How Bitcoin Will Impact El Salvador's Geopolitics

Originally published on BitcoinMagazine.com on July 15, 2021 (archived)

El Salvador made waves in June 2021 by adding bitcoin as a legal tender alongside the U.S. dollar. It was a historic event. The use of bitcoin has the potential to dramatically benefit the small Central American country, but by how much? And what will it look like?

Let's briefly examine El Salvador's geopolitical situation and try to predict how bitcoin will affect the following:

History and Politics
Economy
Geography
Demographics
Bitcoin
Conclusion

THE HISTORY OF EL SALVADOR

Prior to Spanish colonization, the area of El Salvador was inhabited by two cultures. The more relevant to the modern state and capital city of San Salvador are the Pipils, arriving around 900 A.D. They likely came from the northwest due to language and religious ties to the Aztecs. The second culture is the Lenca, populating the eastern parts of the country with strong cultural ties to central Honduras.

The area of El Salvador was the frontier for many pre-Columbian Mesoamerican cultures. First, the Olmecs, then the Mayans, then the Lenca and finally the Pipils from central Mexico. Despite all of this cultural heritage, El Salvador never grew to become the center of a great empire itself and suffered from tense tribal warfare. The only impressive classical site is called Tazumal, which became uninhabited circa 1,200 A.D., long before the Spanish arrived (though there are many small sites around the country).

Historical sources are scant prior to the Spanish. If the Pipils were descendants of the Toltecs, they did not replicate the scale of megalithic buildings seen in central Mexico. The most important reason being the natural limits placed on their development by geography.

The region that is present day El Salvador has seen a few periods of relative prosperity, the Tazumal era of 700 to 900 A.D. and immediately preceding the arrival of the Spanish are two such eras. In the 16th century, their political organization was a somewhat decentralized confederation of city-states, dominated by the city of Cuzcatlan (modern day San Salvador). They had an extensive irrigation system and long distance trade routes northwest into Mexico and south, along the coast, to Costa Rica.

I suspect that if we did have records going back further, the political makeup would have been the same. Loosely affiliated city-states belonging to a dominant culture, which would band together to fight a common enemy, but spent most of the time infighting. The Pipil never rose to become more than a local influence in Mesoamerica, nor were they able to consolidate into a strong central state for long.

NEW SPAIN AND INDEPENDENCE

Spain incorporated Central America into the vast administrative district of New Spain in the early 16th century. This lasted 300 years, ending with a War of Independence (1810 to 1821), which saw New Spain dissolved into several successor states, one being the Federal Republic of Central America, composed of present-day Costa Rica, El Salvador, Guatemala, Honduras and Nicaragua.

This federation was ill fated from the beginning. It lumped together many distinct groups from different cultures, and by 1838, it began to fall apart. El Salvador, with San Salvador serving as capital to the Federation, was the last of the five nations to give up and declare a new government in 1841.

The Federal Republic of Central America experience is a great model for this region's history as a whole. The local proximity and potential synergy of unification makes these nations seem destined for a united government, with San Salvador at its center. However, geopolitical realities make it impossible.

20TH CENTURY

The 20th century in El Salvador was, for the most part, a continuation of the same. It was a constant struggle against political strongmen, war with neighbors and civil war. Not until 1931 did El Salvador achieve the milestone of its first freely-contested election, only to be toppled nine months later by a military coup.

In the 1970s, the internal situation in El Salvador deteriorated to a new low, culminating in the El Salvador Civil War (1979 to 1992). It was a brutal conflict with atrocities committed on both sides. Estimates are that up to 75,000 were killed. This conflict, its causes and aftermath, to a large degree, form the West's opinion of the country.

NEW IDEAS AND NAYIB BUKELE

There is fresh hope and vigor in El Salvador today. The elections in 2019 appear to be a landmark in its history, with the election of a young and motivated new president, Nayib Bukele.

He took the country by storm and immediately implemented sweeping reform. The murder rate, which was among the highest in the world, has plummeted by over 60% and gang violence has been dramatically curtailed. While he's used some tactics that might offend Western sensibilities, they are tailored for the specific challenges of El Salvador detailed above. And they seem to be working.

