The recent downturn in the global crypto market has driven many investors in those digital assets into agonies. The slump is also causing difficulty in El Salvador, whose president, Nayib Bukele, approved bitcoin as one of the country’s legal tenders alongside the US dollar last year and has invested more than $100 million in bitcoin.
So what might this entail for El Salvador’s economy? The international community is observing El Salvador’s policies to see if they represent the future of money or an economic disaster.
Snapshot of the Salvadoran Economy
Before President Bukele’s belief that bitcoin was a miraculous elixir to solve the nation’s persistent economic problems, the country was in dire straits.
The World Bank forecasts that the economy of El Salvador will expand by 2.9% this year and 1.7% in 2023, compared to 10.7% in 2021. However, this expansion rebounded from an 8.6% decline in 2020.
Its debt-to-GDP ratio is around 90%, and its debt is at roughly 5% per year, compared to 1.5% in the United States. The country also has a significant deficit, with no plans to decrease it through tax increases or spending cuts.
JPMorgan analysts warned in a research note that El Salvador’s Eurobonds have entered “distressed territory” during the past year, and S&P Global data indicates that the cost to insure against a sovereign debt default is at multi-year highs.
The International Monetary Fund has also cautioned that the nation is on an unsustainable path, with gross financing requirements expected to exceed 15% of GDP beginning in 2022 — and public debt expected to reach 96% of GDP by 2026 if current policies continue.
According to Muci, an expert in economic diversification and public financial management who joined applied research projects for El Salvador, Venezuela, and Honduras, El Salvador has implemented pretty expensive fuel subsidies over the past three or four months.
The specialist also said that this country lacks direction in terms of economic policy. They have no idea where they are going or what they are doing, which is a typical instance of taking things day by day.
El Salvador confronts looming debt payback obligations in the billions of euros, including a January maturing Eurobond of $800 million.
El Salvador has attempted to acquire a $1.3 billion loan from the IMF since early 2021. However, these efforts appear to have failed due to President Bukele’s reluctance to accept the organisation’s suggestion to abandon bitcoin as legal tender.
This is consistent with Fitch’s recent decline, which was related to El Salvador’s uncertain access to multilateral finance and external market financing, given its high borrowing rates and limited ability to get more local market financing.
The efforts of the president to consolidate power have also contributed to the increase in this risk premium. Bukele’s New Ideas party controls the Legislative Assembly. In 2021, the new parliament was criticised for ousting the attorney general and the highest-ranking judges. The US Agency for International Development redirected funds from civil society groups to El Salvador’s national police and a public information institution in response to this action.
In addition, El Salvador cannot print money to stabilise its finances. In 2001, El Salvador abandoned its currency, the colón, in favour of the United States dollar. The Federal Reserve is the only body to print more dollars. The nation’s second currency, bitcoin, is highly valued since it cannot be minted out of thin air.
El Salvador’s Experiment on Bitcoin
On June 9th, 2021, the government of El Salvador published the official legislation making Bitcoin legal tender in the country. The law entered into force on September 7th, 2021.
The effort included the purchase of bitcoin with public funds and the establishment of a national virtual wallet called “chivo” (Salvadoran slang for “cool”), which enables no-fee transactions and facilitates speedy cross-border payments. In a country with a cash-based economy, where 70% of the population lacks bank accounts, credit cards, and other standard financial services, chivo was designed to provide an easy entry point for individuals who had never used the banking system.
The experiment also included the establishment of a countrywide infrastructure of bitcoin ATMs and the requirement that all companies accept the money.
In November, the president upped the ante when he revealed plans to develop a “Bitcoin City” near the Conchagua volcano in southern El Salvador. The bitcoin-funded city would provide considerable tax relief, and bitcoin miners would be powered by geothermal energy from the nearby volcano.
#Bitcoin City is coming along beautifully ❤️ pic.twitter.com/A6ay8aAREW
— Nayib Bukele (@nayibbukele) May 9, 2022
Overall, the government has spent approximately $375 million on the bitcoin rollout, including a $150 million trust to instantly convert bitcoin into dollars, a $120 million bonus given to each citizen who downloaded the chivo wallet (no small sum in a country where the monthly minimum wage is $365), and roughly $104 million the government has publicly admitted to spending on bitcoin. Muci observes that these costs and the $50 million in unrealised losses on the country’s bitcoin holdings total $425 million spent on “making bitcoin happen.”
However, nine months into its nationwide bet on bitcoin, it does not appear to fulfill many lofty promises.
In January, President Bukele tweeted that the app had 4 million users (out of a total population of 6.5 million).
4 million users!
*Total population: 6.5 million (including people under 18 that are still not allowed to use the app).
We have the receipts👇🏼#BTC https://t.co/y3jvEdOtex
— Nayib Bukele (@nayibbukele) January 19, 2022
Still, a report published in April by the US National Bureau of Economic Research revealed that only 20% of those who downloaded the wallet continued to use it after spending the $30 bonus. The study was conducted based on a “nationally representative survey” of 1,800 households.
