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El Salvador Bets the House on Bitcoin

Categories : Cash does not require a technology infrastructure, Cash has legal tender status, Cash is the first step of financial inclusion, Cash is the most widely used payment instrument, Future of Cash
May 24, 2022
Tags : Cryptocurrency, El Salvador, financial crisis, financialisation, Legal tender
Bitcoin became legal tender in El Salvador in September 2021. Since then, its volatility has worsened the country's precarious financial situation.
Manuel A. Bautista-González

Ph.D. in U.S. History, Columbia University in the City of New York

Post-Doctoral Researcher in Global Correspondent Banking, 1870-2000 – Mexico and South America, University of Oxford

This post is also available in: Spanish

IMF: Bitcoin as Legal Tender is (Very) Risky Business

“Bitcoin is going to change the world. It’s the evolution of humankind, and we’re going there.” – Nayib Bukele, President of El Salvador.

El Salvador has had a dollarized economy since 2001. In June 2021, millennial president Nayib Bukele announced that El Salvador would become the first country worldwide to make bitcoin legal tender. Bitcoin acquired legal tender status in the country on September 7, 2021.

El Salvador’s financial situation (already weakened during the Covid-19 pandemic) has worsened since then. Moody’s, Fitch, and other credit rating agencies have downgraded El Salvador’s sovereign debt, and the country is getting closer to a default.

According to the Financial Times, Salvadoran sovereign debt amounts to more than USD13 billion (equivalent to 85% of the country’s GDP). The government has less than USD3.4 billion in foreign exchange reserves (equal to three months of imports).

Bukele’s decision surprised the International Monetary Fund (IMF), as the country sought USD1.3 billion in emergency funding. In January 2022, the IMF urged El Salvador to remove bitcoin’s legal tender status. “Using cryptocurrency as legal tender entails large risks for financial and market integrity, financial stability, and consumer protection,” said the IMF Executive Board. Although digital payments might promote financial inclusion in the country, bitcoin and the Chivo e-wallet require “strict regulation and oversight.”

Bitcoin’s Price Tag

“The government is betting more than [USD]200 million in a virtual casino, and that’s taxpayer money.” – Ricardo Castañeda, senior economist at the Central American Institute for Fiscal Studies.

According to the Financial Times, El Salvador would have spent USD101.5 million to purchase 2,280 bitcoins as of May 10, 2022. The government has also spent USD180 million to develop the Chivo digital wallet and install 200 bitcoin ATMs in El Salvador and 51 in the United States.

President Bukele is the country’s day trader and crypto evangelist, buying bitcoin from his phone during the crypto assets’ periodic selloffs. “Most people go in when the price is up, but the safest and most profitable moment to buy is when the price is down. It’s no rocket science. So invest a piece of your McDonald’s paycheck in #Bitcoin. Now go back to flip more burgers you lazy fvçk,” tweeted Bukele.

Staving Off Default? The Bitcoin-Backed Volcano Bonds

During a bitcoin festival in November 2021, Bukele announced that La Geo, a state-backed thermal energy company, would issue USD1 billion in 10-year, 6.5% bitcoin-backed bonds. The government planned to use USD500 million to buy bitcoin. The other USD500 million would finance the construction of “Bitcoin City,” a tax-free zone for bitcoin mining companies supplied with thermal power from the extinct Conchagua volcano.

Blockstream, a Canadian blockchain technology company, would sell the “volcano” bonds as crypto tokens on the Bitfinex platform. U.S. citizens and entities are barred from using this crypto exchange.

“If this [bitcoin-backed bond issue] is a failure, a lot of doors close. This issuance is going to define a lot.” – Carlos Acevedo, former president of the country’s central bank.

With the volcanic bonds’ issuance, the Bukele administration could bypass the IMF and prevent El Salvador from defaulting on its debt, securing the president’s reelection. According to the IMF, bitcoin-backed sovereign bonds would “require a very careful analysis of implications for, and potential risks to, financial stability.”

“Bizarre Things” and “Big, Attractive Bets”

“The bitcoin community does some bizarre things. If they end up providing an avenue of financing without the IMF, that could totally change El Salvador’s fortunes for the next few years.” – Bradley Wickens, founder of Broad Reach, an emerging markets hedge fund holding conventional El Salvador bonds (emphasis added).

At first, the volcano bonds captured the attention of retail and “meme” investors. Josué País, the owner of a cab company accepting bitcoin payments from foreign tourists, planned to buy USD200 in volcano bonds. “The curiosity is what gets me. Number one, I’m going to do it to support the country. Number two, because it’s a big, attractive bet,” said País, 36 (emphasis added).

Large institutional investors with massive holdings of crypto assets (the so-called bitcoin “whales”) remained sceptical. “Some of our users have proactively reached out to us to express their interest, […] but they are waiting for the details to be published,” said Paolo Ardoin, chief technology officer of Bitfinex. By late March, Bukele backtracked, postponing the volcano bonds’ issue to focus on pensions reform.

“Cryptoisation” and Capital Flight

“The impact of bitcoin in El Salvador so far has been to increase macroeconomic potential risks rather than introduce any material change in how economic transactions are conducted.” – Barclays analysts, March 2022.

“Cryptoisation,” or replacing national currencies with crypto assets, poses significant risks to small economies. There has been little to no discussion in El Salvador about bitcoin’s role as a vehicle for capital flight and financial instability.

Bitcoin’s price went from USD35,809.66 on June 6, 2021 (the day of Bukele’s announcement) to USD29,072.73 on May 23, 2022, a fall of 23.2% in value (see Graph 1).

Graph 1. Price of Bitcoin in USD, June 2021-May 2022

Source: Coindesk.

By their very nature, crypto networks lack centralized authorities. The volatility in crypto markets has magnified El Salvador’s structural weaknesses, bringing the country closer to financial collapse and economic crisis.

“Crypto is being used to take money out of countries that are regarded as unstable. It is a big challenge for policymakers in some countries. […] Capital flow management measures will need to be fine-tuned in the face of cryptoisation. Applying established regulatory tools to manage capital flows may be more challenging when value is transmitted through new instruments, new channels, and new service providers that are not regulated entities.” – Tobias Adrian, head of the IMF’s monetary and capital markets department.

CAR adopts Bitcoin as Legal Tender

In April 2022, the Central African Republic (CAR), one of the world’s poorest countries, became the second country to grant bitcoin legal tender status. According to Reuters, less than half of the CAR’s population have a mobile phone, only 14% of people have electricity, and just 11% have internet access.

The CAR is a member state of the Central African franc zone (CFA), a monetary union governed by the Bank of Central African States (BEAC). On May 13, 2022, the Banking Commission of Central Africa (COBAC), the union’s financial regulator, reminded member states that using cryptocurrencies is banned in the CFA zone.

This post is also available in: Spanish