El Salvador’s bitcoin adoption ‘may come at a high cost’

By Raffaele Redi

El Salvador should brace for a hit to its credit rating, warns S&P

New York / USA - July 12 2019: S&P Global headquarters signboard                                 
Ratings agency S&P has warned of the credit and fiscal implications of El Salvador adopting bitcoin as legal tender. Photo: Shutterstock

El Salvador should brace itself for a hit to its credit ratings if it adopts bitcoin as legal tender, analysts warn.

Ratings agency S&P says the planned move could come at a high cost, as bitcoin's extreme volatility would drive large swings in prices.

El Salvador no longer has its own currency and currently uses the US dollar.

However, S&P's analysts say bitcoin's volatility would reduce the incentive to use it for day-to-day transactions – and stressed the risks could outweigh any benefits.

Threat to IMF deal

In a briefing note, the S&P analysts underlined how bitcoin adoption could threaten El Salvador's deal with the International Monetary Fund (IMF).

Credit from domestic banks could also be hit if they are forced to accept bitcoin but continue to make loans in dollars. This would create a balance-sheet mismatch and encourage banks to automatically convert all bitcoin they receive into US dollars.

“The country is in a tough fiscal position: the deficit is 10% of GDP and public debt about 90% of GDP. With about $2bn in debt repayments in 2021, the government is seeking a $1bn IMF loan," the note said.

"Bitcoin's potential lowering of financial integrity, by indirectly encouraging illicit financial activities such as money laundering and tax evasion, could complicate ongoing negotiations."

Crypto wallet glitches

Although President Nayib Bukele recently announced on Twitter that the government-backed crypto wallet, Chivo is “100%” working, the launch immediately suffered from several missteps, especially over the use of the application, which had to go temporarily offline because of technical glitches.

However, several merchants reported they had started to process payments in bitcoin, especially larger corporates.

Credit markets have reacted negatively, with yields on sovereign bonds heading higher, fluctuating at around the 9.5% level since the bitcoin law was approved, while their price has been falling on secondary markets.

A survey conducted by El Salvador’s Chamber of Commerce and Industry showed that 75% of respondents said they would continue to use US dollars, while protests against mandatory bitcoin adoption have also taken place, both pre and post-launch day.

The government, at its own cost, is transferring $30 worth of bitcoin to every national who registers to the Chivo crypto wallet – “a de facto fiscal transfer”. It is also funding a $150m trust fund to mitigate volatility in the BTC-USD exchange rate.

However, S&P said it was “unclear whether it will commit to replenishing the trust fund if it falls below a certain USD balance”.

Exchange risks

Moreover, the analysts warn that the introduction of bitcoin, if the cryptocurrency is widely used, would undermine financial integrity, facilitating criminal activities and tax evasion, while exchange-rate risks would have potentially disruptive implications for trade and cross-border financial flows.

“El Salvador's small, open, dollarised economy status means bitcoin's impact could be sizable. The country's GDP is $25bn, or about BTC600,000, with trade accounting for 60% of GDP, (goods exports plus imports), and remittances close to 25% of GDP," they said.

"This means that if bitcoin was widely used for cross-border transactions, the effect of the cryptocurrency's high volatility on the wider economy would be significant."

The benefits

On the other hand, S&P says the move to bitcoin does have some advantages as a hedge against sanctions from the US government and other external risks.

Bitcoin could also increase the financial inclusion of those without a bank account – 70% of the population – and reduce costs on cross-border transactions, such as remittances.

However, the cryptocurrency's potential benefits are unlikely to materialise in the short term.

“These benefits will only be realised if there is widespread trust in bitcoin, and surveys indicate the contrary," analysts wrote.

"Without trust, bitcoin transactions are likely to be immediately converted into USD due to exchange-rate risk and the propensity by bitcoin holders to retain their bitcoin as a store of value, as opposed to using it as a medium of exchange."

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