Many people in the 'crypto space' have been celebrating the adoption of Bitcoin as a legal tender by a Central American nation. How has it been going and what obstacles does it face?  

Why El Salvador’s Bitcoin Experiment May End in Disaster
To understand bitcoin’s risk as a currency, let’s look at how it compares against 22 other global currencies

To understand bitcoin’s risk as a currency, let’s look at how it compares against 22 other global currencies

The small Central American country of El Salvador (population 6.5 million) recently became the first country to make bitcoin legal tender. The country now holds 550 bitcoins, currently worth around $25 million. Is this small country — and the world for that matter — ready for bitcoin as an actual medium of exchange? How volatile is bitcoin compared with other currency fluctuations relative to the U.S. dollar? As a follow-up to my earlier blog that described the risk and return of bitcoin, I compare the volatility of bitcoin price changes with that of 22 currencies based on daily data back to 1999, when the Euro was created. Through the lens of five charts, I tell the story of currency fluctuations and how the dollar has performed in the past 22 years, and I compare currency reserves as well — data and charts are available in a downloadable spreadsheet. Bitcoin is about four times riskier than the Brazilian real and about as risky as the Venezuelan bolivar, a country experiencing hyperinflation. El Salvador is embarking on a risky course that may not end well.

Chart 1: Currency Fluctuations

Chart of US dollar vs foreign curre

I gathered data for every currency exchange rate relative to the U.S. dollar that was available through the Federal Reserve Economic Data (FRED) website since January 1999, coinciding with the introduction of the Euro. This chart shows the fluctuation in the exchange rates of 21 countries’ currencies in the past 22 years. Ending values above 1.0 indicate that the foreign currency has depreciated relative to the U.S. dollar. For example, relative to January 1999 exchange rates, in September 2021, it takes 4.3 times more Brazilian reals to buy one U.S. dollar. Any ending value above 1.0 indicates that that currency has depreciated against the U.S. dollar. Whether that is good, bad, or neutral from the perspective of a U.S. investor depends. If they invested in, say, Brazilian stocks unhedged, then they would see currency losses; being fully hedged would have resulted in a neutral position; while a speculator who anticipated the decline in the real relative to the U.S. dollar could have placed bets (for example through derivative products) to capitalize on the decline.

The legend on the right part of the graph lists the currencies in order of the exchange rate changes, starting with Brazil, which weakened the most relative to the U.S. dollar, to Switzerland, which strengthened the most relative to the U.S. dollar. The Hong Kong dollar was essentially pegged to the U.S. dollar (within a very tight band), therefore countries listed above (below) it saw their currencies depreciated (appreciate) relative to the U.S. dollar.

What’s interesting is that half the currencies (excluding Hong Kong) depreciated, and the other half appreciated, indicating that over a reasonably long period of time, there’s usually no reason to expect the U.S. dollar will either appreciate or depreciate relative to most foreign currencies, but we can expect shorter-term movements. It isn’t clear that today we could say the same about bitcoin, which might dramatically appreciate or depreciate in U.S. dollar terms over, say, the next five plus years.

Chart 2: The Case of Venezuela and Hyperinflation

US dollar vs Venezuelan bolivar

This chart shows the performance of the Venezuelan bolivar soberano, newly created on August 20, 2018, after a series of currency devaluations in light of Venezuela’s hyperinflation — recently estimated at an annual rate of over 5,000 percent. The natural result of hyperinflation is the severe deterioration of the currency relative to the U.S. dollar. We see that in this chart which is presented in a log scale — every higher horizontal line represents a tenfold deterioration in the currency relative to the U.S. dollar. Note that the time period is only three years.

In that short period of time, it took more than 68,000 times as many bolivars to buy one U.S. dollar. Put another way, $1 million invested in bolivars in August 2018 would be worth $14.68 today. What’s interesting is that while most currencies fluctuate in a relatively narrow band — almost two-thirds of the currencies changed by about 20 percent or less over the cumulative 21-year period — there can be some outliers. As we’ll see, “outliers” like the bolivar can behave a lot like bitcoin.

Chart 3: 22 Years of Currency Returns and Risk

US dollar vs foreign currency return and risk chart

This chart compares the returns (the annualized foreign exchange changes relative to the U.S. dollar) as well as the volatility or risk (as measured by the annualized standard deviation of daily exchange rate changes relative to the U.S. dollar) of the various currencies. In this context, a positive “return” indicates that the U.S. dollar has strengthen relative to the foreign currency.

What we see is that foreign exchange or currency investments, as an asset class, are relatively low return and risk compared to many other types of investments such as country-specific equity returns and risk. For example, the long-term annual U.S. return is around 10 percent with a standard deviation of returns of around 18 percent. None of the currency returns are close to 10 percent, and only Brazil and South Africa are nearly as risky as, say, the S&P 500 index.

Chart 4: Currency Risk Compared with Bitcoin

currency risk vs US dollar chart

This chart looks at the last seven years (since U.S. regulators approved the first derivative product involving bitcoin) and compares the volatility or risk (as measured by the annualized standard deviation of daily exchange rate changes relative to the U.S. dollar) of the various currencies including the Venezuelan bolivar, as well as bitcoin price changes. What’s striking is how much riskier bitcoin is to all of the other currencies with the exception of the Venezuelan bolivar. Bitcoin is about four times riskier than the Brazilian real, and a similar order of magnitude as the bolivar.

A critique of envisioning bitcoin as a “stable currency” and medium of exchange is that it’s just too volatile, and this chart drives home that point. Unless you have a huge appetite for risk, I don’t think many investors would even consider buying or selling Venezuelan bolivars, and yet there seems to be a huge appetite for investing in bitcoin as well as other cryptocurrencies. While I haven’t looked at the data yet, I’d conjecture that bitcoin is among the least risky of all cryptocurrencies.

Chart 5: Currency Reserves

foreign reserves chart

This final chart gives a sense of the 22 countries’ central bank foreign exchange reserves (excluding gold), including U.S. dollars as well as other major currencies converted into U.S. dollars. According to IMF data, global reserves are about 60 percent U.S dollars, 21 percent Euros, 6 percent Japanese yen, 5 percent pound sterling, and other currencies. China, Japan, and Switzerland each have over $1 trillion in currency reserves.

Let’s take Brazil as an example, with around $350 billion in reserves. Based on volatility since 1999, the standard deviation of returns has been around 17 percent. If we assume currency movements roughly follow a bell-shaped normal distribution, an unfavorable weakening of the currency by one standard deviation or more over a year — which tends to occur about one-third of the time — would deplete reserves by about $350 billion x 0.17 or $60 billion, which might have negative economic consequences including higher inflation.

The El Salvador Bitcoin Experiment

Now let’s do the same type of calculation for El Salvador, which has around $3 billion in reserves. While the country currently has just under 1 percent of reserves in bitcoin, let’s suppose that amount got up to 50 percent, or $1.5 billion. If we use bitcoin’s standard deviation of around 74 percent, that implies there’s a one-in-three chance that reserves would be depleted by $1.5 billion x 0.74 or $1.1 billion, about a third of total reserves. Of course, it’s quite possible that the pendulum might swing the other way, in which case the country would experience a huge windfall. But is El Salvador, or any country for that matter, ready to take on the incredible amount of risk associated with this?

I’m usually reluctant to make predictions, but I don’t have a very good feeling that El Salvador’s bitcoin experiment is going to end well.

Article by Stephen Foerster and originally published at: https://sfoerster-5338.medium.com/why-el-salvadors-bitcoin-experiment-may-end-in-disaster-e5e05f53b1ae

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