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Written by Moses Lim
As the the race to the 2023 Argentine general elections heats up, the country is looking for an end to years of financial mismanagement which led to triple digit inflation, extensive currency losses and social unrest. Presidential hopeful Javier Milei's proposal to dollarise the Argentine economy has emerged as a popular yet controversial solution. This long-form opinion piece will examine the effects of such a move, and what it means for South America's second largest economy.
Demonstration at Buenos Aires' Casa Rosada. Photo via AP Photo/Natacha Pisarenko
As incumbent Argentinian President Alberto Fernandez drops out of the presidential race, Libertarian candidate Javier Milei has stormed into the limelight and has energized young Argentinians with his scathing criticism of the Argentinian establishment. Emerging from the pandemic, Argentina has been plagued with exceptionally high inflation figures that have dwarfed that of other developing economies, reaching highs of 109% y/y in April 2023. Being an Economist by trade, many voters hope that Javier Milei is the solution to the soaring inflation in the country and brings much-needed macroeconomic stability to the country. His campaign’s flagship policy has been controversial yet popular amongst Argentinians as Javier Milei has proposed substituting the Argentinian Peso (ARS) with the US Dollar (USD). However, we opine that dollarisation brings with it more costs than benefits and it is unlikely to bring about economic stability and generate economic growth as intended.
Currency Substitution could stabilize prices and increase FDI
Javier Milei’s radical proposal to the dollarisation of the Argentinian economy is meant to directly address the rampant inflation experienced in the economy. As it stands, Argentina currently has a series of capital controls to shield the domestic economy from imported inflation and stabilise prices for consumers, however, this control has resulted in a complicated currency regime where different players and segments of the economy have access to different sets of exchange rates, increasing the complexity in conducting business.
Currency Substitution has two desired effects, firstly, it replaces the weak ARS, which has been exacerbating inflation through inflated costs of imports, and secondly, dollarisation also makes it easier to conduct business and access to borrowing. Instead of navigating through the complicated set of rules in acquiring ARS, one could simply use the highly traded and liquid USD.
Prima facie, replacing the ARS and the USD can be a quick fix for the economy to achieve macroeconomic stability, the central bank loses its ability to influence monetary policy, and inflation would theoretically dissipate quickly to fall in line with the US inflationary trends. By surrendering control, the government would be unable to influence the monetary policy to achieve social or political goals, resulting in the economy being insulated from political perturbation which breeds a business-friendly environment that encourages growth and investment. Some might point to the success of this policy in Ecuador as evidence that the dollarisation of the Argentine economy is the way to go, with Ecuador facing similar levels of inflation pre-dollarisation while mimicking US levels of inflation post-dollarisation. Supporters of dollarisation would point toward Ecuador’s rapid economic growth in the 2000s and use this as a model that Argentina could follow.
Currency substitution would also enable international businesses to invest or loan or conduct business in Argentina. Under the current Peronist government, there has been a vast and complicated capital control regime, with preferential currency exchange rates being offered to export-oriented industries like the agriculture industry and differing levels of exchange rates offered to different segments of society. These segmented exchange rates create a convoluted system where businesses will have to jump through several bureaucratic hoops to trade and engage in economic activity within the country.
The replacement of the ARS with the USD streamlines the transactions as the USD is widely traded and highly liquid, allowing businesses to easily invest and trade with Argentinian firms. With the financial industry being built around the USD, it becomes easy for transactions to take place as the Argentinian economy may build its commercial infrastructure on the already established US systems. This reduces the risk premium on borrowing for local firms and allows them to have greater access to global financing. Dollarisation also reduces transaction costs and may bring in Foreign Direct Investments (FDI) to build the Argentine economy. As we see in Figure 1, the Argentine economy has been struggling to bring in foreign money, FDI inflows have been persistently lacklustre and hovering around 2% of GDP for the past decade, strongly underperforming its neighbours. This indicates the presence of strong and persistent structural factors that disincentivize foreign capital from flowing into the country, preventing local firms from gaining access to much-needed capital to expand and grow. Dollarisation could theoretically address this issue.
Purchasing power will immediately worsen
Immediately after Currency Substitution is implemented, consumers will likely experience a strong decline in purchasing power. With most Argentinians being paid in ARS and conducting everyday transactions in ARS, the immediate transition to dollarisation would mean that the government must be a source of USD. Considering that the Argentinian government has been struggling with maintaining a healthy foreign reserve, it is likely that the government is unable to convert privately held ARS to dollars at a fair value. Furthermore, as the ARS would be phased out, the international financial market will be unlikely to be willing to exchange ARS into USD, and Argentinians will be forced to transact with the government and accept worse exchange rates. Argentinians will experience a strong initial decline in their purchasing power which would disproportionately impact the working class and see their material conditions immediately decline.
