Gallery: 10 Questions to Challenge Your Money Smarts

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"Bitcoins" either sound like a futuristic, implantable, laser-guided and rocket-pack equipped form of money, or the latest coin-shaped chocolate snack. In reality, it's probably a bit of both. The bitcoin, a digital currency, started the year worth about $15. Less than four months later, one bitcoin now trades above $70. While this past performance may be enticing and a sign of its legitimacy as a future currency, the bitcoin market is full of risks -- risks that may make bitcoins worth as much as a foil-wrapped piece of sugar.

Bitcoin: A Crypto-Currency

Bitcoin is based around the idea of a currency created and transacted through cryptography instead of issued and tracked through a central bank. And to add to its mystique, the creator of bitcoin only goes by a pseudonym and has never been positively identified.

Instead of any legal authority, bitcoin transactions are verified through peer-to-peer interactions. If a user sends bitcoins to another user's "wallet" file, that transaction is verified through other users, and is written into the collective transaction log. And given the ease of transactions, any fees for transfers are minimal.

Instead of a mint, bitcoins are created through a process called "mining," where computers attempt to solve for a certain number, and once found, are rewarded with new bitcoins. The rewards decrease with time, however, and there will only ever be about 21 million bitcoins created, three-quarters of which by 2016, and all by 2140.

Even if you don't understand any of the above, the recent jump in valuation probably still has your interest. But there are plenty of reasons to continue to educate yourself before attempting to trade in bitcoins.

• In 2011, the third-largest trading site, Bitomat, lost its wallet file, which held 17,000 bitcoins worth more than $200,000 at the time.
• In the same year, the exchange MyBitcoin lost 51% of its users' deposits, amounting to 78,000 bitcoins worth over $1 million at the time.
• In 2012, Bitcoinica was hacked and lost $220,000 worth of customer funds. Two months later, it was hacked again and lost another $90,000. As Bitcoinica attempted to repay claims, the company was hacked a final time for another loss of $320,000.
• In the fall of 2012, in what might have been the first Bitcoin Ponzi scheme, the creator of Bitcoin Savings and Trust promised returns to investors. The founder has since disappeared with 500,000 bitcoins.

Fool contributor Dan Newman owns shares of eBay. The Motley Fool recommends eBay, Google and Visa. The Motley Fool owns shares of eBay and Google.

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• For one thing, the actual metals-value of recently minted (1982 and later) pennies is closer to six-tenths of a cent than two and a half. (Most of the extra cost of minting goes to energy, labor, circulation, etc.)
• And even if you can find pennies old enough to serve as a valuable source of copper, there's the tiny technicality that in the United States of America, it's illegal to melt U.S. currency. Sorry about that.

Gallery: Fascinating Facts About U.S. Currency

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For years, U.S. officials have ritually complained that China's currency is undervalued and that the country should let it appreciate. But President Obama soft-pedaled the problem at the White House summit with President Hu Jintao last week.

Why? Washington is quietly celebrating that fact that Fed Chairman Ben Bernanke has outsmarted the Chinese government, forcing it to revalue its currency or face increasing domestic unrest.

"No U.S. official will admit this, but Bernanke has succeeded in breaking the Bank of China in the same way George Soros broke the Bank of England in 1992," says James Rickards, senior managing director for merchant bank Tangent Capital in New York. "The U.S. has won the first round of the currency war."

He adds: "People forget that one of the factors that caused the Tiananmen Square protests of 1989 was popular discontent with inflation, and the Chinese leadership doesn't want anything like that."

China Gets "Hot Money"

How did Bernanke pull off the magic trick that previous U.S. administrations were unable to accomplish? Last fall, he announced a program of quantitative easing -- a federal bond-buying program -- which was targeted, he said, at raising U.S. inflation to head off possible deflation.

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But in reality, it had a completely different result: Money poured out of the U.S. and flowed into China. According to Adam Wolfe, research analyst at Roubini Global Economics, the amount of so-called hot money entering China reached $1 billion a day in 2010.

Coming on top of China's massive trade surplus, those inflows presented a dilemma for the Bank of China. In order to maintain its exchange rate with the U.S. dollar, which was fixed after 2008, the Chinese government bought dollars from exporters and banks and printed local yuan for each dollar it purchased.

But last fall, the supply of yuan skyrocketed, increasing by 19.7% in December, Wolfe says. Increasing the money supply causes prices to increase as more money chases fewer products. Chinese inflation had ramped up 4.9% in November, compared with the same month in 2009.

Two Available Options

China has attempted to keep a lid on prices by cooling the economy, raising interest rates twice last autumn. But that prescription has failed. According to fourth-quarter GDP figures, the economy grew by 9.8%, raising the likelihood that the Beijing government will have to slam even harder on the economic brakes.

It has just two ways to limit prices: impose price controls or raise the value of the yuan, which reduces the price of imports. Price controls rarely work for more than a short time because people find ways around them, such as the black market.

It now seems likely the Chinese will opt for raising the yuan's value. Since last June, the currency has appreciated about 3.5%, or an annual rate of about 7%. When you add inflation, that's 12%. Wolfe says he expects the same level of appreciation for 2011, while Rickards says he sees the yuan rising by at least 10%.

For investors, the yuan is a good one-way bet because it's highly unlikely to come down anytime soon.

