El Salvador’s Bitcoin Default

El Salvador became the first country to accept Bitcoin as legal tender in September 2021. Fast forward to the present, discussions about El Salvador’s bitcoin default are becoming commonplace.

El Salvador's Bitcoin Default

Bitcoin was the economic salvation for El Salvador, but so far, the bet is not paying off as President Nayib Bukele had planned.

The government’s cryptocurrency holdings have been reduced by half, bitcoin adoption is not really picking up across the country, and most importantly, the nation needs a lot of money, quickly, to satisfy its debt obligations of more than $1 billion over the course of the next year. This occurs as bitcoin prices have dropped more than 70% from their peak in November 2021 and more than 55% since Bukele first revealed his scheme.

El Salvador’s economic development has slowed, its deficit is still large, and the country’s debt-to-GDP ratio, which measures how much a nation owes in relation to its income, is expected to reach about 87 percent this year, raising concerns that El Salvador will not be able to pay back its debts.

When you combine these economic problems with a reinvigorated campaign on gang violence, a nation is on the verge of collapse.

A London-based fintech data researcher named Boaz Sobrado claimed that “on the surface, the whole bitcoin thing hasn’t really paid off.”

The fact that the government is on the verge of bankruptcy is not bitcoin’s responsibility.

The finance minister notes that the government’s unrealized paper loss on bitcoin is only about $50 million, or less than 0.5 percent of the total budget. According to estimates, the entire experiment (and all related expenses) only cost the government $374 million in total. Even though El Salvador has bonds worth $7.7 billion that are still due, that figure is still relatively tiny compared to the country’s $29 billion economy.

But the optics are poor.

Because they are reluctant to give money to a nation that is spending millions of tax dollars on a cryptocurrency whose price is subject to tremendous volatility, negotiations with international lenders have halted. The introduction of bitcoin as legal cash has caused rating firms to downgrade El Salvador’s credit rating, notably Fitch, citing the uncertainty of the nation’s financial future. President Bukele would now have to pay even higher interest rates to acquire the money he needs.

“In terms of their financial situation, El Salvador is in a very difficult place. They have a lot of bonds that are trading severely discounted,” continued Sobrado.

Frank Muci, a policy scholar at the London School of Economics with expertise advising governments in Latin America, claimed that “the economic policy of the country is essentially magical thinking.”

Nobody wishes to loan money to Bukele unless it is at “eye-gouging rates” of 20 to 25 percent, according to Muci, who continued by saying, “they’ve spooked the bejesus out of financial markets and the IMF.”

“The country is sleepwalking into a debt default,” said Muci.

However, the youthful, tech-savvy president has tied his political future to this crypto bet, so there is a huge incentive to make it succeed in the long run — and to pay off the country’s debt in the meantime. He once referred to himself as the “world’s coolest dictator” in his Twitter account. In 2024, Bukele will run for reelection to a second five-year term as president.

Snapshot of the Salvadoran economy

The nation was in serious difficulty even before President Bukele developed the idea that bitcoin was a magical cure-all that would cover long-standing economic weaknesses.

The Salvadoran economy will grow by 2.9 percent this year and 1.9 percent in 2023, down from 10.7 percent in 2021, according to World Bank projections. However, its expansion represented a recovery from 2020’s 8.6 percent drop.

Its debt is expensive, costing about 5% annually compared to 1.5% in the US, and its debt to GDP ratio is close to 90%. The nation also has a sizable deficit, and there are no plans to lower it, either by tax increases or significant spending reductions.

El Salvador’s Eurobonds have reportedly reached “distressed territory” in the past year, according to analysts in a research note from JPMorgan. Additionally, S&P Global data apparently reveals that the cost of insurance against a sovereign debt default is at multi-year highs.

The government is on an unsustainable path, according to warnings from JPMorgan and the International Monetary Fund, with gross finance needs expected to exceed 15% of GDP starting in 2022 and public debt on track to reach 96 percent of GDP by 2026 under current policies.

“In the past three, four months, what they’ve done is implement gasoline subsidies, which are super expensive,” said Muci, who specializes in economic diversification and public financial management and has worked on applied research projects in El Salvador, Venezuela, and Honduras.

“This is a country that’s rudderless in terms of economic policy. I mean, they don’t know where they’re going, or what they’re doing. I think it’s a classic case of one day at a time,” he said.

All of this comes as El Salvador confronts billions of dollars in debt service deadlines, including a $800 million Eurobond maturing in January.

El Salvador has been attempting to acquire a $1.3 billion dollar loan from the IMF since early 2021, but the initiative appears to have stalled due to President Bukele’s unwillingness to accept the organization’s advice to abandon bitcoin as legal tender. This is consistent with Fitch’s previous downgrading, which cited El Salvador’s “uncertain access to multilateral funding and external market financing given high borrowing costs,” plus its “limited scope for additional local market financing.”

This risk premium has also risen as a result of the president’s efforts to consolidate power. The country’s Legislative Assembly is controlled by Bukele’s New Ideas party. The new assembly came under fire in 2021 after it removed the attorney general and top judges. As a result, the US Agency for International Development withdrew financing from El Salvador’s national police and a public information institute, redirecting cash to civil society organizations.

Furthermore, El Salvador cannot print money to shore up its finances. El Salvador dollarized in 2001, which means it abandoned its native currency, the colón, in favor of the US dollar. Only the Federal Reserve may create new money. Meanwhile, the second national currency, bitcoin, is admired for being hard to create out of thin air.

The bitcoin experiment

El Salvador became the first country to accept bitcoin as legal tender in September 2021.

