Central banks are increasingly taking actions that may cause harm to the economic stability of El Salvador. In order to mitigate the negative impact from central banks, it becomes necessary to authorise the circulation of a digital currency with the supply that cannot be controlled by any central bank.
El Salvador President Nayib Bukele
On 9 June, El Salvador – the smallest country in Central America – became the first country in the world to make bitcoin unrestricted legal tender and thereby an official national currency. This move attracted a lot of attention, not only in the cryptocurrency community. As the quote at the beginning of the blog shows, one of the reasons for doing so was to insulate the country from the monetary policy actions of ‘other’ central banks, the main one being the US’ Federal Reserve. Under the so-called Monetary Integration Law, El Salvador fully dollarised in 2001, meaning that the US dollar became the sole legal tender in the country. This resulted in a loss of economic sovereignty, monetary independence and seigniorage, but little impact on subsequent GDP growth.
While dollarisation has at least not been detrimental to El Salvadoran growth in the period after 2001, US monetary policy in the very recent past may not have been optimal, as the depreciation of the US dollar following the Federal Reserve’s large-scale asset purchases led to a loss in El Salvador’s international purchasing power. This left the country ever more dependent on remittances which, close to USD6 billion per year recently, make up almost a quarter of the country’s GDP.
In fact, El Salvador is not the only developing country complaining about spillovers from advanced countries’ (unconventional) monetary policies. With dollarisation no longer being regarded as helpful for El Salvador, can the introduction of bitcoin as legal tender deliver on all the benefits that are being sought, such as macroeconomic stability, economic growth and financial inclusion?
Lest a country that still prints its own currency is tempted to follow El Salvador’s example, this blog offers some cautionary thoughts on the six preambles and 16 articles of the country’s Bitcoin Law as they have been stated at the time of writing. One of the blog’s main aims is to explore whether there are any general aspects of the El Salvadoran Bitcoin Law that hold lessons – or could serve as a blueprint – for other countries that want to follow suit.
Art. 1. The purpose of this law is to regulate bitcoin as unrestricted legal tender with liberating power, unlimited in any transaction, and to any title that public or private natural or legal persons require carrying out.
What is mentioned in the previous paragraph does not hinder the application of the Monetary Integration law.
Article 1 of the Bitcoin Law states that bitcoin is deemed unrestricted legal tender, which is obviously the raison d’être of the law and not at all contentious. The same cannot be said for the second sentence, which indicates that the Monetary Integration Law, and hence the US dollar as legal tender, will remain in place. In essence, El Salvador is adopting a dual currency system, under which two national currencies will be circulating side-by-side, both of them being legal tender. As such, the government will be operating a dual currency regime system, with neither of the two currencies under the control of the domestic authorities. Being fully dollarised, the country will remain dependent on US monetary policy. But it will now also be exposed to the fluctuations in the price of bitcoin relative to the US dollar. In other words, the new system will exacerbate the constraints that were brought to the fore under dollarisation, namely the lack of an independent institutional framework around which to organise and operate its macroeconomic stabilisation policies.
Preamble 5. That in order to promote the economic growth of the nation, it is necessary to authorize the circulation of a digital currency whose value answers exclusively to free-market criteria, in order to increase national wealth for the benefit of the greatest number of inhabitants.
Art. 2. The exchange rate between bitcoin and the United States dollar, subsequently USD, will be freely established by the market.
Not only will there be two concurrent legal tenders, but the price of one will be fluctuating against the other. Since bitcoin’s creation in 2008, academics, policymakers, rule-setters, accounting boards, taxation authorities and regulators have been at pains to define what bitcoin is and how it should be treated. While bitcoin may technically be classified as a digital currency, many jurisdictions define it as a speculative asset. This is borne out by its volatility over the past two years (and even before), which makes it at best a speculative asset and perhaps an – extremely risky – store of value, but certainly not a means of exchange. As noted by Paola Subacchi, between 8 and 15 June 20201, bitcoin’s value swung between USD32,462 and USD40,993, and in the period from 15 May to 15 June, it ranged from USD34,259 to USD49,304. This period includes a 30 per cent fall on 19 May alone. The price of bitcoin is much more volatile than the US dollar; indeed, it is much more volatile than most (floating) exchange rates and most other financial assets.
