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El Salvador's Experiment With Bitcoin - What's It All About?

Sep 8, 2021 4:27 PM 5 min read

El Salvador becomes the first country to make Bitcoin legal tender.

Yes, if you have been following the news then this may be the hundredth time you've read this statement. And not just over the past week but since June 5th when Nayib Bukele, the President of El Salvador, first announced the plan. 

No doubt, this is a watershed moment in the history of cryptocurrency and on the road to its widespread acceptance in the future (potentially!). But that hasn't prevented critics from positing theories about what this policy actually intends to achieve. 

Some say it's a stunt. Others say it's a "costly gimmick" meant to fan the crypto-enthusiasm of the President and his brothers. Others, however, are more optimistic and hopeful that the move will attract deep-pocketed crypto-investments and reduce remittance costs. 

That being said, the same optimism didn't pan out much on the day of inauguration (christened as Bitcoin Day or B-Day). The process of "legal-tenderisation" got off to a bumpy start yesterday as the government-launched Bitcoin e-wallet (aka "Chivo") went offline for several hours. 

To make matters worse, Bitcoin lost 8.66% of its value in the last 24 hours (post the official adoption in El Salvador).

To make matters interesting, the El Salvador government took advantage of this dip to buy 150 Bitcoins yesterday taking its total tally to 550 (worth $25m).

So, what is going on here? And more importantly, how meritorious is this new Bitcoin policy?

Legal and Tender

The term "legal tender" is used to describe an instrument not just for its value of money but most specifically for its acceptance (by law) as a medium to settle debts. 

This means that from now on, creditors in El Salvador are legally obligated to accept Bitcoins (in addition to banknotes and coins) towards repayment of debts. However, private businesses may refuse to accept it provided that a transaction has not already occurred and a debt has not been incurred by the customer. 

This was clarified after much confusion over the last two months. But even if the government isn't compelling stores to accept Bitcoins, it's incentivising them to a great extent. 

How? First, by establishing close to 200 Bitcoin ATMs. Second, by offering a $30 stimulus to every citizen who signs up on the "Chivo" e-wallet app. Third, by creating a trust with $150m in public funds to facilitate Dollar conversions. Fourth, by augmenting a plan to have state-run enterprises harness volcanic energy for use in Bitcoin mining. 

But why, oh why make all this effort to tarry people's attention and utility away from the currency notes? 


Not Note-Worthy?

The first likely motivation is, of course, lower cost of transactions. The El Salvadoran diaspora sends nearly $4bn worth remittances annually which equals 20% of the country's GDP. Cross-border wire and bank transfers being evidently slow and expensive, Bitcoins transfers offer a quicker and cheaper alternative. 

El Salvador is a nation with a more than 70% unbanked population (with no access to bank accounts). Peer-to-peer transactions enabled by cryptocurrency to anyone with a smartphone and internet connection, is therefore, not a totally unprecedented solution.

Third motivation - ease of amendment. One may think that a massive overhaul in a country's currency system would require a heavy legal framework and legislative process, but not really (cite: demonetisation, circa 2016)! The law in El Salvador which gave effect to Bitcoin as legal tender is very crisp and succinct which was passed within three days of the president's announcement by a parliament in which his party enjoys a majority. 

Fourth, an aversion towards the US Federal Reserve's monetary policy. By virtue of accepting the Dollar as its currency for over 20 years, El Salvador has experienced sufficient dependence on a monetary system that it has no control over. Breaking with this "Dollar colonialism" is a motive as good as any to adopt an alternate finance strategy.

Make no mistake, the US Dollar still remains a legal tender and reference currency in the country, especially for accounting purposes. But its use is not promoted by the government.

The Look After the Leap

Even with such pro-regulatory gusto, it is a long way from here to widespread adoption of Bitcoin in the Central American country. However, as far as short-term effects go, there are quite a few concerns that El Salvadorans could face following yesterday's impact. 

The issue of reduced transaction fees, which we noted as a likely benefit of using Bitcoins, can stretch only so far, in light of evidence indicating fees more than 5% being levied at the Bitcoin cash machines. 

On top of it, most Bitcoin transactions are speculative and their values highly volatile. The state has taken some effort to control the volatility by creating a trust fund for Dollar conversions wherein the government will essentially take on the fluctuation risk for those who don't wish to bear it. 

But the sharp price swings in Bitcoin could greatly challenge the government's ability to meet conversion needs, especially if and when the trust fund is liquidated and the taxpayers are left holding the bag. A country with roughly $25bn annual GDP, whose total Bitcoin holdings come nowhere close to those of companies like Tesla and MicroStrategy, neither has the reserves nor the policy tools and financial firepower to contain a speculative attack. 

Incidentally, that is not where El Salvador's problems come to a stop. The International Monetary Fund has taken a dim view of the country's policy shift, even as far as lending procedures. In July, Moody's pushed El Salvador's debt rating deeper into junk territory questioning the ongoing "financial shocks" that could jeopardise the government's ability to repay debts starting in January 2023. 

The World Bank declined a request from El Salvador's government to assist in the process of adopting Bitcoin. The news has also triggered a sell-off in El Salvador's Dollar bonds. 

What was perhaps inspired by the will to not participate in a currency framework controlled by a foreign country could soon turn into a currency framework not controlled by anyone.

And if that wasn't enough, a recent poll suggests that an overwhelming two-thirds of the country's population was shown to be against the implementation of the new Bitcoin policy. This isn't a far-fetched outcome considering less than a third of the country uses the internet and at least a quarter of the population lives below the poverty line. 

Despite all that, the President's will to promote Bitcoin's use and popularity in the country remains unabated. His resolve to cement the cryptocurrency's integration into El Salvador's financial system, in spite of popular disapproval, remains firm, a sentiment that has been likened by some to a reflection of his rising autocratic policies. 

Using crypto assets as legal tenders comes with substantial risks to macro-financial stability, financial integrity, consumer protection etc. But the advantages that come with their underlying technology and inclusive financial services are lucrative enough for other countries (especially its neighbours) to follow El Salvador's suit. 

Argentina is contemplating doing so already. The Bahamas and Venezuela have launched some form of their own digital currency or electronic money while Cuba, Panama and Uruguay are on track to legitimise the use of cryptocurrency.  

All that remains to be seen is if the Latin American litmus test for cryptocurrency manages to spread all around the world in the future. 


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