The idea entailed purchasing bitcoin with public funds and developing a national virtual wallet called “chivo” (Salvadoran slang for “cool”), which facilitates no-fee transactions and allows for rapid cross-border payments. In a country where around 70% of people do not have bank accounts, credit cards, or other typical financial services, chivo was designed to provide a quick onramp for those who had never been a part of the banking system.

The experiment also included the establishment of a nationwide infrastructure of bitcoin ATMs and the requirement that all companies accept the money.

In November, the president increased the ante by announcing plans to develop a “Bitcoin City” near to the Conchagua volcano in south-eastern El Salvador. The bitcoin-funded city would provide significant tax relief, and bitcoin miners would be powered by geothermal energy emitted by the nearby volcano.

Overall, the government has spent about $375 million on the adoption of bitcoin, which includes a $150 million trust created to instantly convert bitcoin into dollars, $120 million for the $30 bonus given to each citizen who downloaded the chivo wallet (no small sum in a nation where the monthly minimum wage is $365), and roughly $104 million that the government has openly acknowledged spending on bitcoin. According to Muci, the country has spent almost $425 million on “making bitcoin happen” after taking into account these costs and the $50 million in unrealized losses on its bitcoin portfolio.

However, nine months into this national gamble on bitcoin, it does not seem to be fulfilling many of its lofty promises right away.

Out of a total population of 6.5 million people, President Bukele tweeted in January that the app had 4 million users. However, a study (read below) released in April by the U.S. National Bureau of Economic Research revealed that only 20% of people who downloaded the wallet continued to use it after using the $30 bonus. The study’s data came from 1,800 families in a “nationally representative survey.”

​​“In terms of actual penetration of bitcoin transactions, it seems to be quite low,” explained Sobrado. “There seem to have been issues with regards to the state-issued wallets. Lots of people downloaded it, but it was buggy. It wasn’t really the best user experience.”

Some of those who did use the government’s cryptocurrency wallet had app-related technical issues. Other Salvadorans reported incidences of identity theft where thieves opened a chivo e-wallet using their national ID number to receive the free $30 worth of bitcoin the government was offering as an incentive to sign up.

Another expectation for the Chivo wallet was that it would reduce remittance fees by hundreds of millions of dollars. More than 20% of El Salvador’s GDP is made up of remittances, or money sent home by migrants, and some households get more than 60% of their income from this one source alone. For those foreign transfers, which might sometimes take days to arrive and call for a physical pick-up, incumbent providers can levy fees of 10% or more.

However, according to latest data, only 1.6% of remittances were sent via digital wallets in 2022.

According to a poll conducted by the Chamber of Commerce and Industry of El Salvador in March regarding merchant adoption, 86% of companies have never transacted business in bitcoin.

“They gave people the wallets, they forced businesses to accept them, but essentially, in my opinion, it’s a big nothing burger,” said Muci, who previously worked at the Growth Lab at the Harvard Kennedy School of Government. “Nobody really uses the app to pay in bitcoin. People that do use it, mostly use it for dollars.”

Both Bitcoin City and the $1 billion bitcoin bond offering, which was previously postponed in March due to adverse market conditions, are currently on pause.

According to the president’s tweets, the government’s personal bitcoin investment is on paper down by around $50 million. (These losses are not locked in until the nation sells all of its bitcoin.)

“Ultimately, El Salvador’s problems are just tangential to currency,” said Muci.

“The issues have to do with security, economic productivity and other things. And bitcoin has nothing to do with any of that,” he said.

Debt default unlikely

Although El Salvador’s major bitcoin bet is currently having trouble, Sobrado tells CNBC that it has unquestionably been a success in terms of drawing bitcoin tourists.

“While they might be down in terms of unrealized losses in their bitcoin investment, they are extremely up in terms of tourism,” said Sobrado.

“They have attracted a lot of people who are bitcoin believers and a lot of capital from these people. And I think it is entirely possible that if you think of the unrealized losses as a marketing campaign, El Salvador has already achieved what it wanted to,” continued Sobrado, who added that nations like Costa Rica invest billions of dollars in advertising campaigns.

According to estimates from the official government, the tourism sector has increased by 30% since the Bitcoin Law went into effect in September. The nation’s tourism minister also reports that 60 percent of visitors now originate from the United States.

The president’s popularity has not been harmed by the bitcoin experiment either. Bukele’s approval ratings are above 85%, in large part due to his tough-on-crime style of leadership. To a nation that was five years ago more hazardous per person than Afghanistan, that is no small accomplishment.

“Mr. Bukele is, to this day, one of the most popular presidents that is in power,” said Sobrado. “He has approval rates of 80 plus percent, that people in other parts of the world just dream of.”

Regarding the oppressive levels of debt the nation is carrying, almost everyone is in agreement that President Bukele will do whatever it takes to raise enough money this year and next to pay off the nation’s debt. A significant portion of that motivation stems from the 2024 presidential election, in which Bukele is running for a second five-year term.

The $800 million bond maturity is expected to be paid in January, according to JPMorgan, in order to “avoid disruptive credit events that might derail his prospects for a potential re-election.” Although the credit rating firm Fitch anticipates El Salvador to make its short-term debt service obligations, it issues a warning that the country’s ability to repay its loans would become “more onerous as the year progresses.”

Although Muci acknowledges that El Salvador will be able to pull together the funds, he issues a warning that the country’s current state of public finances is ultimately unsustainable.

“The plane is gonna crash eventually, if they don’t change things,” said Muci. “If they don’t raise taxes, cut spending, start being much more disciplined. You know, convincing markets that they’re sustainable.”

He added, “Bitcoin doesn’t solve any of El Salvador’s important economic problems.”

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