May 04, 2022 - 13 min read
Starting in 2017, El Salvador began to experiment with using Bitcoin as a national currency, and in September 2021, officially announced that Bitcoin would be legal tender across the country, making it the first country in the world to allow a cryptocurrency as legal tender. Since then, El Salvador’s government, headed by controversial president Nayid Bukele, has announced plans for a sweeping Bitcoin-based financial initiative. This includes a national Bitcoin wallet, issuance of international bonds in Bitcoin, and even a nearly tax-free “Bitcoin City”, which would encourage mass Bitcoin mining via the use of low-cost geothermal energy from a nearby volcano.
International and domestic reactions to these developments have been mixed, with some in the crypto community praising Bukele as a pioneering genius, while many others have criticized the plan as a potential financial disaster for the already impoverished nation. International financial organizations, including the IMF, have strongly encouraged the Bukele government to abandon its ambitious plans. In recent months, additional questions have arisen over Bitcoin’s drastic fall from nearly $70,000 to less than $30,000 in only a few weeks.
Many might think that such volatility could put a damper on the government’s plans, but it’s looking like Bukele and his administration are going full speed ahead in a daring attempt to make the small central American nation the world’s Bitcoin capital. Much of the success of El Salvador’s plans will depend on the growth and stability of Bitcoin itself, which is far beyond the control of its relatively small economy. Only time will tell whether the inspired gamble ends up as a fantastic success, a horrible failure, or somewhere in-between.
Before going deeper into the specifics of El Salvador’s plans for a Bitcoin-focused economy, it’s important to understand the current economic conditions in the country and why an aggressive shift to an industry like crypto may seem so alluring.
El Salvador currently has a population of nearly 6.5 million people, and, as of 2020, had a GDP of a little more than $24 billion. This makes it the fifth-poorest country in North America with a per capita GDP of $4,131. To provide some context, Vermont, the state with the smallest GDP in the U.S. has a GDP of $32.8 billion, about 36% larger than El Salvador, and Mississippi, the state with the lowest per capita GDP, has a GDP per capita of more than $35,000, around nine times larger than El Salvador.
El Salvador’s economy is primarily agricultural, exporting commodities such as coffee beans, cotton, corn, and sugarcane. The economy was significantly damaged by a civil war in the 1990s and rebounded significantly in the early 2000s with the expansion of the country’s service industry. However, since then, rising oil prices, natural disasters, and a decline in manufacturing have had a significant negative impact on the nation’s economic growth.
Overall, this has led the country to rely on both foreign debt and foreign aid to sustain its economy. The country currently has a national debt of more than $21 trillion, close to 100% of its overall GDP, which is quite large for a country without a strong currency and influential central bank, such as the U.S., which can “get away” with a larger debt load. Due to perceived instability and other factors, Fitch recently downgraded El Salvador’s sovereign debt from “B” to “CCC,” which will likely make it more difficult for the country to issue and sell large bonds in the near future.
All of this leaves El Salvador with few options in the near term if it wants to aggressively improve international investment, lift its citizens out of poverty by expanding job opportunities and social services, and reduce its debt burden. Therefore, the adoption of Bitcoin may be a move made more out of desperation than out of reasonable academic or economic calculations and forecasting.
In fact, El Salvador’s Bitcoin program may be more of a cover for its current debt issues than a true solution to the problem. El Salvador is currently at risk for defaulting on its sovereign bonds due in 2023, and the income from a Bitcoin bond could potentially be diverted to avoid defaults on current bonds, even if this is not the bond’s stated intention.
Over the last year, El Salvador has been in talks with the International Monetary Fund (IMF), which was considering offering a $1.2 billion loan to the country in order to help relieve the government’s current financial issues. However, the organization has withdrawn the offer due to the government’s new Bitcoin policies and has urged them to remove Bitcoin as legal tender, fearing that it will cause more instability to the already financially troubled country.
El Salvador’s experiment with Bitcoin as legal tender began in the small, seaside surf town El Zonte in mid-2020, when the activities of a mysterious, yet generous Bitcoin donor injected funds to develop the small community. Since then, nearly all businesses in the town have started to accept Bitcoin as legal tender. Those small successes have inspired a much larger rollout of Bitcoin in the country, but it’s far from certain that this will have a positive impact.
As previously mentioned, the cryptocurrency officially became legal tender in September 2021. Shortly after, the government released a new digital wallet app, via which it gave away $30 (£22) in Bitcoin to all El Salvadorian citizens. Shortly after, more than 200 new Bitcoin ATM machines were also installed across the country.
In addition to stimulating international investment and economic growth, El Salvadorian president Nayib Bukele believes that Bitcoin will help promote financial inclusion for the more than 70% of El Salvadorians who are currently unbanked. Unlike setting up a bank account, which may require a minimum amount of assets, as well as ID paperwork, which many poorer El Salvadorians may not possess, setting up a Bitcoin wallet is relatively easy. However, setup and use of a wallet require internet access, so for any such financial initiative to truly bank a wide swath of the unbanked, it would also require a substantial increase in low-cost internet access.
