Betting on bitcoin

El Salvador plans bitcoin-backed bond to build world's first bitcoin city. Genius or folly?

President Nayib Bukele of El Salvador unveiled the government’s plan to build the world’s first Bitcoin City, supported by a USD 1 billion bitcoin-backed bond in early 2022. The bonds were named “Volcano bonds” as half of them will be used to buy bitcoin and the other half will be invested in building a geothermal plant in the nearby Conchagua volcano to supply power to the new city.

“The issuance of these Volcano bonds does not solve the needs of 2022,” explained a former president of El Salvador’s central bank, “not only because the government needs more money than this but also because the bonds do not generate liquidity for the government, unless the government seizes the USD 500 million supposedly for the Bitcoin City and diverts it for budget support.”

International markets remain sceptical about this financial tool, as conventional markets are unlikely to provide these sums and the Salvadoran government has not sought approval from the International Monetary Fund (“IMF”) to issue these Volcano bonds. Meanwhile, Fitch Ratings warned that El Salvador’s 2022 budget underestimates the country’s fiscal and financial needs and said that the government’s 13% GDP growth is unrealistic and projects its growth in the region of 6%.

The former central bank president continued, “I think it will be hard for markets, even cryptocurrency markets, to be willing to take the risk of buying Salvadoran debt, considering the country’s precarious fiscal situation. If this bet on bitcoin doesn’t work it’s going to be even harder for El Salvador to negotiate with the IMF.”

“I think it will be hard for markets, even cryptocurrency markets, to be willing to take the risk of buying Salvadoran debt.”

Former President, Central Bank of El Salvador

An economist at the Central American Institute for Fiscal Studies (“ICEFI”) agreed, “It will be hard for them to raise this money, especially given the terms currently on offer. If they offered a higher interest rate, it could be more effective, but that is not on offer, yet. I don’t think many investors are brave enough for this. The government is trying to show the IMF that they don’t need them, but sooner or later all roads for El Salvador will lead back to the IMF.”

It is unclear what would happen if Volcano bonds defaulted. Government bonds are traditionally strict legal contracts which hold governments accountable in case the debt is not repaid. The lack of detail in the Volcano bonds strategy makes it unlikely that these bonds can be placed on the international markets. The situation is not helped by the World Bank’s disclosure, in June 2021, of the environmental and transparency shortcomings of the government’s bitcoin plans.

“El Salvador’s main problem is the maturities of their existing traditional bonds. I estimate that the country needs about USD 3.5 billion over the next two years.”

Economist, Central American Institute for Fiscal Studies

Meanwhile, El Salvador faces problems in meeting the next USD 800 million repayment of traditional bonds, due in January 2023. The country’s total debt amounts to USD 21.71 billion and its economy contracted by 21.9% in 2020 due to the COVID-19 crisis.

The economist concluded, “El Salvador’s main problem is the maturities of their existing traditional bonds. I estimate that the country needs about USD 3.5 billion over the next two years, I struggle to believe this can be covered by bitcoin bonds. Also, what the government is not taking in to account is that, just as bitcoin could be worth USD 1 million, it could also be worth zero. If they really believed in bitcoin, the government would not be so involved, I think they are pursuing a strategy to issue their own digital token and move to de-dollarise the economy.”

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