China might feel some resentment about its position. "The Chinese feel betrayed by the U. S.," Rickards says. "They feel that part of the deal for buying all those Treasurys was that the U.S. would maintain the value of the dollar. There's an old saying, 'if you're in a poker game and you don't know who the sucker is, then you're the sucker. The Chinese have just woken up to the fact that they're the sucker."

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China's foreign-exchange reserves jumped by a record 7.5% during the fourth quarter, increasing inflation concerns, The New York Times reported Tuesday.

China logged about $2.85 trillion of foreign-exchange reserves at the end of the fourth quarter, up $199 billion from a quarter earlier, the newspaper said. Reserves had already increased by $194 billion during the third quarter, although about half of that jump came from euro appreciation and interest payments.

As foreign currencies have grown in value, the Chinese government has been rapidly printing the renminbi. That's kept its value comparatively low and helped Chinese exporters retain a competitive advantage. China's fourth-quarter money supply jumped 20% from a year earlier, higher than the 19% increase forecast by economists.

Nonetheless, China's consumer price index in November rose 5.1% from a year earlier, the Times reported. The nation's trade surplus, as well as the growth of foreign investment in China, has helped to spur the growth. And Chinese economists say true inflation is likely even higher because the index excludes higher home-ownership costs and tracks some items that are no longer popular, according to the Times.

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Nobel Prize-winning Columbia University economist Joseph Stiglitz fears the dangers of capital flowing into emerging markets. He has a point about the dangers of such flows, but he underemphasizes their benefits. Still, countries need to protect themselves against the risks while profiting from the dangers. But how?

Three ways: Give capital providers a chance to earn long-term profits, don't get too dependent on them and prepare for their departure.

Stiglitz gave a speech on Dec. 10 in Chile suggesting that the country would be vulnerable as U.S. investors shovel a good chunk of the $600 billion in cash from the Fed's so-called QE2 into faster-growing emerging markets like Chile, whose GDP is forecast to grow by 6% in 2011. As I posted on DailyFinance, Stiglitz is certainly right about the flow of capital to emerging markets: They're expected to rise 42% to $825 billion by the end of 2010 compared to the previous year.

Stiglitz also warned Chile that such capital inflows could boost the value of its currency -- its peso is up 6.6% in 2010 relative to the dollar -- making it more difficult for Chile to export its goods to countries with weaker currencies. He noted that in October, Brazil introduced a big increase in a tax on foreigners' fixed-income purchases to 6%, triple 2009's level. The effect of that tax increase was to tamp down Brazil's currency because a rapid rise in its value would have made it more difficult for Brazil to export..

Copper and China and Chile

But when it comes to Chile, I'm not sure whether Stiglitz's warnings are on target. After all, copper is Chile's biggest export, and China is its biggest importer. As long as China -- with 2010 GDP of $5.7 trillion -- keeps growing at its current rate of around 10%, its demand for Chilean copper through state-owned copper company, Codelco, is likely to persist.

If China sustains that growth rate, it'll be the world's largest economy a mere decade from now -- with GDP of $21.6 trillion by 2020. Since China will need Chile's huge copper deposits more than ever, I doubt Beijing will care about Chile's modest currency appreciation.

Unlike Brazil, Chile -- which benefits handily from China's growth -- has so far resisted calls to introduce barriers to global capital flows. And it's not alone. India also doesn't see dangers in global capital inflows. A recent report in The New York Times explains that India welcomes foreign money and is letting its rupee rise -- despite the challenges that creates for exporters, such as its textile industry. The higher rupee, however, helps boost Indian consumer purchasing power and provides the money to build domestic retail space, hotels, offices and condominiums.

India is betting that a rising rupee won't hit its higher-value exports -- such as information technology services and pharmaceuticals -- as hard as it will textiles. Ultimately, this will mean India has to exit industries where customers buy based on having the world's lowest price and invest in industries where customers buy based on high quality.

Beware of Hot Money

The biggest danger of global capital flows is what happens when the money leaves suddenly. As I described in my book, Capital Rising: How Global Capital Flows Are Changing Business Systems All Around the World, co-authored with Srini Rangan, global capital flowing into high-yielding bank deposits and real estate development is often "hot money" that will flee when financial troubles appear.

That's what happened to Iceland in 2008. Landsbanki, then one of Iceland's biggest banks, attracted $7 billion to its IceSave accounts from 300,000 British retail investors. To pay the higher rates that attracted the Brits, Iceland's banks lent out those deposits to risky projects around the world, which paid even higher interest rates.

But with the global financial crisis beginning in September 2008, those hot-money investors got nervous and started withdrawing their capital. Iceland's banks suffered a cash crunch, leading ultimately to the Icelandic government nationalizing them.

Iceland Missed Opportunities to Protect Itself

Chile, India and other emerging nations that enjoy the benefits of foreign capital flows must protect themselves by keeping their reserves in a currency that's likely to hold its value in the event that the capital leaves the country suddenly. Iceland, unfortunately, kept its reserves in its own currency, the krona, whose value plunged as the foreign capital fled.

So, Stiglitz is right that emerging-market capital flows can be risky for their recipients. Indeed, a major slowdown in China's growth rate would have serious repercussions for countries like Chile and Australia that are cruising on China's demand for commodities.

But as the cases of India and Chile demonstrate, those flows can also help create valuable companies that hire people and pay taxes. The trick for emerging nations is to take steps to protect themselves against the risks of capital flows while welcoming the benefits.

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