflation numbers, which is what you are seeing in the headlines on a day-to-day basis.

More of our focus as an investment team is spent on whether or not these temporary inflation trends can become more structural in nature. By way of example, in May, McDonalds in the US announced that they would be increasing the wages of over 36,000 workers by 10% over the next several months. Similarly, Amazon is offering $1000 sign-on bonuses to new employees at starting salaries higher than minimum wage rates (and what would likely have been the going hourly rate otherwise). To us, these are indicators that the labour shortages in the US may manifest in structurally higher wages in time. Given the strong demand levels for goods and services in the near-term, we would expect them to get passed through to the end consumer in higher prices. Essentially, once McDonalds has increased staff wages, we would expect wages to remain at those levels and not to revert lower. The risk here is that this type of wage increase leads to an upwards adjustment in the cost of production/services, leading to cost-push inflation. This dynamic could lead to inflation taking a step-change higher and not be merely 'transitory' in nature (though in time it could be offset by greater automation). As you might suspect, we are watching developments on the wage front closely.

Actions taken in the Fund

Importantly, while the nature of inflation (transitory or structural) and the rate of inflationary increases remain uncertain at present, we have worked to position the Fund to take advantage of this current environment. We have invested in businesses with strong balance sheets and considerable pricing power. By and large, our businesses have utilized the past year to remove costs from their operations without sacrificing the capacity to service their customers. We expect this will translate into sustainably higher margins over the medium term, a point that seems to be ignored by the broader market at present (which seems fixated on the inflation print from now to December 2021). Given the nature of the unique products they sell/services they deliver and their strong market position, our businesses are using the current inflationary environment to not only pass on rising input costs, but in many instances raise prices above inflation. In short, these businesses prefer to operate in the current environment where demand for their goods is strong and they can more easily pass on price increases. We expect this inflationary period to be a tailwind for the businesses in the Fund.

However, business fundamentals are often not reflected in the market (at least, in the short run). Should the inflationary outlook result in central banks globally raising interest rates materially, this will likely negatively impact valuations across all asset classes (equities, bonds & property) as the 'risk-free' rate of return (achieved through owning a government bond or placing money on deposit) will move higher, meaning investors' will reassess how much risk they need to take to generate a specific level of return. Stated more simply, if interest rates are 0% (and inflation remains contained), you'd pay up a lot more for a business that can grow earnings at 15% p.a. for the next five years than if interest rates were 5% and inflation at 4%, (at which point you might well consider having some money on cash deposit). If inflation REALLY takes off, prices might need to come down quite a bit for a period of time. Stocks at the hyper-growth end of the market (think very, very expensive tech names with no demonstrable cash flows) will be disproportionately hurt in such a scenario, which is why we have reduced our overall tech weight since September 2020.

One common theme shared by our businesses is that they are run by management teams who have a demonstrated ability to allocate capital wisely; combined with the fact that they understand how to generate shareholder value (return on capital > cost of capital) the same way we do, they are very sensitive to the acquisition price paid. We believe owning a portfolio of cashed-up businesses with good capital allocators, strong cash flows and little debt is exactly what one would want to do in such a scenario, as it would give CEO's such as Mark Leonard (Constellation), Messrs. Buffet and Munger (Berkshire), the Mendelson family (HEICO), etc. the opportunity to finally deploy their balance sheets in a meaningful way. Seen in this light, we would argue our ability to actively back superior capital allocators places us at an advantage to the major indices (& the ETFs that track them) through such a period, as our businesses have the ability to 'create' value in a shareholder friendly manner (whereas our opinion of the capital allocation skills of the average business in the index is not nearly as benign.)

There is a school of thought that says commodities and commodity producers are a good inflation hedge. This may work for a period of time, but in the long run, doesn't actually hold true. To quote from the 1983 letter to Berkshire Hathaway shareholders (written just as inflation was subsiding):

Any unleveraged business that requires some net tangible assets to operate (and almost all do) is hurt by inflation. Businesses needing little in the way of tangible assets simply are hurt the least.

And that fact, of course, has been hard for many people to grasp. For years the traditional wisdom - long on tradition, short on wisdom - held that inflation protection was best provided by businesses laden with natural resources, plants and machinery, or other tangible assets ("In Goods We Trust"). It doesn't work that way. Asset-heavy businesses generally earn low rates of return - rates that often barely provide enough capital to fund the inflationary needs of the existing business, with nothing left over for real growth, for distribution to owners, or for acquisition of new businesses.

In contrast, a disproportionate number of the great business fortunes built up during the inflationary years arose from ownership of operations that combined intangibles of lasting value with relatively minor requirements for tangible assets. In such cases earnings have bounded upward in nominal dollars, and these dollars have been largely available for the acquisition of additional businesses. This phenomenon has been particularly evident in the communications business. That business has required little in the way of tangible investment - yet its franchises have endured. During inflation, Goodwill [intangibles] is the gift that keeps giving.