According to Sobrado, the real penetration of bitcoin transactions appears to be pretty modest. There seem to be some issues with the state-issued wallets. Numerous users downloaded it, but it was flawed. It failed to provide an optimal user experience.
Some users of the government’s crypto wallet had technical difficulties. Other Salvadorans reported identity theft in which hackers exploited their national ID number to establish a chivo e-wallet to claim the free $30 worth of bitcoin granted by the government as an incentive for joining.
The chivo wallet was also anticipated to save hundreds of millions of dollars in remittance costs. Remittances, or the money migrants send to their home country, contribute to more than 20% of El Salvador’s gross domestic product. Over 60% of the income of specific households comes from this source alone. For these foreign transfers, which might take days to arrive and need a physical pick-up, incumbent providers can charge a fee of 10% or more.
Recent research indicates that in 2022, 1.6% of remittances were sent via digital wallets. A March poll by the Chamber of Commerce and Industry of El Salvador regarding merchant adoption revealed that 86% of businesses have never made any sales in bitcoin.
After almost one month, a significant increase in mass adoption and usage has been observed:
- Over two million citizens use Chivo, the national Bitcoin wallet, accounting for nearly half of the country’s population;
- An average of $2 million in remittances are transacted daily via the Chivo wallet;
- An average of more than 65k transactions per second on Chivo wallets;
- An average of more than 14k transactions per day on Chivo ATMs;
- Since September 7th, Salvado’s citizens have inserted more cash to purchase bitcoin than what they are withdrawing from Chivo wallet ATMs;
- El Salvador’s government fervently supports Bitcoin adoption through schemes such as discounts on fuel for Chivo wallet users.
Technological Implementation Model
Transactions on the Bitcoin network may be highly costly and time-consuming to complete, which is one of Bitcoin’s primary drawbacks. A potential solution that will be implemented in Salvador is to use the Lighting Network.
Using the Lightning Network, a “layer two” solution built atop the blockchain, Bitcoin payments might be executed in seconds with zero user fees. Adopting such a method might also enable accepting Bitcoin as a form of payment.
In addition to supporting minor retail transactions such as paying for a cup of coffee, a book, or lunch, Lightning Network might also enable essential use cases like remittances, eliminating the current high costs and long wait times.
Some of the most complicated problems include allowing the access and purchase of bitcoins in all of El Salvador through simple and efficient processes, erasing the complexities and costs associated with purchasing fees, and reducing phenomena such as the application of premium prices on top of the spot price due to the difficulty of the crypto market access.
Salvadorans can obtain bitcoin through a Government Exchanger for these reasons. To prevent arbitrage activities, the Exchanger should not charge citizens a purchasing fee, and the pricing must be synchronised with other private exchangers operating on El Salvador’s territory. It is plausible to suppose that the government might engage in arbitrage activities about the spot prices of exchangers outside El Salvador.
Citizens of El Salvador have the option of storing their bitcoins in a custodial or non-custodial wallet. The first electronic wallet embraced by the Salvadoran people is the government-issued “Chivo” wallet. Chivo serves as an Exchanger and a Wallet, serving as the initial entry point for Salvadorans to acquire and store bitcoin.
The “Chivo” wallet app. Image: Coinmarketcap
Sending or receiving remittances, making or receiving payments, or converting bitcoin to dollars or vice versa will incur no fees or charges while using the Chivo wallet. Additionally, the Chivo wallet is compatible with other Bitcoin wallets. There is no requirement, and users can use other alternative wallets.
Chivo may represent a custodial wallet based on the available description of the service, as it does not appear to be a wallet where users have complete control over their funds. A non-custodial wallet would incur fees and could not convert seamlessly between Bitcoin and US dollars due to the lack of a native service on the Bitcoin blockchain, and the exact nature of this newly introduced remedy will remain to be seen. On the other hand, Salvadorans can opt to rely on other non-custodial systems (e.g. Bottlepay, Breez, Zap, Éclair) in which only the user has access to funds.
One of the most well-known non-custodial wallets already receiving widespread acceptance in El Salvador beginning in early 2021 is the U.S.-based wallet Strike, a payment platform similar to Venmo that also leverages its Lightning Network wallet named Zap. Strike focuses primarily on use cases such as remittances, allowing Salvadorans to trade cross-border funds utilising Bitcoin technology with low expenses. In this instance, Strike moves fiat by buying and selling bitcoin in real-time via the Lightning Network. The procedure works so that Strike automatically converts the fiat (of the sender) into bitcoin before moving the funds. This bitcoin is transmitted to a Strike Lightning node in the beneficiary’s jurisdiction. A bitcoin-to-Fiat Money autoconversion completes the transaction and deposits Fiat Money into the Strike app.
