El Salvador, Dollarisation, and Bitcoin — What to Expect From Here

As you may have guessed, I have a lot of thoughts about the announcement that (as of the time of publishing, 7 June 2021) the president of El Salvador is going to introduce legislation that will make Bitcoin legal tender in their country. Their congress is expected to pass this law as his party controls a vast majority of seats. To say this is unexpected and a surprise to me is a bit of an understatement. However, given the amount of time and resources Jack Mallers and Strike have spent in El Salvador in the last year; to quote a far less serious businessman, “in retrospect, it was inevitable”.

My thesis was that the first nation state action related to Bitcoin would be a central bank or treasury establishing an official reserves position. I was thinking that a G20 nation (like Argentina) might be the first to do something along those lines. I thought that legal tender/medium of exchange would come second after some price discovery once nations began to establish reserves positions, possibly in the next epoch. This is an interesting development, and frankly, quite refreshing given my earlier views on Bitcoin when I first got into it (in favour of medium of exchange and private, uncensorable payments). The Lightning Network is a potent piece of technology and I’m excited (and honestly a bit nervous) to see it put into application like this on such a scale. This is going to be a massive experiment and we’re going to find out in a trial by fire if the tools the community has built are ready for widespread use. Exciting times.

I thought it would be useful and interesting to look into the currency situation in El Salvador and to analyse President Bukele’s decision to embrace Bitcoin in that context. First, we need to understand dollarisation, the history of currency failure in Latin America, and how El Salvador’s situation compares to others. Then, we will have a look at what this decision means in actual potential outcomes.

The History of Dollarisation

Dollarisation can mean different things depending on context. For the majority of cases, dollarisation refers to a nation abandoning its own national currency in favour of the dollar. This has happened on a spectrum ranging from full legal substitution to cultural preference in a mixed system in dozens of countries. Some countries, like Ecuador, El Salvador (nominally, more on that later), Panama, or Palau use actual US Dollars from the United States as their sole circulating currency and unit of account. Other countries, like Belize or Costa Rica officially peg their currency against the dollar (usually 2:1). Yet others still have a strong cultural preference for dollars and one may be able to pay for goods and services with dollars instead of the official currency of the country (such as in Guatemala or Haiti). For this article, we will be looking at both Ecuador and El Salvador.

The Effects of Dollarisation — Why Dollarise?

Nations generally have dollarised for two reasons — the first and most pressing is as a means to escape high levels of inflation or hyperinflation. The second is to make trade and commerce between the United States and the country in question easier (one of the reasons Panama has used US Dollars for over a century).

There are three chief concerns for nations when pursuing dollarisation: Seigniorage, being subject to US monetary policy, and elimination of exchange risk. The first two being negatives, the latter positive.

Seigniorage is a concept probably familiar to many Bitcoiners, but to briefly summarise; seigniorage is the difference between the cost to produce money versus what it is worth. In the context of dollarisation, the need for Ecuador or El Salvador to source US Dollars from the only entity that can produce them, the Fed, is a source of seigniorage for the United States as the only way to acquire the dollars is through international trade. This, essentially, is free upward pressure on GDP for the United States as the cost to produce US Dollars is very small compared to their face value. Seigniorage is essentially a tax that dollarised economies must pay for the privilege of using the US Dollar as it is a direct cost — goods and services must be exchanged for the dollars.

Loss of independent monetary policy is how most mainstream economists describe the inability to control the supply of currency, but we will simply call this being at the mercy of US monetary policy. The nuance is subtle. In most cases, countries dollarise in order to escape the printing press, so to describe the loss of this tool as a negative is only relevant if you discount what even led to the dollarisation in the first place. However, interest rate policy is also largely at the discretion of the Fed, an entity that does not take into account the effects of interest rate changes on Panama, El Salvador, Ecuador, etc. when they make these decisions. So a country may encounter a need for interest rates to be higher, but are subject to whatever interest rate policy the Fed is pursuing at that time — adrift in a sea where the currents are beyond your ability to influence.

Lastly, the elimination of exchange risk makes it so that common pricing can occur and make trade easier within the de facto currency union. Think about the anxiety that may surface when preparing to travel overseas if you’re watching your home currency depreciate versus the currency you’re about to travel to. That exists on a more macro scale for many nations, especially those with highly unstable currencies versus the “strong and stable” cohort of usual suspects. By adopting the US Dollar and essentially bringing yourself into a monetary union with the United States, you eliminate that concern entirely. A US Dollar in El Salvador is more or less a US Dollar in the United States and it enjoys the same pricing power, relatively speaking, in both places.

El Salvador and the Dollar: Mixed Results

Unlike Ecuador, where dollarisation is largely considered to have been a success, dollarisation in El Salvador appears to have achieved a much more mixed result. Some mainstream economists consider the move to be more of a failure than anything else as El Salvador has largely stagnated in a few key areas where dollarisation was theorised to provide benefits.