The whole piece written by Mr. Buffett on the type of business to own during periods of inflation is worth reading, though it is quite lengthy. (Those readers who are interested can find it here: https://www.berkshirehathaway.com/letters/1983.html - simply search for the phrase 'Goodwill and its Amortization: The Rules and The Realities' to skip to the relevant part.)

We are grateful for the interactions we have and feedback we receive from our investors. We view ourselves as a long-term partner rather than simply a fund manager, and would encourage any investor (or prospective investor) to reach out to us with any questions. As an investment team, we are committed to responding personally (and promptly) to these kinds of queries.

While the uncertainties around inflation in the near term persist, we believe the Fund is well positioned to capitalise on a range of outcomes that may unfold in future.

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CoreLogic has just reported that national dwelling prices rose by 2.3 per cent in May. That's an annualised rate of more than 28 per cent. And with lenders continuing to provide cheap and easy access to credit, and investors showing lots of interest, I don't see the property market cooling off any time soon.

Here at Montgomery, we've always kept a close eye on the property market. By now you should know we believe access to credit ultimately determines short and medium-term property prices. On that front lending data has been strong for some time and housing credit has accelerated. Unsurprisingly, as we have previously predicted, house prices have risen.

Other factors can have a 'micro-economic' effect on prices through the behaviour of buyers and sellers each weekend, but ultimately the meaningful changes in property prices are driven by credit, and immigration in the longer-term.

The Commonwealth Bank of Australia (ASX:CBA) has just published property lending data, which helps paint a picture of the state of the current property market.

According to the CBA economics team, new housing-related lending rose by 3.7 per cent in April to a new record high (excluding re-financing), while lending to owner-occupiers surged by 4.3 per cent and lending to investors was up by 2.1 per cent. Thank ultra-low rates for that.

Interestingly, lending to first home buyers has fallen for three consecutive months and the CBA believes this reflects declining affordability.

Clearly, the Australian property market is booming and the latest lending data suggests there are ample people looking for property with cheque books approved. That will continue to keep property prices supported.

The CBA notes the lending mix, is shifting. First home buyers are declining while investor buying is strong and lending to owner-occupiers excluding first homebuyers rose by 7.0 per cent.

According to the CBA, housing finance data is a strong leading indicator for dwelling prices.  Mind you, the relationship weakened during COVID when the CBA forecast significant house price declines that never eventuated.

Now prices are rising to record levels, houses are selling faster than ever and the proportion of homes exceeding asking prices is also at a record. It's all thanks to cheap, abundant and easy access to credit. The rate of price increases is quite spectacular. CoreLogic has just reported national dwelling prices rose by 2.3 per cent in May. That's an annualised rate of more than 28 per cent.

Despite the surging property prices, or perhaps because prices are rising so fast, owners are reluctant to sell, resulting in listings remaining stubbornly low. According to CoreLogic again, in the three months to May there were approximately 164,000 dwelling transactions Australia-wide. During the same period however only 136,000 new properties were put up for sale. It seems potential sellers fear missing out on further price rises or being locked out altogether. Consequently, the lack of stock, itself a function of rising prices, is fuelling further price rises.

For what it's worth, the termination of the RBA's Term Funding Facility at the end of June should mean bank borrowing costs for three and four year fixed rate mortgages will rise, and so will rates on those loans. That could dampen demand for loans and if it does could slow the rate of price increases for properties, particularly for owner occupiers.

If investor loans and properties continue to accelerate at the expense of first home buyers, it might be possible some macro-prudential measures by APRA could be implemented. This would serve only to slow the pace of property price rises because interest rates remain ultra-low relative to history and employment, wages and economic data continues to improve. While aggregate wages might not be rising, you only need a bunch of IT or digital recruits to switch jobs for a reported 10-15 per cent wage increase to impact what happens at this weekend's auctions and ultimately impact property prices for everyone else.

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In 2019, which seems like 100 years ago, the cruise industry was booming with bookings and pricing both at record levels. 2020 was set up to be a phenomenal year. What could go wrong?

With the onset of Covid the world changed drastically, and the travel sector in particular continues to experience significant difficulties. The cruise lines found themselves right in the eye of the storm with the Ruby Princess in Sydney and the Diamond Princess in Japan making headlines for all the wrong reasons. For approximately 15 months now and counting, ships have been sitting idle and the operators burning through cash. In order to stay afloat literally and figuratively they have been forced to raise significant amounts of capital - both equity and debt.

