Why did El Salvador accept bitcoin as legal tender: Reasons & Road Ahead

El Salvador a country formerly known for its exquisite volcanoes and surf beaches will now be known as the first country in the world to adopt bitcoin as legal tender. On June 10, El Salvador achieved this historic feat when 62 out of 84 possible votes of lawmakers were voted in favor of the move to create a law to adopt bitcoin.

To understand the motivating factors to legalize bitcoin, a little knowledge about the economic background becomes necessary.

El Salvador had a very rocky past. The country had witnessed it all from the autocratic regime, civil war to corrupt leaders.

Before bitcoin, they had two official currencies

  1. Colón
  2. US dollar

In 2001 country decided to dollarize its economy and made the US dollar their official currency like some other of its counterpart central American nations i.e. Panama & Ecuador. They did it with intention of giving a boost to their economic growth and achieving stability.

Some economists argue in favor of the dollarization of the economy and believe that it can help developing countries to counter the problem of inflation and stabilize the economy which also increases its chances of getting investment. It is because the US dollar is the global reserve currency and is most dominantly used around the world by countries for trading & funding purposes.

On the other hand, the other group of economists is against the dollarizing strategy as it causes these developing nations to relinquish their power to control the nation's monetary policy. This means that these nations are at mercy of the federal bank of the U.S. because every change in the monetary policy of the U.S. will impact these nations as well. While designing their monetary policy U.S. only have one objective in their mind: the welfare of its citizen and they are not concerned by the ramifications their decisions can have on these dollarized nations.

Bitcoin has been made the legal currency of El Salvador under the Bitcoin law of the country. It is important to note that the US dollar and Colón are still their official currencies, bitcoin is an additional currency. For the regulation of bitcoin, a separate law named ‘BITCOIN LAW’ has been published by the government.

Some important provisions of law

Article 7 of the law mandates that an economic agent must have to accept bitcoin as a payment from the consumer for any goods or services discharged by him. Although, Article 12 of the law provides for an exception that is those agents who don’t have access to technology that allow them to carry out transactions in bitcoin are excluded from the mandate of Article 7.

Article 13 states the retrospective nature of the law that all the existing debts expressed in the US dollar can now be paid in bitcoin.

Article 4 and Article 5 state that taxes can be paid in bitcoin to the government and bitcoin will not attract any capital gains tax just like any other legal tender doesn’t attract any capital gains tax.

Articles 8 and Article 14 state that the state will provide alternatives to users to transact in bitcoin and immediately convert the bitcoin to US dollar if they wish. For automatic and instantaneous conversion of bitcoin, a trust will be created by the government under 90 days before the law comes into force.

  1. Remittances

The Economy of El Salvador relies heavily on remittances (money sent home from abroad) which makes more than 20% of the GDP of the country. El Salvador comes in the top 5 countries of the world whose remittance is the main source of their GDP.

Over 2 million Salvadorans live outside the country and send money around $4 billion every year. Roughly 70% of people do not have bank accounts or credit cards and work in the informal economy. The process of sending money takes place through the help of intermediaries. These intermediaries can charge 10% or more in fees for those international transfers, which can sometimes take days to arrive and that sometimes require a physical pick-up. A digital currency like bitcoin provides an efficient way out of this hefty commission charged by intermediaries i.e. remittance banks.

2. Possible Increase in GDP

There’s a massive probability that legalizing bitcoin will show a substantive change in the GDP of El Salvador as the chances of Investment and tourism also increases. This is one of the crucial reasons behind this decision.

President Bukele is optimistic that the change will be positive. He said in one of his tweets that even if 1 % of the total market cap of bitcoin is invested in El Salvador it would increase their GDP by 25%.

3. Over-Reliance on US dollar

More than two million Salvadorans (about a quarter of its population) live outside the country, but they continue to keep close ties to their place of birth, sending back more than $4bn each year. Last year, despite the pandemic, they sent home more than $6 billion in remittances.

The U.S. federal reserve has been printing money at an unprecedented rate since 2020(as shown in the graph below) to cope with the impact of covid and to give a boost to their economy. El Salvador is not getting any benefit from all this printing of money. In fact, they are at disadvantage as the value of the dollar is diminishing. This increase in the supply of dollars raises inflation concerns to the economy of El Salvador.

Rate of Money Supply since 1960. A sharp spike can be seen from 2020 which shows increase in printing of money at an unprecedented rate.
Rate of Money Supply since 1960. A sharp spike can be seen from 2020 which shows increase in printing of money at an unprecedented rate.

