cryptocurrency
gopixa / iStockphoto.com

El Salvador’s move to adopt Bitcoin as legal tender may threaten the government’s efforts to reach a funding deal with the International Monetary Fund (IMF), says Moody’s Investor Service.

Last week, El Salvador’s legislative assembly approved the world’s first law to designate Bitcoin as legal currency for settling transactions in the country, alongside the U.S. dollar.

A Moody’s report on Monday said the step “carries risks for the financial system, the stability of the country’s monetary regime and signals a lack of a coherent economic framework because the IMF is unlikely to have been consulted about the law while negotiating economic and fiscal measures related to the funding program.”

The decision to make Bitcoin legal tender may hamper the government’s negotiations with the IMF over funding, which the rating agency said had stalled over policies to improve governance and transparency.

“In recent weeks, El Salvador’s government has adopted successive measures that undermine governance in the country, raised diplomatic tensions with international partners and risk thwarting progress toward reaching an agreement with the IMF,” it said.

This includes dropping out of an international commission to fight corruption and replacing five of its Supreme Court judges with justices who are “considered more friendly to the current administration,” Moody’s reported.

As for the move to adopt Bitcoin as legal tender, Moody’s said the government hasn’t “yet properly established a plan for laying out the infrastructure and regulations needed to manage all Bitcoin transactions in the economy.”

“Although the potential effect on the banking system is largely uncertain and will depend on the specific details of the digital currency’s implementation and the appetite for its acceptance, adoption will likely increase Salvadoran banks’ disintermediation risk as some deposits shift into Bitcoin,” the report said. “This would add pressure to their profitability as funding costs increase in the wake of a substitution and as they face more competition in their payments and transfer businesses.”

Unlike proposals to create central bank digital currencies, Bitcoin “is inherently more volatile and could be slower than centrally processed payments, which could be a disincentive to its usage and mitigate some of the risks for banks,” the report said.

However, Moody’s also noted that “a significant share of Salvadorans” are outside the existing banking system, so designating Bitcoin as legal tender could encourage its adoption in that segment of the population.

Ultimately, “acceptance will depend on the characteristics and transaction costs associated with the new payment platform,” it said.