Moving forward to today, global travel is slowly resuming and more specifically we are seeing an enormous amount of pent up demand for leisure travel. Consumers want to go on holidays and they love to cruise. Using Norwegian Cruise Lines as an example, their booked position for 1H 2022 is meaningfully ahead of 2019 which was a record year and at higher prices. Recently launched new ship Norwegian Prima, with voyages scheduled to begin in August 2022, set a company record for the single best booking day and best initial booking week. It warrants emphasising that this is all being achieved with almost no spending on marketing, further demonstrating the strong demand for cruise travel.

The revenue economics for the major cruise lines are quite straightforward. Prior to covid all ships sail at close to 110% occupancy. The only variable is price as the opportunity cost of an empty cabin is significant. The business model is to get the passengers on board then upsell them with things like shore excursions, dining upgrades, internet, casino, drink packages, etc. Revenue is split roughly 2/3rd ticket price, 1/3rd on-board spending. For this reason, Norwegian is strongly advocating for cruises to be fully vaccinated so that they can firstly fill the ship and secondly the onboard experience will be as close to 'normal' as possible.

In the very short term, the US Centre for Disease controls (CDC), which has been making life hard for the cruise industry by imposing excessively onerous conditions to the extent where Norwegian CEO Frank Del Rio accused them of being and I quote "un-American". His source of frustration is the different rules for every other transportation, entertainment and hospitality venue which are all open to varying degrees. However, in the last few weeks, the CDC has started to ease, providing cruise operators with greater confidence that they will be able to meet their return to sailing timelines.

As any army general will tell you, it is easy to start a war but difficult to end it. This is very similar to the cruise ships and Covid where we have been through lock down and now the path out remains a little foggy. While we don't expect smooth sailing from day 1, for investors that are prepared to take a more medium-term view, we know that cruising will resume in full force and we know that demand is there in abundance.

Keep Calm and Cruise On.

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Twelve months ago we wrote our second note on Mineral Resources (ASX: MIN) titled "Can Mineral Resources be a $40 stock?". Within seven months our question was answered with an emphatic yes. Like all good sequels that enjoyed debatable success, we thought why not go a trilogy? We realise we may sound a bit like a broken record suggesting parts of the company remain underappreciated but hopefully some of the areas highlighted in this note make it less pointless than the Karate Kid III movie.

As a recap, from our last note we felt the market was: underappreciating the quality and growth potential of Mining Services; behind the curve on iron ore projects; and mispricing lithium optionality. Ultimately some of this boiled down to being under-covered, which appears to no longer be the case with increased broker coverage. This probably brings with it reduced ability for unique insight but we still see a couple of interesting parts of the business that present meaningful upside to market (sell-side) valuations and the share price, including:

• The minimal value attributed by the market for the Southwest Creek project
• The limited value attributed by the market for Ashburton
• The FMG implied iron ore price well above that used by us and the market to value MIN (with the exception of one analyst)
• International deals for NextGen crushers present as meaningful upside
• Mixed approaches by the market in valuing Wodgina and Mt Marion hydroxide optionality
• Energy blue sky

Our updated valuation is presented below with more detail following.

Source: Chester Asset Management

 

Lithium

12 months ago, we summarised the lithium market in FY20 as follows: "lower prices, operational issues, curtailments/mothballing, value destruction and bankruptcies". With hydroxide prices now ~USD15,000/t CFR into North Asia and 6% spodumene (SC6) ~USD700/t, share prices up multiples in 12 months, lithium contracts being agreed and consolidation taking place, the tables have certainly turned.

Obviously, prices are now up but we ask ourselves has spodumene become more attractive? Since the days of Standard Oil markets have been debating the appropriate economic split between upstream and downstream operations. It is not an easy question, and like many in markets can be answered by supply and demand fundamentals. When lithium markets were oversupplied spodumene was bid down to marginal cost of production (lower in some cases as entities like Alita/Tawana and Altura went into administration) however 2021 has seen the market tightening and prices reflecting that. Furthermore, with upstream producers expressing an increased desire to vertically integrate the spodumene left over for the hydroxide refineries is limited, so the margin available to upstream producers potentially increases. Companies like Pilbara Minerals (PLS) are even going a step further: by creating an exchange to sell spodumene into and investigating a midstream product with Calix (CLX).

Source: Pilbara Minerals Corporate Presentation, May 2021

Hence we see a natural progression for downstream players, facing potential spodumene shortfalls to also seek increased integration via JV tie-ups/ acquisitions. Given the political climate it seems likely FIRB would stymie attempts to acquire Australian operators by certain players and see greater integration between African upstream (hardrock) entities and China downstream players to avoid these players ending up like the HBO show Ballers (1). As we commenced writing this note, supportive of our thesis, it was announced Gangfeng would pay Firefinch (FFX) USD130m for a 50% stake in the Goulamina mine in Mali.

