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Think Outside The Box

El Salvador became the first country in the world to legalize bitcoin

El Salvador passed a new law on Wednesday that would make the small Central American country the world’s first to deem bitcoin legal tender, a move that analysts say risks putting its economy at the mercy of the digital currency’s sharp swings.

The designation allows bitcoin, the world’s largest cryptocurrency by market value, to be used to buy goods and pay taxes and bank loans. Businesses would be required to accept bitcoin for payment, with the bitcoin-dollar exchange rate set by the market.

Converting bitcoin into other currencies won’t be subject to capital-gains tax, according to the three-page bill that was submitted Tuesday evening and swiftly approved after midnight by lawmakers of President Nayib Bukele’s New Ideas party, which enjoys a supermajority in the 84-member Legislative Assembly.“Bitcoiners around the world, the time has come. We are ready. We did our part, now the ball is on your side,” said William Soriano, a ruling party member and one of the 62 lawmakers who voted for the bill.

The Central American country of 6.5 million, one of the region’s poorest, has struggled over the years to manage its finances and has used the U.S. dollar as its official currency since 2001.The 39-year-old Mr. Bukele, a populist who was elected in 2019 as a political outsider amid discontent over violence and poverty, surprised cryptocurrency devotees when he first announced his government planned to adopt bitcoin over the weekend. Known for his black leather jackets and baseball caps worn backward, Mr. Bukele has a “laser eyes” picture on his Twitter profile, a social-media fixture of cryptocurrency aficionados.

“Every restaurant, every barber shop, every bank” will be required to accept bitcoin, he said on Tuesday night as legislators debated his bill. He said the use of bitcoin would increase financial inclusion, as 70% of Salvadorans don’t have access to traditional financial services.

But the adoption of bitcoin comes as Mr. Bukele is facing increasing economic headwinds and diplomatic strains with the Biden administration as he ratchets up authoritarian control of the country. Mr. Bukele recently replaced the magistrates of the Constitutional Court and the attorney general. Last week, his administration cut ties with an anticorruption commission set up by the Organization of American States.

“The plans for bitcoin under an increasingly autocratic regime will likely only compound concerns about corruption, money laundering and the independence of regulatory agencies,” Siobhan Morden, head of Latin America Fixed Income Strategy at Amherst Pierpont Securities, wrote in a note to investors on Wednesday.Adopting cryptocurrency could also help the country cushion potential economic sanctions if bilateral relations with the U.S. continue to deteriorate, said Ricardo Castañeda, senior economist at the Central American Institute for Fiscal Studies, a think tank.

El Salvador has been particularly vulnerable to U.S. economic sanctions since it ditched its own currency, the colon, 20 years ago. Ecuador adopted the dollar in 2000, and Panama has long used the greenback as its only currency.The adoption of bitcoin also seeks alternative hard-currency sources to narrow a wide budget gap and rising government debt, just as the Bukele administration engages in talks with the International Monetary Fund to get a financial-aid package of about $1 billion.

The country’s use of the U.S. dollar provided macroeconomic stability as remittances from Salvadorans abroad grew steadily to reach a high of almost $6 billion last year. Nearly three of every 10 dollars in the country’s economy come from remittances. Other than Haiti, no country in the Western Hemisphere relies more on remittances than El Salvador. One in four Salvadorans live abroad, mostly in the U.S., as extreme poverty and endemic criminal violence sparked mass migration.

But dollarization has made El Salvador more vulnerable to external shocks, like the Covid-19 pandemic, which led to an economic contraction of about 9% last year.“Dollarization in times of crisis takes away the possibility of using monetary policy to stimulate economic activity,” Mr. Castañeda said. “It’s like eating Chinese food with just one chopstick.”

With a budget gap that widened to almost 10% of gross domestic product last year, the government could convert bitcoin inflows when the price is high to cover the deficit, said Manuel Orozco, a Central America expert and director of the Center for Migration and Economic Stabilization, a U.S.-based think tank. But it could also be extremely risky for a country with a significant fiscal deficit if things go the other way, given the volatility of bitcoin, he added. Capital buffers for its dollarized banking system could also be depleted.

While the cryptocurrency was designed to be a method of payment, it has struggled to meet that goal due to its high volatility. Consumers and businesses are reluctant to use a currency whose value could swing sharply from week to week. Bitcoin closed at $36,405.81 Wednesday, down almost 50% from its April peak

Much of bitcoin’s adoption to date has been as a speculative investment, with traders betting on the price rising or falling. Because bitcoin and other cryptocurrencies don’t have fundamentals to trade off, prices can shift quickly based on sentiment. Tweets from Tesla Inc. Chief Executive Elon Musk this year caused swift declines and rallies in bitcoin.

To allow the automatic convertibility of bitcoin to U.S. dollars and cushion volatility, the Bukele administration will set up a $150 million trust at state-run development bank Bandesal.“Betting on bitcoin is like playing roulette in Las Vegas,” wrote Carlos Acevedo, former governor of El Salvador’s central bank. “Who could explain to the IMF and multilateral banks if part of their loans are lost in a casino round?” he asked in an opinion column published Monday in El Faro daily.

Regulators in developed nations have approached digital currencies with skepticism. By nature, they provide users anonymity, making them attractive to move around proceeds of illicit activities. Those risks are higher in an impoverished nation like El Salvador, in which criminal gangs control vast swaths of territory.

The legislation passed by El Salvador is unusual because legal tender status generally just determines whether taxes and other debts can be paid through a specific instrument, rather than compel businesses to accept a specific form of payment, according to George Selgin, director of the Cato Institute’s Center for Monetary and Financial Alternatives.

Other poor nations have talked about using cryptocurrencies as a way to free themselves from reliance on the U.S. dollar, the dominant currency in international financial transactions.

In 2018, Venezuela launched its own cryptocurrency tied to its oil reserves, the petro, as a way to circumvent punishing sanctions and its dwindling supply of U.S. dollars. But the plan failed to gain global relevance as the U.S. banned the use of the currency, calling it a desperate scam by Venezuela’s regime to raise money.

The Bahamas has introduced a government-issued digital currency as a means of giving more people access to banking services, a move other nations are looking to follow.