Why El Salvador adopted Bitcoin, and why it doesn’t matter.

On 9th June this year El Salvador passed a bill making Bitcoin its legal tender. This was the first time any government in the world has accepted Bitcoin as actual currency however, El Salvador has its reasons for doing so.

A Country without a Currency

El Salvador is one of the few countries in the world without any currency of their own, they did used to have their own currency called the colón but since 2001 it has been discontinued. El Salvador uses the US Dollar as its de facto currency which has both advantages and disadvantages.

First of all, printing and maintaining a currency is expensive for such a small nation. While countries like the US spend millions printing and transferring currency, this amount is a drop in the ocean for them. The advantages of maintaining a currency far outweighs the costs associated. But for a small developing country, these costs add up.

Secondly, it makes it very easy for American firms to invest in the country as they don’t have to avoid foreign exchange risk.

However there are huge drawbacks.

El Salvador is a Net Importer, meaning it buys more things that it sells. For most countries this is not a problem as the workers in the country are paid in the local currency while exporters earn Forex. This makes it easy for the Central bank to print local currency and solve this problem.

In El Salvador’s case, the central bank can’t print money to solve the problem as both the exporter and worker earn dollars. But, if importers also buy goods with the dollar, and their expenditure is greater than exporters, the money supply in the country will go down.

Where El Salvador is different is that it has a huge workforce working in foreign countries(mainly USA) who send their income back home. This aids the problem but is not a permanent solution.

Bitcoin : El Salvador’s Savior(?)

Attracting foreign investors is hard. Especially if your country is a small nation with no major natural resources, poor geographical location, high crime rate and the homicide capital of the world.

Bitcoin, like the dollar opens up the opportunity for foreign firms to invest in the country and so the country has also has programme to give citizenship to anyone who invests 3 Bitcoin or more into the country.

Source of Income?

Making Bitcoin a legal tender also reduces Salvador’s dependence on the dollar and makes way for it to develop new financial institutions specializing in De-Fi (Decentralized Finance).

Another source of income suggested by El Salvador’s president is the usage of geothermal energy from volcanoes to mine Bitcoin. In the past, countries have extracted ores, drilled for oil, levelled mountains for coal but El Salvador may become the first to mine something that’s not in its soil, that being Bitcoin.

Underbanked

Considering that one of the core objectives of Bitcoin is to make yourself your own bank, El Salvador offers a perfect opportunity to test this theory as 70% of the El Salvador population does not have access to banking.

Making bitcoin legal tender also makes it easy for its foreign workers to send their income back home as most of them are low income and a fee for international wire transfer may significantly cut into the income they receive back home. Now, Bitcoin does have transaction fees associated with transfers, this is much smaller than wire transfer fees.

The most likely technology to be used here is the lightning network which is a Layer 2 solution with miniscule fees(This is very likely as the number of lighting nodes has gone up since the announcement) . This would not only make transfers extremely cheap but also fast, seconds fast. This is extremely important as the current speed for a transaction on Bitcoin’s main network is a minute at least.

The Rosy Picture Ends

Though all the points I discussed above may make you think that Bitcoin will singlehandedly turn El Salvador into a developed nation, the reality is far bleaker.

In a country that uses the dollar foreign investments should not be a problem, but the truth is rampant corruption and crime makes investing for foreign companies risky. The market seems to thinks the same too, as after the announcement Bitcoin’s price has moved down still as if nothing happened.

Ending Thoughts

It is possible that wide adoption of bitcoin would make crypto critics eat their words but it may bring inherent flaws in cryptocurrencies out.

However, many counties in Latin America have express their interest to adopt bitcoin in some way or the other, it remains to be seen if these interest turn into legislation.