In addition to helping bank the unbanked, Bukele believes that Bitcoin adoption will help significantly reduce the cost of family remittances from expatriate citizens, which constitute a large portion of the country’s economy. Today, remittances often need to be processed and sent through expensive services that often charge 7% or more, and the use of Bitcoin would reduce this transaction cost substantially.
Despite these potential benefits, the adoption of Bitcoin by ordinary citizens in El Salvador has been patchy, at best, with many businesses attempting to accept the cryptocurrency and later ditching it due to technical or logistical issues. One complaint has been the lack of Bitcoin ATMs, which allow users to cash out their Bitcoin for cash, and the high cost of these ATMs when they are available.
Of course, the most substantial issue negatively impacting the adoption of Bitcoin is the currency’s high volatility. Many vendors who have started to accept Bitcoin in recent months have ditched the idea due to losing money by keeping their assets in Bitcoin. Thus, to retain the value of their savings, business owners have needed to immediately convert their Bitcoin to dollars, adding an extra level of inconvenience and expense to their operations.
It should be noted, however, that the resistance to Bitcoin adoption in El Salvador has gone beyond simple frustration and a lack of widespread adoption. In fact, protests broke out around the country right after Bukele officially announced the currency would be adopted as legal tender, with many saying that the move would only bring further instability and inflation to the country. Protestors even burned and destroyed a Bitcoin ATM machine in an act of defiance against the legislation.
A final risk that should be noted is the fact that making Bitcoin acceptable as a fiat currency could lead to an increased potential for money laundering, particularly if the country does not utilize strong KYC (know your customer) and AML (anti-money-laundering) laws in concert with its broader Bitcoin legislation. While the potential of dirty money may be an acceptable risk for a country potentially facing a near-term financial crisis, it could lead to negative international scrutiny and make it even more difficult for the country to obtain loans from institutions like the IMF.
This is particularly salient due to the international community’s increased focus on preventing money laundering and tax evasion in the wake of scandals like the Panama Papers, in which more than 11 million documents pertaining to Panamanian money laundering were released, starting in 2016. The papers implicated thousands of powerful individuals, including current and former heads of government in major countries as well as the British Royal Family. The international focus on AML increased even further in 2022 after Russia’s invasion of Ukraine led many major governments to conduct in-depth investigations of the financial assets of Russian oligarchs, many of which are hidden in off-shore bank accounts and in crypto wallets.
In addition to adopting Bitcoin as legal tender, one of El Salvador’s major Bitcoin initiatives is the creation and issue of “Bitcoin bonds.” The first $1 billion bond issuance was initially planned for between March 15 and 20th, 2022, though this date was recently pushed back to legal and logistical issues, as well as the financial disruption caused by the Russian invasion of Ukraine. The bonds, according to the government, will have 10-year terms and an annual coupon of 6.5%. This is around 50% of the 13% returns currently generated by El Salvadorian government bonds.
The funds from the first Bitcoin bond, once issued, will be used for several purposes. Reportedly, 50% of the funds will be used to purchase more Bitcoin to increase the nation’s Bitcoin reserves, while the other 50% will be utilized to fund government infrastructure, including geothermally-powered Bitcoin mines. Some of the funds will also be used to begin building El Salvador’s “Bitcoin City.” The government plans to lock up the Bitcoin for five years after purchasing it, with the hope of providing an additional coupon to investors should the coins generate sufficient profit.
The bonds, unlike traditional government bonds, which trade conventional bond markets, will be tokenized via the Liquid Network, a Bitcoin layer-2 which allows for the issuance of security tokens. They will be initially traded on Bitfinex, which is not currently available to U.S.-based investors. As of late February 2022, the bonds, according to the government, had $500 million in verbal commitments.
The tokenized, digital nature of these bonds could increase the use of derivatives trading, such as futures and options trading even more so than if they were issued via traditional markets, which could lead to increased price volatility. In addition, protocols like AAVE may be willing to issue loans based on the bonds, though this is unlikely to have a significant impact on their price. On the other hand, if a large portion of the bonds were staked or locked into yield farms, it could stabilize the price of the bonds, potentially making them more popular for ordinary investors and institutions.
Additionally, it should be noted that recent reporting suggests that the bonds may not be issued by the El Salvadorian government itself, and will instead be issued by government-owned geothermal power company La Geo. This could be an attempt to reduce the government’s liability or the impact on the government’s credit rating should the bonds drop in value, but, if so, is unlikely to be a particularly effective strategy.
