Bitcoin as legal tender can expose El Salvador to Zimbabwe-like risks

Policy decisions may or may not be productive. In worst cases, they can be counter-productive.

Banking system is the backbone of any economy, and there is a reason behind it. Money supply in the market is managed by banks that engage in safekeeping of depositors’ money and lending a portion of it to others. The central bank oversees the functioning of banks, prints currency notes, drafts monetary policy, and all these actions infuse stability in the country’s financial system. Central banks manage interest rates and tweak them to either infuse liquidity in a slowing economy or suck liquidity to control higher levels of inflation. Policy decisions like these are productive exercises.

A digital currency has finally become legal tender

In the traditional financial system where central banks and multilateral forums like the Basel Committee manage currency circulation and dictate prudential banking norms to prevent bank runs, digital currencies are an outlier.

The adoption of bitcoin, world’s largest digital currency, by El Salvador can be seen as the first baby step of cryptocurrencies within the formal financial system. Bitcoin is legal tender in the country, which means people can use it to pay off debt. The rationale given by the 39-year old president of El Salvador appears appealing. A sizeable chunk of population lies outside of formal banking system, remittances in US dollar cost the economy, and even a small portion of bitcoin market cap if invested in El Salvador can help GDP grow in double-digits, said President Nayib Bukele. The basic premise is that payments in bitcoin will be quick and cheap.

But history tells us that currency management is not that easy a task.

Currency flip-flops in Zimbabwe

Long queues were seen outside banks in Zimbabwe when the country decided to issue local currency in 2019. A decade before, local currency was withdrawn, and the economy relied on US dollars or other foreign currencies. The shift to US dollars in 2009 owed to hyperinflation, which shattered the value of local currency. The central bank was at one time forced to print currency worth 100 trillion Zimbabwe dollars to cater to skyrocketing prices.

But the return to local currency hasn’t been a smooth ride. Foreign currencies made a comeback in March 2020, and they were allowed in payments for goods and services. The country, however, is facing foreign currency shortages, which has led to dearth of essentials including fuel, electricity and medicines. At the time when El Salvador was mulling legalization of bitcoin, Zimbabwean authorities mandated local businesses to compulsorily quote prices in local currency. Despite policy flip-flops, neither the economy recovered, nor inflation in Zimbabwe could be reined in.

El Salvador’s policy decision does not compare with Zimbabwe’s situation. But in both the cases, the authorities are looking to undercut the clout of US dollar within the local economy.

The chances to achieve this feat may be very slim.

The US dollar is a widely accepted currency, and despite China’s yuan making it to the coveted International Monetary Fund’s major reserve currencies, it accounts for just two percent of global foreign exchange reserve assets. Central banks across the world hold dollar reserves to manage overseas trade account where most payments for imports are made in US dollar.

Pragmatic vs. impulsive policy action

In El Salvador, bitcoin is now on par with US dollar. The nation does not have a local currency, but since it is the first in the world to legalize bitcoin, the cryptocurrency fills this space.

The biggest concern is hyper-volatility in the value of bitcoin that can weaken El Salvador’s financial stability. The US dollar is stable, and even a trivial change in its value can impact profitability of local companies. For example, companies exporting IT services to the west will gain on a rising dollar, while companies importing crude will suffer losses.

The president of El Salvador has also drawn criticism on various occasions, often been accused by the opposition of undermining the system of checks and balances. The removal of judges, use of force to limit lockdown violations, and extrajudicial methods to curb gang violence has irked the United Nations High Commissioner for Human Rights and even the US Vice President, Kamala Harris.

In this backdrop, bitcoin, which has lost nearly 50 percent of its value over last one month, was declared legal tender.

The Zimbabwean experiment with its currency landscape also serves as a warning call for the latest development in the cryptocurrency space. It comes against a background where major world economies, including the largest and second largest, have indicated tougher stance on digital assets, and central banks are looking to launch their own digital currencies that will be both stable and regulated. Lately, the Swiss-based Basel Committee recommended that banks must set aside adequate capital to provide for any losses on cryptocurrency holdings, which carry ‘unique risks’.

Bitcoin becoming legal tender for the first time can make news headlines, but it cannot add to utility and stability of digital currencies. Besides, currency flip-flops in Zimbabwe and ensuing economic upheaval indicate that the policy action in El Salvador can be fraught with risks.

Image credit: Parilov / Shutterstock

Kunal Sawhney is CEO, Kalkine Group. He is an entrepreneur with revolutionary ideas; financial professional with wealth of knowledge in Equities, aiming to transform the delivery of equity research through tech-driven digital platforms. With his knowledge, skillset, and overarching vision, Kunal established one of the fastest growing equity market research firms across Australia in year 2014; and subsequently, in other emerging developed markets -- Kalkine -- a business that is based on Digitally Powered Architecture and Extensive Data Science led Premium Research.