Why Argentina should not dollarise its economy to tame inflation

Bhagwan Das

The newly elected Argentinian President has promised to make the U.S. dollar as legal tender in his country replacing his own national currency the peso, a process known as dollarisation, where a country replaces its national currency with the currency of another nation as its legal tender. Currently Argentina is suffering from very high inflation of 140%, brought about by high budget deficits. The other economic issues troubling this South American nation are high interest rates which are being used to tame inflation, growing unemployment and declining economic growth and standard of living.

In the 90s, Argentina faced with a similar situation, entered into a Currency Board Arrangement (CBA) with the U.S. dollar, where it rigidly pegged the exchange value of its currency to the U.S. dollar (1 peso equal to 1 U.S. dollar), to assure foreign investors and to tame hyperinflation, which worked well till the year 1999, when its largest trading partner and economic rival, Brazil, devalued its currency (the real) and also allowed it to float freely. Now left with an overvalued peso (as it was rigidly tied to the U.S. dollar), declining export competitiveness, fiscal indiscipline (uncontrolled budget deficits) and recession, Argentina defaulted on its huge foreign debt in January 2002 and was forced to abandon the CBA with the U.S. dollar and allow the peso to float. By September 2002, the peso had depreciated by 350% against the U.S. dollar!

In a Currency Board Arrangement or under Dollarisation, the central bank of the country adopting it ceases to exist, as its monetary policy function is now taken over by the central bank of the country to whose currency it has rigidly pegged its value or has adopted as its own legal tender. The domestic central bank fails to act as the lender of the last resort for domestic financial institutions in distress and gives up its power to set domestic interest rates and manage the exchange value of its currency. The interest rate regime of the other country becomes its own interest rate regime, and the exchange value of the foreign currency becomes its own exchange value, which can prove counterproductive when applied to counter cyclical fluctuations of the domestic economy. For example right now, the central bank lending rates in the United States are at their maximum (5.25 to 5.50%) while its inflation is tapering off to around 4% or below. Once U.S. inflation rate declines to 2%, the U.S. Federal Reserve may start cutting its lending rate to support its own economic growth. Meanwhile, if Argentina has adopted U.S. dollar as its own currency or legal tender, then with the prevailing budget and trade deficits and inflation rates, a reduction in interest rates will only worsen the inflation situation and drive the economy deeper into recession and unemployment, leading to social unrest and riots as happened in the early 2000s.

Dollarisation works best for small open economies for whom U.S. is the dominant economic partner and which have a history of poor monetary performance and hence very little economic policy credibility. Most Central American countries like Panama, Ecuador, El Salvador and Guatemala have adopted the U.S. dollar as their legal tender, apart from Puerto Rico and the U.S. virgin islands. Dollarisation has helped these countries in eliminating exchange transaction costs and the need to hedge against foreign exchange risk, achieving inflation and interest rates similar to those of the U.S., fostering budgetary discipline, avoiding foreign exchange crisis and foreign exchange and trade controls and international financial integration.

The costs of dollarisation on the dollarising country, which involves replacing the domestic currency with the U.S. dollar, are estimated to be around 4 to 5% of its GDP for an average Central American country, apart from the loss of monetary sovereignty and the ability of its Central Bank to bail out financial institutions in distress. Argentina certainly is not a fit candidate for dollarisation under the current circumstances, as its exports to the United States account for a meagre 1%, whereas its exports to Brazil, its neighbour and largest trading partner, account for 25% of its total exports. Its banking institutions also lack discipline and are highly inefficient. The country has huge budget deficits and interest rates are also very high.

Dollarisation works best between countries which are geographically contiguous and previously integrated through trade and other arrangements. For example, Mexico, Canada and the United States are neighbouring countries in North America and are integrated through the North Atlantic Free Trade Agreement (NAFTA). Still they have their own individual currencies, as they are unwilling to give up their monetary sovereignty. The Eurozone is another example of dollarisation, when some countries of the European Union gave up their national currencies in favour of a common currency called the Euro from January 2001. These countries have integrated not just their monetary policies, but also a whole range of economic policies including agriculture, labour, trade and investment policies, taking advantage of their geographical proximity and hitherto higher level of trade integration. The same cannot be said of Argentina and the United States. For Argentina, the way forward could be that instead of pursuing dollarisation, restoring its fiscal discipline, which essentially means cutting down on wasteful expenditure, while exploring options for raising tax and non-tax revenues, improving efficiency in the banking system, exploring opportunities for promoting and diversifying international trade through free trade agreements within the region as well as outside the region, keeping interest rates sufficiently high and long enough to tame inflation and improving the supply of commodities, if inflation is due to supply bottlenecks.

(The writer is former head and associate professor of economics, Loyola College, Chennai and current economics faculty at Asian College of Journalism, Chennai)