The argument that this speculative asset should now be used to promote the economic growth of the nation in order to increase the national wealth is therefore somewhat troubling, especially in light of the fact that, as outlined in Preamble 5 and Article 2, these fluctuations are entirely market-driven, with no effective scope for policymakers to manage the swings. The nation will thus be prone to the vagaries of the volatile bitcoin exchange rate without recourse to any of the regular monetary policy tools, such as exchange rate interventions or capital flows management measures.
Interestingly, El Salvador’s move to put bitcoin on par with all other national currencies may have wider ramifications for the international monetary and financial system. More specifically, it may force a re-appraisal of bitcoin in both national and internationally accepted accounting principles and suchlike. The same will be true for national and international tax agreements. Many jurisdictions regard bitcoin as either an indefinite-lived intangible asset, a financial instrument, barter, a commodity or property. But El Salvador bestowing legal tender status upon bitcoin may change this calculus. If national currencies such as pound sterling, the Japanese yen, the Mexican peso or the Malaysian ringgit, to name just a few, have special tax status, why not the legal tender of El Salvador, which just happens to be bitcoin? Will accounting bodies still be able to regard bitcoin as an asset? Bitcoin as legal tender in El Salvador could potentially elicit a different international accounting regime in which bitcoin will have to be treated more like cash.
Art. 3. Prices may be expressed in bitcoin.
While prices ‘may’ be expressed in bitcoin, prices for goods and services throughout the country will also still be quoted in US dollars, meaning that in addition to a dual currency system we also have a dual pricing system. In other words, if something costs USD1.50 before, it will still cost USD1.50 after the introduction of bitcoin. But how much would it cost in terms of bitcoin? We reckon that going shopping without a smartphone to make the conversion between the two prices will become impossible. Can there be one-sided transactions in US dollars, i.e., I pay in US dollars for a good or service expressed in bitcoin? What would be the exchange or conversion rate? How would the process work? We will have a more in-depth look at these issues and some of the implication further below.
Art. 4. Tax contributions can be paid in bitcoin.
Let us raise some questions to which we cannot really provide satisfactory answers. If tax contributions can be paid in bitcoin, should private- and public-sector wages also be paid in bitcoin, seeing that it makes economic sense to pay agents in the economy in the same currency in which they pay their taxes? In fact, a government might decree that public servants must accept bitcoin as salaries, although the El Salvadoran government had to back down on this idea. There might also be an issue with payroll systems if some workers get paid in US dollars while others prefer to be paid in bitcoin. Would a government be happy to accept taxes paid in bitcoin and how would they enter into the national accounting system?
Art. 5. Exchanges in bitcoin will not be subject to capital gains tax, just like any legal tender.
Art. 6. For accounting purposes, the USD will be used as the reference currency.
Articles 4 and 5 of the Bitcoin Law state that the US dollar retains its role as a unit of account and means of exchange. This throws up some subtle accounting issues, as all bitcoin holdings at some point will have to be accounted for in US dollars for tax purposes. More specifically, if the US dollar is the reference currency for accounting purposes, is there an issue with unrealised gains and losses? Say an El Salvadoran corporation buys bitcoin at USD10,000 and holds them on their books. What happens in case the price of bitcoin falls to USD5,000? If the current price of bitcoin is lower than the purchase price, this realised loss is frequently written down as an impairment. On the other hand, what happens if the price of bitcoin increases to USD20,000? Some accounting practices regard an appreciation as an unrealised gain and treat it as such. Does Article 6 mean that there is no such distinction and corporations will face neither impairments nor unrealised gains?
Art. 7. Every economic agent must accept bitcoin as payment when offered to him by whoever acquires a good or service.
There are – at least – three points to note here. With bitcoin a compulsory legal tender, all agents in the economy are forced to accept it, whether they are ready and willing or not. According to El Salvadoran President Bukele, “If there is a lady selling fruit on the market, she is obliged to be paid in bitcoin”. There is an underlying presumption that she will be able to be paid in bitcoin and in a position to further process the transaction in terms of accepting bitcoin and either storing it or forwarding it to be converted into US dollars. By contrast, in most countries, merchants are in their right to either refuse legal tender or, at a minimum, refuse certain large-denomination notes. Finally, the mandatory nature of Article 7 certainly runs counter to bitcoin’s original libertarian ideals.
