Since mid-2021 the small Central American republic of El Salvador has placed itself at the vanguard of Latin America's experimentation with cryptocurrencies. How well - or how badly - the experiment works in a country with a population of 6.5m is being closely watched by regional giants such as Brazil (population of 212m) and Mexico (129m). By way of background, it is important to note that in February 2019 Nayib Bukele, a populist and self-declared political outsider, achieved a sweeping victory in the presidential race, gaining 53% of the vote, which made a second-round run-off unnecessary.
The big losers in the elections were the parties of the traditional right and left that had dominated national politics since the civil war (1979-1992). Although Bukele, a former mayor of San Salvador, had been a member of the left wing Frente Farabundo Martí de Liberación Nacional (FMLN), by the time of the election he had severed ties, creating his own movement through the Nuevas Ideas (NI) political party. In power since June 2019 the president, a millennial (he was 39 when he first took office), displayed increasingly authoritarian behaviour.
In 2020 he orchestrated the so called 9F crisis (for 9 February) when, at his bidding, a group of army soldiers invaded the Legislative Assembly to intimidate deputies to vote through an enlarged security budget. His hard line on security matters and his repeated attacks on the corruption of the traditional parties were wildly popular. In the February 2021 legislative elections Bukele's new party won a landslide, taking 66.5% of the vote and 56 of the 84 seats. His enhanced majority in the legislature gave him sweeping powers. Bukele used this support to push through initiatives to tighten his control of the judiciary and to restrict press freedoms. Under his rule El Salvador's populist and authoritarian policies attracted increasing criticism from the Joe Biden administration in the United States.
This was the background for the country's big cryptocurrency experiment. Like a handful of other Latin American countries (including Panama and Ecuador) El Salvador has a dollarised economy. On 5 June 2021 President Bukele announced that, alongside the US dollar, El Salvador would now also use Bitcoin as legal tender. A briefly worded bill with 16 articles outlining the change was approved by 62 out of the 84 deputies, requiring the new dual-currency monetary regime to come into effect within 90 days.
The president used various arguments to defend the move into crypto. He said it would give Salvadorans access to a secure and efficient global payments system. This would be particularly important for the estimated 2m Salvadoran expatriates living in the United States, who would be able to send remittances home without having to pay large commissions and fees (remittances play a key role in the local economy, representing US$5.9bn or 20% of GDP in 2020). Bukele also claimed that adopting Bitcoin would boost financial inclusion for the roughly two-thirds of the population that is poor and unbanked. And in an early response to environmental concerns over energy-intensive Bitcoin mining, the president said El Salvador could use its volcanoes to generate renewable geothermal energy to do the job.
At this stage there was already an early foreshadowing of some of the macro-economic problems involved in the shift to crypto. With a heavy foreign debt burden the Salvadoran government was at that stage negotiating a US$1.3bn, three-year IMF extended fund facility (EFF) with the IMF. Such a financial support package was seen by both sides as essential to avoid a foreign debt default and to engineer a gradual reduction in the country's fiscal deficit. But on 10 June the IMF warned that adopting Bitcoin as legal tender would have macroeconomic, financial, and legal risks that would require careful analysis. Other critics pointed to Bitcoin's volatility and its potential use for the purposes of tax evasion and money laundering.
Bitcoin became legal tender in El Salvador on 7 September 2021. All Salvadorans were encouraged to download the Chivo or 'cool wallet' app that came pre-loaded with US$30 worth of Bitcoin credit to encourage adoption. The launch was troubled by a series of technical glitches, with the app crashing at various points. While Bukele remained popular, public opinion surveys suggested that up to 70% of respondents opposed the idea of Bitcoin as a new national currency. However, according to officials, one month after launch, an estimated 3m out of the population of 6.5m had downloaded the Chivo app
Using illicitly obtained ID and contact deals, fraudsters were able to steal a number of the pre-loaded US$30 Chivo balances. The government announced the creation of a US$200m fund to underpin crypto currency risks, but the IMF described this as insufficient. The Fund also noted that allowing individuals and companies to pay taxes in highly volatile Bitcoin currency would make it much more difficult for the government to reliably predict its revenues or to set out a credible fiscal plan. Other criticisms included the lack of government transparency over its own Bitcoin trading accounts, or over the progress being made to instal Bitcoin-enabled ATMs around the country. Critics of the government noted that the company running the Chivo programme had been chosen without any competitive tendering.