ECONOMY

The El Salvadoran economy was traditionally dominated by agriculture until very recently. In the last century, much of the country's export agriculture has shifted from cacao and indigo to coffee and dramatically dropped in importance. Currently, service activities make up 69.3% of GDP (travel: 32%, maquila: 25%), the manufacturing industry 16.1%, and agricultural activities only 5.9%.

Bitcoin gains are not taxed since it is now legal tender. There are also import/export taxes, sales taxes and municipal taxes. A corruption index of 104/179 places it far better than all other Central American countries except Costa Rica.

CAFTA

The Dominican Republic-Central America FTA (CAFTA-DR) is the first free trade agreement between the United States and a group of smaller developing economies: Costa Rica, El Salvador, Guatemala, Honduras, Nicaragua, as well as the Dominican Republic (note: El Salvador is the only signatory without a Caribbean/East Coast port).

It was signed in 2004, and although it tackles tariffs and promotion of service sectors in these countries, it is important to note that nearly all imports into the U.S. from these countries were already tariff-free since the 1984 Caribbean-Basin Initiative. So, CAFTA primarily helped U.S. exports and U.S. foreign investment into these nations. It is the second-largest Latin American trade area for the U.S., second only to Mexico.

FREE TRADE ZONES

The free trade zones in El Salvador are interesting. They are tax-free zones for export-oriented services and manufacturing. The sales that these companies do domestically, however, are still taxed at the typical rate.

What is striking is their broad, multi-partisan popularity. These zones give the local population a great source of income and enable a build-up of important infrastructure in the country. It also fits with the pre-colonial past, of a more decentralized governance structure.

REMITTANCES

Remittances from the U.S. are a very important source of income for the country with nearly one-third of all households receiving this type of payment. The total has increased quite dramatically in recent years, reaching $5.7 billion and 24% of GDP in 2020. It is roughly double the entire export income of the country.

This amount of cash injection into the country has mixed results. Though wages have increased rapidly, the country still has problems attracting domestic workers, who are happy to live on their remittances from family members abroad. This leads to migration from Honduras and Nicaragua into El Salvador for the relatively high wages.

TOURISM

Although the country had a very high crime rate until recently, tourists are generally pretty safe. Prior to the pandemic, tourism was growing rapidly, and hopefully it can recapture that growth.

Tourism-related activities make up 8% of the country's GDP (2019). Of course, 2020 and 2021 were a huge hit to this revenue, but the government has plans to bounce back. It has unveiled a new "Brand El Salvador" campaign which will highlight the country's many travel destinations along with local crafts and culture

Source

El Salvador is a very small country, with almost any corner of the country accessible from the capital San Salvador in 40 minutes. It has surfing, beaches, cultural archeological sites and local arts and crafts. If gang violence can continue to decline, there is a big opportunity to be a destination for people from the U.S. and Canada, and a growing opportunity to attract Mexican and other Central American tourists.

TRADITIONAL FINANCIAL SYSTEM

Since 2001, El Salvador has used the U.S. dollar as legal tender. This was a big move because it effectively gave up control over their own monetary policy and printing press. All government programs must be paid for with fiscal policy or international loans, keeping the government more fiscally responsible. Its banks can still issue dollar-denominated loans, which is printing money, but the use of the USD has kept a lid on corruption and inflation.

As a developing nation that doesn't have the ability to print their way out of trouble, El Salvador has looked to international bodies for loans in recent years. It wasn't just 2020 and the pandemic that forced El Salvador to reach out for funding, recent loans from the World Bank started in 2019 after a six-year hiatus. Total loans from the World Bank and the IMF were roughly $900 million in 2020 ($520 million and $390 million, respectively).

When the country announced the adoption of bitcoin as a legal tender, it drew immediate commentary from these international organizations. The IMF specifically said it would examine the impact of this decision on future loans.

El Salvador banking is relatively stable and well capitalized. In the 1980s, the banking system was nationalized but now has been privatized again, consisting of 14 institutions: 12 private banks (96%) and two state-owned banks (4%). As of 2016 "ATM and POS terminal deployment in El Salvador is below the average for the Latin America and the Caribbean, but above the average for lower-middle income countries," according to World Bank Group.

As part of its bitcoin strategy, the government has contracted with Athena, a bitcoin ATM provider, to add 1,500 bitcoin ATMs in El Salvador.

GEOGRAPHY

"Demographics are destiny," as the saying goes, but geography sets the limits.

