Bitcoin has put El Salvador in the spotlight. On September 7, the country became the first to make Bitcoin—or any cryptocurrency—legal tender. The move was spearheaded by the nation’s president, Nayib Bukele, and has garnered praise in the international cryptocurrency community but skepticism from the World Bank and IMF, among others.
As part of its Bitcoin initiative, the Salvadoran government launched its own free Chivo wallet, which allows users to receive and make free payments in Bitcoin and U.S. dollars. (El Salvador is a fully dollarized economy.) However, the app faced technical difficulties, and had to be shut down a few hours after it launched. This caused the price of Bitcoin to fall by almost 15%, reducing the value of the global Bitcoin market to $851 billion, for a loss of $136 billion in just 24 hours. However, as of October 11, the price of Bitcoin has recovered all loses, rising to $57,000, a 23% increase relative to the launch date. The government of El Salvador currently owns 700 Bitcoin (about $40 million). The Bitcoin rally generated a $4 million profit for the Salvadoran government. The President announced the profits would be used to build a hospital for pets.
Innovation and Inclusion
Before laying out our criticisms of the decision, let’s first view it through the lens of innovation and inclusion. According to Statista, El Salvador ranks third to last among its regional peers in terms of banking access. In a country where 70% of citizens remain unbanked, Bitcoin/digital wallets can serve as a savings instrument and promote financial inclusion. As a starting point, there are already 161 mobile subscriptions per 100 inhabitants in El Salvador, and it is likely easier to provide financial services linked to cellphones than trying to open new bank accounts. Financial innovation in El Salvador can follow the path established in other emerging markets like China and India, where payments systems via phone (Alipay, PayTM, etc.) have seen wider acceptance and usage compared to traditional banking products. The key to financial inclusion is the ability of lenders to extend credit at an acceptable interest rate. The digital records generated by the Chivo wallet could serve as proof of income, provide data to lenders and facilitate lending to small businesses and individuals who do not yet have access to financial products. Also, Bitcoin legalization could lower the cost of paying and receiving money. In El Salvador, remittances accounted for more than 20% GDP in 2020. On a global basis, according to the World Bank’s Remittance Prices Worldwide (March 2021), sending remittances costs an average of 6.38% of the amount sent, but can reach more than 10% for small transactions. The high cost of remittances means that El Salvador loses more than 1% of GDP on remittances fees.
Over the past month, many Bitcoiners have visited El Salvador to support the initiative. Bitcoin enthusiasts around the world have shown interest in moving to the country, where their Bitcoin trading profits would be tax-exempt and where tax rates are relatively low. El Salvador is offering permanent residency to anyone who invests at least three Bitcoins (about $160,000) in the country. Legalization of Bitcoin could attract investment of both cryptocurrency investors and miners and could generate additional tourism. Neighboring Costa Rica, which has a similar natural environment to El Salvador, has been more successful in achieving its tourism potential (see below), but perhaps that could change.
Regional Tourism Receipts ($ Billions) and Visits (Millions)
Source: World Tourism Organization, 2019.
The criticisms of establishing Bitcoin as an official currency are understandable and straightforward: exposure to Bitcoin volatility, environmental concerns about Bitcoin mining, depletion of banking assets, money laundering, capital flight and loss of central bank reserves. Also, many of the benefits of Bitcoin could be achieved by using a dollar-based digital wallet rather than a Bitcoin wallet. In today’s El Salvador, banks connect savers and borrowers. If most Salvadoran start using Bitcoin, their savings will be stored in digital wallets away from potential borrowers who would otherwise use it to fund projects. Massive adoption of Bitcoin would drain banks of savings and raise the cost of borrowing for companies and individuals, who will face higher interests to expand a factory or to buy a new house. This phenomenon would not be unique to El Salvador. For example, in India many people buy gold rather than use banks, which precludes the banking system from absorbing and circulating their savings. If banks take deposits in Bitcoins, they must also lend in Bitcoin (for which there is little appetite right now). Otherwise, they have an asset and liability mismatch that could affect their stability. While Bitcoin can be used as a speculative asset to generate significant gains, it can also generate major losses. Bitcoin went from more than $60,000 per Bitcoin on April 15 to less than $40,000 on June 15. Salvadorans with limited financial education might be tempted by potential outsized Bitcoin returns and later become victims of a significant collapse, like that seen this past summer. If the savings of a whole nation were cut by a third in two months, it would be a destabilizing event. In that same way, if the government or any other entity quoted their revenues in advance in Bitcoin but had expenditures in dollars, it could be exposed to highly volatile exchange rate risk.
Likewise, Bitcoin raises concerns about lack of transparency and environmental cost. Internationally, the cryptocurrency has been used for money laundering and to pay for illegal activities. In addition, the system on which Bitcoin is based is highly energy-intensive, making it particularly taxing for the environment.
El Salvador currently carries a large debt burden (about 65% of GDP) and has a challenging amortization schedule, with $800 million due in January 2023. To navigate this difficult fiscal environment during the pandemic, El Salvador has reached out to the IMF for a $1.3 billion financing package. However, the IMF opposes the adoption of Bitcoin as a legal tender. Thus, the funding program could be put in jeopardy at a time when El Salvador is running out of financial alternatives.
Finally, Bitcoin could facilitate a capital flight, especially during a crisis. Many emerging markets control the flow of capital in and outside of their countries to avoid a macroeconomic crisis or to prevent one from worsening. However, Bitcoin can facilitate such a flight: Once dollars are converted to Bitcoins, they can easily be sent to anyone in the world, without any control or tracking. In a matter of seconds, millions of dollars could leave El Salvador—in our view, capital flight remains the biggest tail risk of Bitcoin’s status as legal tender in El Salvador.
Most of the international financial and regulatory establishment has looked at the Salvadoran Bitcoin decision with suspicion. In our view, Bitcoin adoption there is likely to be gradual and the risks around capital flight will need to be monitored. At the same time financial inclusion and innovation via adoption of Bitcoin could hopefully ignite economic progress in a country that certainly needs growth.