Could El Salvador’s Bitcoin Adoption Spark Economic Crisis?

The El Salvador Bitcoin surprise was the green light seen around the world.

When El Salvadorian President Nayib Bukele announced during the Miami Bitcoin conference that his country would be the first to accept Bitcoin as legal tender, maximalists bathed in glory. MicroStrategy CEO Michael Saylor called the announcement “hope for El Salvador,” while Tether founder Brock Pierce led an “official” delegation to El Salvador in a meeting organized by the El Salvadorian Ambassador to the United States—which confused many cryptocurrency advocates given Bitcoin has no “official” representatives.

#Bitcoin is hope for El Salvador. https://t.co/oCFfU13wmV

— Michael Saylor⚡️ (@saylor) June 25, 2021

The International Monetary Fund was less amused, and warned about “a number of macroeconomic, financial, and legal issues.”

As the first country to accept Bitcoin as legal tender, El Salvador’s announcement comes with significant risks not only for its own economy, but cryptocurrency markets and the entire global financial system. Paradox has outlined four central issues, and how they could work in tandem to create a financial contradiction.

1. Bitcoin is extremely volatile.
2. El Salvador’s reserves will face considerable challenges contending with this volatility.
3. The compulsory mandate for businesses to accept Bitcoin will pigeonhole El Salvador’s government into dipping into its reserves.
4. El Salvador has officialized a crypto-to-fiat offramp that could lead to strange arbitrage and artificial economic activity.

The most obvious of these reasons is that Bitcoin is a volatile asset. Bitcoin’s price skyrocketed to an all-time high of $65,000 this year, only to crater and lose half its value following Elon Musk’s tweets and the China mining lockdowns. The asset is not pegged to anything other than scarcity and what buyers are willing to pay for it, unlike stablecoins (many of which like Tether and USDC hold a peg to the U.S. dollar).

With a GDP of roughly $27 billion and $3 billion in foreign exchange reserves, El Salvador is one of the weaker Latin American economies. Bukele has set aside $150 million, or 5% of El Salvador’s trust, to buffer Bitcoin’s volatility. The fact that Bitcoin isn’t the best medium of exchange, and that it’s now legal tender (which means businesses must accept it), forces El Salvador’s government to make up for potential economic losses.

If a corporation is required to accept Bitcoin, the payment goes into the company’s treasury. However, the costs factored into goods, manufacturing, and labor are not accounted for in the immediate. While this isn’t a problem with stable currencies like the U.S. dollar, it is a problem with volatile cryptocurrencies like Bitcoin: What someone pays for something one day may not be what it’s worth the next. Sharp Bitcoin selloffs could severely impact company bank balances and lead to liquidity crises El Salvador’s government has obligated itself to intervene in; again, with limited resources to do so. Since El Salvador has dollarized its economy, it cannot print money like the United States to replenish the trust.

Even Bitcoin’s biggest advocates have cautioned Bukele from making Bitcoin payments mandatory. Castle Island Venture Funds Partner Nic Carter, who recently interviewed the El Salvadorian president during a Twitter Spaces conversation, called the policy “politically unwise.”

“Very real impediments exist to implementing a digitized transactional network in El Salvador,” wrote Carter in a column for CoinDesk. “Not everyone has access to a smartphone, power or the internet, and learning how to use bitcoin- whether on-chain, via Lightning or through a custodial app – takes time and effort. Bitcoin is great for some types of exchange, but brick-and-mortar retail transactions are not among them.”

Problems arising from Bitcoin’s volatility and El Salvador’s low reserves will likely be exacerbated by the foreign capital flocking to take advantage of the only government sanctioned crypto-to-fiat offramp. Traders often capitalize off Bitcoin’s arbitrage discrepancies across various exchanges, and a situation could easily emerge where the price of Bitcoin in El Salvador increases relative to other parts of the world, which in turn fuels more volatility and makes hedging more difficult for businesses and the government.

Artificial economic frenzies could occur in-contradiction with the fundamental problem that Bitcoin is not the best medium of exchange. The parties using El Salvador as a crypto-to-fiat ramp to convert Bitcoin to U.S. dollars have no incentive to keep their capital parked in the country, and could prey off arbitrage discrepancies and volatility affecting businesses in the region.

Bukele’s announcement is a significant one that could transform the global financial system. It could also reveal a contradiction and set off a chain reaction, given how immeshed cryptocurrencies have become within the global economy.

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