Supporters of dollarisation would proclaim that this short-term hurt is a worthwhile sacrifice as in the long term there will be price stability which would lead to great economic growth. This would justify the sharp decline in purchasing power as the resulting economic growth would more than make up for the decline. Ecuador’s decline in inflation from 96% in 2000 to 12.5% in 2002 and the resulting average annual 4.3% growth from 2000 to 2008 are strong indicators that dollarisation works.
However, this surface-level analysis of Ecuadorian growth does not account for the global macroeconomic conditions that Ecuador enjoyed immediately after the dollarisation of its economy. The early 2000s was marked by a commodity boom which they have greatly benefitted from with oil proceeds accounting for more than half of government revenue and 74% of total exports in 2004. As the commodity cycle began its downturn and the world was rocked by the 2008 Global Financial Crisis, the weakness of the Ecuadorian economy was unveiled. While many believe that the dollarisation had resulted in impressive economic growth in Ecuador, once the commodity boom ended, it became immediately clear that dollarisation failed to develop Ecuador economically and the economic growth was revealed to be a mere consequence of elevated oil prices. As Figure 2 illustrates, with oil prices sinking in 2012, Ecuador experienced a corresponding fall in Real GDP per Capita in successive years, evidence that the Ecuadorian economy continues to be weak and highly reliant on oil exports to support its economic growth. The purported benefits of the dollarisation have failed to materialise as it had not significantly developed the real economy of Ecuador as hoped by decreasing transaction costs for foreign firms and stabilising prices.
While the Ecuadorians managed to dollarise during a commodity boom, it is unlikely that Javier Milei will be able to mimic the same macroeconomic conditions should he win the Presidential Elections. Given present global headwinds including persistent inflationary pressures, supply chain, trade flow dislocations, and rising geopolitical risk. The world may be entering a prolonged phase of slower growth. Such a macro environment is in turn unlikely to produce stable and business-friendly conditions as economic activity becomes an arena for politicians to apply geopolitical pressure.
As Ecuador has shown, dollarisation is not a substitute for sound economic policies. The cost of switching to the USD is extremely high with no guarantee of a resulting economic boom. Dollarisation is a risky strategy to solve inflation and the cost of such a policy is borne by the already beleaguered Argentinian workers.
The economy will still not be fully isolated from politics
One purported benefit of dollarisation has been the insulation of the economy from political squabbles leading to economic stability. With the monetary policy taken out of the hands of individuals appointed by the government, it reduces the potential for the state to interfere with the economy to achieve political goals. However, this is not necessarily true as fiscal spending is still under the government's prerogative and it is still possible for the government to destabilise the economy with significant debt.
Without the monetary policy, the government is restricted in the methods it must maximize employment within the economy. As extensive foreign reserves are required for the function of the state as the central banks must be able to guarantee its liabilities to the public, financial institutions and firms are backed by liquid foreign reserves. Therefore, this ensures that the government must have significant foreign reserves for the functioning of the state. This especially constrains the ability of a dollarised government to promote economic development in the country as foreign currency needed to be earned and saved to bolster the country’s reserve. The dollarisation does not resolve the structural incentive for democracies to pursue short-term economic policies to gain voter approval. With an independent currency, governments may increase spending without increasing tax revenue by increasing the money supply to make up the difference. A dollarised nation in the same situation would lead to the government taking on debt instead to fund spending to induce short-term economic development.
Dollarisation is no substitution for good fiscal planning and policy. Increased borrowing to make up for government spending is a strategy that El Salvador has undertaken upon dollarisation that has led to the rampant accumulation of government debt. When El Salvador dollarised in 2001, their benchmark interest rates fell from 14% to 7.5% almost overnight, this was because it gained increased access to the US financial market and reduction of risk premium attached to its international borrowing capacity. El Salvador could borrow to boost their foreign reserve to guarantee its liabilities to the public, furthermore, it could also borrow at low rates to fund government spending and sustain pre-dollarisation levels of spending.
Consequentially, El Salvador experienced a rapid accumulation of government debt and has maintained this high level of borrowing as shown in Figure 3. This level is high even amongst its peers in comparison, Guatemala, a neighbouring country with a similar economic composition but with an independent monetary policy, has maintained vastly lower levels of debt as they are able to tweak its monetary policy to make up for current account shortfalls. This increased debt level will be a drag on the El Salvadoran economy as a larger proportion of the government budget has to be dedicated to financing its loan obligation and exposes the economy to a greater level of external risk.
