The Daily Update: What Could Possibly Go Wrong

After writing the daily a few days ago about a $600 million cryptocurrency theft, one of the fund managers here at SSC stumbled across an article about how El Salvador (as I’m sure you are all aware, not a country at the top of our buy list) will become the first country in the world to adopt bitcoin as legal tender. The move comes after Its Congress approved President Nayib Bukele’s proposal to embrace the cryptocurrency or as he put it ‘Bitcoin Law‘, a move that naturally delighted the currency’s supporters, and raised eyebrows back in the real world.

Bukele has touted the use of bitcoin for its potential to help Salvadorans living abroad to send remittances back home, while saying the US dollar, El Salvador’s currency since 2001, will also continue to be legal tender. He has not ruled out the idea of placing a percentage of the central bank reserves in the cryptocurrency. ‘It will bring financial inclusion, investment, tourism, innovation and economic development for our country’ Bukele said on social media shortly before the vote in Congress. Seeing as 70% of the population does not even have a bank account, it's going to be an uphill struggle. One institution that is not overly impressed with the idea is the IMF.

So what could possibly go wrong for El Salvador in legalising bitcoin? The central bank cannot set interest rates on a foreign currency. The reason El Salvador adopted the USD at the turn of the century was to ‘import’ the credibility of the US dollar and to bring its economy, and interest rates, in line with the foreign business cycle. Neither of these would be possible in the case of adopting bitcoin. As a result, domestic prices will become highly unstable. If prices were quoted in Bitcoin, the prices of imported services and goods would fluctuate massively, following the whims of the markets. Year to date Bitcoin (vs the USD) has traded at a low of around 28.5k (the start of the year), a high of over 63.5k, just over 3 weeks ago it was at 30k, and at time of writing is over 46k.

Financial integrity will also suffer. With crypto currencies it's nigh on impossible to have robust anti-money laundering regulations; they can also be used to fund terrorism, evade taxes, avoid capital controls plus a wealth of other unsavoury goings on. This in turn could pose a risk to a country’s financial system, fiscal balance, and relationships with foreign countries and international finance . Additionally, if services and goods are to be priced in both bitcoin and USD, businesses and households need to spend a considerable amount of time and resources choosing which currency to hold as opposed to engaging in productive activities.

To make matters worse, mined crypto assets such as Bitcoin require an enormous amount of electricity to mine. Mining bitcoin consumes more electricity than Argentina, roughly equal to the annual output of 23 coal-fired power plants. Not exactly eco friendly.

I think Ricardo Castaneda, senior economist and co-ordinator for El Salvador at Icefi, a think-tank, hits the nail on the head when he was asked his thoughts. He said ‘I don’t think they thought through all the implications’ adding ‘It’s an experiment. It will be interesting to see if it works or not, but the implications, if it doesn’t, are very serious’.

That could be the understatement of the year.

Enjoy your weekend.