The Central American state’s adoption of bitcoin as legal tender could catalyse the use of cryptocurrencies as a standard means of payment around the world
El Zonte is a small coastal town about an hour’s drive south from El Salvador’s capital, San Salvador. The palm-fringed Pacific resort has long been known to surfers, but more recently it has found fame in the cryptocurrency community. In 2019, it started an experiment to run the local economy on bitcoin. El Zonte never before had a bank, but now it has an ATM where people can buy crypto with US dollars (the nation’s official currency since 2001), earning the town the nickname Bitcoin Beach.
In June 2021, El Salvador’s president, Nayib Bukele, announced that bitcoin would be adopted as legal tender nationwide, making his government the first in the world to designate a cryptocurrency as a primary means of payment.
John Wu is president of Ava Labs, developer of the Avalanche blockchain platform. He believes that El Salvador’s adoption of bitcoin is “extremely significant. It shows that governments really believe that this is something that can be widely adopted and secure enough to be used as legal tender. From a philosophical perspective, it moves the whole crypto space into utility, as opposed to something that people speculate on.”
Bukele’s decision is rooted in the fact that El Salvador hasn’t had its own currency for two decades, having dropped the colón for the dollar in 2001. About 70% of the country’s citizens are unbanked, with many relying on dollars sent back from relatives abroad. The total remitted this way each year is equivalent to 22% of El Salvador’s annual GDP, according to Deutsche Bank.
“It’s an interesting experiment,” says Frances Coppola, an independent economist, blogger and author. “Given that 70% of the nation’s economy runs on physical dollars that can only be obtained from outside the country, introducing something that is more accessible online could make life a little easier for people in El Salvador. Moving to a digital means of payment is a step forward, although I’m not convinced that they’re going about it the right way.”
Bitcoin volatility poses problems for payments
One problem with the government’s decision is that it compels merchants to accept bitcoin whether they want to or not.
“It’s not legal tender; it’s forced tender,” says Steve Hanke, a professor of applied economics at the Johns Hopkins University in Baltimore and an expert on troubled currencies.
To Hanke, who helped El Salvador to draft parts of the legislation that replaced the colón with the dollar, it’s unclear why the government is abandoning a system that has served the country relatively well over the past 20 years.
“Inflation has been just over 2% a year on average. That’s the lowest in Latin America,” he says. “El Salvador’s economic growth and GDP per capita have also been higher than those of most countries in the region. Exports are strong too, so you have to ask why they’d want to change something that isn’t broken.”
Moreover, there are disadvantages to using bitcoin as a means of payment. First, it is notoriously volatile – its value has fallen by about half from its peak in April 2021, for instance.
Coppola notes that many Salvadorans are very poor and/or dependent on money sent from abroad. “If these remittances come through in bitcoin and its price drops by 30%, say, they’ve lost a substantial amount,” she says. “To be fair, they have an equal chance of gaining on the price movements. But such volatility is bad news for people seeking a safe way to save and a reliable means of payment.”
Another snag is that bitcoin attracts high transaction costs.
“At the moment, there isn’t a reliable means for doing low-value transactions in bitcoin, so using it is expensive,” says Coppola, who adds that networks such as Lightning, which allow for faster and cheaper payments, remain relatively unproven.
A superior cryptocurrency could replace bitcoin
Despite the caveats surrounding El Salvador’s adoption of bitcoin, Hanke still believes in the potential of cryptocurrencies to transform how people use money.
“As a means of payment, this is the future,” he says. “It will come to fruition, but superior cryptos will come in and push bitcoin out of the picture completely.”
Wu believes that El Salvador has been too impatient in adopting bitcoin. The government should, he argues, have held out for the emergence of a cryptocurrency that’s more suited to payments.
“It’s like El Salvador saw what Yahoo could do, but couldn’t wait for Google to turn up,” he says. “Its reason for choosing bitcoin is that it’s the largest and most liquid crypto. But part of being a legal tender is being a payment system – and, unfortunately, bitcoin is still far, far away from being a good payment system. It’s still good as a digital store of value, but in the long run bitcoin is not going to be the right solution for payments.”
Wu adds that, for cryptocurrencies to be widely adopted as a payment mechanism, their transaction times need to be faster. At present with bitcoin, it takes too long to confirm a payment. In addition, crypto payment systems need to be able to accommodate a far larger number of users.
There are several emerging platforms, including Avalanche, that are trying to solve the speed, scale and cost problem. Which cryptocurrency will win that race is open to debate, but it may not be a private cryptocurrency at all.
While other dollarised emerging-market economies will may be watching El Salvador’s experiment closely, countries such as China, the US and the UK and currency blocs such as the eurozone are all at various stages of developing or considering their own cryptos in the form of central-bank digital currencies (CBDCs).
“People often ask: ‘Would a power such as the US ever adopt an externally produced cryptocurrency?’ The answer to that is a resounding ‘no’,” Coppola says. “But the likelihood that they would issue their own cryptocurrency is quite high.”
The issuance of CBDCs is unlikely to be greeted with much enthusiasm among traditional crypto users, given that using these would remove their anonymity.
“The problem with CBDCs is that they go against the ethos of why cryptocurrencies became popular around the world in the first place,” Wu says. “A CBDC like the digital yuan in China makes it easier for a government to intrude upon the individual.”