Dollarisation is the de facto currency paradigm rather than the de jure one in El Salvador. The currency of El Salvador is the Colón, and it kind of, sort of, still exists. When El Salvador dollarised, the currency was fixed to the dollar at a final, set rate and the central bank was legislatively stripped of the power to create or print any more units. In effect, almost overnight, all of the banks changed their unit of account to dollars. People switched over too. Today, the US Dollar circulates as the currency of El Salvador. Things are priced and paid for in dollars, and the large immigrant population of Salvadoreans¹ that resides in the United States earns dollars and remits some of those home.

On the flip side, Ecuador went all in on dollarisation. They ended their currency, the Sucre, completely and the only legal currency in Ecuador is the US Dollar. For cents, Ecuador issues their own physical coins in identical denominations as US coins, but from their own mint with custom designs (if you’re curious, you can view them here).

One possible theory for why dollarisation has been less successful in El Salvador is that El Salvador, while they did experience high inflation, never hyper inflated their currency. One of the biggest reasons that dollarisation was successful in Ecuador was that it brought price stability to a system that was running out of control. For a variety of reasons, El Salvador was never brought to this point (although an argument can be made they were on their way as the rate of inflation was increasing leading up to the decision to dollarise).

More likely, the high rate of crime and violence in El Salvador is a factor. Unlike Ecuador, which is relatively stable and has a crime rate comparable to the overseas territories of the United States, El Salvador has the highest murder rate per capita of any nation on Earth. This is a twofold problem for capital. Foreign investment tends to avoid jurisdictions with high crime and corruption, and for good reason — your investments are not safe and are exposed to inherent instability or the possibility of destruction or total loss. Secondly, and we’ll get into this in more detail as this is probably the core of what’s happening with El Salvador and Bitcoin, capital that is remitted to El Salvador in the form of US Dollar pay from relatives in one jurisdiction to the other is not being put to productive use, for likely the same reason. If you receive $500 in capital back from the States, are you likely to try and build a business if you know that either corrupt government forces or gang violence will destroy your investment? The answer must be no.

Another problem for El Salvador is that they have consistently ran large budget deficits without the corresponding “benefits” of printing. One of the reasons the United States is able to effectively print its way to prosperity is that the global demand for US Treasuries is so great (and the Fed’s ability to stack them on the balance sheet is so high) that the consequences are always out of reach². Not so for El Salvador as the demand for their dollar denominated bonds does not carry the same effect.

Lastly, trade and labour priced in dollars is less competitive internationally than their peer nations with less valuable currencies. In effect, Salvadoreans compete globally on the same footing as American citizens (and Ecuador) for their labour and exports. Trade is difficult in a free floating currency exchange system in which your GDP is low but your currency is strong. For example, the daily wage in El Salvador is about $7.00 USD. The price of exports is roughly on par with those of equivalent value across the USD system. So you have less buyers of El Salvador products due to strong pricing, less exports available for sale thanks to low GDP, all contributing to lower wages (which begets lower buying power). It’s a hard cycle to break out of and requires capital investment to boost GDP — see previous points about why this hasn’t materialised.

So Why Bitcoin?

A number of reasons that are complex. I suggest reading my previous piece on International Relations Theory and Bitcoin for some background on key concepts, some of which apply here. I think three main drivers are at play here: 1) this is an opportunity to attract foreign capital 2) this is a path to secure sovereign wealth that will translate to prosperity for the people of El Salvador and 3) while in a de facto monetary union with the United States, no de jure benefit arises from this (think remittances and the costs and burdens).

Attracting Foreign Investment and Capital

This one is easy to understand. By offering something unique, El Salvador is setting itself apart from any of its sovereign peers — a jurisdiction in which not only are Bitcoin transactions perfectly legal, they are not subject to capital gains taxation, and all the headaches of documenting and complying with investment tax laws are eliminated. With Bitcoin being made legal tender as well, merchants must³ accept payment in Bitcoin if offered. This is a totally different paradigm than those on offer from the other nations that offer tax advantages to Bitcoin holders. Those nations all presuppose that the Bitcoin will be exchanged for some other government paper currency in the future. In this case, Bitcoin can be directly exchanged for goods and services without tax consequences, with the added benefit of law recognising the transaction as legal payment of debt. Combine this with the anticipated ease with which permanent residency will apparently be offered to entrepreneurs in Bitcoin, and you have incentives that just might be enough to overcome the negatives of high rates of crime and violence to bring real capital into the country — and put it to work.

