El Salvador’s crypto foray offers a cautionary tale for other countries

Synopsis: The tiny Central American nation of El Salvador has embarked on an interesting experiment by recognizing bitcoin as legal tender. This is proving painful for many of its citizens, but it’s a useful “pilot” project for larger economies that are contemplating about this new asset class.

Introduction

El Salvador has a population of 6.5 million and GDP of about $27 billion. At a nominal per capita of less than $4,200, it is not a rich country.

In 2001, it “dollarised” meaning it replaced its currency, then the colon, with the USD.

This month, at the urging of its President, a crypto-enthusiast, it adopted bitcoin as legal tender as well. This means it now has two parallel legal currencies, USD and bitcoin.

Every business in El Salvador, must accept bitcoin as legal tender for goods or services, unless it is unable to provide the technology needed to process the transaction.

What has been the impact of El Salvador’s decision?

The adoption has led to turmoil in the cryptocurrency market and doesn’t seem to have been well-received in El Salvador itself.

– The value of bitcoin crashed by 19% on September 7, the first day of adoption. Chivo, the govt’s wallet for Bitcoin, was overwhelmed by users trying to register.

– There have been riots and demonstrations against the new currency. Most citizens don’t want to accept the crypto in normal transactions. They are understandably doubtful of holding an asset, which often swings 10% in value on an average day and 25-30% on “swing sessions”.

– The spread on the interest El Salvador pays on its national debt over US treasury rates has widened.

– Ratings agencies downgraded El Salvador once the bitcoin plan was announced in July.

What are some issues with adopting Bitcoin?

Bitcoin mining consumes more power than Belgium on a daily basis. So this is not environmentally friendly. That’s one of the reasons China has offered for cracking down on cryptocurrency.

Another issue is that the money supply increases at a fixed rate, and every transaction recorded on the blockchain involves a unique bitcoin. This makes it hard to carry out normal lending operations. Fractional reserve banking is difficult, except by converting every transaction to a fiat currency before lending, and converting back when servicing the loan. This means accepting massive risks on the exchange rate.

It can take a long time for any transaction to be registered and verified on the blockchain since this must be confirmed by multiple blockchain-watchers.

One of the barriers to adoption is lack of understanding and another is lack of technology. Also, transactions are hard without a smartphone which means a deep penetration of smartphones is needed to encourage widespread adoption.

What are some positive implications?

The world will get a sense of how crypto works as it’s used in normal daily transactions in El Salvador. McDonald’s, local groceries, taxi services, etc., have started accepting bitcoin, and it’s estimated that around 10 per cent of daily transactions by value are now being done in bitcoin.

Source: This post is based on the article “El Salvador’s crypto foray offers a cautionary tale for other countries” published in Business Standard on 29th Sep 2021.