El Salvador’s planned creation of a “Bitcoin City” located next to a volcano is perhaps its most ambitious initiative. The city would focus on low-cost Bitcoin mining using geothermal energy and would be virtually tax-free, save for a 10-13% flat tax used to fund the city’s infrastructure and fund government bond coupons.
While the promise of cheap energy and low taxes is likely to attract a fair amount of Bitcoin miners, this may not be enough to make the city worth the initial investment, and may not be enough to make it a strong, long-term contributor to the country’s economy. Bitcoin mining is more difficult and more expensive than ever, and may not be realistically profitable for any more than a few more years. Most other blockchains use some form of proof-of-stake model, which requires little energy, and even Ethereum, which still relies on the energy-intensive proof-of-work model, is in the process of attempting to shift to a proof-of-work consensus model.
In many ways, one might say that the concept of a Bitcoin-mining-based city is really a few years behind the curve– such a venture would have likely been far more profitable 3-5 years ago when Bitcoin mining was still less expensive and had a lower-cost entry point for smaller players. Instead of simply focusing on Bitcoin mining, El Salvador’s Bitcoin bond money could likely be better spent offering grants and low-interest loans for crypto and Bitcoin startups. This is especially due to the potential that the broader blockchain industry may end up becoming far larger than the market cap of Bitcoin.
El Salvador’s attempted switch toward a crypto-based monetary system may not be as misguided as it seems, but it is perhaps plagued by an over-reliance on Bitcoin. Bitcoin, while it may be the largest and best-known crypto, may not be the best for legal tender due to its high volatility, and may not be the best for growth due to its already sky-high price in comparison to other cryptos. In essence, by focusing so much on Bitcoin, the country is putting all of its monetary eggs in one basket– and this is far from the only option the country has if it wants to increase crypto adoption in the hopes of boosting its struggling economy.
One option could be to create a CBDC (central bank digital currency) backed by a variety of cryptocurrencies and fiat currencies, including traditional dollars, stablecoins, Bitcoin, Ethereum, and others. This would likely remain far more stable than Bitcoin alone via its incorporation of dollars and stablecoins, and could take advantage of a small percentage of higher-growth cryptos to potentially increase the value of the currency over time, much like an investor might allocate a small portion of assets to higher risk stocks or bonds.
This would potentially give the country more control over the value of its cryptocurrency, while still promoting greater financial inclusion and reducing the cost of remittances. This type of diversified and crypto slash fiat-backed CBDC would also likely be far more attractive as backing for government bonds, which would potentially increase foreign bond investment far more than the issuance of Bitcoin-only backed bonds.
Alternatively, the government could make multiple cryptos legal tender, including ETH, which would give people a wider array of payment options. They could also make various stablecoins, such as USDC legal tender, which would allow merchants to keep their assets in crypto without worrying so much about the extreme volatility of Bitcoin.
Overall, El Salvador’s multi-pronged effort to use Bitcoin to prop up its economy is both ambitious and fraught with risk. Many of the ideas behind the various legislative efforts seem to have elements of merit, but seem to be both too aggressive in some ways, and not aggressive enough in others. For example, rolling out Bitcoin as legal tender could have been done more gradually to reduce any potential market risks (too aggressive), but El Salvador could easily have made more cryptos, particularly more stable ones, legal tender (not aggressive enough).
El Salvador’s plans for a Bitcoin bond are also fraught with excessive risk. The potential failure of the bond to generate profits for investors could easily further degrade the country’s credit rating, which has already slipped in recent months, and could make it even harder to get bailouts from institutions like the IMF, who have already stated that they will likely not do business with El Salvador as long as the country keeps Bitcoin as legal tender.
While El Salvador’s Bitcoin bond and legal tender efforts are fascinating, perhaps the country’s most interesting project is its plans for a nearly tax-free Bitcoin city powered by geothermal energy. As mentioned previously, in some respects, the peak days of Bitcoin mining are over, at least for small enterprises, so the city’s success may be based on a declining industry. However, this doesn’t mean it couldn’t be repurposed to help attract entrepreneurs and investors in the larger crypto and blockchain industry.
In the end, El Salvador’s Bitcoin dreams rest on one thing and one thing alone: the future price of Bitcoin. While Blockstream, the company operating the Liquid network on which El Salvador’s Bitcoin bonds will be tokenized, believes Bitcoin will reach $1 million within 5-10 years, there’s no guarantee that it will even retake its 2021 high of close to $70,000. Therefore, Bukele and his government’s myopic focus on Bitcoin could be its downfall, but it also could be its salvation.
For El Salvador’s Bitcoin plan to truly thrive, Bitcoin won’t just need to stay steady; it will have to grow in order to provide investors the impressive returns they’ve been promised– and to incentivize more investors to do business in– and with, the small nation. Even if its Bitcoin project fails, El Salvador has brought a ridiculous amount of attention to its economy, which, all else held equal, could be a major boon for a place most never hear about.
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