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El Salvador’s Adoption of Bitcoin – Path to Salvation or Road to Perdition?

  • El Salvador became the first nation to make bitcoin legal tender.
  • Opportunities and challenges lie ahead.
  • Time is needed to evaluate the success or failure of this historic step.
  • Time is needed to evaluate the success or failure of this historic step.

Adoption

El Salvador made history by being the first country in the world to adopt bitcoin as legal tender. The Central American nation had been using the US dollar, as its currency, after it controversially scrapped the colón (₡) in 2001.

On 8 June 2021, the “Ley Bitcoin” (Bitcoin Law) was approved by the country’s Legislative Assembly with 62 votes, out of 84, in favour. The law's objective, as laid out in article 1, is “to regulate bitcoin as unrestricted legal tender with liberating power”. Article 5 stipulates that bitcoin will not be subjected to capital gains tax and article 8 obliges the government to convert its citizens’ bitcoins to dollars, automatically and instantly. The government will achieve the latter through a network of hundreds of commission-free cash dispensers and a $150m state trust.

In the law, the government further pledges to expand the training and infrastructure needed to facilitate the population’s access to bitcoin. It also ensures that those without the required technological access, will not be obliged to accept bitcoin. In parallel to the legislation, the government launched a virtual wallet called Chivo and incentivised its adoption by giving $30 worth of bitcoin to new users. Chivo allows users to send payments anywhere in the world for free.

The law came into effect on 7 September and the first day of its implementation was predictably eventful. The Chivo app had to be taken offline, until midday, because of the high demand on its servers. The price of bitcoin crashed up to 20%. Protestors gathered outside the Supreme Court, to oppose the move, and set fire to one of the new cash machines.

On the flip side, major companies have already adapted and are now accepting bitcoin. According to the government, Chivo now has over three million users almost 50% of the country’s entire population. In less than three weeks, it has acquired more uses than any bank in the country and is on course to having more users than all banks in El Salvador combined. Chivo is also being used to receive almost $2m in remittances every day. On an annualised basis, this would equate to almost 10% of all remittances.

El Salvador also just published its latest economic figures and is projecting a 9% annual growth, after having grown 24.5% in the second quarter of 2021. It is obviously premature to attribute any of this growth to bitcoin, as it is equally premature to declare the Ley Bitcoin a failure or a success. It is wiser, instead, to determine where the opportunities and challenges lie.

Opportunities

  1. Remittance costs - Remittances account for over a fifth of El Salvador's GDP and come mostly from Salvadoran expatriates in the US. It is estimated that 70% of the Salvadoran population receives remittances and the Salvadoran government estimates that they will save $400m in remittance fees, as a result of bitcoin becoming legal tender. In parallel, the option to send money on Chivo is likely to put competitive pressure on remittance companies to lower their fees.

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  1. Financial inclusion - 70% of El Salvador's population was unbanked at the time of the passing of the bitcoin law. The principal reason for this is the preponderance of informal employment and the inability to provide the required documentation to open a bank account. Bitcoin, through the Chivo app, can fix this by bypassing the banking sector entirely.

  2. Foreign investment - In being the first country to make bitcoin legal tender, El Salvador may benefit from a first-mover advantage. Whereas a lot of countries are now increasing regulations on cryptocurrencies and some are even banning them, El Salvador is not only making bitcoin legal tender, but is also exempting it from capital gains tax. This, coupled with easy access to residency permits for crypto entrepreneurs, means that El Salvador could become an El Dorado for the crypto industry. This inflow of capital could lead to more employment and greater economic growth. In turn, this could reduce violence in the country, even further, and slow down the pace of emigration, which negatively impacts the country’s economy.

  3. Innovation - In attracting foreign investment, through the crypto industry, El Salvador could become an innovation hub. This could materialise by being home to new and exciting crypto projects as well as providing cutting-edge infrastructure. Signs of the latter are already emerging. In striving to achieve a fully renewable, emissions-free method of mining bitcoin, El Salvador joins Iceland and Norway in using volcanic geothermal energy. The first bitcoins mined through volcanic energy in El Savador took place on 1 October.

  4. Financial independence - By moving away from its dependence on the dollar, El Salvador is breaking free from the monetary decisions of the US government.

  5. Sound money - El Salvador will be shielded from the dangers of monetary excesses, as no government agency will have the power to change the supply of bitcoin. This means that monetary inflation should not pose a problem and that the currency will not be debased. In the long run this could mean greater purchasing power, through deflation, as we recently discussed.

Challenges

  1. International pressure - In July, through its blog, the IMF warned that making a cryptocurrency legal tender was “a step too far”. The World Bank, for its part, refused to hold talks with the Salvadoran government, regarding this issue, and Moody’s downgraded El Salvador’s credit rating. The international media piled on with ominous headlines such as El Salvador’s dangerous gamble on bitcoin, El Salvador’s adoption of bitcoin as legal tender is pure folly and El Salvador Runs a Bitcoin Scam. If the international pressure continues and escalates, it could endanger El Salvador’s access to international finance and make it subject to various forms of political and diplomatic pressures.

    El Salvador’s move clearly ruffled some feathers. One wonders if the blowback is genuine concern over the fate of El Salvador or part of an effort to protect a number of privileged interests. El Salvador’s move risks setting off a domino effect of de-dollarisation across the region. This is evidenced by legislators in Panama, Paraguay, Mexico, Brazil, Nicaragua and Argentina, who mentioned interest in following El Salvador’s lead.

  2. Volatility - As evidenced by the first day of El Salvador’s adoption of bitcoin, bitcoin’s price can fluctuate quite sharply. This could pose a risk to the public’s purchasing power, public finances and the balance of trade. Some of this should be offset by the option to continue dealing in US dollars, which will be especially important for importers and exporters. Should the value of bitcoin go up and its use become widespread, however, the value of El Salvador’s foreign debt would decrease and the public’s purchasing power increase.

  3. Digital access and literacy - It is estimated that 50% of El Salvador’s population is without internet access. This will complicate the rollout of Chivo and the adoption of bitcoin. The government is addressing these issues, as laid out in the Ley Bitcoin and the situation is looking likely to improve. Time will be required to educate the general population about the nature of bitcoin and its potential benefits.

  4. Domestic pressure - Thousands of demonstrators protested the measure. Here too, time is needed to determine whether the reasons for this discontent are likely to be dissipated or aggravated. Increased digital education and time to adapt may help assuage early concerns.

Conclusion
The effect of bitcoin’s adoption will be revealed bit by bit. But, what if bitcoin leads to growth, prosperity and innovation? Will the international community be humble enough to learn from El Salvador? Whatever the outcome, everyone should hope for El Salvador’s success. Perhaps, they will show the world the way to economic salvation!

Nothing in this article constitutes professional and/or financial advice. The content is provided exclusively for informational and/or educational purposes. Nothing is to be construed as an offer or a recommendation to buy or sell any type of asset. Seek independent professional advice in regards to financial, tax, legal and other matters.

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