Bitcoinization: The Spread of a Bad Idea
You can read part one of my writing on Bitcoinization in El Salvador here.
The price of Bitcoin has dropped by more than 47 percent since the start of last month, prompting major losses for fans of the popular online cryptocurrency. The crash came as an unpleasant surprise for Bitcoin’s strongest advocates, many of whom see it as a potential solution for the world’s greatest problems: poverty, inequality, inflation, war, climate change, and more.
Nowhere has the hype around Bitcoin grown stronger than in El Salvador, which last year became the world’s first country to accept the cryptocurrency as a form of national currency. Right-wing populist President Nayib Bukele has made “Bitcoinization” into one of his signature policies, but despite his high popularity ratings, most Salvadorans oppose the law. The rollout was plagued with countless issues, uptake is low, and even among the 14 percent of Salvadoran businesses that report having used Bitcoin, only one in four say it has actually helped their sales.
With El Salvador’s Bitcoinization experiment seemingly falling flat, one might expect the idea to slowly fade into obscurity. On the contrary, however, the movement to incorporate Bitcoin into the economies of developing nations has only grown stronger. The Central African Republic recently became the second country to accept Bitcoin as currency, and others around the world are considering the option. Why is such a flawed policy gaining so much popularity?
The Great Experiment
Nayib Bukele entered office in 2019 with high approval ratings, contrasting his outsider New Ideas party with the nation’s more established parties. He came to power at a very risky time for El Salvador’s economy: missed debt payments in 2017 put its public finances in a tough spot, and the increased spending needed to deal with COVID-19 drove Bukele to accept a new deal with the International Monetary Fund (IMF) as the deadlines for their prior debt obligations approached.
El Salvador’s hesitancy to rely on the IMF is well-rooted in recent history. After the end of the Salvadoran civil war, international financial institutions required the nation’s economy to undergo “structural adjustment,” or, as a 1993 World Bank report described it, “to reexamine the role and function of the State” and “accelerate privatization efforts.” Critics termed El Salvador’s neoliberal model during this period as “growth without development,” with real wages falling dramatically even while economic growth was positive.
Bukele has since ignored the IMF’s latest calls for austerity by increasing public investment in the government’s 2022 budget, which is enough by itself to draw the organization’s ire. But in 2021, Bukele also approved the world’s first law to accept Bitcoin as an official currency alongside El Salvador’s primary currency, the US Dollar (USD). The IMF has been strongly opposed to this decision.
This clash between Bukele and the IMF has further strained tense negotiations between the two over potential IMF support for El Salvador’s upcoming debt payments. Concerns over a possible default have spread through financial markets: the value of Salvadoran bonds have been collapsing at a rate comparable to Ukraine’s, and both Moody’s and Fitch Ratings recently downgraded El Salvador’s debt to its lowest ratings in modern history. Bukele’s official response was that he “DGAF [doesn’t give a fuck].”
For Bukele, the political benefits of Bitcoinization were obvious: his embrace by crypto fans around the world boosted his online presence, which is key to maintaining his popularity even as he prolongs a draconian state of emergency which has left left dozens dead. But, from the very beginning, his government also appeared interested in ways that it could use Bitcoinization to help it escape its financial troubles. There were early plans for the government to introduce its own national cryptocurrency which the Salvadoran Central Bank could use to “give out subsidies and loans…” This could have been a major expansion of the government’s monetary policy-making powers, which are currently severely limited by the adoption of the USD as El Salvador’s official currency in the early 2000s.
After this proposal was abandoned, the idea of “Bitcoin Bonds” soon emerged. The Salvadoran government plans to issue $1 billion USD in bonds (El Salvador Bitcoin Bond 1, or “EBB1”). After the bond’s fifth year, returns would be tied to Bitcoin’s performance. Half of the money raised would go toward new Bitcoin purchases by the government, even though its current Bitcoin investments have suffered a cumulative 56 percent loss so far. The other $500 million would fund the creation of “Bitcoin City,” a coastal municipality with nearly zero taxes and an economy based around Bitcoin.