In this situation, the decision between a custodial wallet and a non-custodial wallet is heavily subject to the trade-off between the security and efficiency of the given services. Merchants will not be charged a commission, and the Development Bank of El Salvador (Bandesal) will support automatic convertibility (probably by establishing a Bitcoin reserve), so firms paid in bitcoin can choose to receive US dollars. The funds maintained or received (in US dollars or bitcoin) in the Chivo wallet can be withdrawn at any moment in US dollars. Additionally, the conversion might be completed at one of the nearly 200 specialised ATMs around the country.
Notably, the Chivo Mobile App will be accessible for download from September, and each El Salvadoran resident who registers the wallet will earn $308 in Bitcoin from the government. The president stated that those thirty dollars are intended to promote the usage of bitcoin and urge others to download the application. This $308 free credit is the only Chivo money that cannot be changed into actual currency. This is designed for use when the retailer can withdraw it for dollars.
Reactions of World Monetary Authorities
The International Monetary Fund (IMF) previously cautioned El Salvador against adopting Bitcoin as its official currency. According to the IMF, accepting Bitcoin as legal cash poses several macroeconomic, financial, and legal challenges that require a thorough examination.
According to the IMF, El Salvador’s legal framework necessitates substantial investment and complex policy decisions, such as defining the roles of the public and private sectors in creating and regulating digital forms of currency.
The IMF focuses on the economic effects of local pricing that might become highly volatile. Even if all prices were quoted in Bitcoin, the pricing of imported products and services would continue to change dramatically based on market evaluations.
Notably, the most significant risk identified by the IMF is associated with Bitcoin’s broad acceptance and proportional effects on macroeconomic stability.
The World Bank initially denied El Salvador’s request for assistance with using Bitcoin as legal tender. They emphasise that while the Salvadoran government requested assistance with Bitcoin, the World Bank cannot provide it due to environmental and transparency concerns.
Implications of Bitcoin as Legal Tender in El Salvador
The government of El Salvador should build regulatory frameworks and complete a mechanism for converting bitcoin to US dollars since all companies are required to accept bitcoin as legal tender unless they lack the necessary technology to handle transactions.
It is also unknown how the decision would influence El Salvador’s credit on the Capital Markets and the valuation of its foreign exchange reserves. All current commitments in the nation, including bank debts, may be settled in either bitcoin or US dollars. Capital gains will be exempt from taxation, and taxes can be paid in bitcoin, which might attract overseas investment.
In addition, for vendors to take bitcoin, they must address the asset’s presence in the Balance Sheet, P&L, and Tax Reports and the risk of volatility. From a fiscal standpoint, Salvadorian enterprises paid in Bitcoin have to record the cost of assets at T0 (the time the respective coins were received) and report it at the end of the period under the Cash, and cash equivalents account from IFRS.
If the entity trades Bitcoin during the reporting period, the realised gain or loss will be determined using the FIFO technique. The gain or loss will be deemed unrealised and computed using the FIFO technique if the Bitcoin is kept without being exchanged.
El Salvador companies can quickly control their assets’ volatility by changing Bitcoin into US dollars as soon as they get it (daily or weekly). However, two significant challenges occur. One of these is the FIFO accounting for the entire term, which will demand the accounting department’s full attention.
The second challenge might be establishing and presenting Bitcoin pricing. The country has not set stable Bitcoin prices and changeable US dollar values. They are established in US dollars, and the Bitcoin equivalent must be determined at the time of payment. Due to the possibility of intentional or negligent conversion problems, both parties must independently calculate prices.
What Could Happen in The Future?
Bitcoin legal tender in El Salvador can significantly impact the future of decentralised currencies by demonstrating how Bitcoin can be used as an everyday medium of exchange and how this is made sustainable and scalable via innovative systems like the Lightning Network.
The El Salvador experiment has the potential to be a game-changer, but associated repercussions must be handled.
- Economic and financial risks: The adoption of Bitcoin in the financial system of El Salvador might pose specific threats to the country’s economic and financial stability. Such risks must be mitigated so as not to threaten the financial stability of El Salvador.
- Technological challenges: Bitcoin is a new technology, and the tools required to deal with it are also new and somewhat complicated. Thus, it’s necessary to develop effective technology solutions that generate new financial services that are available to everyone and are user-friendly and straightforward to use.
- Social challenges: The key to overcoming this obstacle will be persuading Salvadorans to use bitcoin as a medium of exchange by demonstrating its potential advantages to the populace.
- Security risks: In the process of accepting Bitcoin as legal tender, there are dangers associated with Know Your Customer (KYC), Anti-Money Laundering (AML), and Combating the Financing of Terrorism (CFT). This is especially true when individuals access non-custodial wallets. Therefore, user verification mechanisms that adhere to legislation and norms are required to limit security concerns.
Due to El Salvador’s current action, there are several possible future outcomes, and it will be crucial to examine what will happen to the country’s economy.