Much like El Salvador, dollarisation will not fully insulate the Argentinian economy from political intervention. The Libertarian ideal whereby dollarisation results in a free-market environment where the local economy is boosted by increased access to foreign capital and loans are unrealistic. The deeper integration with the US financial system may, in fact, lead to an increase in incentivisation of borrowing by the Central Government to maintain a high spending level which becomes a drag on the economic growth of Argentina.
The loss of Seigniorage revenue
If Argentina chooses to adopt the USD it sacrifices its Seigniorage, the profits enjoyed by the central bank due to the difference between the exchange value of the currency and its cost of issuance. This Seigniorage loss may further manifest in two forms, firstly a “stock” cost and the loss of future Seigniorage revenue.
The “stock” cost refers to the cost of transition between the ARS and the USD. As mentioned earlier, the ARS being removed from circulation would require the government to offer a swap between the existing circulated ARS with the newly circulated USD. While Argentinians may suffer from a fall in purchasing power due to having to accept lower exchange rates between their held ARS and USD, the government will have to spend a vast amount of money to provide the initial stock of USD for circulation within the economy. This effectively returns the accumulated Seigniorage revenue from the issuance of ARS by the government.
Currency Substitution will lead to a removal of an additional source of government revenue. The International Monetary Fund has estimated that the Argentinian government enjoys USD 5bn in Seigniorage revenue annually which totals up to 1% of GDP. They also further estimated that the government enjoys USD 0.7bn in interest a year on the existing stock of currency. As Argentina struggles to balance the books, removing a significant source of funding from the government is sure to increase the budget deficit. To make up for this deficit, the government might choose to take on more debt which increases future expenses when servicing this debt.
While it is important to ensure that Seigniorage revenue remains a viable source of funding for the Argentinian government, it is important to use this mechanism with prudence. Many economists have identified that Argentina has overly exploited the Seigniorage mechanism and has been a key factor in inducing depreciation in the ARS as the government issued too much currency to fund its budget. The solution, however, is not to completely remove the potential for garnering revenue through Seigniorage, but rather to limit and use it prudently, total removal of it would further exacerbate their budget deficit without a viable short-term alternative.
This deficit will be further amplified by the “stock” cost as it will be improbable that the Argentinian government is able to bear the full cost of the transition. As of April 2023, the total amount of ARS in circulation is ARS 4tn which is about USD 16bn when converted at official rates. This is extremely significant considering that Argentina currently sufferers from weak foreign reserve balances at USD 28bn. Even with a significant devaluation of the ARS, it is unlikely that the Argentinian government will be able to fully bear the “stock” cost of transitioning into USD after considering the vast foreign reserve requirements needed to guarantee the government’s liabilities to the public.
In the present circumstance, dollarisation is not viable as the end of Seigniorage revenue and the high “stock” cost in transition means that the move towards the USD will be an expensive and painful one. A move that will further increase debt in Argentina, which is especially painful considering its poor credit rating while being under pressure from its existing debts to the IMF.
Currency substitution amplifies external shocks
Surrendering control of the country’s monetary policy is extremely risky, especially for a developing country like Argentina. With full dollarisation, the country will face the full brunt of external shocks and global pressure. For instance, during the initial stages of the Russian invasion of Ukraine, there was a significant hike in global oil prices, in countries with an independent monetary policy, these effects may be offset by looser monetary policy. Countries may drop rates or depreciate their currency, preventing the domestic economy from experiencing the full transmission of the rise in oil prices due to sanctions on Russia. Argentina, should Javier Milei implement dollarisation, would absorb these shocks through lower worker wages and a significant rise in inflation, this means that what would otherwise be transitory inflationary pressure could translate to a knock-out blow to a struggling Argentinian economy.
The dollarisation of the Argentinian economy would mean that policymakers are relinquishing their ability to devalue their currency. To see the full negative effects of this, one could look to the Great Depression and the recovery of various nations to see the importance of monetary policy in cushioning external shocks and facilitating its recovery. On the eve of the Great Depression, most countries around the world pegged their currency to the gold standard, severely constraining any potential for countercyclical monetary policy. As the crisis unfolded, deflation ran rampant as aggregate demand in the global economy fell, leading to a global economic crisis. Without the option for countries to meaningfully devalue their currency, firms were deprived of credit as the money supply got choked out which exacerbated the fall in aggregate demand.