It became evident that there were serious obstacles to reaching an agreement with the IMF, and that the country's adoption of crypto was one of them. In October 2021 Douglas Ramírez, vice-president of the central bank (Banco Central de Reserva), said he hoped the country would “soon” sign the US$1.3bn agreement with the IMF. His comments came after 11 civil society organisations, including the national private sector organisation ANEP and human rights lobby Cristosal, published an open letter to the IMF requesting that any loan to the country be made conditional on measures to restore democracy and the rule of law. In the same month there were protest demonstrations against the government in general, but also specifically against the introduction of Bitcoin.
In November the IMF appeared to take a step back, saying that discussions with El Salvador did not “currently” include any talks on a financial assistance package. While it praised the government for its handling of the economic impacts of the Covid-19 pandemic, and for presiding over a strong economic recovery in 2021, it highlighted risks posed by a larger fiscal deficit, low currency reserves (expected to dip below three months' worth of imports) and unsustainable public debt (reaching 85% of GDP). The Fund also highlighted “unaddressed regulatory and supervisory gaps related to the use of Bitcoin”.
In December diplomatic tensions between El Salvador and the US increased, with the Washington government saying it was sanctioning Carolina Recinos, Bukele's cabinet chief, for alleged corruption and bribery in Covid-19 procurement. Other officials were later to become the subject of similar sanctions.
By January 2021 the government was following a new tack, fleshing out earlier plans to issue a 10-year US$1bn Bitcoin-denominated bond, to be known as a ‘Volcano bond’. The bond would be launched on the Liquid platform operated by Blockstream and would carry a 6.5% coupon, a much lower interest rate than available on other sovereign bonds and loans (which, reflecting rising risk premiums at the time, had soared to as much as three times higher). However, it would also include a share of the eventual proceeds of Bitcoin appreciation. Finance minister Alejandro Zelaya said the bond would be launched in February or March.
The minister suggested that the government still had a number of funding options including the IMF, the traditional international bond market, investment and development banks, and the new crypto currency markets. Zelaya later was more specific, suggesting the bond would be issued between 15 and 20 March, but that window was missed. The finance minister then said the country remained ready to launch the Bitcoin bond but was waiting for better market conditions and the go-ahead from President Bukele. Zelaya also suggested the bond would be issued after El Salvador completed plans for pension reform, which were also running behind schedule.
Many analysts reached the conclusion that the Bitcoin bond would at best be delayed until late 2022, and in a worst-case scenario might never actually materialise. Zelaya insisted that there was zero possibility of El Salvador defaulting on its foreign debt. However, amid strongly rising risk premiums on the country's debt, analysts were suggesting there could be a crunch point in January 2023, when the country would be required to make a US$800m Eurobond repayment.
After six months most analysts are giving El Salvador's Bitcoin experiment mixed reviews. Despite extensive media coverage, the physical network of Bitcoin ATMs has expanded slowly. Many users simply downloaded the Chivo app, changed the US$30 incentive into dollars, and continued as normal without Bitcoin becoming a regular, ongoing part of their daily financial lives. People without smartphones (including many of the elderly living in rural areas), and those without internet connections, have remained out of the loop. Even in El Zonte - the seaside resort known as 'Bitcoin Beach', where cryptocurrencies were first introduced to the country, many traders continue to prefer cash.
A major disincentive for adoption has been the volatility of Bitcoin - a fall in its price versus the dollar in late 2021 caused many to experience currency losses. The government points to the fact that just under 4m people have downloaded the Chivo app - well over half the population - as a sign of success. A report by Ark Investment Management was also optimistic, saying that 3.8m had downloaded the app “suggesting an 84% adoption rate among eligible citizens”. Ark also said more people now have Bitcoin wallets (3.8m) than traditional bank accounts (1.9m), and the Chivo wallet is being used for 12% of remittances sent home by Salvadoran expatriate workers in the US. However, critics say the number of app downloads with a US$30-per-account incentive cannot really be taken as synonymous with full adoption.
Indeed, supporting a more pessimistic view, a March 2022 survey by the Chamber of Commerce and Industry of El Salvador found that 86% of businesses had never conducted any transactions in Bitcoin at all, with 91.7% saying the switch to crypto had not influenced their business in anyway, positive or negative. A survey conducted just before launch by the Central American University found that 67.9% of respondents disagreed with making Bitcoin legal tender, nine out of ten lacked a clear understanding of Bitcoin, and eight out of ten said they had no confidence in its use.
Bitcoin City: the next big thing?
