Popular economic frustration has increased sharply in Argentina in recent years against the backdrop high and rising inflation. Argentina is faced with the prospect of hyperinflation and a renewed external default in the run-up to the first round of presidential election on October 22. Wide-spread frustration with the economic situation has led Javier Milei, a libertarian presidential candidate, to propose dollarization as a solution to Argentina’s economic problems. Dollarization would see the dollar replace the peso as the national currency.
Argentina appears to be coming full circle. A little more than thirty years ago, Argentina under the Menem government established a so-called currency board, which closely tied the peso to the dollar and can be thought of as a lesser form of dollarization, only to abandon the regime in the wake of the 2002 financial default. Two decades later, one of the leading presidential candidate wants to get rid of the peso altogether and tie Argentina’s economic fortunes even more closely to the dollar than the currency board did. Is this a good idea?
Fixed-exchange rate regimes in emerging markets have gone out of fashion
Tempora mutantur. Three decades ago, fixed exchange rates were very popular among emerging economies. They provided a monetary anchor to establish and maintain domestic price stability and they kept the value of the currency stable vis-à-vis an anchor currency, typically the dollar, thereby facilitating international trade and cross-border capital flows. Fixed-exchange rate pegs or, in the case of Argentina, a currency board helped countries overcome high inflation and economic instability following the developing market debt crises of the eighties when many governments resorted to printing money to manage their financial problems.
Currency pegs have since gone out of fashion, at least among the top-tier emerging economies. Most Asian economies were forced off their pegs in the 1997 crisis. Mexico was pushed off its peg in 1994-95, Brazil in 1998-99, Russia in 1998. Today most major emerging economies have moved towards more flexible, if not necessarily completely flexible exchange rate arrangements. Oil-exporting Gulf countries and many small Caribbean island economies are an exception. Countries that abandoned their pegs managed to put in place sufficiently credible institutions, including independent central banks, that allow them to maintain price and general economic stability in the context of more flexible exchange rates. A more the flexible exchange rate regime affords policymakers greater macroeconomic flexibility.
Dollarization constrains macroeconomic flexibility
Under a fixed exchange rate system, a country largely foregoes control over monetary and exchange rate policy. A fixed exchange rate means that policymakers are obligated to do what is necessary to maintain the external value of the currency against an anchor currency. Unless controls limit capital in- and outflows, domestic interest rates need to be changed in lockstep with the interest rates of the country to whose currency the local currency is pegged. If the domestic interest rate is lower than in the anchor country, capital outflows will lead to a loss of foreign-exchange reserves and ultimately currency devaluation. A fixed exchange rate under conditions of an open capital account sharply constrains central bank monetary policy. Effectively, short-term interest rates are set by the Federal Reserve if the currency is pegged to the dollar.
In this case, the relative lack of control over domestic interest rates and the exchange rate means that fiscal policy needs to be even more flexible. If, for example, a country suffers an exogenous shock, as Argentina did in the late nineties following Brazil’s currency devaluation and the deterioration of its terms-of-trade (the ratio of export to imports prices), economic growth slows. Unable to cut interest rates or devalue the currency, an expansionary fiscal policy can help support the economy. But if fiscal space, the ability to run an expansionary fiscal policy, is limited due to a high debt burden, the economy will run below potential, at least temporarily. In fact, if public debt is high and investors worry that low growth and inappropriately high interest rates lead to a rapid increase in government debt, a country may be forced to pursue a restrictive fiscal policy instead of an expansionary policy, leading to a further slowing of economic activity.
Dollarization creates financial vulnerabilities
Besides constraining macroeconomic flexibility and the ability to respond to exogenous shocks, dollarization, even more so than other types of fixed exchange rate regimes, creates potential financial vulnerabilities. If a government already has high debt, the risk of a loss of investor confidence and a debt crisis is greater, given the unavailability of monetary and exchange rate policy to increase growth and reduce debt payments by way of a weaker exchange rate and lower interest rates . This risk is even higher under full dollarization because the central bank only has a limited amount of dollars to address liquidity crisis in case investors are reluctant to finance the government.
