El Salvador: The first country to accept the cryptocurrency Bitcoin as legal tender might see many unintended consequences
On June 9th, the Congress of El Salvador approved a law to accept Bitcoin, the private cryptocurrency, as legal tender. The law will take effect 90 days after its publication in the official gazette. As a consequence, probably by mid-September, Bitcoin will become the country’s official currency alongside the USD, which the Central American country made legal tender in 2001. When the law comes into force, businesses will have to accept Bitcoin as a means of payment for goods and services. Only those who do not have access to the technologies required to process transactions will be exempt from this obligation. Under the law, Bitcoin can also be used for tax payments while Bitcoin exchanges will not be subject to capital gains tax. The new law is still lacking in detail. For example, it is unclear if the government is also planning to pay public salaries and its (domestic) suppliers in Bitcoin. Furthermore, the Central Reserve Bank and the Financial System Superintendence have to draw up relevant regulations by September 2021 to tackle potential financial risks within El Salvador’s financial system. The government also intends to set up a USD 150 million trust at El Salvador’s development bank that will enable citizens to convert Bitcoin into USD. However, it is not yet clear whether an exchange rate between Bitcoin and USD – other than the volatile market one – will be set. There is also a lack of clarity regarding the convertibility between Bitcoin and USD and the impact of the introduction of Bitcoin on the currency in circulation in El Salvador (namely impact on inflation, financial stability, capital flows, etc.).
President Bukele has justified Bitcoin’s adoption by saying it will be financially beneficial for remittances to El Salvador, which accounted for about 40% of current account revenues and 20% of GDP in 2019. There are high fees for international money transfers while, in theory, Bitcoin offers a quick and cheap way to send money across borders. However, many people in El Salvador lack the knowledge, the advanced mobile phone technology or even the internet access that are required to process cryptocurrency transactions. Furthermore, the biggest remittance firms, which could prove to be an alternative channel, are rather hesitant about offering cryptocurrency services. President Bukele also states that El Salvador can become a Bitcoin mining hub (mining being the process of verifying transactions in exchange for new coins), which could be a new revenue source for the country. Besides, according to President Bukele, the high energy consumption of Bitcoin mining could be tackled by using geothermal energy from the country’s volcanoes (though a detailed plan is lacking).
Moreover, there are many other disadvantages to Bitcoin. First of all, Bitcoin is notorious for its high price volatility. Bitcoin lost 30% of its value in a couple of hours in May 2021. As a result, companies and financial institutions accepting Bitcoin can potentially face large financial losses overnight. Furthermore, Bitcoin has a rather slow transaction speed due to the underlying computing capacity it requires. In combination with transaction fees (as the Bitcoin network requests a fee to verify the transactions), this makes the cryptocurrency rather unattractive for small and frequent payments. Moreover, the adoption of Bitcoin could lead to negative legal and financial consequences. Indeed, the lack of transparency and the pseudo-anonymity offered by Bitcoin make it a favourite token in criminal milieus. Currently, there are no anti-money laundering controls in place in El Salvador. Therefore, international criminal organisations are likely to be willing to profit from weakened financial transaction oversight to move and convert currencies through El Salvador. As a result, the Central American country could face sanctions from the United States and other countries if it proceeds with Bitcoin use. A possibility is the USA taking action to block IMF and other multilateral loan approvals, something that Nicaragua already experienced. Accepting Bitcoin as legal tender could imperil the conclusion of a requested IMF programme that has been under discussion for more than a year due to ongoing political issues. Unlike Nicaragua, El Salvador had a public debt standing at a high 88% of GDP at the end of 2020, making multilateral financing crucial. A number of other risks also remain unresolved for now. Indeed, the pseudo-anonymity of Bitcoin poses corruption risks in El Salvador. Last, the adoption of Bitcoin can lead to higher security costs for companies and financial institutions that would need to protect themselves against cyberattacks aimed at hacking Bitcoin reserves.
Given the latest events, the medium- to long-term political risk (category 5/7) and short-term political risk (category 4/7) have a negative outlook. The fiscal policy performance, potential US sanctions, the conclusion of an IMF programme and the trajectory of external debt (service) ratios will be key. The evolution of the business environment risk (F/G) will depend on the exact implementation of Bitcoin for companies and, more generally, on the business cycle.
Analyst: Jolyn Debuysscher – J.Debuysscher@credendo.com