This preamble is a long-winded way of saying anyone with uncommitted spodumene should receive a greater share of value for it. Before the market got tight MIN was already planning for this and recent announcements have reinforced a desire to convert all spodumene to hydroxide within their own supply chains.

Mt Marion

Mt Marion continues to perform strongly with a steady run rate of ~450ktpa, recoveries (>85%) and costs (~USD350/t CFR) best in class. Although we don't have updated reserves/ resources on the project MIN point to the project having a 20+ year mine life. We now value MIN 50% stake in Mt Marion at ~AUD560m assuming an ~20 year mine life, providing MIN steady state EBITDA of AUD90m p.a. (ex Mining Services) (2).

Wodgina

In relation to Wodgina planning is currently underway to restart the mine after it was placed on care and maintenance in November 2019 following construction. Given greater scale, lower strip ratio, higher grade and more favourable cost structure, potential exists for Wodgina to have a far superior cost structure to Mt Marion, albeit we await clarity on what this may look like.

MIN had previously suggested a cost of USD296/dmt at 65% recovery for 750ktpa of SC6 but given the learnings from Mt Marion (and other operators) we see potential for production at a higher rate and lower product spec (5.5-5.8%) at improved recovery and cost.

We now value MIN 40% stake in Wodgina at ~AUD1,060m assuming a ~30 year mine life, providing MIN steady state EBITDA of AUD150m p.a. (ex Mining Services) (2).

Lithium Hydroxide - International Opportunity

We reiterate our view that Kemerton will likely be fed by Greenbushes and MIN's owns 40% even if it's not fed by Wodgina. Furthermore, Kemerton being fed by Greenbushes does not alter MIN's ultimate ambition of converting all of their spodumene (both Wodgina and Mt Marion) to hydroxide. Given quoted costs in China for downstream(3) vs more than double that in WA it is likely we see JVs established in China as the likely location of hydroxide refineries. We have provided an updated summary of our lithium hydroxide valuations below.

Source: Chester Asset Management (with reference to various announcements around lithium hydroxide plants)

 

Iron Ore

At the time of our last note iron ore (62% dmt CFR fines) was trading at ~USD105/t and Fortescue (FMG) at AUD14.00/share. We admitted 12 months ago we weren't predicting >USD150/t and still expect at some stage prices will roll over but MIN has certainly benefited from that strength. Due to our complete inability to predict the iron ore price we continue to use our FMG model to interpret a long term (LT) iron ore price implied by the market with FMG at AUD22.00/share. We continue to acknowledge this as an imprecise science but for us remains a useful exercise. Notably we now acknowledge that previously we had only modelled reserves but appreciate that higher iron ore prices would see resources convert to reserves. Hence we've added an additional scenario showing the implied iron ore price from 100% resource conversion.

The outcome of this is we continue to use consensus USD66/t (real) LT as our assumed base case 62% Fe price (after 3 years using ~consensus) but flex this to USD80/t LT as an upside scenario.

MIN notably at their most recent AGM announced a strategy around the four hubs of: Utah Point, Yilgarn, Ashburton and Southwest Creek. We provide an update on each of these below.

Utah Point

Currently MIN are exporting Iron Valley tonnes from Utah Point but in addition will export Wonmunna, Lamb's Creek and Wedge Iron Ore through the port. MIN is currently developing a 10 year, 14Mtpa mine plan for the hub (within 12 months). Iron Valley and Wonmunna will form the base of production. Wonmunna was notably acquired (Q1 FY2021), developed and commenced production (March 2021) in the space of 6 months, showing all of the benefits of Next Gen Crushing plants referred to in this document. The all in cost of acquisition and development for 5Mtpa of capacity was quoted at AUD126m with output potential of 10Mtpa for "little additional capital cost".

Yilgarn

The Yilgarn hub consists of infrastructure at Carina and Koolyanobbing. MIN is currently in the process of finalising a 10 year mine plan that includes Koolyanobbing, Parker Range and Mt Richardson. Planned capacity for the hub is 13Mtpa.

Valuations of Existing Operations

Source: Chester Asset Management, Mineral Resources Announcements

Ashburton

The latest with regards to the Ashburton iron ore project is that it is anticipated to be construction ready in August 2021 with a 2 year development (so first production 2H CY23). The project hub has been earmarked as 25-30Mtpa. The key sources of supply for Ashburton are Bungaroo South and Kumina.

Notably, recently a subsidiary of MIN has also bought a 15% stake in Aquila resources that has a 50% stake in the Australian Premium Iron JV. I.e., MIN now has effectively 7.5% of the API project. Baowu owns 42.5% while US company AMCI and South Korea's POSCO each own 25% of API. The key project of the JV is the 40Mtpa West Pilbara Iron Ore project. It was reported MIN paid AUD10m for the stake which also gives them exposure to Eagle Downs Coking coal project in QLD and Manganese assets in South Africa. We watch with interest how this asset may play into the strategies around Ashburton and Southwest Creek.

