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2021 in Review: El Salvador’s Bitcoin Experiment

27 Dec 2021
By Cagri Kumru

The growing importance of remittances in El Salvador has opened the doors to increased use of digital currencies. But the volatility of crypto-currency presents a significant barrier to this process.

On 8 June 2021, the smallest country in Central America, El Salvador, was thrust into the spotlight due to legislation that made the Bitcoin legal tender in the country. In order to understand the reasons behind this decision, it is necessary to look at the broader context in El Salvador.

El Salvador has a population of 6.4 million and is one of the most densely populated countries. Interestingly, more than 1.5 million El Salvador citizens live abroad. El Salvador is a middle-low-income country with a relatively low economic growth rate for a developing country, high unemployment rate, and a large trade deficit. Remittances sent by El Salvador citizens living abroad finance the majority of trade deficit. While exports of goods and services are equal to 26 percent of the gross domestic product (GDP), the remittances are equal to 24 percent of GDP, highlighting the importance of remittances for the El Salvador economy. El Salvador is one of the top countries that receive a substantial amount of remittances.

In 2001, El Salvador replaced its currency, the Colón, with the US Dollar by giving up the monetary policy all together. Having the US Dollar as a legal tender, however, has not positively contributed to the economic prosperity as expected by stimulating exports and tourism.

Remittances have utmost importance for the survival of the El Salvador economy. They provide substantial relief,  reducing the trade deficit and providing livelihoods for the substantial number of El Salvadorians who depend on them. Yet the remittance transactions are quite expensive for many reasons, including underdeveloped financial systems in developing countries and the lack of transparency in fees. In order to overcome the lack of transparency, the World Bank has a dedicated website that shows the fees charged by various service providers. For instance, the cost of making a bank transfer from the US (a major expat destination for El Salvadorians) to El Salvador is on average three percent of the transfer amount. As of 2020, El Salvador received approximately $6 billion in remittances. An estimated $180 million was lost in fees rather than contributing to the wellbeing of El Salvadorians.

Since El Salvador now uses the US dollar as a legal tender, there is no loss due to the exchange rate differences. Yet there are other hurdles regarding money transfers from the US. The banks and online service providers often have their own limits on the amounts that can be transferred.  In addition, they are required to inform the Internal Revenue Service (IRS) of any transfer over $10000. Although the financial institutions’ daily transfer limit is less of a concern, many expats living in the US might prefer money transfers outside the regular channels to escape IRS scrutiny. In addition, undocumented immigrants might not have an access to the financial products provided by the regular banking system, and their willingness to send remittances might be substantially hampered accordingly.

Although the digital money system (credit cards, debit cards, PayPal, etc.) has developed substantially and acquired a large user base over the years, its usage requires “trusted third parties” such as banks. This implies higher costs, in terms of fees and the loss of anonymity. In contrast, good old fashioned paper money provides anonymity, and there is no transaction cost to use it.

The cryptocurrency bitcoin was created around 2009 as an electronic version of paper notes that retains the benefits of both paper notes and digital money: no need for trusted third parties such as banks creating anonymity, no transaction cost, no need for physical storage, and perfect divisibility (exchanges can be any amount with no cost). Although the bitcoin was born as a perfect alternative to the paper and digital money, it lacks legal backing. Over the years, the bitcoin price increased unprecedentedly, and its value became too volatile, making it more a speculative asset than money.

Over the years, the number of cryptocurrencies has skyrocketed. The total number of cryptocurrencies is 7,812, with a total market cap of $324.716 billion as of 20 January  2021 . Hence, the viability of cryptocurrencies, including bitcoin, is still debatable. The current cryptocurrency market resembles the stock market bubble of internet-related companies of the late 1990s. There is no doubt that the cryptocurrency market will eventually reach a stable equilibrium. Yet, it does not look like this will happen soon.

Given the importance of remittances for El Salvador, it is understandable that the El Salvador government tries to maximise the remittances received. In contrast to strict economic reforms that the put the country into a high growth path, maximising the remittances is less risky for the incumbent government. Using bitcoin to transfer money to El Salvador can generate a substantial amount of savings in fees. In addition, the anonymity provided by bitcoin will remove any legal concerns regarding transferring money to El Salvador. Finally, the senders will not be burdened by the transfer amount restrictions imposed by the banks and other online financial intermediaries. Yet, the high volatility of bitcoin is the major hurdle in maximising the remittances received. The volatility might deter willingness to make transfer in bitcoin. Similarly, bitcoin holders in El Salvador might refrain from using it.

In my opinion, adopting the bitcoin as a legal tender in El Salvador does not have many direct benefits except potentially increasing the remittances received and putting the country into the spotlight for a certain period of time. Unless the volatility settles down, I do not see a widespread usage of bitcoin in El Salvador. Since El Salvador has its own peculiarities as explained above, I do not think that the future results of the El Salvador experiment should be seen as an example by countries that want to adopt a cryptocurrency as a legal tender.

This article was originally published on 6 October 2021.

Cagri Kumru is an associate professor in the Research School of Economics at the ANU. He teaches and researches in Macroeconomics. 

This article is published under a Creative Commons Licence and may be republished with attribution.