Central banks in every country always keep a certain level of financial reserves. In most cases, these reserves will consist of foreign fiat currencies, as well as precious metals, such as gold and silver. But the Central Bank of Barbados is looking at whether or not digital currencies should become a part of their reserve holdings portfolio. Due to the utility for international transactions, digital currencies lend themselves perfectly to become part of the portfolio of external assets.
Diversifying Central Bank External Assets
The main goal of central banks maintaining a portfolio of external assets is to make them easily convertible to cash and provide liquidity to engage in international transactions. What makes this type of portfolio so interesting is how the external asset does not have to be tangible per sé, as long as it can be used for liquidity purposes.
A little-known fact is how the demand for international reserves has shifted since the 1997-98 period, which is known as the East Asian Financial crisis. From that point forward, central banks have been hoarding international reserves to provide some form of self-insurance if the country’s economy would go into recession.
In a way, a diversified external asset portfolio provides many opportunities for central banks. Not only can the central bank maintain a certain level of financial stability within its country, but it can directly influence the exchange rate of those reserves. Last but not least, this “reserve accumulation” can provide investment vehicles for the private sector as well.
Fast forward to today and the Caribbean area finds itself in an awkward situation. All of the smaller countries making up the Caribbean region have accumulated more reserves than are deemed “necessary” to provide reserve adequacy. While this region might be more prone to financial shocks, it is becoming increasingly expensive for these countries to hold enough reserves to offset any upcoming financial shocks.
Banks are still involved in the payment processing aspect, and converting international reserves to cash can only occur through these major financial institutions. But there is a new trend in the form of internet-based currencies, who do not require bank intervention to process payments. Bitcoin is the leading digital currency, and due to its fixed supply cap, it provides an appeal to the Central Bank of Barbados.
It would be the first time anyone outside the private individual or business sector explores the possibilities of using Bitcoin to shore up a country’s international reserves. According to an independently produced document by Jeremy Stephen and Winston Moore, the country’s demand for international reserves is mostly driven by the prosperity to import, capital account liberalisation, and real income.
Putting Theory into Numbers We Can All Understand
Adding Bitcoin to the reserve portfolio of the Central Bank of Barbados would serve multiple purposes. On the one hand, the addition of Bitcoin would increase volatility, but it would also provide opportunities to offset exchange rate depreciations against major currencies. Portfolios denominated in traditional currencies follow a straightforward pattern, as they are all linked to the US Dollar regarding purchasing power.
A counterfactual simulation, as outlined in the documents shows how putting 0.01% of the Central bank’s reserves in Bitcoin between November 2010 and April 2015 would have been 20% greater compared to other major currencies.
Assuming the Central Bank of Barbados had put 0.1% of their reserves in Bitcoin during this period, their return balances would have twice the actual amount. A higher portion of the international reserve portfolio converted to Bitcoin would result in exponential balance gains of up to factor 100.
While hindsight should never be used as a measuring stick, a separate forecast has been made regarding the future path of reserves over the next decade. It should come as no surprise that the potential returns are quite impressive. Over the course of ten years, a 0.01% diversification in Bitcoin could yeah a US$223.9m gain by the end of 2025.
It is important to keep in mind that, while these numbers are quite spectacular, there is a large margin of error to take into account. All of these numbers are based on the Bitcoin price trend over the past five years, and there is no guarantee of history repeating itself in this market. But while taking that into account, the numbers paint a scenario that is well worth considering.
Perhaps the most interesting bit of information to take from this document is how the Central Bank of Barbados would not be negatively affected by the diversification in Bitcoin. Up until 2018, the coefficient of variation would be so small, it can almost be neglected. As the portion of Bitcoin holdings increases, volatility will be affected in the long run.
To Diversify, Or Not To Diversify?
Central banks looking to diversify their portfolio of international reserves with Bitcoin and other digital currencies should be careful of overinvesting. Smaller investment amounts- such as the 0.01% model referred to above – falls within the acceptable margin of volatility. With a likely chance of significant returns, it is well worth considering.
In the conclusion segment of the document, it is mentioned how the Central Bank of Barbados should keep its share of international reserves denominated in Bitcoin relatively small for the time being. Increasing that amount will depend on the evolution and adoption of digital currencies in the next ten years.
Note from the Author: This document was originally presented to the Central bank of Barbados in May of 2015.
What are your thoughts on this proposal by the Central Bank of Barbados? Should they diversify part of their portfolio to Bitcoin? Let us know in the comments below!
Source: Central Bank of Barbados
Images courtesy of Shutterstock, Central Bank of Barbados, USA Today