Common Currency for Latin America: Too Good to be True?

Authors: Aaron Lionel D’cruz, Keeven Cheong Aik Wei

Region Head: Clarice Lim Hui Wen

Editor: Chok Geow

Abstract

The Bolivia President proposed in Apr 2007 to introduce a new currency system that will circulate in 10 countries and to implement a unified monetary system with the Bank of the South (S. Paulo, 2007). This article examines how to achieve a common currency and weighs the benefits and drawbacks before concluding on its possibility.

Introduction

Other Latin American economies like Ecuador and Peru have pushed for a single currency system in South America for better trade relations and to strengthen the union of the currencies (Quito, 2007). This allows Latin American economies to compete freely and effectively with economic powers and mature economies like the US and the UK.

What Does It Take To Have a Common Currency?

Synchronisation of Fiscal and Monetary Policies

Firstly, it requires a union of fiscal and monetary policy schemes to maintain the resilience of a common currency.

Monetary policy has a direct implication on the strength of the currency. An expansionary monetary policy increases the money supply, lowers interest rates, which increases the demand for money and thus decreases the value of the currency and therefore, the exchange rate.

Fiscal policy serves a functional and key role in affecting the currency of a country through income changes, price changes, and interest rates. Taxation can affect one’s income and consumption. This affects the number of imports, which will impact the exchange rate.

For expansionary fiscal policy, if taxes are reduced, demand will increase, pushing prices higher. If the government spends more, it will raise interest rates to attract foreign investment, increasing the exchange rate. A coordinated monetary and fiscal policy system is necessary.

Floating Exchange rate system

Increasingly, due to the turmoil and uncertainty, a more inflation-targeted approach is undertaken in managing monetary policies, resulting in more Latin American economies like Uruguay, Bolivia, and Honduras moving away from the intermediate to a floating exchange rate system (Berg, Borensztein & Mauro, 2003) (Figure 1)

Even though a floating exchange rate system might increase the volatility of the currency, it provides reasons to unite the economies under a single currency if they can be adjusted relative to one another instead of being adjusted as standalone economies. Additionally, the floating exchange rate system is that it can diversify the risks of economic shocks experienced from one economy to multiple, dampening any kind of shock (IMF, 2000).

Figure 1: Breakdown of countries converting to a floating system of exchange

Similar patterns of trade required

The trade patterns in Latin American economies are largely diversified with no dominant trade partners where the share of exports though largely from Asia and US export share is only marginally larger than other economies. Mexico serves to be the only exception where the US takes up 80% of the trade shares in exports.

Benefits of Common Currency

Established routes for free trade and foreign investment

Having a common currency ensures exchange rate stability and eliminates transaction costs, attracting trading between countries with common currency as there is a home bias toward domestic trade (Frankel & Rose, 2002).

Ability to compete with key economic powers

As observed from the maintenance of the Euro currency, we can see that the common currency system can unite different economies and their respective currencies to sufficiently combat larger and more mature economies like the US and the UK (Andor, 2018).

Interestingly, the Euro currency was set up to overcome the various forces of nationalism that had further divided and segregated different parts of Europe. For instance, the polarisation of the North and South reinforced the need for closer cooperation in the wake of the Euro crisis, which resulted in the move towards the fiscal union, banking union, and political union among the different European countries. Economists have agreed that such solidarity had helped to combat the rampant nationalism and allowed for greater trade in a manner that generated more prosperity in the long term.

It was also beneficial that the use of the common currency was instrumental in bringing down the inflationary pressures that inflated various modes of trade such as in the management of interest rates and the supply of money in different parts of Europe. As a result, such a union by a form of currency helped to not only ensure greater cooperation but allow strong cooperation with stable and mature economies that have either plateaued or declined in economic performance such as Japan, the US, and the UK.

Risk sharing and portfolio diversification

Through a common currency system, this allows for Latin America to better manage their adverse shocks more effectively. Furthermore, a common currency delinks consumption and income at the local level, which happens through integrated capital markets (Draghi, 2018). As such, people can shift their consumption to better-performing parts of the union.

Additionally, it also delinks the capital of local banks from the volume of local credit supply through retail banking integration (Beetsma & Larch, 2018). For instance, local banks in local economies will face large losses and reduction in lending during a downturn. However, cross-border banks which operate in regions sharing a common currency, can offset losses in some regions with gains in others and continue lending

Difficulties in establishing Common currency

Prevalence of Nationalism Through Currency Name

From the case study of the Euro, nationalism remains to be a key area of contention with regards to the use of the currency, and a literal application of such contention would be through the discussion of the names that the Latin American currency should take.

Although the name of the currency has yet to be defined, several names of the currency had been proposed such as condor, American Peso, Latino, Pacha, Sucre, Colombo, and Peso-Re (S. Paulo, 2007). From this, we can see that it is perhaps that a local currency carries legal tender and legitimises transactions within the countries themselves.

Although not all countries have a single currency and some use a shared currency, the currency used within the country varies for convenience sake more so than a legitimised form of currency that is used within the country. Simply put, the currency name carries value and reflects the economic sovereignty of the country (Broda, 2006). Moreover, it strengthens the political influence of a global union, thus diminishing the individual countries’ validity and economic power.

The Bandwagon Effect

Furthermore, there would be a free-riding effect where the resilience of the common currency is upheld by a few economies instead of being supported by all the participating economies. When compared with the Euro currency, there are already latent signs that the currency system might only be maintained by a few and thus a united currency system in South American countries might not be feasible if the contributions to the strength of the currency are only supported by a few well-performing economies.

The Big Mac index is a good indicator to demonstrate the disparity between countries and how the single currency unit removes this and maintains the currency at a reasonable rate. While this might be beneficial for developing economies such as Bolivia and Peru, other better-performing economies are restricted based on the marginal growth rates of economic performance at a reasonable rate. Interestingly, the countries that prefer single unified currencies tend to be developing economies. For example, the Uruguayan peso is 15% undervalued compared to the US dollar in January 2021 while Nicaragua’s cordoba is 37% undervalued compared to the US dollar based on the raw index alone (Figures 2 & 3).

Figure 2: Big Mac Index Comparison of Uruguayan Peso

(Source: https://www.economist.com/big-mac-index)

Figure 3: Big Mac Index Comparison of Nicaraguan córdoba

(Source: https://www.economist.com/big-mac-index)

Furthermore, there are also differences in currency performances where the currency of an individual economy might outperform the overall unified currency system. This can also be observed in the European currency system where the Swiss Franc has a stronger currency in terms of GDP per capita compared to the monetary system of the Euro dollar alone (Figure 4).

Figure 4: Big Mac Index Comparison of the Swiss franc, against the Euro dollar

(Source: https://www.economist.com/big-mac-index)

Conclusion

In the region of South America, inequality among different countries is amongst the highest in the world. With a single currency, it can encourage mutual interdependence to exploit each countries’ comparative advantage to compete with other regions instead of harming each other. However, with the opposing leadership styles of countries like Brazil, Venezuela, and Peru, reaching a compromise for different matters relating to a common currency will be extremely difficult. Given the existing difficulties in managing a common currency within the mature economies in Europe itself, it seems to be a bigger problem for the developing and emerging economies in Latin American.

References

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