A SMALL NORTH AMERICAN COUNTRY SENT SHOCKWAVES AROUND THE WORLD BY ADOPTING BITCOIN AS ITS LEGAL TENDER. HERE'S THE WHOLE PICTURE.
El Salvador, the smallest Central American country took a giant step recently. It has a mixed economic system that includes a variety of private freedom, combined with centralized economic planning and government regulation.
The country’s economy has traditionally been an agricultural one but now a greater proportion of the population is employed by the service and industrial sector and accounts for a much higher proportion of GDP. The economy was severely affected by the 12 years of civil war. However, attempts were made to revive the country's economic life, and the economy had recovered by the beginning of 2001 when El Salvador adopted the U.S. dollar as its official currency.
THE PERKS OF EMBRACING A CRYPTOCURRENCY
El Salvador became the first country in the world to adopt bitcoin as legal tender after the country’s Congress on Wednesday, June 9, 2021, approved President Navib Bukele’s proposal to embrace the cryptocurrency, a move that delighted the currency’s supporters. According to Mr Bukele, in the short term, this will generate jobs and help find financial inclusion to thousands outside the formal economy. There are still many questions over how the digital currency would become the country's legal tender - a major overhaul of El Salvador's financial infrastructure would be needed with Bitcoin at its heart. But, in essence, it appears that is what Mr Bukele is proposing. Much of El Salvador's developing economy is based on remittances from abroad and the move to a digital currency may allow family members to avoid the costly fees involved in sending money home each month. Either way, it is a move which is likely to bolster Bitcoin's image as the "currency of the future" and President Bukele's standing among his supporters as an innovator.
President Bukele
El Salvador abandoned its own currency (the “colon”, named after Christopher Columbus) in 2001 and adopted the US dollar as its legal tender. This process of “official dollarisation” was seen as a reform that would curb inflation and increase trade with the US (by far its major trading partner). So El Salvador has less to lose than other nations in adopting a second currency as legal tender. There is no controversy about losing sovereignty and monetary policy autonomy. There will be no loss of “seignorage” – the profit made on issuing currency that’s worth a lot more than the cost of making it. But having two legal tenders will complicate matters – particularly when one of those currencies is subject to wild swings in its value.
THE PITFALLS OF A VOLATILE CURRENCY
Consider the provision in the new law that “all obligations in money expressed in USD, existing before the effective date of this law, may be paid in bitcoin”. Even that is complicated. How, and by whom, will the number of bitcoins necessary to pay a debt to be determined? Will it be based on the Bitcoin price at the time the debt was incurred, or when the debt falls due? The difference of even a few days could be significant. If the expectation is the price of Bitcoin is going to rise, why would you want to buy things with it? Why not wait? If the expectation is the price is going to fall, why would you want to accept it? For most transactions, using US dollars will still make the most sense. So, making Bitcoin legal tender could help destabilise El Salvador’s economy.
The rationale that Bukele stated for this decision was that even if only 1% of bitcoin is invested in El Salvador, it would increase their GDP by 25%. Also, bitcoin will have 10 million potential new users and the fastest growing way to transfer 6 billion dollars a year in remittances. It is also believed that El Salvador will turn into a financial powerhouse of the future.
This move is a positive step towards making Bitcoin will be the future of currency. However, with so much volatility in the market, risk-averse investors are still hesitant to buy Bitcoin, much less any other cryptocurrency.
Since Bitcoin isn’t controlled by any central entity, its monetary policy is much sounder than any other government. With governments printing out more money than ever before in light of the pandemic, investors are looking for alternative investments to hedge against inflation. Many are turning to Bitcoin to do so, facilitating the adoption of cryptocurrency over the long term.
It remains to be seen what the future beholds for bitcoin. This can be a monumental failure by a crazed leader or a stroke of genius by a futurist. Whatever happens, EL Salvador is n for a topsy turvy ride!