El Salvador, Bitcoin, CBDC and other digital assets

Today bitcoin officially joined the USD as legal tender in El Salvador. While some logistical issues have been addressed since the original announcement, I continue to be skeptical about the benefits and do not expect many others to follow the example. (see my CNBC podcast interview from a few months back). there’s still a lot of challenges that argue against broad adoption by governments including today’s volatility.

El Salvador is relatively unique, its a country that had already abdicated monetary sovereignty as the USD is legal tender and they don’t have their own currency. They are one of a few countries who adopted use of a foreign currency tying their hands and their economic policy to an external anchor. A few others may consider it, but many governments would prefer some greater control and thus may prefer to opt for CBDC or use the infrastructure of the blockchain to solve particular problems for a range of different financial instruments.

Still, The biggest use case for bitcoin and alternative coins right now is in countries with significant domestic and international capital controls and those that have the highest fees for financial transactions like remittances. These tend to be countries where economic policies are not serving the population and capital controls sharply restrict private sector activity. Nigeria, Argentina, Lebanon for example. It’s also very attractive when those controls are externally imposed including highly sanctioned countries like Venezuela, North Korea and even Iran. Tho power supply issues can limit even their attraction.

Allowing bitcoin to be an alternate currency could reduce the need for dollar cash locally alleviate and help support government revenue via new ways of disseminating remittances. However, it also exposes users to another source of asset volatility given limited intrinsic value and no intrinsic link to domestic economy. Moreover it doesn’t change the balance of payments. Officials were looking for something that would put them on the map and encourage some associated investment. Its not clear the current plan actually reduces reliance on the USD.

 However they haven’t solved the high energy needs for bitcoin mining, the distribution issues, need for government and private sector to be prepared for this volatility. For example – El Salvador may face the risk of two competing currencies which are uncorrelated, neither of which are linked to its own financial or economic fundamentals.  Some of the implementation challenges have been addressed including the terms/costs of the new tether-based conversion system and who benefits from the fees but there are still challenges including relatively little access to digital payments systems and connectivity, the limited access of bitcoin ATM and fact that the country is still cash based. One potential upside is that Salvadorans may reduce the amount of cash imports and may be able to negotiate lower fees if they can displace some of the existing payment systems.

Overall, we should see more experiments in digital currencies and assets and use of blockchain technology (see Domjan et al for a number of great examples). For most countries, the concern about loss of control argues against bitcoin and other privately run digital/crypto assets. It also can present a challenge monitoring for illicit flows and tax evasion and consumer financial protection. One way to address this is by subjecting crypto assets and tokens to the same financial transaction notification and taxation guidelines as other assets, a process the US treasury, SEC etc are doing. Others are stepping up consumer financial protection warnings Central bank digital currencies, especially that of China are likely to allow for more monitoring of domestic actors, potentially even greater influence of central banks over economic policy and perhaps in some countries a reduction in the influence of private banks. There are also some national security risks involved, most concerning in countries with risk of broader surveillance capabilities such as China or those that find such approaches appealing. 

As my CNAS colleagues Emily Jin and Yaya Fanusie note, China is currently following a two track approach with eCNY. Domestically it helps to increase control potentially taking market share from private alternatives like WeChat or co-opting them. Internationally, China is more focused on setting standards for future digital currencies and related assets rather than allowing the digital CNY to circulate in particularly strong volumes.  Overall, the use of CNY beyond its borders remains constrained by Chinese government management of the external accounts and capital flows. Overall, this remains a key area to watch for standard setting, illicit flow monitoring and other linked trends.

The push for international regulation and reporting will likely only grow.

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