Recently, a small Central American nation, El Salvador, again made headlines.
This was due to the impending economic crisis that is going to hit the country. Last year, El Salvador became the first country to make Bitcoin a legal tender, hoping it would save the nation from the economic fallout and reduce its dependence on the US Dollar.
Yet, as it turns out, El Salvador President Nayib Bukele’s cryptocurrency gamble has caused severe ramifications for the country’s debt crisis. Bitcoin’s value has reduced to 45% since September, when Bukele launched the plan.
Resultantly, the $150 million Bitcoin investment has caused an extra burden on the country’s exchequer. The investment is about 4% of the country’s reserve.
Now let’s go deep into the discussion and understand the causes and consequences of El Salvador’s bleeding economy.
El Salvador is the smallest and most densely populated country in Central America. Its history is replete with constant civil wars, high crime rates, inconsistent economic growth, and natural calamities.
Also known for the highest crime rates in the world, El Salvador pegged its currency, El Salvadoran Colon, with the US Dollar in 2001 to save its economy from a major collapse and with the hope of attracting massive foreign direct investment and tourists to the country.
However, even after the introduction of the US Dollar, the nation’s economy could not witness any major foreign investment or tourists. It was due to high corruption and crime rates. Though the country has its own domestic currency, it is rarely used by the citizens.
Moreover, as the country does not have a major export market and has high imports, there is a massive burden on the balance of payment. This has caused serious deficits in the budget and high debts.
Thus, President Bukele passed a law making Bitcoin the legal tender to attract higher foreign investments and reduce its reliance on the US Dollar and foreign remittances as a reserve source.
The reasoning was that the rise in Bitcoin’s value would help the country reduce its debts and maintain the balance of payment.
With this, El Salvador became the first country to recognize Bitcoin as an official currency. The government further announced that anyone could get citizenship in El Salvador by investing 3 Bitcoins in the country.
It also devised a plan to build a volcano-powered crypto mining center and city and launch the first bitcoin-powered sovereign bonds.
Even after all these initiatives, the experiment seems to have failed and has caused a further burden on the common people of the country. Now the question is how the Bitcoin-induced economic crisis has led the country to an almost economic collapse.
What Led To This Economic Crisis
El Salvador was already suffering from a major economic crisis before the Bitcoin Blunder. And making Bitcoin legal tender only added fuel to the fire.
The country’s national debt has increased from $19 billion in December 2019 to more than $24 billion in 2022, with the debt to GDP ratio reaching as high as 87%.
Though the Bitcoin investment represents only 4% of the country’s reserve, it certainly has affected the economy of El Salvador. This becomes disastrous for a country whose GDP is only $25 billion.
Apart from the debt repayment crisis, the falling US share market, along with rising inflation around the world, has caused a further headache for the country. As a result, major credit agencies have downgraded the country’s credit rating. Now it has become more difficult to invite foreign investment.
For instance, Moodys has reduced the credit rating of El Salvador to Caa3, indicating that the country is on the verge of becoming a defaulter and is not a safer option for investments. Although remittances from abroad support about 25% of the economic activity, violence, and insecurity adversely affect the productivity and long-term growth of the nation.
Furthermore, Bitcoin Gamble has lessened the confidence of the International Monetary Fund to come in support of the country. El Salvador asked for $ 1.3 billion from the IMF to balance its current account deficit and debt repayment.
However, the organization has asked the government to remove Bitcoin as legal tender. It further asked to bring about economic changes to receive a bailout package.
Rising inflation, the US Stock Market’s downfall, and the Russian invasion of Ukraine have caused the cryptocurrency to lose $1.3 trillion in just a fraction of time.
Bitcoin’s value is reduced to half since September 2021, causing El Salvador’s Bitcoin investment value to reduce to $ 67.9 million from $104 million. Bitcoin has become an additional burden on the Debt crisis of the country, which has to release around $1.12 billion on interest and mature bonds in 2023.
But, Bukele is still using the government treasury to buy Bitcoin in this slump, thus pushing the country to the hem of ultimate economic fallout. Meanwhile, he has also announced plans to build a Bitcoin city that is fully powered by Bitcoin.
Bukele’s desperate measures to save the Salvadoran Economy seem to have the opposite effect and have become a part of the problem itself.
With the waning confidence of investors in Salvadoran sovereign bonds and the failure of Bitcoin, the policy has put the country into a complex situation.
The government has all in all invested around $425 million in building the bitcoin ecosystem in the country. It includes the launching of the national virtual wallet Chivo (Latin for “cool”) to facilitate payments through bitcoin. They are also giving a $30 incentive to the people who register on the app.
However, in a country where 70% of the population still does not have internet connectivity, bitcoin is still not preferred by the citizens. Nor is the Chivo wallet used by the citizens after receiving the incentive.
But the investment has not failed on all levels. Making bitcoin legal tender has invited crypto enthusiasts as tourists to the country. The tourism industry of El Salvador has risen by 30% since September. And interestingly, the majority of the tourists come from the US.
Moreover, the Chivo app will also help the citizens to send remittances from foreign countries at a nominal service cost. Earlier, the service cost of transferring payments was as high as 10%.
However, the wallet will still take time to be used by people on a large scale. As of 2022, Chivo wallet processed only 1.6% of the remittances.
What’s Next For El Salvador
As far as it concerns debt repayment, the country seems to have two options. First, Bukele should accept the IMF conditions on removing bitcoin as the legal tender and introduce massive economic reforms.
However, this might backfire on the popularity of the Autocrat President Nayib Bukele. Given that Bukele has prominent plans for cryptocurrency and maintaining his populist policies, the option doesn’t seem viable.
The other option, as put by Ricardo Castaneda, senior economist at think tank Central American Institute for Fiscal Studies (ICEFI), is to ask the Central and Latin American Development Banks, CABEI and CAF, to finance their loan payment. Otherwise, the government might have to nationalize the pension fund to maintain its fiscal deficit.
As for Bitcoin, the government is trying luck in a highly volatile market when uncertainty is looming over all the nations and investors whether it be of inflation, stock market, or war. This has caused a steep downfall in demand in the global economy.
Moreover, as the country’s credit rating is already downgraded due to its high debt, violence, and the government’s crypto gamble, the investors are not willing to pump money into the falling economy.
Although Salvadorans receive one of the highest foreign remittances, it cannot save them from coming anywhere close to decreasing their fiscal deficit.
But not everything is going downward. Due to his policies on decreasing crime rates and effective management during covid-19, the President has maintained one of the highest percentages of approval ratings for any president in the world. His approval ratings are more than 85%.
From launching the world’s first bitcoin sovereign bonds to creating a bitcoin city powered by a volcano, the plans of Nayib Bukele are enormous. Yet, as the world is not going to stabilize in the coming years, it will be interesting to see how El Salvador will manage to go through the tough times.
Bukele might cover the debt repayment requirements for now. But, his increasing stronghold on the Judiciary and governance has further deteriorated the chances of receiving aid from international institutions.
Therefore, it remains to be seen how El Salvador will sustain itself in the future, given that the economic crisis is nowhere going to end soon.