El Salvador’s Road to Currency Chaos and Economic Collapse

In the middle of the night of June 8, El Salvador passed a law that made Bitcoin legal tender. The Bitcoin Law is the brainchild of El Salvador’s populist president, Nayib Bukele. Its most controversial feature is Article 7, which stipulates that every economic agent in El Salvador must accept Bitcoin as payment for goods and services. Accordingly, after September 7, Bitcoin will not only be legal tender, but forced tender. To make this radical change more palatable, the government promises to put $30 into the digital wallet of each Salvadoran who downloads the government’s cryptocurrency app.

President Bukele’s radical crypto initiative made headlines around the world. It also made him somewhat of a folk hero in the crypto community. But, in El Salvador, Bukele received little more than cynical glances. After all, since El Salvador dumped the colón and replaced it with the U.S. dollar in 2001, its average annual inflation rate has been only 2.03 percent, the lowest rate in Latin America. And if that’s not enough, even though the greenback is legal tender, all currencies are legal to use in El Salvador. So, Salvadorans ask, “Why change our dollarized competitive exchange-rate regime?” It works like a charm. The World Bank and International Monetary Fund have made the same observation and asked the same question. And rightfully so.

They won’t be the only institutions asking questions. So will the Financial Action Task Force (FATF), the international money-laundering and terrorist-financing policeman. From an FATF regulatory perspective, El Salvador has been as clean as a hound’s tooth. That will change if the Bitcoin Law is implemented on September 7. In a Johns Hopkins Studies in Applied Economics working paper, I identified 27 FATF regulations related to virtual‐​asset transactions that will be nearly impossible for Salvadoran banks, businesses, and their customers to comply with under the new law. For example, the FATF mandates that the parties engaging in virtual‐​asset transactions provide complete and sufficient know‐​your‐​customer information. It also requires that senders and recipients of virtual assets obtain accurate knowledge and information about “the transaction, the source of funds, and the relationship with the counterparty.” The chances of Bitcoin transactions meeting such requirements are slim to ​none.

If you are wondering whether the FATF and other regulatory bodies will cast their eyes onto the shady side of El Salvador come September 7, the answer is an unambiguous “yes.” Just look at what the U.S. State Department has recently done. On July 1, it released a list of corrupt and/​or undemocratic actors from Central America’s Northern Triangle (El Salvador, Guatemala, and Honduras). Of the 55 Central Americans now banned from the United States, 14 are Salvadorans. They include high‐​level members of President Bukele’s administration, including his cabinet chief, minister of labor, vice minister of security, and legal adviser. They’ve been nailed for a laundry list of charges such as money laundering, accepting bribes, and undermining democracy.

Bukele himself has a history of overstepping his democratic powers, including using the military to influence congressional legislation and ousting five supreme court judges who had previously ruled against him. Most recently, Bukele has ordered the arrest of former president Salvador Sanchez Ceren and nine former government officials.

If all these concerns and questions aren’t enough, some Salvadorans are questioning whether the Bitcoin Law could pass constitutional muster. In consequence, Bukele is proposing to rewrite El Salvador’s constitution. The new proposed constitution, specifically Article 111, would allow the government to grant legal tender status to currencies that do not exist in a physical form (read: cryptocurrencies).

While Bukele marches forward, the markets are unsurprisingly in retreat. Following the passage of the Bitcoin Law, Moody’s downgraded El Salvador’s long-term foreign-currency issuer and senior unsecured ratings. As night follows day, El Salvador’s U.S. dollar-denominated bonds due in 2035 have also plunged since the Bitcoin Law was passed and recently hit a nine-month low. And El Salvador’s bonds due in 2029 are trading near distressed levels, with a massive spread of 945 basis points over comparable U.S. government bonds.

The markets are telling us that Bukele’s authoritarian tendencies and crackpot cryptocurrency ideas will result in currency chaos and economic collapse. For the United States, this would mean yet another wave of migrants from an unstable Central American failed state.