Caribbean & Central America - June 2022

In mid-May, El Salvador’s President Nayib Bukele welcomed representatives from 44 countries to discuss the country’s adoption of cryptocurrency bitcoin as legal tender.

The event was ostensibly an opportunity for other nations to learn about the rollout, after El Salvador became the first country in the world to adopt bitcoin as an official currency in September 2021. “Tomorrow, 32 central banks and 12 financial authorities (44 countries) will meet in El Salvador to discuss financial inclusion, digital economy, banking the unbanked, the bitcoin rollout and its benefits in our country,” tweeted Bukele on the eve of the event, on 15 May.

But while Bukele continues to try and paint his bitcoin adventure as a success, the main lessons to be learned are in fact about the risks of adopting the cryptocurrency. Major financial institutions such as the International Monetary Fund (IMF) warned El Salvador about the effects of the volatility of bitcoin on the country’s already fragile public finances, and a recent collapse in its price has justified those concerns. After hitting a record high in excess of US$67,500 in November, bitcoin was trading at US$42,000 in mid-March, with the volatility having a knock-on effect on public finances.

In the short-term, Bukele has also lost around US$40m on the country’s bitcoin holdings, according to an estimate from Bloomberg published 12 May. At the time, bitcoin was worth around 45% less than it was when Bukele first bought into the cryptocurrency, which meant El Salvador’s 2,301 bitcoins were worth around US$66m. The US$40m cumulative loss is almost equal to El Salvador’s 15 June coupon payment on foreign debt. While losses from bitcoin trading are unlikely to bankrupt a nation state, the experiment is diverting resources that could be put to much better use and affecting investor confidence.

Perhaps the most important effect of the mid-March price crash is due to the fact that it came shortly before the planned issuance of a 10-year US$1bn bitcoin-denominated bond, known as a “Volcano bond,” and as a result the Bukele government decided to delay the bond issue. Finance Minister Alejandro Zelaya said that the government had a number of other options to raise money, and there was zero chance of the country defaulting on its foreign debt. However, analysts suggest there could be a crunch point in January 2023, when the country would be required to make a US$800m Eurobond repayment.

Adding to concerns are a series of recent downgrades from international credit ratings agencies. On 1 June Standard and Poor’s (S&P) Global Ratings downgraded El Salvador’s long term sovereign credit ratings to CCC+ from B- with a negative outlook. S&P cited a high fiscal deficit, which it expects to remain around 4.5% of GDP between 2022 and 2024 and a high level of debt which it expects to remain at 80% of GDP between 2022-2025. It also cited fewer financing options, a situation widely attributed in part to the government’s decision to adopt bitcoin as legal tender and its fall-out.

On 4 May, Moody’s downgraded the Salvadorean government's long-term foreign-currency issuer rating and long-term foreign-currency senior unsecured debt ratings to Caa3 from Caa1 (see sidebar) while in February Fitch Ratings downgraded the country’s Long-Term Foreign Currency Issuer Default Rating (IDR) to ‘CCC’ from ‘B-’. Fitch said that the downgrade reflects heightened financing risks stemming from increased reliance on short-term debt; the US$800m Eurobond repayment due in January 2023; a still-high fiscal deficit; limited scope for additional local-market financing; and uncertain access to additional multilateral funding and external market financing given high borrowing costs.

This means that it has become much more expensive for El Salvador to borrow in order to finance its debt. “El Salvador’s fiscal problems don’t stem from bitcoin, but it is true that it [the bitcoin law] has contributed to the deterioration of the country’s risk profile,” Ricardo Castaneda, an analyst at Guatemala-based thinktank Central American institute of fiscal studies (Icefi), told local investigative media El Faro in a piece published on 13 May. “If El Salvador were to look to issue bonds now, assuming that somebody would buy, they would have to pay 25 to 26 percent interest,” Castaneda said, “whereas a year ago they would have paid around 7 percent.”

One possible lifeline is a US$1.3bn three-year programme with the IMF which the two sides have been discussing for over a year. However, the adoption of bitcoin as legal tender has complicated negotiations. El Faro cites London-based financial research firm EMFI as saying that El Salvador’s bonds are already trading as if the country had announced a default, and, if no deal with the IMF is announced, the risk of insolvency in the next five years is 87%.

Bukele has shown no signs of rowing back on his gamble on the cryptocurrency, continuing to tweet about “buying the dip” when bitcoin prices crashed. He remains popular, receiving a score of 8.34 out of 10 in a survey published on 25 May by the Universidad Francisco Gavidia in El Salvador. His continued popularity three years into his term is remarkable, particularly considering the anti-incumbent wave that has swept the region in recent years.

“There are those in international finance who suspect that if Bukele is…re-elected in 2024 [a possibility following the controversial decision by the judiciary last year to overturn the ban on consecutive presidential re-election], he could unilaterally rewrite the terms of the debt, or decide not to pay altogether,” Salvadorean journalist and California State University, Fullerton academic Ricardo Valencia wrote for El Faro. “Bukele would have the perfect cast of scapegoats: multilateral financial organizations, the US government, and the political opposition.” But while some try to predict Bukele’s next move, the reality of strained public finances at a time of rising living costs is affecting ordinary Salvadoreans, a ticking time bomb could bring the whole house of cards tumbling down around Central America’s biggest bitcoin proponent.

• Moody’s

Moody’s said its decision to downgrade El Salvador “reflects an increased probability of a credit event – restructuring, distressed exchange, or default – with relatively high severity, as the sovereign faces a challenging debt amortisation schedule with bond maturities in 2023 and 2025 in a context of continued funding stress and persistently high financing needs”. At the same time the agency lowered El Salvador's foreign-currency country ceiling to Caa1 from B2 “to reflect the low predictability of institutions and government policies, weak policy effectiveness and the government's relatively large share in the country's total external debt”.