header banner
Default

Analysis | Argentina is thinking about dollarization: What is it and why is it happening?


Table of Contents

    Argentina has a long history of printing money to compensate for government overspending. That’s produced long periods of high inflation, even hyper-inflation. Small wonder, then, that the South American nation periodically considers the radical step known as dollarization, which to date has been fully tried only by much smaller economies.

    1. What is dollarization?

    It means adopting the US dollar as the legal tender and unit of account. Full dollarization means all local currency in circulation is exchanged for greenbacks, and all assets and contracts are converted to dollars. A country can make such a move unilaterally, without consultation with the US. (The unrelated term “de-dollarization” refers to periodic efforts to challenge the greenback’s dominance in international commerce and status as the world’s de facto reserve currency.)

    2. Who uses the dollar besides the US?

    Four sovereign nations that have abandoned their currencies to adopt the dollar are: 

    • Panama, which dropped the peso and adopted the dollar as legal tender upon gaining independence from Colombia in 1904. It has a national currency, the balboa, but that coin is fixed 1:1 with the dollar.

    • Ecuador, which dropped the sucre for the dollar in 2000.

    • Timor-Leste, which dropped the rupiah for the dollar upon gaining independence in 2002 from Indonesia, with which is shares the southeast Asian island of Timor.

    • El Salvador, which in 2001 effectively dropped the colon — still an official currency, but not in circulation — for the dollar. In 2021, El Salvador added Bitcoin as another legal tender.

    Zimbabwe shifted to the dollar in 2009, after the local currency collapsed and a bout of hyperinflation decimated savings, then reintroduced the Zimbabwean dollar in 2019, to mixed success. Several other small countries and territories use the dollar, in most cases because their economies are very small or have strong historical ties to the US. These include the British Virgin Islands and the Dutch island of Bonaire in the Caribbean, and the Federated States of Micronesia, Palau and the Marshall Islands in the western Pacific.

    3. Why would a country do this?

    By adopting another currency, a country gives up the power to print more money and thus eliminates the main driver of inflation. That’s why dollarization is in part an act of political capitulation: It acknowledges a loss of faith in the ability of elected and appointed officials to maintain a sustainable fiscal policy. International Monetary Fund economists, in a 2000 paper, said the main attraction of full dollarization “is the elimination of the risk of a sudden, sharp devaluation of the country’s exchange rate. This may allow the country to reduce the risk premium attached to its international borrowing.” 

    4. Has that been the experience for countries?

    For the most part, yes. Ecuador, for instance, replaced the sucre with the dollar following a decade in which annual inflation averaged 40%. That helped stabilize financial conditions and, eventually, restore confidence in the banking sector. Though prices leaped at first by 91% in 2000 — largely because the government fixed the final exchange rate at an artificially weak level — inflation then declined rapidly. Since 2003, inflation has averaged just below 3%. There’s been no big growth boom, however. Since 2015, economic expansion has averaged just below 3%, excluding the pandemic crisis of 2020. And per capita gross domestic product has declined, World Bank figures show.

    5. Why is dollarization a topic in Argentina?

    It’s been proposed by Javier Milei, a libertarian economist and flamboyant populist who will face Economy Minister Sergio Massa in a Nov. 19 runoff election for the presidency. Dollarization has been one of Milei’s campaign pledges aimed at putting a lid on inflation that’s running at more than 130% a year. “The peso melts like ice in the Sahara Desert,” Milei has said of the currency’s rapid depreciation. Argentina pegged the peso to the dollar in the early 1990s as a weapon against inflation, and then-President Carlos Menem announced his intent to fully dollarize in 1999. But the dollar peg fell apart during a deep recession, and President Eduardo Duhalde severed the 1:1 link in early 2002. 

    6. Is Argentina ready for such a move?

    Even if Milei wins, and public opposition is overcome, dollarization would be a huge financial challenge. That’s because the central bank would need enough dollar reserves not only to purchase all currency in circulation but to provide a credible cushion to banks to handle a potential surge in withdrawals. Local analysts estimate net foreign reserves at negative $6.5 billion to as low as negative $10 billion, or about $50 billion short of what might be necessary to consider dollarization. (The Central Bank of Argentina doesn’t publish its net foreign reserves, only its total reserves, which include all sorts of illiquid assets.) The country could try to fill that gap by raising money on the bond market from foreign investors and weakening the official exchange rate. Even then, the switchover to dollars could be undone by a widespread bank run, putting the country closer to hyperinflation.

    7. What’s the downside? 

    The biggest problem associated with dollarization is the loss of an independent monetary policy. Countries that adopt the greenback can’t adjust interest rates to regulate the supply of money in response to changing economic conditions. That function is essentially outsourced to the US Federal Reserve, which sets rates according to the needs of the US economy. At times, that can mean misaligned priorities. At present, for instance, Argentina’s economy is expected to contract by 3% in 2023, according to a Bloomberg survey, while the Fed is maintaining a tight monetary policy to fight inflation. Also, dollarization does not, by itself, impose fiscal discipline on government leaders; it merely eliminates the ability to avoid default by printing money. For these reasons, many economists conclude that if a country can find the discipline necessary to avoid default, it would be better off retaining its own currency, with a floating exchange rate, and pursuing a credible policy of inflation-targeting at the central bank.

    8. What do US and international financial officials think?

    US Treasury officials have traditionally advised countries considering dollarization that it’s not a substitute for sound macro-economic policies, including responsible fiscal management. After Ecuador adopted the dollar in 2000, both the US and the IMF provided technical guidance on handling the transition, and the IMF quickly concluded a standby lending agreement tied to pledges of budgetary restraint.

    --With assistance from Scott Squires and Juan Pablo Spinetto.

    More stories like this are available on bloomberg.com

    ©2023 Bloomberg L.P.

    Sources


    Article information

    Author: Brian Ward

    Last Updated: 1698663361

    Views: 519

    Rating: 3.7 / 5 (104 voted)

    Reviews: 98% of readers found this page helpful

    Author information

    Name: Brian Ward

    Birthday: 1938-08-04

    Address: 22476 Lucas Lodge, Allenmouth, MO 27000

    Phone: +3655918279513795

    Job: Article Writer

    Hobby: Fishing, Cooking, Hiking, Telescope Building, Geocaching, Running, Dancing

    Introduction: My name is Brian Ward, I am a Gifted, unreserved, expert, artistic, fearless, persistent, resolved person who loves writing and wants to share my knowledge and understanding with you.