Art. 8. Without prejudice to the actions of the private sector, the State shall provide alternatives that allow the user to carry out transactions in bitcoin and have automatic and instant convertibility from bitcoin to USD if they wish. Furthermore, the State will promote the necessary training and mechanisms so that the population can access bitcoin transactions.
Art. 9. The limitations and operations of the alternatives of automatic and instantaneous conversion from bitcoin to USD provided by the State will be specified in the Regulations issued for this purpose.
Art. 14. Before the entry into force of this law, the State will guarantee, through the creation of a trust at the Banco de Desarrollo de El Salvador (BANDESAL), the automatic and instantaneous convertibility of bitcoin to USD necessary for the alternatives provided by the State mentioned in Art. 8.
Following on from above, these three clauses mean that the government guarantees the convertibility between bitcoin and the US dollar at the time of transaction, which is an extremely risky proposition. The government proposes to manage this process and facilitate the automatic and instantaneous convertibility of bitcoin to US dollars by setting up a USD150 million ‘trust fund’, which will take the opposite side of Salvadorans’ bitcoin bets. This government-run exchange or Casa de Cambio will be set up by BANDESAL (Banco de Desarrollo de la República de El Salvador), El Salvador’s government-owned development bank.
El Salvadorans who do not want to hold bitcoin or who find bitcoin’s volatility too risky will not have to maintain it on their balance sheets. But the trust fund will be exposed to losses whenever the value of bitcoin offered to it declines between the time merchants themselves receive it and the conversion by the Casa de Cambio into US dollar. In short, the Casa de Cambio will shield El Salvador’s bitcoin-receiving merchants from volatility risk by having the government, i.e., taxpayers, bear that risk.
In essence, the government is temporarily ‘pegging’ a highly volatile domestic currency to the US dollar in order to make the conversion. To put the size of the trust fund into perspective, each year, Salvadoran emigrants send back USD6 billion in remittances, with the majority coming from the US, where 2.2. million people of Salvadoran ancestry live. That is 40 times the size of the ‘trust fund’ reserve. Emigrants could transmit bitcoin to businesses and relatives on their smartphone, who would then use the Casa de Cambio to convert the bitcoin remitted from abroad into US dollar, thereby bypassing official bitcoin exchanges or other middlemen, some of whom charge up to eight per cent for converting bitcoin into US dollars. Without wanting to stretch the analogy too far, this sounds like a variant of a currency board arrangement, but without the full backing normally assumed, and against a volatile asset. While there is no fixed exchange rate against bitcoin, for practical purposes the exchange rate is fixed as far as the Case de Cambio is concerned. It will also not be able to devalue its way out of the problem of not having enough US dollars. Another apt analogy might be the set-up associated with a Diamond and Dybvig (1983)-type run on a bank.
There remain a few unanswered questions, such as the composition of the trust fund, in particular the decomposition between digital bitcoin and US dollars. What does the Casa de Cambio give me in return for the bitcoin I am exchanging? Will it be physical US dollars, or will it be digital US dollars? With 70 per cent of Salvadorans being underbanked, where do either of these forms of US dollars go?
Under this conversion process, merchants can instantly re-convert the received bitcoin back into US dollars or keep bitcoin on their accounts of they prefer. Assuming I go from US dollars to bitcoin and prefer to stay in bitcoin, where do I keep them? In a bank? In a cryptocurrency wallet? (While Salvadorans can use any compatible wallet to interact with the new bitcoin-based monetary system, there is an official, government-sanctioned smartphone wallet engineered by Strike.) This situation may arise when the price of bitcoin versus the US dollar increases. In this case, I am incentivised to hold back on the automatic and instantaneous conversion into US dollar. I can bide my time, collect a small number of bitcoin transactions in my wallet and then exchange them all together. Converting bitcoin into US dollars outside the Casa de Cambio is time-consuming and costly – exchange commissions are on the order of eight per cent of the transaction amount. In this situation, merchants may become bitcoin HODLers, waiting for bitcoin prices to rise before exchanging their bitcoins for US dollars. This obviously translates into a higher US dollar amount to be transferred by the Casa de Cambio. But in the opposite case of the bitcoin price falling, the merchant may lose more money than exchanging bitcoin for US dollars the old-fashioned way, i.e., paying a hefty commission, immediately at the time of purchase.