Rather than being sold to the traditional bond investors who are concerned by IMF opposition and credit downgrades, EBB1 is aimed at crypto investors with a higher tolerance for risk. Crypto backer Mauricio Di Bartolomeo describes EBB1 as “100 percent targeted to Bitcoiners and Bitcoin enthusiasts … they are looking for a meme effect on this bond where the average person can get behind this.” Just as Bukele used the hype around Bitcoin to build his social media presence, Bitcoin Bonds could translate that “meme effect” into demand for a new government financing tool.
EBB1 is currently behind schedule, and despite the government’s claims, this delay might be due to a serious lack of demand. Nonetheless, the government continues to promote Bitcoin City and seems committed to issuing the bonds by September at the latest. In fact, it has even floated the idea of issuing up to $5 billion more in Bitcoin Bonds to help pay off its existing debt, essentially swapping it for even riskier debt that would only be sustainable if the price of Bitcoin rises over time.
The idea for Bitcoin Bonds first came from Blockstream, a Canadian crypto company that proposed it to the Salvadoran government shortly after the Bitcoinization law passed. Samson Mow — the former Chief Strategy Officer of Blockstream who has served as an advisor to Bukele — explicitly acknowledged that Bitcoin Bonds are “a way for a huge flood of capital to flow into this [B]itcoin-based financial system … That’s going to be hard for organizations like the IMF to swallow, but I just don’t think there’s anything they can do about it.”
US and Canadian businessmen have played a significant role in developing Bitcoinization. Mow helped convince Bukele that it was “entirely possible for the country to fully pay its debt and eradicate its foreign debt in 10 years with one or two Bitcoin bonds.” He, in turn, was first introduced to Bukele by Jack Mallers, a US businessman whose company Strike is responsible for the electronic payment system that El Salvador uses. Mallers also helped advise the government on Bitcoinization policy, and has described it as a way for El Salvador to “opt out of their relationship and reliance on a central bank or an institution like the IMF …”
A Losing Bet
There is a long list of reasons to doubt that Bitcoin Bonds will succeed. Mow’s claims of high returns are based on an estimate that the price of a Bitcoin will reach $1 million within 10 years — nearly 50 times its current value. Unless the price of Bitcoin skyrockets in this fashion, EBB1’s guaranteed minimum annual return of 6.5 percent will remain less attractive than regular Salvadoran bonds offering much higher rates. For most Bitcoin enthusiasts, there is also little reason to buy these bonds rather than just buying Bitcoin itself.
EBB1 is intended to be issued by a state energy company that appears to lack the financial strength to cover the bond’s interest payments. Unlike with normal bonds, this company does not have any major obligations to bondholders in the case of a bankruptcy. Also unlike traditional bonds, EBB1 will be issued under Salvadoran law, which Bukele can change at will due to his party’s control of the country’s legislature. Taken together, all this means that investors will lack most of the legal protections that usually make bonds a relatively safe investment.
Even worse, the Bitcoin Bonds will be sold exclusively on Bitfinex, an unregulated crypto exchange that has gotten into so much legal trouble that it is banned from operating in the United States, the world’s second-largest crypto market. Any US citizens interested in purchasing El Salvador’s Bitcoin Bonds will have to find indirect workarounds.
There are also the more fundamental problems with using Bitcoin as a currency at all. Research has found that Bitcoin is far too volatile to actually function as a currency. Nor is it safe from manipulation. While the cryptocurrency may operate on a decentralized system, its actual ownership is centralized among a handful of “whales,” large investors whose trading behavior can create waves across the entire market. Tether — a crypto asset run by Bitfinex — nearly collapsed last month after instability scared whales into selling off $710 million in a single day.
If a proposed project like Bitcoin Bonds faces this many issues, why would a government still seek to launch it? One answer is that some of its backers may benefit from the issuance of Bitcoin Bonds, regardless of whether or not they turn out to be a bad deal for investors or the Salvadoran government.