As argued by Eichengreen and Sachs in Exchange Rates and Economic Recovery in the 1930s countries that recovered from the Great Depression the fastest were those that devalued their currency. When the United Kingdom took the Pound off the gold standard, they unilaterally devalued it. This switched domestic expenditure from the external market towards the domestic market, inducing domestic production which drove up domestic aggregate demand. This started the recovery for most nations as this devaluation was followed by an expansion of the money supply which exerted a downward pressure on global interest rates. With the expanded money supply, the economy regained much-needed liquidity and output began to recover with domestic demand rising.
It would be a mistake for Argentina to abandon its currency as it loses the ability of the country to adjust monetary policy to cushion and protect the domestic economy from global economic shocks and constraints of the resulting economic recovery. The workers of Argentina would bear the full brunt of the cost of this policy as they will have to directly face a fall in wages and price surges should an external shock occur and tolerate the slow economic recovery.
The Weakening of Financial Stability
Full dollarisation threatens the Argentinian banking sector as without an independent currency, the central bank can no longer fully carry out its role as the lender of last resort. The bank will be severely handicapped when responding to financial emergencies and will have to rely on the country’s existing supply of USD. Considering the poor track record of Argentina in preserving a strong foreign reserve, this is a dangerous proposition.
Although dollarisation theoretically should not impede the central bank’s ability to provide short-term liquidity or assist banks in distress, it loses the ability to guarantee whole payments systems in the country. The ability of the central bank to print money is the cornerstone for trust in banks as it allows the central bank to provide an absolute guarantee that all claims in the domestic currency may be satisfied under any circumstances. Once the ability to print money ceases to exist, it introduces doubt in the financial sector as limits to the notion of the central bank being the lender of last resort begin to appear.
Extraterritoriality of the USD
As is the case with many Latin American countries, Argentina has had a storied history with the US. As part of Operation Condor, the US instigated and supported state terrorism starting in 1974 and only ended in 1983. Known in Argentina as Guerra Sucia or the “Dirty War,” the US supported the military dictator of Argentina to conduct raids and terror attacks on Peronists and anti-government dissidents. This led to the estimated death and disappearance of 30,000 people which still plagues Argentinian and US foreign relations. With a sizable portion of the country identifying as Peronists, dollarising gives the US unprecedented influence over the domestic affairs of Argentina.
Through the Russian invasion of Ukraine, the US has led Western efforts to economically isolate Russia through sanctions and more recently through the freezing of assets and cutting off Russian banks from the S.W.I.F.T system. The US has exceptional influence over the global economic structure. With the USD remaining the global foreign reserve, most international transactions involve the USD as well as US financial infrastructure and intermediaries. After the US imposed sanctions upon Russia in 2022 due to their support of Ukraine in the war, as illustrated in Figure 4, Russian exports to the rest of the world significantly fell.
Should Argentina transition to the full adoption of the USD, they would be particularly susceptible to US foreign policy. The US will have full control and unprecedented influence over the Argentinian economy. This will be a significant threat to the national sovereignty of Argentina, as South Korean economist Ha-Joon Chang points out, it would relegate Argentina to a “US Colony”. Considering Argentina’s left-leaning population base, which has historically faced persecution under the direction of the US, this move will be unpopular and may throw Argentina into political turmoil.
Conclusion
While Currency Substitution may seem like a silver bullet to Argentina’s rampant inflation, it brings about significant economic drawbacks that negate any potential benefits from price stability. Dollarisation will immediately and significantly cause a decline in the purchasing power of Argentine workers. Their savings and wages will immediately be devalued in order to transition towards the USD. Even then, this will not fully insulate the Argentine economy from politics as politicians will still be incentivized to recklessly spend for short-term gain, incurring more debt. The dollarisation will also cut off a revenue source in the form of Seigniorages and amplify external shocks which transfer its impact onto the workers of Argentina. Lastly, dollarisation undermines the sovereignty of Argentina and puts its fate in the hands of a historical rival.
While Javier Milei is a well-educated and practiced economist, this policy suggestion to engage in Currency Substitution fails to consider the far-reaching and long-term effects of such a radical policy. This policy has vastly more drawbacks than what it is intended to do, currency substitution is not a quick fix to reset the Argentine economy. The burden of transition will fall squarely on the working class of Argentina, and they will face the full brunt of the external shocks in the global economy.
Moses Lim is a research analyst the SMU Economics Intelligence Club (SEIC), and a sophomore Economics and Sociology undergraduate.
The views expressed are the authors’ own and do not represent the official position of the SMU Economics Intelligence Club. This article may not be reproduced without prior permission from SEIC and due credit to the author(s) and SEIC.
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