The “harder” the currency regime, the more fiscal policy flexibility needs to be preserved. This can be very difficult to do, politically,. Full dollarization may increases the susceptibility to debt crises, particularly in the absence of a highly disciplined fiscal policy. A loss of investor confidence can and does occur in dollarized regimes, jeopardizing government debt sustainability of the financial and the stability of the financial system. If history is anything to go by, Argentina will find it difficult to conduct such a forward-looking, disciplined fiscal policy.
Moreover, a country loses seigniorage under full dollarization. Seigniorage refers to the income that is generated through currency issuance. Denying the government seigniorage is, of course, is a big part of the rationale for dollarizing the economy in the first place, namely to remove policymakers’ incentive and ability to generate extra revenue by way of higher inflation. In addition to the ongoing loss of seigniorage, dollarization also generates significant one-off costs related to the acquisition of the dollars necessary to dollarize the economy. You may call this negative seigniorage because it involves repurchasing previously issued currency.
Finally, dollarization sharply curtails the central bank’s ability to act as a lender-of-last resort. Under dollarization, the central bank cannot “print” money or offer unlimited amounts of liquidity. Only the Fed can. This increases liquidity and hence default risk in terms of sovereign debt and the banking sector. Even if the central bank requires banks to hold a liquidity reserve, the fact that there is a limit to how much the central bank can lend to the sovereign or the banking sector during a crisis will increase the risk of a financial crisis turning systemic. Not being able to print domestic currency may lead to stable inflation, but it can also limit the ability of the government to deal with financial crises. Under a fixed exchange rate regime, the country would be forced off the currency peg if it provides liquidity. In a dollarized regime, the government and the banking sector will be forced into default in the event of a severe financial shock.
Argentina’s trade structure is not conducive to successful dollarization
Dollarization makes more sense, if it makes sense at all, for countries that are highly integrated in terms of international trade and financial flows, particularly with the economy whose currency they adopt. (This is why creating a common currency in Europe made or more sense.) If a large share of trade is conducted with dollar-based economies, a fixed exchange rate can help improve access to their markets by creating exchange rate stability.
Less than 10% of Argentine exports go to the United States. (Argentina exports more to Brazil and China.) If the dollar appreciates by 30% against all other currencies, Argentina’s exports will become less competitive. If 90% of Argentina’s export went to the United States, a sharp dollar depreciation would have only a minimal impact on Argentina’s export revenues. And Argentina is also vulnerable to large terms-of-trade shocks given that 2/3 of its exports consist of agricultural products, not counting other commodities like energy or metals.
Moreover, if an economy has a large traded sector and suffers a negative terms-of-trade shock, only small price changes are needed to increase export revenues (so-called internal devaluation). But Argentina is a very closed economy, and it conducts very little trade with the United States. Argentina is one of the most closed economies in the world with trade accounting for only 1/3 of GDP. This puts Argentina at 169 out 179 countries for which data are available.
Operational challenges
Operationally, Argentina would need to acquire sufficient dollars to dollarize its economy. But the government is a net foreign-currency debtor as well as a net international debtor. It does not have enough dollar assets to finance dollar purchase. The government just repaid the IMF in yuan rather than dollars. Even the central bank, typically a net foreign-currency creditors, sits on a negative net dollar position. Argentina is also on the verge of yet another default, which would make it even more impossible (if anything can be more impossible than impossible) to borrow the dollars required to replace the peso. Finally, a recent ruling by a New York court that awarded $16 billion worth of damages to a plaintiff to compensate it for financial losses incurred in the context of Argentina’s expropriation of YPF a decade ago will further complicate Argentina’s attempt to raise dollars, whether it defaults or not in the coming months.
Nationalizing private-sector dollar assets would be politically extremely controversial and it might be legally impossible. It may also not help Argentina make dollar purchases. Few foreign investors would be prepared to enter a transaction where such assets are pledged as collateral or where they would be expected to purchase them outright, given that they would become subject to litigation. In short, it is not clear where Argentina would find the dollars to dollarize its economy.
Some commentators have highlighted the risk of a bank run and a broader financial crisis that dollarization would trigger. It should also be pointed out that the Ecuadorian president who decreed dollarization was ousted within a couple of weeks of his decision. So regardless of the economic-financial effects of a conversion, political risk would increase independently. In addition, a banking crisis might be triggered if depositors were to withdraw their deposits in order to try to convert them into dollars. Such a scenario could be avoided, though, if the authorities impose a bank holiday. But this may not happen if the new government commits to dollarization before entering office.