Southwest Creek (SWC)

In our previous note we provided a model for a 20Mtpa Marillana operation. Since then, MIN announced the desire for the business to be a 40-50 Mtpa operations consolidating more than just Marillana but also Ophthalmia and other stranded deposits. MIN has also announced that farm in agreements under the JV with Brockman had been satisfied and the JV had been amended(4) to include the Ophthalmia Project. Hence at least half of the SWC is proposed to come from Marillana/Ophthalmia.

MIN are still competing for berth rights (3 and 4) at Southwest Creek which are reserved for emerging / junior iron ore miners. Although there is no guarantees around access there are certainly other options if they aren't successful in securing rights. Hence we are surprised to see little value reflected in analyst valuations for the project.

Valuations of Growth Projects

Our valuations for Ashburton and SWC are summarised below. Notably capex is a key area of uncertainty however we have provided analogues below to drive our assumed capex figures.

Source: Chester Asset Management with input from BHP, RIO and MIN announcements

 

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• Central bank digital currencies (CBDCs) are already operating in the Bahamas and being trialled in China. They will be introduced by many countries over the next five years.
• CBDCs enjoy the crucial advantage of total security, because a central bank can't go broke. But, in order to achieve broad acceptance, CBDCs also need to be cheaper or faster or more efficient or more private or more convenient than the alternatives.
• CBDCs differ from other cashless payment instruments such as credit transfers, direct debit, stablecoins, or cryptocurrencies, because they are "government money", being direct liabilities of the central banks. Issuing this "extra currency" involves costs, but CBDCs also allow central banks to see real-time transactions, create audit trails, monitor criminal activities, and prevent money laundering.
• Although an Australian CBDC is unlikely in the near future, the technology is evolving rapidly, and may have important effects on the global financial system.

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INTRODUCTION

We've all heard of digital currencies like Bitcoin, Dogecoin, and other cryptocurrencies. What most people haven't noticed is that the world's central banks are planning to issue their own digital currencies. In fact, China has already been trialling digital renminbi on its unsuspecting citizens. What will central bank digital currencies (CBDCs) mean for banks, payment systems, and national economies?

CBDCs differ from other cashless payment instruments such as credit transfers, direct debit, stablecoins, or cryptocurrencies, because they are "government money", being direct liabilities of the central banks. Issuing this "extra currency" involves costs, but CBDCs also allow central banks to see real-time transactions, create audit trails, monitor criminal activities, and prevent money laundering.

Central banks had been quietly pondering CBDCs for several years, but most of them kept their ideas under wraps for fear of confusing their political masters. The world's parliaments are largely composed of middle-aged white men who know less about online phenomena than their teenage kids do. Until two years ago, talking about CBDCs would simply confuse the politicians.

The turning point came in June 2019 when Facebook unveiled its plan for a global digital currency called "Libra" (as in the tampon). Libra was to be a blockchain-based currency operating under Swiss regulation, which could be used in any country and also for money transfers between countries. In order to avoid the wild fluctuations in value which we have seen in Bitcoin and other crypto-currencies, Libra was to be a "stablecoin", which meant that its value was to be based on a fund of actual currencies and US government bonds.

Unfortunately or not, Facebook completely screwed up the launch of Libra. Management was not prepared for the regulatory requirements, even for such basic issues as talking to the Swiss regulator (that speaks 4 languages, in addition to English), incorporating privacy protections, and complying with anti-money-laundering rules.

More importantly, the company was totally deluded about its reputation in the eyes of US politicians and the US public. Questioning by US congressmen was mostly very hostile, making it abundantly clear that Facebook was neither liked nor trusted. No, really. Politicians in other countries expressed similar criticisms of Libra and Facebook. In response, the company announced in September 2019 that it would not launch Libra anywhere in the world until it had gained approval from US regulators.

This public relations disaster saw the departure of some of Facebook's key partners, extensive re-design of Libra (including basing it on the US dollar alone), the renaming of Libra as "Diem", and the indefinite deferral of any launch.

For central banks, however, it now became possible - even desirable! - for them to talk about their plans for digital currencies. A new sense of urgency also came from the Chinese central bank's announcement in October 2019 that it had been developing a digital renminbi since 2014, and would start public trials in April 2020.

 

TRIALLING CHINA'S DIGITAL RENMINBI

China's central bank has not yet finalized the design of its digital renminbi, which is also known as the e-CNY (for electronic Chinese yuan) or DCEP (for Digital Currency and Electronic Payment).

DCEP is intended to simplify retail and wholesale digital transactions and inter-bank settlements, with the added aim of reducing money laundering, gambling, corruption, and terrorism financing. The DCEP technology will allow users to transfer money by touching each other's phones, regardless of whether they are connected to the internet. But the DCEP will operate entirely through the banking system - Chinese individuals and companies will not have accounts at the central bank.