El Salvador has several important geographic features which shape its politics and culture; a hot coastal plain, the Sierra Madre mountains, a temperate central plateau and several active volcanoes. In Central America, population centers tend to be in the mountain plateaus with a more temperate climate, and El Salvador is no different. San Salvador has been the economic and population hub of the country for 1,000 years.

Source

RIVERS, RAIL, ROADS AND PORTS

In El Salvador, large scale industrial transportation is very lacking.

"Commercial navigation along the rivers of El Salvador is almost nonexistent," per the Logistics Capacity Assessments (LCA) tool. There are no contiguous stretches of navigable river to link together a trade network. In fact, even though the country is so small, it still has three, roughly equal and distinct, zones defined by water: the far west Paz River basin, the central Lempa basin and the Gulf of Fonseca bordering Honduras and Nicaragua. None of these, however, give access to cheap and easy transportation inland.

The rail situation is also extremely limited, "the private railway that exists in country [has] been out of service since 2002," according to LCA, and recently was retrofitted into a public passenger rail. There appears to be very little, maybe no, kilometers of commercial track in the country.

Almost all commercial transportation within El Salvador is done by road. This is workable only because it is such a small country and the road network is extensive and well maintained. The Port of Acajutla, for instance, is 85 kilometers from the capital San Salvador (52 miles), and is connected by a good road.

Speaking of ports, Acajutla is the main port handling more than 70% of cargo for the country. That being said, it is not even close to being a major port. It's the 47th largest by volume in Latin America/Caribbean and seventh in Central America (not including Panama). The eastern Port of La Unión is in a wonderful strategic location on the Gulf of Fonseca. Completed in 2010 and billed as the most advanced port in Central America, it has been virtually unused since.

FUTURE PROJECTS

El Salvador is currently working on several transportation-oriented projects. I will just highlight two.

The first is a dry canal in coordination with Honduras, which will connect central Honduras to the Port of La Union, and perhaps in the future be extended into an Atlantic to Pacific corridor. The second project is a network of roads around the Gulf of Fonseca, again, to better connect the Port of La Union to Honduras and Nicaragua.

ENERGY

El Salvador has vast energy potential in the form of hydro and geothermal sources. It is already the largest geothermal producer in Central America and has plans to expand its lead.

Typically, when small nations have energy reserves, they are in the form of fossil fuels. That gives them the ability to export oil or natural gas easily to a global market. However, in the case of El Salvador, the energy must be produced domestically and cannot be exported cheaply. This creates an interesting dilemma of having energy resources but not being an energy exporter.

El Salvador is a member of the Central American Electrical Interconnection System (SIEPAC), a project completed in 2014, connecting 37 million consumers in Panama, Costa Rica, Honduras, Nicaragua, El Salvador and Guatemala. This system provides a regional market for El Salvador's energy production but it is not ideal. There is massive loss in transmission lines resulting in long-distance electricity being very expensive.

TRADE ROUTES

El Salvador is the only Central American nation, other than Belize, without access to both the Atlantic and Pacific oceans. This obviously limits its ability to get involved with potential trade routes. It is situated along a land route from Panama to Mexico, but that's not saying much, it pales in comparison to the importance of seaborne trade.

El Salvador lacks a major port and is unlikely to ever have one, due its small population and lack of internal trade routes, like waterways and rail to other regions of Central America. El Salvador does not sit at a strategic geographic chokepoint, like Panama or Singapore do, so container ships not bound specifically for El Salvador have no reason to stop there when it is a relatively short journey to Mexico or Panama.

There is an opportunity to expand trade through the Gulf of Fonseca and the port of La Unión, but expensive infrastructure is needed. There is also some possibility of expanding Pacific trade relations with South American countries.

DEMOGRAPHICS

El Salvador's demographic situation is excellent, it has the highest population density in Central America, and is part-way into the modern demographic transition. In the last 50 years, the fertility rate has fallen from six births per female to replacement rate today. High religious faith in the country may help keep fertility rates up, along with a rise in populism and nationalism globally. El Salvador may yet avoid a painful demographic transition.

For the next several decades, the El Salvador economy should benefit from its large millennial generation in their mid-20s today, entering their most productive and highest consumption years.