In November 2021, Bukele announced another big crypto initiative, the idea of a 'Bitcoin City', to be built in the south-eastern region of La Unión, at the base of one of El Salvador's volcanoes. The city perimeter would be round, representing the shape of a large coin. It would use geothermal energy from the Conchagua volcano for Bitcoin mining. The president said it would “include everything...residential areas, commercial areas, services, museums, entertainment, bars, restaurants, an airport, port, rail - everything devoted to Bitcoin”. The president also said no income or other taxes would be levied in the city, apart from VAT, which would be used to help cover the construction costs. Bukele gave no dates for construction or completion of the city.
The president and his officials also said half the proceeds from the planned US$1bn Bitcoin or ‘volcano bond’ would go towards funding construction of the city. The other half - US$500m - would be used to add to the government's stock of Bitcoin holdings, with a pledge not to re-sell for five years.
The idea of building a Bitcoin city appears to have been any least partly taken from a recent project in Kazakhstan to attract crypto-currency investors by offering cheap electricity for Bitcoin mining. A Kazakhstan-registered company, Bitfinex Securities, was reportedly approached by the Salvador government about the project. However, unlike Kazakhstan, El Salvador currently has an electricity supply deficit, importing 22% of its total electric power needs from its neighbours in Central America. As of the time of writing it appears no feasibility studies have yet been commissioned for either the city or for the necessary expansion of generating capacity, whether geo-thermal or from any other source.
Bitcoin City could end up as the flagship project for Bukele's entire five-year presidential term, with its success or failure forming a critical part off his legacy. Ricardo Castaneda, an economist at Instituto Centroamericano de Estudios Fiscales (Icefi), has argued that the fate of the Volcano bond will impact on the president's entire political project. Castaneda says that if the government can launch the bond successfully, “it can laugh at the multilateral financial agencies, because it will have found an alternative source of funding...and will not be troubled by issues of transparency, fiscal responsibility, or democracy”. But if the Volcano bond fails the Bukele government will have to retreat, perhaps negotiating a deal with the IMF where Bitcoin loses its newly acquired role as legal tender.
The awkward audit questions
Hanging over the entire debate over Bitcoin in El Salvador is a significant lack of financial transparency. It is for example proposed that the country's Bitcoin bond will be sold on the Bitfinex platform, which has suffered previous hacking attacks and does not have regulatory approval in the US. As of the time of writing, no prospectus had been issued. In addition, unlike traditional sovereign bonds, which are usually governed by New York law, the bond is to be governed instead by El Salvador law. This is a serious issue for investors, particularly since the Bukele administration has controversially (and according to the opposition, illegally) appointed a majority of pro-government magistrates to the Supreme Court. It is their opinion that will count in any dispute over investment terms.
In addition, and despite any initial expectations, the plan is for the bond to be issued not by the sovereign, but instead by La Geo, a small, state-owned thermal energy company. La Geo is responsible for generating around 22% of El Salvador's electricity and in 2021 had revenues of UDS$136m and profits of US$36m. Its cash flow and collateral appear insufficient to manage such a large bond (it already has had to defer payments on US$200m worth of pre-existing debt because of the impact of the pandemic). Frank Muci, an economist at London School of Economics (LSE), has argued that issuing the bond through La Geo many be a move to protect the Bitcoin City project if El Salvador should in future default on its more traditional bonds. In an alternative scenario he notes it could also protect traditional bond funding in the event that the Bitcoin City project fails.
Some crypto enthusiasts have hailed the plan as a way of allowing El Salvador “to bypass the Wall Street banks and international institutions that have held a century-long choke hold on loans to developing economies” but Muci says too much of the small type is unclear. Muci’s unanswered questions include whether there is insurance against hacking attacks; and whether interest on the bond will be payable in US dollars, Tether (USDT), or Bitcoin. Muci's conclusion (in March 2022) was that “we are expected to be hyped about this ‘historic opportunity’ even though the legal framework that will govern the instrument still hasn't gone through El Salvador's congress, and no draft versions of the laws have been made public”.
Another area of concern is the government's own Bitcoin trading. Under the legislation approved by Congress the government can itself transact Bitcoin through a trading account at Bandesal, a state-owned development bank. However, there is no obligation to make public the details of buy/sell operations in this account. What details are known have been revealed by the president himself on Twitter.
Many of the transactions appear to have been executed directly by the president on a smartphone, raising potential security and conflict of interest concerns. As of January 2022, and according to public announcements, it appeared that the government had spent US$71m to acquire 1,391 Bitcoins. Since Bitcoin prices had been falling since the previous November, it was likely that the country had made a net loss of US$10m on these operations. Whether the president was using public funds to pursue any documented short-, medium-, or long-term trading strategy was also unclear.
Source: Statista data