DCEP will certainly not undermine the Chinese banking system. The four biggest banks, with about 40% market share, are not only State-owned but also play essential roles in the Chinese government's fiscal and monetary policy mechanisms. DCEP will employ encryption which will allow users to carry out transactions without identifying themselves to merchants. The Chinese authorities may also choose to pay some salaries or benefits in DCEP, and they may require some taxes to be paid in DCEP.

According to the central bank, DCEP is not intended to replace cash completely, or to supersede the two privately-owned digital payments systems, Alipay and WeChat Pay, which are used by more than 90% of China's population. The two systems are operated by the tech giants Alibaba and Tencent respectively. These systems are able to collect detailed data on all users and their transactions, then to analyse this data in order to market other products to them.

Although the central bank has said that DCEP will not replace Alipay and WeChatPay, the owners of these two payment systems know very well that they are being targeted. China's financial regulators have spent the last three years bringing both payments systems very firmly under government control in terms of settling, reporting, and reserving.

In 2021 the regulators forced the parent companies to become fully regulated financial holding companies, which meant that they had to clean up their activities, and also to divest a number of lucrative peripheral businesses which they had started in recent years. In addition, Alibaba and Tencent have "given" DCEP access to the details of their hundreds of millions of users. China's tech giants will do exactly what the Party tells them to do, and they WILL do so with visible enthusiasm (cue the enthusiasm, please).

The Chinese central bank will be able to see and record all account balances and all transactions for every DCEP unit, and the resulting economy-wide picture will give it a fine-grained, real-time view of macro and micro trends. It will, however, apply the principle of "controllable anonymity" to sharing this information. Participating banks and merchants will only be able to see transactions in which they are involved, and they will not be permitted to retain their part of the transaction data for any longer than needed.

The DCEP will eventually be used for cross-border payments, once all the kinks have been ironed out of its domestic operations. For example, it is not yet clear how overseas DCEP users could make purchases in China, or what DCEP access would be given to foreigners visiting China. (See Chorzempa 2021.) But China's central bankers have been at pains to stress that, although DCEP may eventually facilitate the internationalization of the renminbi, it is not intended to compete with the US dollar as a means of international transactions or a global reserve currency. These functions depend on long-term factors such as capital export controls, trade volumes, available swap lines, user preferences, and relative volatility, which are mostly outside government control. (See Zhou 2021.)

 

THE FIRST CBDC IS ALREADY UP AND RUNNING

The Bahamas launched its Sand Dollar on 20 October 2020 after ten months of trials. The new digital currency is not a stablecoin or a cryptocurrency. It is issued as a liability of the Central Bank of the Bahamas, equivalent to the existing paper currency and backed by the same reserves as the paper currency. It is open to wholesale and retail use by all banks, merchants, and payments providers operating in the Bahamas, although prohibited from acceptance by non-domestic payees.

The transactions trail is fully auditable and will be monitored for fraud prevention and criminal activities, but user confidentiality will be preserved by strict regulatory standards. Holdings of Sand Dollars by individuals, businesses, and non-supervised financial institutions are subject to size restrictions, so that the Sand Dollar does not operate as a close substitute for traditional bank deposits. Circuit breakers will be used to prevent systemic failures or bank runs. (See Central Bank of the Bahamas 2019.)

The Bahamas is over-endowed with banks, but most of them do not cater to the local population of 389,000, who are scattered across more than 700 islands. GDP per head is USD$27,000 (about half of Australia's), with a sharp division between rich and poor. The Sand Dollar is intended to:

• Encourage financial inclusion, with a minimum of basic deposit and checking facilities for individuals and point-of-sale terminals for businesses
• Reduce the fees which payments providers charge merchants
• Support offline functionality
• Improve delivery of government services, such as pensions
• Improve financial literacy
• Prevent money laundering and tax evasion
• Be usable on digital wallets and mobile phone apps
• Provide real-time monitoring of banks' transactions and liquidity.

The Sand Dollar could be described as cash without the anonymity. Its use is also subject to some restrictions which are intended to reduce systemic risk and protect financial stability. Its economic function is similar to the effect which the spread of mobile phones had in many under-developed countries, where they improved national connectivity quickly and cheaply by skipping the traditional step of building a landline network.

 

POLICY CONSIDERATIONS

For the next few years, CBDCs will be in the design and testing stage. Their parent central banks know that they enjoy the crucial advantage of total security, because a central bank can't go broke, whereas any privately-owned bank may default at any time. (Remember how the GFC took down Lehman, Bear Stearns, Wachovia, ABN Amro, Royal Bank of Scotland, Northern Rock, and many more banks?). But, in order to achieve broad acceptance, CBDCs also need to be cheaper or faster or more efficient or more private or more convenient than the alternatives. (See Brainard 2020.)