Both Blockstream and Bitfinex are said to be involved in designing the regulations under which EBB1 will operate. A Bitfinex executive denies this poses a conflict-of-interest because the company won’t charge fees on the bonds themselves. However, any business with significant Bitcoin holdings naturally stands to gain from higher Bitcoin prices. As such, they would have an incentive to use the financial power of the Salvadoran government-issued Bitcoin Bonds to raise the price of Bitcoin generally, even if the issuance of new bonds would be detrimental to the Salvadoran economy.
Samson Mow hinted at this motivation while next to Bukele on stage at a major press event:
There’s a five-year lock-up on the bond [before it begins paying dividends on Bitcoin gains to investors], so that’s half a billion dollars of Bitcoin taken off the market for five years. Now, if you do nine more bonds, that’s ten bonds: that’s five billion in Bitcoin taken off the market for ten years. And if you get ten more countries to do these bonds, that’s half of Bitcoin’s market cap right there.
The implication here is that convincing nations like El Salvador to use their public finances to purchase Bitcoin would raise its price, benefitting Bitcoin holders like him.
The Gamble Goes Global
The combination of El Salvador’s precarious financial position and Bukele’s desire for publicity created the perfect storm for crypto backers to swoop in and offer false solutions. Rising interest rates will only create more demand among low- and middle-income economies for unorthodox solutions to their own debt issues — solutions that don’t involve turning to the IMF and their harmful policy recommendations. Milena Mayorga, Salvadoran ambassador to the US, argued that “a lot of countries are looking at us, and they will follow our leadership.”
The idea that Bitcoinization could spread to other countries seemed unlikely as recently as the beginning of this year. Then, with little warning, the Central African Republic became the second nation to adopt Bitcoin as currency in April. Like El Salvador, the Central African Republic lacks its own currency, and instead uses the CFA Franc — a French-backed regional currency frequently criticized as a form of neocolonialism. Martin Ziguélé, a former prime minister now in the opposition, described Bitcoinization as “a way of getting out of the CFA franc …”
This debate is already global. Adopting Bitcoin as currency has now been proposed in the Pacific island nation of Tonga, which uses a pegged currency and, like El Salvador, is heavily reliant on remittances. When officials in Malaysia’s communications ministry suggested the government may accept Bitcoin, the finance ministry stepped in quickly to shoot them down. Though stopping well short of making it official currency, right-wing governments from Florida to Hungary have also been adopting Bitcoin-friendly legislation in recent years to try and capitalize on its popularity.
Reactions to El Salvador’s policy elsewhere in Latin America have been mixed. The “special economic zone” of Prospera has begun to accept Bitcoin as currency in the neighboring nation of Honduras, though the Honduran Central Bank refuses to back the scheme. On the other end of the spectrum, the Argentine government sought to gain favor with the IMF by pledging to “discourage the use of crypto-currencies …” in their latest debt deal. All over the region, attention-hungry politicians are trying to duplicate Bukele’s strategy of backing Bitcoin to build a fanbase.
If it truly wants to discourage other countries from using Bitcoin, the IMF should look inward. Insofar as Bitcoinization is an attempt to avoid unappealing IMF policies, reforms can lessen the institution’s poor reputation. Fundamental quota reform is a must. Serious efforts to reduce the usage of loan conditionalities can go a long way towards rebuilding trust. And a new issuance of Special Drawing Rights could help provide struggling economies with the liquidity required to manage their large debt burdens.
Until then, figures like Samson Mow and Jack Mallers are eager to expand Bitcoinization globally. Mallers has remarked: “We’re going to launch in a lot of emerging markets.… We’re just getting started.” Mow recently left Blockstream to focus on promoting “nation-state #Bitcoin adoption” around the world (he has also raised $21 million for his latest cryptocurrency start-up). “El Salvador has already bet everything,” he told a convention of Salvadoran government officials. “The fate of El Salvador and Bitcoin are linked.” Other countries could soon find themselves in the same position.