The reliance on the US dollar hasn’t reaped any substantive benefits so far. Legalizing bitcoin could be the 1st step by El Salvador to gradually reduce their reliance on the US dollar. Bitcoin has the potential to penetrate deep into the mass and become people's currency. In this case, the government of El Salvador can get some extent of control in designing the monetary policy of the country.

4. Net importer of goods

In 2001 to provide stability to their economy El Salvador dollarized their economy. The Monetary Integration Act, 2001 created a fixed exchange rate between the colón and the dollar and took away the Central Reserve Bank’s exclusive right to issue currency. El Salvador is a net importer of goods which means their imports weigh more than their exports.

El Salvador Balance of Trade.El Salvador recorded a trade deficit of 673.61 Million in April of 2021.

As a result, eventually, they are going to run out of money. Now, for a normal country, it wouldn’t be a problem because they can print their own money and maintain a healthy circulation of money but the same is not the case with El Salvador as they are unable to print their own money. This is the reason they rely on loans from external sources such as International Monetary Fund (IMF).

5. No substantive increase in GDP since dollarization

The common reason for the adoption of the US dollar as an official currency was to provide stability to the economy against inflation and to keep interest rates in check so that new investment could flow in. However, El Salvador never had a problem of hyperinflation in past and therefore stabilizing of the economy didn’t show any major benefits. Also, there were no considerable inflows of investment after this decision as investors considered El Salvador not safe because of its high crime rate and violence.

Their GDP hasn’t improved as per expectations after dollarizing the economy. In fact, the GDP was doing considerably better before dollarization.

1) Influx of Investment & Employment

This legislation can appeal to companies around the world who are dealing in blockchain technology. These companies can establish their headquarters in El Salvador. These companies around the world are striving to get regulatory clarity and their main concern is political uncertainty. Right now there are only a handful of countries that provide a conducive environment for blockchain companies such as Malta, Switzerland, Estonia, etc.

El Salvador can start seeing some investments from companies or investors who want regulatory clarity with this landmark decision. Companies would be able to show BTC much more easily in their balance sheets in the cash at hand column as they will be given treatments just like any other currency.

2) Alteration of International Law

Law regulations around the world need to be changed to deal with El Salvador. The Bitconization of El Salvador has created complexities and raised a few eyebrows such as IMF. The designation of bitcoin as legal tender by El Salvador has mechanical implications for its treatment in larger economies under tax law, banking and financial regulations, and other areas, analysts at JPMorgan said in a note.

According to them this step of El Salvador can create complexities in existing International laws and regulations. It’s only natural because existing laws didn’t take into consideration bitcoin yet. This can be taken as a positive that BTC will get recognization in the legal framework at the international level.

3) Inclusion in the financial system

70% of the people will be able to become part of the financial system. Citizens of El Salvador would be able to enjoy financial services without becoming part of the traditional banking system. Strike a mobile payments app which is powered by bitcoin’s Lightning Network was launched in March, and it quickly became the number one downloaded app in the country.

The objective of financial inclusion of the majority of the mass can be achieved with the legalization of bitcoin.

4) Persuasive Value

Now any other country that is the trade partner of El Salvador cannot ban bitcoin easily because it would mean that they are banning the official currency of their trade partner.

Now that El Salvador has recognized bitcoin as a currency, this would mean no capital taxes will apply to the gains made from bitcoin. This will put pressure on other countries to start seeing bitcoin as a currency and classify it as currency as opposed to an asset or commodity.

Also, if this pilot program of adopting bitcoin by El Salvador goes well and if all the potential benefits get materialized. The other countries in similar situations to El Salvador could also consider legalizing bitcoin.

Conclusion

El Salvador has taken an audacious step and haven written itself into history books. This is considered a pilot project by countries around the world and they will be following it diligently. The make or break of this project will have a huge impact on the future adoption of bitcoin as a currency by countries worldwide.

Indeed, the path ahead is filled with challenges for EL Salvador like imparting technological know-how about bitcoin and its usage to its citizens, making negotiations with IMF to secure a $1 billion loan deal, providing clarity to its global trading partner countries about the payment structure about its future operations and the biggest challenge would be to handle the volatility of bitcoin.

There are both critics as well as proponents of this move. Critics are mostly the people who are averse to the philosophy or instability of bitcoin and the proponents are a strong believer in the concept and philosophy of bitcoin. In the end, it will all come down to the referendum of mass. Sure, El Salvador will face difficulties in the short term. But, the history of bitcoin has taught us one thing that bitcoin is a force to reckon with and it has not only stood strong but thrived in the last 12 years. El Salvador also together with bitcoin can stand the test of time against all odds.

Lawyer/Writer/ Blockchain Enthusiast/ Finance Buff