CBDCs also bring new risks for financial stability. For example, they may be so attractive that they begin to replace bank deposits, thereby depriving banks of a vital source of funds. They may crowd out cash in retail transactions, and thereby limit the choices of the poor, rural, and elderly, as has been happening in China. Because CBDCs can be moved from account to account almost instantaneously, they could trigger a run on a bank, or even a run on the currency. Thanks to Facebook's PR disaster, many governments are now legitimately worried that their money supply and payments system - as well as their citizens' personal data - may one day fall under the control of some foreign technology company. (See Panetta 2021.)

Two weeks ago, Fed Governor Lael Brainard set out some of the major policy considerations which need to be taken into account when designing a CBDC:

• Preserve general access to safe central bank money
• Improve efficiencies in payments, clearing, and settlements
• Lower transaction costs
• Promote competition and diversity
• Reduce cross-border frictions
• Complement (rather than replace) existing currency and bank deposits
• Preserve financial stability and monetary policy transmission
• Protect privacy and safeguard financial integrity
• Increase financial inclusion.

No matter how a CBDC is designed, it will have to be written into a country's legislation regarding the central bank, legal tender, and the banking system. This task will be neither quick nor easy.

What regulators will not do is to give legal tender status to unregulated stablecoins or crypto-currencies, because if these become legal tender, they may be hoarded or suddenly transferred, which would make it possible for financial stability risk to be concentrated in issuers or holders whose operations, cash flows, and balance sheets are not visible to the authorities. That means the regulators might have to deal with "a run on the bank" when it didn't even know there was a bank, let alone that it was in trouble. (See Brainard 2021.)

 

DESIGN FEATURES OF CBDCS

China's DCEP and the Bahamas' Sand Dollar are not the only ways to run a CBDC. For example, both are designed as an account-based, centralized ledger with total visibility for the purpose of preventing money-laundering and other crimes. A CBDC could also be designed as a token-based, anonymous transaction tool, offering the same level of privacy as cash. (See Bache 2021.) To Chinese policymakers, a CBDC is a means of resisting the dominance of the two tech giants Alibaba and Tencent in the payments system.

CBDCs may be retail (for everyone) or wholesale (big users only). A retail CBDC may operate through the banking system, like China's, or it may interface directly with consumers and companies, allowing them to own accounts at the central bank. A wholesale CBDC would be restricted to wholesale users (such as banks) who will use them for inter-bank transfers of large sums, or for their reserve accounts at the central bank. (See Estenssoro 2021.)

A CBDC may be subject to complete centralized control, like China's, or it may be run as a distributed ledger ("blockchain"), perhaps with partial oversight and selective permissioning in order to restrict its use for illegal activities. No central bank is likely to issue a CBDC which is purely based on a distributed ledger (blockchain), because this would lack the essential functions of transparency and control.

Would a CBDC pay interest to its holders? Of course, cash does not pay interest, but there may be reasons why a retail CBDC would do so. A CBDC which paid negative interest (i.e. its value decreased the longer it was owned) would contain a powerful incentive to be spent sooner rather than later. For a wholesale CBDC, however, the issuing central bank might pay variable rates of interest when it wished to incentivize banks to hold CBDC deposits or reserves rather in alternative forms.

It is unlikely that CBDCs will be used for cross-border transactions in the near future, because of the legal and administrative difficulties. Any cross-border CBDC would have to meet the regulatory obligations of every jurisdiction where it was used. Because these obligations can differ widely from country to country, the regulatory burden would be considerable. The same goes for the administrative requirements of each country's payment systems. Any cross-border CBDC would have to interface perfectly with payment systems on both sides.

There are two forms of cross-border CBDC which might be adopted relatively early. The first is a CBDC which was restricted to central banks only: it might be adopted by a small group of countries, with its acceptance widening over time. The second is what Facebook still hopes to do with Libra/Diem: a CBDC which handles small-value international transfers such as the remittances of migrant workers. Such a CBDC would need regulatory approval of the sending and receiving countries, but it could be hedged around with restrictions to prevent domestic use, money laundering, and criminal activities. This "remittance CBDC" would fill a market gap, because current global payments systems charge 5% to 7% commission on small remittances.

 

HOW FAR BEHIND ARE OTHER CENTRAL BANKS?

At present, more than fifty central banks are researching the costs and benefits associated with issuing their own CBDCs. (See Boar and Wehrli 2021.) Few of them have made their research public, but the European Central Bank (ECB) set out its ideas in detail last year. (See ECB 2020.) The ECB described seven scenarios under which a digital Euro (e-euro) would be worth creating:

• enhanced digital efficiency in the monetary and payments system
• a decline in the role of cash as a means of payment, which adversely affected vulnerable groups
• providing leading-edge functionality to compete with other currencies or other payments systems
• a tool to improve the transmission of monetary policy
• a backup system to cope with cyberattacks or natural disasters
• to improve access to the euro outside the euro zone
• reducing the cost of the payments system, or to be more environmentally friendly.

