Dollarization: a bittersweet solution for Latin American economies

RIO DE JANEIRO, BRAZIL – Replacing the national currency with the dollar as a payment or pricing instrument has been practiced by several Latin American countries, with different results depending on the economic and financial profile and the type of crisis that led to this measure. It is evident from the experience researched by EFE for a regional overview on the occasion of the anniversary of the exchange rate peg removal in Argentina.

There, it was known as “one for one.” If you had a peso, you had a dollar. Hyperinflation caused fear and terror in the streets, and Domingo Cavallo, Argentina’s Minister of Economy at the time -1991-, found the antidote to the crisis. It was called the Convertibility Plan, and its success depended on the state backing the dollars that circulated from hand to hand with reserves.

Although inflation fell from 1,344% to 25% in the first year, eleven years later, it became apparent that pegging the exchange rate to the U.S. currency to stabilize the country’s faltering economy was a placebo. This Friday marks two decades since Argentina ended that failed experiment. This event reopens the debate over whether dollarization is an appropriate alternative for emerging economies like those in Latin America, whose currencies are constantly vulnerable to devaluation.

WHEN THE DOLLAR IS THE OFFICIAL CURRENCY

With variations, Panama, El Salvador, and Ecuador have officially adopted the dollar. In El Salvador, dollarization has been irrevocable since 2001. At that time, coexistence was allowed with the colón, which ceased to circulate two years later because the banking system converted all accounts to dollars.

According to economist Ricardo Castaneda, this mechanism is “more political than economic” because it lacked “technical elements” for its implementation. The coordinator of the Central American Institute for Fiscal Studies for El Salvador and Honduras (Icefi) tells Efe that dollarization was “an experiment,” similar to the current bitcoin process of President Nayib Bukele.

The measure allows for two different approaches in a country with high poverty, violence, and migration. On the one hand, inflation is “not that high” compared to the rest of the region. On the other hand, there is “evidence” that dollarization “slows economic growth because there are fewer instruments to influence the economy,” Castaneda says.

The situation is different in Ecuador, where dollarization has brought some unusual stability, especially for the banking system, despite the disadvantages of competing with exports or implementing currency reforms in inflationary processes. Introduced due to the financial crisis reflected in the “national holiday” twenty years ago, the measure was the answer to a harsh reality that Ecuador had been dragging along since 1995.

The current model causes constant controversy, but no government, right or left, has dared to abolish it, fearing the impact on international confidence. In the case of Panama, the use of the dollar dates back to more than a century, specifically to 1904, barely a year after independence from Colombia, when the United States began building the canal that would connect the Pacific to the Atlantic, and Panamanians expanded their economy based on their relationship with the North American country.

The National Center for Competitiveness (CNC) of Panama estimates that as early as 1856, when the Transisthmian Railroad was built, the dollar and other regional currencies were in circulation because many travelers were traveling in what they called “gold fever. Dollar and Balboa learned to coexist strangely: It is known that the national currency is equivalent to a dollar, but they know it only in coins of a unit and with a limited monetary mass.

The bet had its advantages. According to the CNC, it allowed for “one of the lowest inflation rates in the region and a competitive supply of credit,” as well as a boost in trade. It was a recipe for a stable economy, the main ingredients of which, according to the banking regulator, are the use of the dollar, the absence of a central bank, the lack of control over the money supply, and the fact that the state does not intervene to set the price of money.

Panamanians, therefore, enjoy competitive interest rates, access to credit, and first-world banking services. And although the use of the dollar makes it impossible to stimulate exports through devaluations, “the benefits far outweigh the costs,” according to the National Competitiveness Center, a nonprofit public-private organization.

INFORMAL DOLLARS

And that brings us to Argentina, where experts say there is a “bi-monetary” economy in which daily life is governed in pesos, but savings are made in dollars. More significant transactions are also conducted in dollars, such as buying and selling real estate, and even the value of goods and services is set in the U.S. currency.

In the late 1980s and early 1990s, Argentines began buying dollars to protect their savings from the country’s high inflation that was an endemic problem. After the “one-for-one” decade, the demand for dollars has increased since 2002, with episodes of intense financial stress and substantial Argentine peso devaluation.

While the official currency cost US$1.20 years ago, it now trades on the informal market for a little less than half a cent, as purchases on the official market are restricted. For its part, Venezuela, with chronic hyperinflation that reached a peak of 130,060% in 2018, has set in motion a process of unofficial dollarization that began with large transactions and today even reaches popular areas.

Dollarization accelerated with the prolonged power outages in 2019, which affected payments in bolivars by card or bank transfer and deepened inequality. However, according to Datanálisis, 42% of the population currently still lacks access to the dollar. In 2012, a year before Nicolás Maduro came to power, dollar transactions did not reach 5%. Today, it is 64.8%, according to Ecoanalítica, a Venezuelan consulting firm.

Citizens learned to cope with poverty then. With daily devaluations, they lost confidence in the bolivar, a problem the government tried to fix in 2021 with currency conversion – the third this century – that removed six zeros from the national currency. After years of demonizing the U.S. currency, Nicolás Maduro changed his strategy and eventually even set the price of gasoline from state oil company PDVSA in dollars.

The process is advantageous when citizens have constant access to dollars, but in Venezuela, the amount of dollars in circulation is the same over and over again. In Cuba, on the other hand, it has been possible to speak of “partial dollarization” since 2021, due to the “Tarea Ordenamiento,” the economic reform package that abolished the dual national currency and replaced it with the Moneda Libremente Convertible (MLC).

The MLC is a virtual currency pegged to the dollar that is used for some payments and is common in the best-stocked stores, but to which the majority of the population does not have access: Millions of people are paid in pesos and do not have dollars to purchase these goods because U.S.-imposed sanctions restrict remittances.

For economist Pavel Vidal Alejandro, this measure is “a counterproductive signal” and proof that “the government has no confidence in the peso or its monetary reform.” So while the national currency is being sharply devalued, the dollar is making an unstoppable advance in the informal market as a utility currency and reserve of value: the official exchange rate is set at 24 pesos to a dollar, but according to the independent media, El Toque, it is currently being exchanged for as much as 100 pesos.

Meanwhile, Brazil has taken some tentative steps. In 2021, the foreign exchange market was revamped, and the central bank now allows individuals to hold foreign currency accounts. Deposits in U.S. currency had been regulated since 1957, but only for tourism agencies, embassies, international organizations, Brazilians temporarily living abroad, and foreign exchange brokers.

According to some economists, this measure will allow for gradual dollarization at a time when the Brazilian real is losing strength against the dollar, which is expected to gain nearly 30% in 2020 and another 7.5% in 2021, making it five consecutive years of growth for Latin America’s largest economy.

With information from EFE