The Dollarization Debate: Pros, Cons, and Implications for Argentina's Economic Future
Main Takeaways:
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Argentina has been grappling with hyperinflation in recent years, prompting its new President, Javier Milei, to propose dollarization as a solution.
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Hyperinflation, characterized by rapid increases in general prices, often leads to a significant reduction in the local currency’s purchasing power and thereby poses severe economic challenges.
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Dollarization is perceived as a potential solution for hyperinflation, as it can help reduce inflation rates and expectations, instil fiscal discipline, and foster the country’s integration into the global financial and trade markets.
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Dollarization also comes with drawbacks, as it can curtail a country’s ability to influence its economy through monetary policy, making the country more vulnerable to economic shocks.
Following Javier Milei’s election as President of Argentina in November 2023, dollarization has emerged as a hot topic. To confront the nation’s hyperinflation crisis, the president has championed dollarization during his campaign, advocating for the replacement of the Argentine peso with the US dollar and the closure of Argentina’s Central Bank. However, Milei’s proposition has sparked contention, drawing criticism from some economists who argue that he has overestimated the benefits of dollarization.
In this article, we will explore the multifaceted impacts of hyperinflation on the economy and analyse the pros and cons of dollarization as a remedy. By contextualizing this discussion within Argentina’s economic landscape, this article offers macroeconomic insights into the interplay between inflation and policies.
More than Inflation: Severe Consequences of Hyperinflation
Argentina, the second-largest economy in South America after Brazil, has experienced economic turmoil over the past three years. Central to these concerns is the nation’s inflation rates. Inflation rates in Argentina have been markedly high compared to the global economy, exceeding 10% since 2013. However, the situation grew more out of control over the last five years. In 2019, inflation for consumer goods surged to 53.55%, which further escalated to 94.80% in 2022. By 2023, inflation rates soared into three-digit territory and are expected to remain high through the initial six months of 2024.
Figure 1: Argentina’s Inflation Rates (CPI) (2013-2022)
Source: World Data
Figure 2: Argentina’s Inflation Rates (CPI) in 2023
Source: trading economics
While moderate inflation—typically around 2-3% annually—can offer benefits like encouraging spending, fostering investment, and preventing deflationary pressures, hyperinflation incurs severe consequences. As prices increase rapidly, the purchasing power of the local currency diminishes significantly, causing economic instability. People’s savings and investments lose value quickly, adversely affecting their living standards and fostering high uncertainty for the future. Businesses struggle to maintain stable pricing for their products and services, impacting profitability and sustainability. Confidence in governmental financial institutions and the local currency wanes, prompting a shift toward using foreign currencies like the US dollar for transactions and value storage, resulting in a system where goods are priced under two regimes. In Argentina, citizens resort to the black market for currency exchanges, and the unofficial exchange rate, known locally as the “dollar blue,” diverges from the official rate. All of this adds to the economic complexities.
Figure 3: Argentina’s diverging exchange rates (official and black market comparison)
Source: Export Planning
With currency devaluation, hyperinflation also has consequences for the country’s import and export dynamics. Due to currency depreciation, imported goods and services become exorbitantly expensive for domestic consumers, affecting the availability of essential items and raw materials and impacting industries reliant on imported inputs. Conversely, hyperinflation theoretically boosts export competitiveness. However, volatile currency fluctuations and pricing uncertainties often deter international traders from fostering long-term trade relationships. Argentina has experienced fluctuations in both imports and exports in recent years, with imports exhibiting greater volatility.
Figure 4: Argentina’s imports of goods and services (constant 2015 US$) (in billion)
Source: The World Bank
Figure 5: Argentina’s exports of goods and services (constant 2015 US$) (in billion)
Source: The World Bank
Last but not least, hyperinflation poses challenges for monetary and fiscal authorities. For the central bank, hyperinflation leads to a loss of control over the money supply and renders some traditional monetary policy tools like interest rate adjustments and reserve requirements ineffective. On the fiscal side, hyperinflation worsens budgetary pressures for the government as real revenues decline, making it more difficult for the government to service existing debts and borrow new debts. For Argentina’s government, the sovereign debt is now a ticking bomb, exceeding $400 billion by 2023, approximately 80% of the country’s GDP.
