Why a Dollarized Developing Country in America’s Backyard Made BTC Legal Tender

On June 9th, 2021, the government of El Salvador adopted legislation officially recognizing bitcoin as legal tender. Nearly twenty years (plus one global financial crisis and one global pandemic) later, El Salvador is embracing bitcoin and opening its doors to the global bitcoin community. With the passage of the Ley Bitcoin (Bitcoin Law) El Salvador is building the first sovereign onramps to a secure, low cost, and globally decentralized value storage and transfer network. 

With abundant geothermal energy, El Salvador is in a position to offer economic incentives to attract bitcoin entrepreneurs and investors from around the world.  What’s more, the new law grants citizenship to persons who’ve shown evidence of ownership of at least three BTC. Connecting the country to the global Bitcoin community will provide a broad conduit for greater foreign direct investment, especially in digital infrastructure and services that in the long run could dwarf a proposed $1.3 billion IMF package currently under discussion. 

Under the new law, Bitcoin would be fully convertible to USD through a $150M bitcoin trust held by the country’s development bank BANDSEL. Investment friendly industrial policy is one thing, but why might El Salvador also be interested in accumulating Bitcoin for the long term?

Dollarization, Debasement, and Inflation

El Salvador officially adopted the US Dollar as legal tender in 2001 in a bid to attract greater foreign investment, with mixed results.  Fast forward to June 2021 and the U.S. government’s liquidity pump is in high gear even while US commercial banks have run out of balance sheet capacity to absorb the $4 trillion flood of money supply coming down the pipe. For the past few months, U.S. commercial banks have been turning away large new deposits by charging negative interest rates. The financial sandbags have been removed as the US Dollar has literally overflowed its banks.

At least 65 countries peg their currencies to the U.S. dollar while five U.S. territories and seven sovereign countries use it as their official currency of exchange. Downstream developing countries, such as El Salvador, that lack the financial and banking infrastructure needed to properly absorb a flash flood of USD liquidity, will experience higher inflation and loss of purchasing power

“While the Fed’s extraordinary measures succeeded in pumping more cash into the coffers of U.S. financial institutions, the stock market, and other aspects of the U.S. economy, the same was not true for Salvadorans, whose banks did not receive infusions from the Fed, but did lose purchasing power due to U.S. monetary inflation.” – Forbes June 7, 2021

BTC provides a low cost switch from gold for smaller nations.  

Today, most gold investments are held, borrowed, or leased in paper form. With Basel III rules coming into effect around the world during the second half of 2021, only physical gold held in vaults will be counted. International bullion markets will experience a sharp tightening and physical gold will become increasingly expensive to buy, sell, or even hold. With most of the world’s physical gold supply locked in China, the US, Russia, and India building up a meaningful supply of physical gold at this point, it will simply not be practical for most sovereign nations to increase their physical gold reserves.  Adopting BTC as legal tender has the added benefit of allowing El Salvador to hedge its bets against long term inflation and a weakening US Dollar.

With a plethora of liquid centralized and decentralized exchanges available for trading, bitcoin does not suffer from the liquidity, transport, and storage constraints of physical gold. For El Salvador, Bitcoin’s low switching costs relative to gold, make it an increasingly attractive inflation hedge and store of value alternative.

Countries that don’t want to be caught between a weakening dollar, rising inflation, and an illiquid market for physical gold would be wise to consider following El Salvador’s lead. One thing is sure, while El Salvador may be the first country to take this step, it almost certainly will not be the last.