Sovereign Wealth

There are many, many questions outstanding on what a move to make Bitcoin legal tender means for government policy in El Salvador (or anywhere for that matter). Will there be 13% VAT charged on Bitcoin transactions? If so, how will this tax be paid and collected, as satoshis to the Treasury in one transaction at the end of the year? By Lightning? On-chain? Will all tax owed to the Treasury be denominated in BTC or will the treasury continue to use USD as the unit of account? These are just a few of the many things that will need to be thought out, explained, and implemented.

In particular though, I am curious about what role the Central Bank of El Salvador and the Treasury will have in all of this. You see, their central bank never really went away, it just lost most of its power to do anything when the country dollarised. It’s not quite clear to me which institution is the one with the most power and control over government reserves policy, but the fact remains that El Salvador has somewhere in the neighborhood of $2.5 billion USD in sovereign reserves. In the past, under a gold standard, the system needed buyers, lenders, and sellers of last resort to provide liquidity in moments of crisis. It might make sense for El Salvador to maintain adequate reserves of Bitcoin to use this tried and true old-fashioned method of central banking to help smooth rough patches.

This of course anticipates a Bitcoin economy with BTC as the unit of account. If we see a hybrid system (which I suspect will be the case), a combination of USD and BTC reserves will provide the central bank with some options. Though, and this is incredible to say (and would have floored even the truest believer in Bitcoin around 2012), $2.5 billion is probably not enough ammunition for an entity to use in Bitcoin to affect the macro environment anymore, at least not more than once. Still, the headline “Central Bank of El Salvador to Temporarily Increase Dollar Conversions into Bitcoin to Support Price” would certainly have some effect.

Never the less, El Salvador will clearly have an incentive of some kind to establish an official position in Bitcoin. Whether that naturally occurs through the collection of taxes in Bitcoin, or whether that’s through the conversion of some part of their US Dollar reserves into Bitcoin, remains to be seen. What is likely to happen, however, is that El Salvador will reap the benefits of first mover advantage. By virtue of being early, El Salvador will gain access to lots of possible appreciation of their sovereign wealth, either by USD denominated appreciation of their Bitcoin, or by virtue of falling prices denominated in BTC as Bitcoin’s issuance and adoption plays out globaly.

What is really interesting, especially from an IR perspective, is that the game theory at the sovereign level starts now. I talked about this quite a bit in my previous piece on IR Theory and Bitcoin. I had figured we would be first experiencing some nations deciding to dabble in Bitcoin via mining or adding small amounts as reserve positions in their treasuries, possibly even a G20 nation doing something in the space. I did not think means of exchange and legal tender would come during this epoch (this halving cycle). El Salvador is a fantastic nation to attempt this (as opposed to a North Korea or an Iran). El Salvador is nominally a friend of the US (though a strained one at best).

What I think happens here is that this cycle will mirror the last epoch — in 2017 we saw some initial institutional interest in Bitcoin on Wall Street, but the interest was fleeting apart from those select few firms that dug in, studied, and learned. There was interest, but no adoption. Similarly, here in our 2021 bull market, we have the first nation state to attempt real, substantive policy on Bitcoin. I think this sets the gears in motion, but I still think the real fireworks will begin after the next halving. But, I could be totally wrong. This has the potential to spark an all-out arms race to acquire sats among non-G20 nations, and maybe even among some G20 nations like Argentina. What’s clear is that El Salvador has made a decision to be the actual first mover on this, the first entity at the final, highest level of sovereignty to interact with the protocol. This is going to be fascinating to watch. One large experiment played out in real time — Bitcoin will either sink or swim now.

Remittances and Banking

One of the huge pains when dealing with moving money between nations is the exchange of currencies. This is a slow, outdated process in which middlemen and rent seekers thrive. I myself currently live a life that requires the use of multiple fiat currencies. Without tax laws and legacy system rails that take days to settle, Bitcoin would make my life really easy. As it stands, (though it appears Strike is going to change this soon), I have to spend multiple days with exchange rate exposure moving money between jurisdictions. It’s a pain — and I have the privilege of legal, official banking relationships in all jurisdictions concerned. For the people of El Salvador, it’s so much harder and much more expensive.

Despite sharing a common currency, because the monetary union is one that has arisen rather than having been legally established, El Salvador is not a part of the US banking system and is not subject to it’s general regulations. It is still the same process to get dollars from the US to El Salvador as it would be to send dollars to Germany, minus the exchange of currencies in the middle (and minus the built out infrastructure Germany has that makes the process easier and bit more accessible to the average person). In El Salvador, most people do not have bank accounts. They have to rely on third party money transmitters like MoneyGram or Western Union who charge obscene fees to facilitate the transfer of cash from one country to another.

This is quite literally something that Bitcoin fixes. Rather than rehashing what has already been explained well elsewhere, I will link this article from Bitcoin Magazine that explains how Strike is solving this problem for regular people.

