Can Dollarisation Save An Economy of Argentina?

Relevance: GS3 - Effects of liberalization on the economy

(Source: The Hindu, 11/28/2023)

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Why in the news?

• Recently, Javier Milei, the winner of the Presidential elections in Argentina had promised to de-dollarize the Argentine economy by replacing the peso with the dollar, cutting government spending, and eliminating the Central Bank.
• The Argentine economy has been suffering inflation of more than 100% which has resulted in a drop in purchasing capacities and an increase in poverty.

What is dollarization?

• Dollarization is loosely used to refer to the replacement of a local currency by a foreign currency like the dollar in any of its functions.
• Significance: Dollarization helps eliminate the risk of a sudden, sharp devaluation of the country’s exchange rate, thereby reducing the risk premium attached to its international borrowing.
• Types:
  • Asset Dollarization: It refers to the use of foreign currency in any of its three functions - as a unit of account, means of exchange, and store of value.
  • Currency Substitution: It refers to the use of foreign money as a means of exchange. The domestic currency may still be used for transactions.
  • Liability Dollarization: It refers to the relatively large foreign currency debt obligations of countries. Here, the country could be scarcely dollarized in terms of assets while loans are mostly in foreign currency.
  • Full Dollarization: Full Dollarization is a situation in which a country abandons its currency and adopts another country’s currency as a means of payment and unit of account.
  • Origin: Dollarization was conceived as a solution to advancing global economic stability and prosperity through exchange rate regimes.
  • Dollarisation has been economically successful in Ecuador, Panama, and El Salvador.

Why have countries advocated dollarization?

• Solution to hyperinflation: Dollarization breaks the feedback link between rising prices and rising money supply, which helps tackle hyperinflation.
  • The replacement of the domestic currency ensures that the money supply cannot be controlled by those with vested political interests.
  • Price rise would slow down as consumption demand drops due to the difficulty in accessing currency.
• Effect on growth: Dollarization would incentivize the economy to focus on exports and ease conditions for foreign capital since small economies can only access the dollar through foreign trade or capital inflows.
  • This would attract foreign capital who prefer to invest in economies with a stable currency.
  • The stability of the dollar’s value will ensure that both foreign and domestic economic agents can make long-term plans regarding economic activity.

What are some of the concerns associated with dollarization?

• Loss of policy leverage: When a country adopts the dollar as its currency, the money supply can no longer be controlled by the monetary supply.
  • In terms of foreign trade, countries would not be able to use depreciation to boost exports.
  • Some experts have claimed that this is a positive aspect since the government would then have to employ productivity-boosting methods to counter recessions instead of modifying exchange rates.
• Risks of over-dependence on a single currency: Over-dependence on a single currency could expose the nation to risks associated with fluctuations in the value of the dollar, changes in US monetary policy, and potential sanctions or restrictions imposed by the US.
• There have been increased concerns about the value of the dollar and inflation due to the consistent budget deficits of the US government.
• US’s geopolitical conflicts: The US has been involved in several geopolitical conflicts in recent years, including the wars in Iraq and Afghanistan, which have affected the dollar.
• China factor: China has been promoting the use of its currency, the renminbi, as an alternative to the dollar.
• Loss of power of central banks: Following the implementation of dollarization, Central banks become bodies with no power.

Case study: Ecuador and Greece

Ecuador

• In the late 1990s, the Ecuadorian economy was afflicted by a series of debilitating crises that led to
• Contraction of economic output by around 7%,
• Inflation at 67%,
• Depreciation of the local currency (Sucre) by 200% in 1999.
• In January 2000, Ecuador adopted the dollar and persisted with the policy of dollarisation despite widespread protests that led to the resignation of President Jamil Mahuad.
• Outcome of dollarisation:
  • The Ecuadorian economy progressed on economic growth and social welfare parameters.
  • Economic growth: According to the World Bank, the economy grew by 4.5% in real GDP terms between 2001 and 2014.
  • Poverty: The poverty rate dropped from 36.7% in 2007 to 22.5% in 2014.
  • Inequality: Inequality measured using the Gini index dropped by 9% in the same period.
  • Impact in recession: Even during the recession of 2008, the economy only lost 1.3% of GDP and later achieved its 20-year growth target by 2010.
  • Inflation: Inflation averaged around 4% between 2003 and 2006, dropping from 108% prior to dollarization. The inflation rate in Ecuador hit a high of 108% in September 2000.
  • Foreign debt to GDP: The ratio of foreign debt to GDP also reduced from 55% in 2000 to 21.5% in 2006.