Dollarization, a Double-Edged Sword
It is amidst hyperinflation that a candidate who promoted dollarization was elected as president. But whether dollarization will work for Argentina is still open to discussion. Essentially, dollarization has proven a double-edged sword, given the mixed results observed historically from similar transitions.
Several countries like Panama, Ecuador, El Salvador, and Zimbabwe adopted the US dollar as legal tender at different points in history. Panama initiated this change in 1904, followed by Ecuador and El Salvador in 2000 and 2001, respectively. Zimbabwe embraced dollarization in 2009 and later underwent shifts in de-dollarization and re-dollarization. These instances became subjects of research assessing the impact of dollarization on economic growth. According to research findings, dollarization may promote economic stability in the short term, but “structural and institutional problems must also be addressed if a dollarizing country is to achieve long-term economic growth and development.”
Figure 6: Inflation, consumer prices (annual %) - Ecuador, El Salvador
Source: The World Bank
On the positive side, full dollarization presents advantages such as decreasing inflation rates and expectations. It also enforces fiscal discipline by relinquishing the government’s ability to finance itself through money printing and seigniorage, preventing fiscal deficits that often precede hyperinflation. For instance, in Argentina, hyperinflation was partly attributed to increased money supply during the pandemic to finance cash handouts and salary programs. With dollarization, however, this potential cause of hyperinflation would be mitigated.
Moreover, full dollarization can enhance a country’s financial and trade integration with international markets. By sharing a common currency with primary trade partners, dollarized countries can eliminate exchange rate risks and reduce costs in transactions. Dollarization may also result in lower domestic interest rates. Firstly, by curbing domestic inflation expectations, nominal interest rates can decrease due to reduced inflation premiums. Secondly, by eliminating exchange rate risks for global investors, dollarized economies may find it easier to access international financial markets.
Figure 7: Term structure of interest rates
Source: Fundamentals of Corporate Finance, Hillier et al.
However, one drawback of dollarization is its limitation on a country’s capacity to influence its economy through monetary policy. By outsourcing the management of the money supply to the US Federal Reserve, dollarized countries lose some tools to influence the economy, such as interest rate adjustments and exchange rate policies. As US monetary policy primarily serves the interests of the US economy, this alignment with US monetary policy may not always serve the interests of dollarized nations. For instance, if the US Federal Reserve increases interest rates to counter domestic overheating while at the same time the dollarized country faces deflationary pressures, it could exacerbate the economic situation for the dollarized nation.
Additionally, under dollarization, the central bank loses its role as the lender of last resort, unable to provide loans to banks facing liquidity issues during a bank run. The inability to print US dollars also makes dollarized nations reliant on export earnings and foreign investments to meet domestic dollar needs. However, export earnings can be affected by various global factors, including regional conflicts, financial crises, fluctuations in commodity prices, or natural disasters like droughts or pandemics. Similarly, fluctuations in foreign investments often arise from uncontrollable elements such as shifts in the Federal Reserve’s policies or alternative market opportunities. As a result, dollarization can make a country more vulnerable to internal and external shocks, introducing volatility into its financial landscape.
Dollarization or Not, That’s the Question
As of the writing on January 29, 2024, debates continue regarding the implications of Argentina’s proposed dollarization, revolving around whether the advantages outweigh the disadvantages in the short and long term. Debates also continue regarding the Central Bank of Argentina’s capacity to support the planned currency conversion with its limited dollar reserves.
Nevertheless, given the complexities of Argentina’s economy, the choice of dollarization or otherwise is just one aspect among numerous issues demanding attention. It does not serve as a panacea for the current challenges. Following President Milei’s inauguration on December 10, 2023, the government appears committed to a free-market agenda. In 2024, Argentina’s politics and economy are expected to be in the spotlight, with changes on the horizon.