Use of Bitcoin will send more value between jurisdictions and end a predatory and parasitic practice of extreme rent seeking from these firms. This will (hopefully) spread like wildfire. 30% savings on transferring money instantly through the Internet will hopefully be enticing for many people.

What Does This Do For Bitcoiners?

Another tough question, this is unprecedented. I suspect that very shortly Bitcoin education is going to be in extremely high demand in Central America, as will sats themselves. This could be a once in a lifetime opportunity for brave entrepreneurs, especially bilingual ones. The opportunity to set up a business to educate people in skills that will be in high demand, in a friendly jurisdiction, is something that should be considered.

I’ve traveled in Central America a lot more extensively than the average person, so I at least have a feel for what it’s like (though I will admit I’ve never been to El Salvador itself). I am not currently in a place where I would consider this myself, but El Salvador is now on my radar in a way it wasn’t quite before. I’ve always been interested in the work that Strike and Bitcoin Beach are doing, but only an arm’s length curiosity. Now they have my attention.

At the very least, I suspect that should this plan be successful, there is going to be an explosion of demand for sats and skills like we haven’t seen yet. No one who is an active trader seems to understand that yet as the price continues to move sideways. The sudden increased demand from a nation of 6.5 million people (and all the people outside their border who will interact with them financially) using Bitcoin in daily commerce is unfathomable. It is most certainly not priced in. Prepare accordingly.

Final Thoughts

This is huge news. It’s actually, in my humble opinion, potentially the biggest thing to ever happen with Bitcoin. The trading market has no idea how to react to this. As of two days after the announcement (7 June 2021) the price has largely moved sideways. I think people are sleeping on the potential implications of this. In order to have Bitcoin circulate as currency in El Salvador, sats needs to make their way into the country. The three concerns listed at the beginning of this piece still apply in their own ways to the adoption of Bitcoin as a national currency, albeit with advantages over dollars.

For one, seigniorage under Bitcoin doesn’t exist in the same way. It costs a lot in capital to create new bitcoins and no nation can decide to make more without consequence or cost. Coins will need to make their way to El Salvador through trade or mining. What’s really interesting is that because of seigniorage, it is in the interest of the government of El Salvador to begin mining Bitcoin while they can still mint usable amounts of sats (for a nation state) — something they cannot do with dollars.

For monetary policy, this is a no-brainer — El Salvador is dumping being at the complete mercy of the Fed and the United States for the solid, predictable issuance schedule of Bitcoin. El Salvador is choosing math over the whimsy of a foreign government that does not care about them. That’s a powerful upgrade that gives the upsides of dollarisation (the forced discipline of revoking the printing press) without the downsides of being held hostage to the political goals of competing nations.

Lastly, as we discussed, adopting someone else’s currency (even a decentralised, global one like Bitcoin) means that you’re hitching your nation’s exchange risk to the host currency. In this case, El Salvador is directly taking on Bitcoin’s pricing volatility. I don’t have many comments on this as of yet, it will certainly be interesting to see play out. My hunch is that if people tend to price things in sats independent of the current trading value of Bitcoin in USD, this will help smooth things out. I am not well read on the Bitcoin Beach experiment, but I suspect their experience will be informative here (and instructive). One thing is certain to me, this is the largest monetary risk for El Salvador in the medium term and the fact Salvadorean immigrants earn US Dollars abroad to send home re-introduces exchange risk (assuming the USD isn’t the main unit of account for most people).

One final thought — many Bitcoiners are saying that El Salvador will be the target of attacks from the US, the IMF, and others over this decision. While this is possible, I don’t see it as a foregone conclusion. More data is needed and I don’t have much of an opinion beyond that at this point (again, unprecedented).

Time will tell.

Footnotes

1. Contrary to popular opinion, citizens of El Salvador in the United States are not illegal immigrants if they do not have an approved visa. The people of El Salvador automatically qualify for asylum in the United States thanks to their civil war. This granting of asylum as never expired. All one must do is reach the United States. This is partly why the population of immigrants from El Salvador is so high in the US.
2. For now.
3. Correction (8 June 2021) I may be overstating this. Thank you to some helpful folks on Twitter who have pointed out I may not be accurately describing legal tender. It will depend greatly on what the actual legislation from El Salvador says if and when it is passed, but it seems that the consensus is that spot payments for goods and services are not subject to the same kind of requirements as contracted debts. It would seem, contracted debts cannot refuse Bitcoin if it is legal tender, but vendors and merchants may as there is no contracted debt in the transaction process. As ever, this situation is fast moving so there is a fair amount of speculation on the specifics. The Twitter thread in question for your edification, dear reader: https://twitter.com/kallerosenbaum/status/1402227571627106304