The ECB's retail euro would be legal tender, operating through banks and other authorised intermediaries. Protecting privacy would be important, subject to the trade-off against identifying money laundering, tax evasion, and other criminal activities. The amounts which individuals and businesses could hold in their accounts would be limited in size. Initially at least, the e-euro would be restricted to EU residents, with the possibility of short-term exemptions and later expansion.

The ECB does leave open the possibility of allowing "bearer e-euros" which would not require the usual identification by users. It also considers the possibility of issuing two types of e-euro: one would be used for basic transactions, offline as well as online, while the other would function as a policy instrument carrying a variable (and potentially negative) interest rate.

 

WHAT WILL HAPPEN WHEN THE RESERVE BANK OF AUSTRALIA CREATES ITS OWN CBDC?

Last year the Reserve Bank of Australia ("RBA") published a short paper outlining the issues associated with a CBDC. (See Richards 2020 and Richards et al. 2020.) The paper concluded that CBDCs were a solution for problems that did not exist in Australia. We already have financial inclusivity, in that almost all Australians have transaction accounts and the means to execute online transactions via mobile phones, credit cards, etc. The current payments system is efficient, relatively cheap, and open to new players. The other policy considerations listed by The US Federal Reserve's Governor Brainard are not material issues in Australia. So Australia's big four banks need not worry about CBDCs in the next few years.

The RBA indicated that it would continue to monitor developments in the global CBDC space, and that it would not hesitate to introduce a CBDC if there were compelling reasons. The RBA paper did discuss some of the design choices for an Australian CBDC. Preliminary indications are:

• A retail CBDC with a "very significant" role for the private sector
• Account-based, token-based, or a hybrid?
• Capable of handling payments in person, online, and offline
• Probably not using a blockchain platform
• Privacy, but not as anonymous as cash
• Restrictions on holdings, for reasons of financial stability
• Unlikely to pay interest.

 

CONCLUSION

The digitization of money has only just begun. It will take at least five years before we will have realistic assessments of what works and what doesn't. The design choices which central banks make in their digital currencies will eventually affect all the players in the financial system. Arminius Capital will provide regular updates on significant developments.

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REFERENCES

Bache, Ida Wolden. 2021. Fintech, Big Tech, and Cryptos - will new technology render banks obsolete? Oslo: Norges Bank. Speech 11 May 2021.

Boar, Condruta and Wehrli, Andreas. 2021. Ready, steady, go? - Results of the third BIS survey on central bank digital currency. Basel: Bank for International Settlements. BIS Paper 114.

Brainard, Lael. 2021. Private Money and Central Bank Money as Payments Go Digital: an Update on CBDCs. Washington DC: US Federal Reserve. Speech 24 May 2021.

Brainard, Lael. 2020. The Digitalization of Payments and Currency: Some Issues for Consideration. Washington DC: US Federal Reserve. Speech 05 Feb 2020.

Brunnermeier, Markus K., James, Harold, and Landau, Jean-Pierre. 2021. The Digitalization of Money. Basel: Bank for International Settlements. BIS Working Paper 941.

Central Bank of the Bahamas. 2019. Project Sand Dollar: A Bahamas Payments System Modernization Initiative. Nassau: Central Bank of the Bahamas.

Chorzempa, Martin. 2021. Testimony to US-China Economic and Security Review Commission. Panel 4: China's Pursuit of Leadership in Digital Currency. Washington DC: Peter G. Peterson Institute of International Economics.

Estenssoro, Amalia. 2021. Central Bank Digital Currencies: Back to the Future. St Louis: Federal Reserve Bank of St Louis.

European Central Bank. 2020. Report on a Digital Euro. Frankfurt: European Central Bank.

Panetta, Fabio. 2021. Evolution or revolution: the impact of a digital Euro on the financial system. Frankfurt: European Central Bank. Speech 10 February 2021.

Richards, Tony. 2020. Retail Central Bank Digital Currency: Design Considerations, Rationales, and Implications. Sydney: Reserve Bank of Australia. Speech 14 October 2020.

Richards, Tony, et al. 2020. "Retail Central Bank Digital Currency: Design Considerations, Rationales, and Implications." Reserve Bank Bulletin, September 2020. Sydney: Reserve Bank of Australia.

Zhou, Xiaochuan. 2021. The Digital Currency and Electronic Payment System. Beijing: Tsinghua PBSCF Global Finance Forum. Speech 22 May 2021.