Reasons for the success of dollarization in Ecuador

• Although dollarisation helped tackle inflation, active fiscal policy played a significant role in ensuring sustainable growth.
• Oil and gas reserves: Ecuador has significant reserves of oil and gas which boosted the country’s economic growth during the commodity price boom of the 2000s and enabled a greater inflow of dollars.
• However, reductions in oil prices post-2014 have led to slowing economic growth, and rising debt and deficits.
• Rising oil prices led to windfall gains in the Ecuadorian economy, which were translated into social spending by the government.
• Expansion of state’s role: Between 2007 and 2017, Ecuador expanded the role of the state in the dollarized economy.
• As a result, government expenditures and deficits rose significantly.
• The government renegotiated contracts with oil exploration companies using the threat of nationalization of oil fields to give the state greater revenue.
• Ecuador’s foreign debt was restructured and certain bonds deemed illegitimate or unfairly beneficial to private parties were defaulted on.
• Social spending increased from 5% of GDP in 2006 to 10.3% in 2011 as a result of the freed-up fiscal space.
• In contrast to mainstream monetary policy approaches, the Central Bank was not independent of the executive in this period.
• Economists have criticized the return to austerity economics in Ecuador as the IMF has set the independence of the Central Bank as a pre-condition for receiving financial assistance.

Greece

• Greece is an example of the dangers associated with adopting an external currency that curtails the state’s ability to implement an independent policy.
• Greece joined the European Union in 1981 and adopted the Euro as its currency in 2001.
• The adoption of the euro, a stable currency, fuelled growth, and rise in capital inflows and boosted tourism in Greece.
• However, Greece was left without fiscal and monetary policy options in the aftermath of the Eurozone crisis as
• The European Central Bank (ECB) retained control over the monetary policy
• Fiscal policy was restrained as a pre-condition for adopting the Euro.
• As a result, Greece was forced to adopt severe austerity measures in exchange for financial assistance from the IMF and the ECB.

Conclusion

• Therefore, dollarisation can be effective if used in combination with effective domestic policy and should not be treated as a silver bullet.
• However, the election of the new President of Argentina who has expressed a desire to slash government spending and abolish the Central Bank has raised concerns.

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FAQs

MCQs

Question: With reference to Central Bank digital currencies, consider the following statements:

1. It is possible to make payments in a digital currency without using the US dollar or the SWIFT system.
2. A digital currency can be distributed with a condition programmed into it such as a time frame for spending it.

Which of the statements given above is/are correct? (UPSC CSE 2023)

\a) 1 only

(b) 2 only

(c) Both 1 and 2

(d) Neither 1 nor 2

Question: In the context of India, which of the following factors is/are contributor/contributors to reducing the risk of a currency crisis?

1. The foreign currency earnings of India’s IT sector.
2. Increasing government expenditure.
3. Remittances from Indians abroad.

Select the correct answer using the code given below. (UPSC CSE 2019)

(a) 1 only

(b) 1 and 3 only

(c) 2 only

(d) 1, 2 and 3 only

Question: Consider the following statements:

1. A reserve currency is typically a globally recognized foreign currency that central banks or other financial institutions hold in large quantities.
2. The US dollar is the world’s predominant reserve currency currently.

Which of the above statements is/are correct?

(a) 1 only

(b) 2 only

(c) Both 1 and 2

(d) Neither 1 nor 2