A high prevalence of English speakers, due to deportations from the U.S., has created opportunities for many companies needing English speakers like telemarketing and call centers. There is a well-established elementary education system and a big pool of unskilled labor. It is a great partner for a reindustrializing U.S., very similar to Mexico. Daily minimum wages between Mexico and El Salvador are also comparable in 2021, with national averages of about $10 and $11, respectively.

BITCOIN

The reason for examining this geological profile of El Salvador is to see the potential benefit the adoption of bitcoin can bring to the country. Can El Salvador become another small country miracle, like Taiwan, UAE, Singapore or Luxemburg? In the exploration above, several opportunities stand out where Bitcoin can offer some specific advantages and perhaps solve some challenges.

REMITTANCES

Bitcoin can immediately add value to remittances in El Salvador. With 24% of the country's GDP coming from remittances, eliminating fees on these payments can have an immediate benefit. For instance, in the traditional remittance networks, smaller payments can have fees that approach 50% of the total value sent. If a family member works in the U.S. and sends home to El Salvador $50 per week, half of that can go to fees. Bitcoin will immediately solve that issue, leading to perhaps billions more dollars reaching the country in the first few years.

That is the obvious benefit to remittances, but there are some possible negatives associated with more money coming into the country.

First, is the possibility of inflation. As more money enters the country, prices may be bid up locally for products. Second, it also could exacerbate unemployment (about 10% for ages 15 to 24). Remittance receivers would have less reason to go out and get a full-time job, perhaps even allowing another family member to stay at home. Third, fewer workers will drive wages competitively higher and attract more immigration from Central American neighbors causing some cultural tensions.

On net, the dramatic reduction of remittance fees will be a huge positive for El Salvador, however, it could have several unintended consequences.

BITCOIN MINING

An opportunity specific to the Bitcoin industry is mining. As we've seen recently in regards to China, regulatory risk is very real for these operations. El Salvador adopting bitcoin as a legal tender reduces that risk to almost nothing. The country also has vast domestic energy potential that it can't export, and is actively looking for investment to expand its capacity. Bitcoin mining brings all of these factors together in a very market-driven and beneficial way, both for El Salvador and for Bitcoin. While Bitcoin will get more hash rate and bolster its clean energy narrative, El Salvador will benefit from more economic activity, the introduction of a whole new industry in the country and the ability to use its abundance of clean energy.

TOURISM

Friendly taxes and regulation around bitcoin will go a long way to attracting people who own bitcoin to the country. It will likely not be a gamechanger in itself, but several thousand bitcoiners might move to El Salvador over the next few years. These permanent residents will have above average wealth with unique skills that could benefit the entire economy.

Bitcoin is also a great tourism currency. It is global and doesn't suffer from arbitrary international roadblocks. When the tourism industry in El Salvador is completely set up to accept bitcoin, it will solve specific concerns for frequent world travelers. If these destinations hold bitcoin as part of their cash balances, they will also benefit from currency appreciation.

CONCLUSION

Bitcoin will be a success in El Salvador, boosting remittances, industry and gains from remuneration. Per capita GDP is likely to double over the next decade as remittances, the energy sector and tourism all grow. That would place El Salvador at the top of Central American countries except Panama. If the new government is able to continue its current trajectory against crime, there is a possibility to catch Panama's per capita levels in the next 20 years.

However, this transition will not turn El Salvador into a stable powerhouse country with extremely high living standards. Poverty will be further mitigated, but the best businesspeople, scientists, engineers, talent, etc. will constantly be drawn away by the naturally bigger markets of the U.S. or Mexico. Political power is highly centralized in the person of Bukele today, but that means it can only go in one direction, back toward its natural roots of a more decentralized region.

Using history as our guide, the stability and decrease in local conflicts of the last few years is not normal. While it is possible that El Salvador has finally conquered its geographic reality, it is unlikely. More likely is that it has come together at a particular moment in time, guided by a vision of a greater standard of living, but will soon revert to old animosities.

Therefore, after a period of prosperity in the next few decades, violence and war will eventually return between the varied internal cultures and interests of different geographic regions, as well as the interests of neighbors. The return to the geopolitical realities of this area will not undo all the progress about to be made, but it puts in perspective the unique challenges and culture of this region.

Historically, El Salvador has punched above its weight in Central America and it will continue to do so. The addition of bitcoin as a legal tender is a great fit for its economy and brings many opportunities.

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