On the other hand, depositors who withdraw their deposits will find that the black market exchange rate has already adjusted in anticipation of dollarization. They may then quickly come to the realization that keeping their funds in interest-bearing bank deposits is preferable than moving them from their money under their mattresses, particularly given very high inflation. But only because depositors may not be able to purchase the dollars after emptying their bank accounts does not mean that the banking sector could come under severe liquidity pressure, unless the government steps in forcefully.
The very weakness dollarization is meant to eliminate will make it challenging to maintain the regime
Plenty of risks attach to dollarization, particularly in Argentina. But how have other countries managed to dollarize their economies and achieve low inflation. In Latin America, Panama adopted the dollar in 1904, Ecuador in 2000, and El Salvador in 2001. Panama has arguably been the most successful of the three, even though it did on occasion experience exogenous shocks and financial instability. But it has managed to maintain dollarization, low inflation and fair levels of economic growth. After more than two decades of dollarization, neither Ecuador nor El Salvador have experienced an economic or financial meltdown. However, both countries are on the verge of a sovereign default. In fact, Ecuador restructured its debt with China in 2022. Argentina is more likely to follow the path of Ecuador and El Salvador rather than of Panama.
Two out of the three cases tend to lend support to the hypothesis laid out above. For dollarization to work, governments need to run disciplined fiscal policies and create ample of space to respond to economic and financial shocks. If they cannot do this, dollarization will lead to a build-up of financial vulnerabilities, financial instability and sovereign default. And a default in a dollarized regime is extremely messy, economically and politically, as banks are typically government creditors, forcing banks to write their debtors, including depositors.
What Argentina’s political history tells us about the sustainability of dollarization
Argentina’s economic and political history gives little reason for optimism that full dollarization will be sustainable in the longer term. Argentina has defaulted more than a dozen times in its history and experienced hyperinflation. It even managed to default on its IMF loans and may do so again shortly. Unless Argentina manages to fundamentally reform its politics and maybe political system, it is unlikely to be able to muster the economic discipline necessary to maintain dollarization. Distributional conflict is too high or the government is too weak to maintain economic discipline, or both.
Dollarization is not a panacea and comes with significant risks. Full dollarization will only prove sustainable if policymakers pursue fiscally responsible policies. But dollarization is being promoted precisely because the government cannot maintain macroeconomic discipline. Leaving aside operational-political issues, such as whether a new president has the ability to push through large spending cuts, particularly if s/he does not have sufficient congressional majorities, maintaining long-term discipline is crucial for the system to deliver both low inflation and financial stability. If Argentina dollarizes, its economy and financial fate will continue to hinge on the government’s ability and willingness to act in a financially responsible way. Otherwise dollarization will go the way of the currency board more than two decades ago.
Argentina would be better off reforming its economic regime along the lines of some of its neighbors, such as Chile, Colombia or Peru. These countries have independent central banks and they pursue fairly disciplined fiscal policies. This allows them to operate fairly flexible exchange rate regimes and conduct more independent interest rate policies capable of absorbing exogenous shocks. Similar to Argentina, both Chile and Peru are highly susceptible to terms-of-trade shocks on account of their commodity-heavy export structure. Commodity prices fluctuate much more than the prices of manufacturing goods.
A comparison with Brazil’s economic policy regime suggests that a somewhat (sic!) less disciplined fiscal policy can be compatible with reasonably levels of inflation as long as the central bank is independent. (In all fairness, Brazil benefits from a low level of foreign-currency debt, making it easier for policymakers to let the exchange rate float and target inflation.) If Argentina managed to put in place such a regime, there would be no need to run the greater financial instability risks that come with dollarization. In this sense, full dollarization is a second-best solution to the inflation and economic instability problem. It is also a solution that is fraught with very substantial risks. Such a regime would limit the monetary policy discretion and translate into lower inflation. But as long as the government is unable to conduct a disciplined fiscal policy, dollarization will not really represent a sustainable solution to Argentina’s long-standing economic problems.