What does El Salvador’s Bitcoin policy means for the rest of the world?

El Salvador's adoption of bitcoin as legal tender poses challenges for the  network, JPMorgan says | Currency News | Financial and Business News |  Markets Insider

On June 8th, 2021, El Salvador became the first country in the world to give Bitcoin the status of legal tender after its congress approved President Nayib Bukele’s proposal to embrace the cryptocurrency with a supermajority. Since then, the media around the world has covered the event like there’s no tomorrow. Bukele went on a Bitcoin-related tweet spree that seemed to be aimed at attracting more crypto supporters from around the world.

The president also announced he has instructed the country’s state-owned geothermal electricity firm LaGeo to develop plans to create Bitcoin mining facilities using the country’s many volcanoes. Implementation of the plans seems to have started already, with Bukele tweeting a drone video of a well that was dug for the purpose. 

According to the bill, Bitcoin can be used in any transaction. All national or international businesses operating in the country would be legally required to accept Bitcoin as payment, except merchants who do not have access to the infrastructure needed. The country is also ensuring businesses who don’t want to take the risk of having exposure to Bitcoin aren’t forced to, with the government setting up a $150 million fund to ensure exchange to US dollars at the price of the initial transaction. 

Why did El Salvador make Bitcoin its national currency?

El Salvador is still a largely cash-based economy, with 70% of the population having no access to a bank account. The country has a large part of the population living abroad, who then send remittances back home. According to data from the World Bank, 21% of the country’s entire GDP is remittances from abroad. Middlemen like Western Union can sometimes charge up to 15-20% of those remittances in fees. Bitcoin makes those remittances significantly faster and cheaper, with the country estimating savings of billions of dollars in fees. 

That’s not the only reason, however. In 2001, after a long period of instability of its original currency, El Salvador adopted the US dollar as its currency, just like dozens of other countries do. Although it brings stability, your sovereign currency being controlled by a foreign country has its disadvantages. In the fallout of the coronavirus crisis, the US federal reserve has increased the supply of US dollars in their economy by an extent never seen before outside of wartime. Measured by the M2 money stock, the circulating supply went from $15.32 trillion in February 2020 to $20.26 trillion in May 2021. An unprecedented increase of 32%. 

That extra cash was used to stimulate economic activity, with most of the dollars going to businesses, financial institutions, and everyday citizens of the US. The same wasn’t true for citizens of El Salvador or any of the other countries that use the US dollar as their currency, who did not receive any of that stimulus in their bank accounts, but did lose purchasing power due to the US’s monetary inflation. El Salvador is also a net importer of goods, which means unless something is changed, they’re going to run out of money. They’re hoping to use Bitcoin to fill in the gaps that using the US dollar leaves.

The move is also likely to attract a lot of crypto entrepreneurs from the West and Asia setting up businesses and even moving to El Salvador, bringing with them their wealth, because as Bitcoin is now classified as a national currency, there’s no capital gains tax. 

El Salvador’s move is being hailed as a tipping point by a lot of people in the crypto community. There are undisputed tangible benefits of using Bitcoin for smaller nations that are currently dependent on the US dollar or other foreign currencies. The implications of making Bitcoin the national currency of a widely recognised sovereign national are wider than just inside El Salvador. 

The legal status of Bitcoin varies widely around the world. While most progressive countries have made it legal, every other country has their own way of classifying it as an asset, some form of currency, security, or something else.

In the above map, the green countries are where it’s legal to use Bitcoin, the yellow ones are countries with some restrictions on its usage, the purple ones have more restrictions, but Bitcoin isn’t directly illegal to use, and the red ones are ones where Bitcoin is outright illegal. The little orange spot in Central America is where it’s legal tender.

Most countries that are hostile towards it or have restrictive rules claim that Bitcoin is a virtual currency in their legislatures. Interestingly, according to the widely-accepted definition of virtual currencies in the directive issued by the European Parliament and the European Union, a virtual currency is “a digital representation of value that is not issued or guaranteed by a central bank or a public authority, is not necessarily attached to a legally established currency and does not possess a legal status of currency or money”

The move by El Salvador, giving Bitcoin the status of a national currency of an internationally recognised sovereign nation, now implies that Bitcoin isn’t a virtual currency anymore according to the most widely accepted definition of a virtual currency. This means that most countries hostile towards Bitcoin, and even some that have made it legal with restrictions, would be forced to revisit their legislatures as they’re based on a now-false assumption. Other countries, where it’s legal to buy and sell Bitcoin, but where it’s classified as an asset, would likely also be advised to revisit their definitions and classifications, like the US where adoption as a payment system is artificially limited by the IRS classifying it as an asset, requiring every transaction to have capital gains taxes reported and filed by every individual. If Bitcoin is re-classified as a foreign currency, it would become massively easier for corporations to hold Bitcoin on their balance sheets, the same way they hold foreign currency of every other country they operate their businesses in.

The Salvadoran government is also working with pioneers in the crypto industry like the Lightning Network payments platform Strike, and Adam Back’s Blockstream with their satellite infrastructure, among others to build a new financial system within the country with Bitcoin as its base layer. They say that this ecosystem would be developed to be a model for the world in adopting the Bitcoin standard.

What would all of these new developments mean for Bitcoin’s price action?

The price of Bitcoin jumped around 10% following the news, but that’s not a huge change considering how volatile the cryptocurrency is. Adoption by a national government is a huge milestone of course, but it’s important to remember that El Salvador only has a population of a bit less than 6.5 million people, with a total nominal GDP of $25.85 billion. Even the fund set up by the country’s development bank to ensure convertibility at the time of transaction is only worth $150 million. Many companies themselves in the US hold more Bitcoin than that. 

In the short term, it’s likely not to affect Bitcoin’s demand, and thus price too much. In the long term, however, a robust ecosystem championed by a national government in a small area is likely to serve as a proof-of-concept for the rest of the world, and especially for other nations in similar boats as El Salvador. If more countries with bigger populations and larger economies adopt it, the demand for Bitcoin would go up significantly, thus raising the price. The move by El Salvador would, without a doubt, be hailed as one of the most significant steps in the worldwide adoption of Bitcoin if and when it happens.

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