The Casa de Cambio provides a means of conversion between US dollar to and from bitcoin, but what will be the exact timing of the transaction? The date and time of the sale? The date and time of the delivery of the good or service? The invoice date? In this respect going to the market for the daily shopping will be very different from paying something from an online vendor that is priced in bitcoin.
Three final thoughts in this regard revolve around the following. One, the Bitcoin Law does not foresee a big role for the traditional banking system, which may not be surprising in a country where 70 per cent are underbanked. In other countries, though, fears about disintermediation in the traditional banking system are more prevalent. Two, the lack of physical bitcoin currency also increases the prospect of a black market. Three, the coexistence of two currencies that are legal tender may also result in a case study of Gresham’s law, which is a monetary principle stating that “bad money drives out good”, although it is a priori unclear which of the two currencies will emerge as the “good” money.
Art. 10. The Executive Branch will create the necessary institutional structure to apply this law.
Articles 9 and 10 reveal that a lot of issues still need to be ironed out, which does not fill us with a lot of confidence. Outside of regime changes forcefully brought upon by major economic or financial crises, such as the UK’s move from a fixed-exchange rate regime to inflation targeting over the course of a weekend after Black Wednesday on 16 September 1992, most transitions to a new legal tender, a new currency regime or a new monetary policy regime are well prepared, with a long lead time to prepare the institutional and operational infrastructure for the eventual change. This was the case with the three-year transition period from legacy currencies to the physical euro after 1 January 1999, for example. By all accounts, this is not what happened in El Salvador. The proposal to make bitcoin legal tender in El Salvador was announced on 5 June at the Bitcoin 2021 conference in Miami, and the Bitcoin Law was passed with practically no discussion, oversight or scrutiny on 9 June.
In addition, it appears that the public may not be ready for the introduction of bitcoin as legal tender. A survey by the El Salvadoran Chamber of Commerce conducted in the days following the announcement found that over 92 per cent of all those surveyed, and 94 per cent of all entrepreneurs, would rather not have to accept bitcoin. In fact, 93 per cent said that they do not want to receive their salary in the cryptocurrency, while 83 per cent assured that they are not interested in receiving their remittances in Bitcoin either. The overarching reason cited for the public’s aversion was a general ignorance of bitcoin and its high volatility.
Finally, if bitcoin is treated like cash, what will international regulators, including the Financial Action Task Force (FATF), make of the automatic and instantaneous conversion of bitcoin into US dollars? The FATF is the global money laundering and terrorist financing watchdog, which sets international standards to prevent these illegal activities. These include such basic checks as Know-Your-Customer (KYC) regulations. To what extent will the Casa de Cambio be able to fulfill these requirements in all their automatic and instantaneous transactions? Establishing customer identity, understanding the nature of customers’ activities, certifying that the source of funds is legitimate and assessing money laundering risks associated with customers and automatic and instantaneous conversion between bitcoin and US dollars and vice versa seem to be at odds.
This blog raised a number of cautionary macroeconomic and financial issues having to do with making bitcoin legal tender in El Salvador. It skirted over some of the organisational and infrastructure issues, starting with the fact that potential recipients of bitcoin would require a bitcoin wallet or a bitcoin-enabled account. While most nationals have a smartphone, formidable challenges remain as only 70 per cent of citizens have a bank account and the country only has a 30 per cent internet coverage. Some – but not all – of these aspects also feature in the ongoing discussion of a central-bank issued digital currency (CBDC).
There may well be other reasons for the introduction of bitcoin, such as El Salvador becoming the world capital of the bitcoin ecosystem, making the country a haven for crypto billionaires, ushering in a monetary version of disruptive innovation, creating what President Bukele calls “a sanctuary country for crypto”, generating capital inflows from sources other than multilateral development banks or trying to break away from the US dollar system all together.
This blog raised more questions than it provided answers, which is probably telling us something about El Salvador’s experiment in macroeconomic policy. El Salvador’s small size and the government’s obvious earnestness and drive in pushing though with the proposals are supporting the endeavour, but unless the issues highlighted here are resolved, El Salvador’s bitcoin experiment ought to be closely watched from a distance and should not be considered a role model for other countries.