El Salvador’s Bitcoin Move Poses More Questions Than Answers

Borrowing is one of the key pillars in finance. Individuals, businesses, and even governments borrow to undertake spending, which may exceed the inward flow of cash. The world of credit is underpinned not just by the borrower’s ‘will and capacity’ but also by certainty and transparency in interests.

Now, imagine Salvadorans availing credit in bitcoin.

The world’s most popular digital currency is now a legal tender in El Salvador. It essentially means it is on par with the US dollar in the Central American country, which does not have a local currency. The ambitious plan has been questioned, given the volatility in the values of digital currencies. Over the last almost two months, Bitcoin’s market value has plummeted by nearly 40 per cent. The downhill trend has refused to subside due to multiple factors, including China’s crackdown on mining and the recent ‘low hashrate’ development.

Borrowing in bitcoin denomination

Questions now arise on the future stability of the Salvadorian financial system once it starts accepting deposits and credit in bitcoin amid the ongoing volatility. Consumers will soon be able to pay for goods and services via cryptocurrency. Once in circulation, the legal tender will inevitably become a part of the broader financial system that include maintaining deposits and availing credit in the bitcoin denomination. The past two months have been a challenging ride for Bitcoin, and if the trend continues, it can hurt predictability in the credit landscape of El Salvador.

For example, if a borrower avails credit facility at a time of bullish trend in Bitcoin, the person may have a much greater spending capacity. If, subsequently, the value falls, repayment will become easier, but it can negatively hurt the creditor, which in most cases will be a commercial bank.

Zimbabwe’s currency experiments

Almost at the same time when El Salvador was warming up to Bitcoin as legal tender, Zimbabwe began a crackdown on local businesses that were quoting prices in US dollar instead of local currency, which was reintroduced in 2019. The authorities in the hyperinflation-inflicted economy of Zimbabwe issued orders in view of businesses purchasing US dollars at official foreign currency auction but charging for goods in rates prevailing in the black market (nearly 40 per cent more). The move was followed by an unwanted but steep hike in prices of goods, including essential commodities, exacerbating the inflationary pressure.

Shunned almost a decade ago due to inflationary pressures in Zimbabwe, which saw prices surging 100 per cent each passing day, the Zimbabwe dollar was reissued in 2019. The government sought to increase the money supply by printing new local currency following a ban on foreign currencies, including the US dollar, in June 2019. All this was preceded by a time in 2008 when annual inflation was as high as 238 million per cent. The move in 2019 to ban foreign currency, which people relied on for over a decade, was neither hailed by Zimbabweans nor did it result in any change in the economic mess prevalent in the country.

In March 2020, the government reinstated foreign currencies in transactions, and then came the latest June 2021 flip-flop when businesses were ordered to stop quoting prices of goods and services in foreign currency.

El Salvador’s Bitcoin adoption

El Salvador may have made headlines by adopting a digital currency as legal tender, but the road ahead may be full of bumps. The country is yet to finalize bitcoin’s adopted process in the financial landscape. The country approached the World Bank to use its guidance in implementing the decision, but the latter rejected it, citing bitcoin’s ‘transparency drawbacks’.

The 39-year-old Salvadorian president, Nayib Bukele, has invited the wrath of various power centres due to his controversial policy actions. This includes a crackdown on the country’s judiciary, which the US vice president Kamala Harris condemned, and a heavy-handed stance to implement lockdown measures, which earned him a rebuke from the United Nations High Commissioner for Human Rights. He recently pulled the country out of the Organization of American States, a regional forum for political and policy analysis discussions in the Western Hemisphere. In his declaration to make Bitcoin a legal tender, the president did not offer any credible rationale to support such a critical macroeconomic policy decision.

Conclusion

Apart from being a legal tender or medium of exchange, currencies are a tool to manage macroeconomic elements such as market liquidity, price rise, international trade, and job growth. An argument that bitcoin will save the Salvadoran economy billions of dollars in foreign remittance cannot outweigh risks associated with using a hyper-volatile asset as a parallel medium of exchange alongside the world’s largest forex currency, the US dollar.

Borrowers in El Salvador may have these aspects at the back of their minds while availing credit in the bitcoin denomination even as the government pushes the crypto.