A report early this year from Argentina’s central bank on the feasibility of full official dol-larization and how it might be achieved has jump-started discussion on dol-larization as a possible alternative exchange rate arrangement. The interest of a country as large and independent as Argentina has swiftly moved the topic from the realm of the theoretical to the realm of the possible, sparking a wide debate on its relative merits and feasibility. To gauge the practicality of dollarization in a large economy and to weigh possible costs and benefits, the IMF assembled a panel of academics and policymakers for an Economic Forum entitled “Dollarization: Fad or Future for Latin America.”
Participants in the July 1 discussion, moderated by David Goldsbrough, offered a range of perspectives on the pros and cons of dollarization. In addition, Jeffrey Frankel contributed a broad review of exchange rate regime options; Guillermo Ortiz examined why floating rates have worked for Mexico; Miguel Kiguel explained why Argentina, despite the effectiveness of its currency board arrangement, is seriously considering full dollarization; and Eduardo Borensztein advised proceeding with some caution, given the scarcity of experience with dollarization in a large economy.
Exchange rate options
From the recent succession of exchange rate crises in emerging markets, some have concluded that only fixed or floating regimes can be effective in a globalized financial environment. But Jeffrey Frankel demurred. Fixed and floating regimes do offer certain benefits: a reduction in transaction costs and risks as well as the provision of a credible nominal anchor for monetary policy in the case of fixed rates, and the ability to pursue independent monetary policy under floating rates. But there is a danger, he warned, in overstating the need to choose one or the other.
According to Frankel, the optimal regime for a country still depends a great deal on individual circumstances, such as size, openness, correlation of shocks, labor mobility, fiscal cushions, desire to integrate with major partners, and the political will to sacrifice monetary sovereignty for stability. Also key are the availability of reserves, the strength of the banking system, and the existence of the rule of law (particularly crucial if a currency board is being considered). The regime itself is not the cure, he argued; neither a currency board nor dollarization will serve up “credibility in a bottle” without the necessary underlying institutions and political will.
Taking up the question of the advisability of dollarization for Argentina, Frankel pointed to the extensive dollarization that already exists in the country and asked whether anything would be lost by going further. Not opting for full dollarization, he suggested, would preserve a modicum of independence, allowing the country to abandon the currency board, peg to a different currency, or keep its limited scope to sterilize and cushion in the event of a reserves outflow. But the theoretical advantages of retaining some residual monetary independence are in practice illusory, Frankel observed.
Under its present currency board arrangement, Argentina is highly sensitive to U.S. interest rates. Under full dollarization, a U.S. decision on interest rates might run contrary to Argentina’s domestic needs, but it is likely to be more advantageous, Frankel’s data indicated, than the current situation. At present, Argentine interest rates rise, on average, 2.7 basis points for every 1 basis point increase in U.S. rates. By contrast, Panama, which is fully dollarized, sees its interest rates rise less, and rates in Mexico and Brazil rise “a lot more.” This suggests, Frankel said, that full dollarization might provide a relative interest rate advantage and ensure, at worst, a one-to-one ratio.
The Argentine dollarization proposal suggested it would seek seigniorage, access to the U.S. Federal Reserve Board’s discount window, and cooperation regarding bank supervision. Frankel suspected, however, that the United States would be wary of incurring contingent liabilities and unwilling to give up the seigniorage. The possible benefits for the United States—seigniorage, ease of business and travel transactions, increased trade (from greater stability and prosperity), and possible foreign policy gains—seemed to outweigh the potential costs, however, and he believed the dollarization proposal merited tacit, if not official, U.S. support.
Ultimately, Frankel observed, full official dollarization is probably a good idea for some Latin American countries, particularly several of the small open economies of Central America. It might even be a good idea for Argentina, he said, if the political willingness to give up all monetary sovereignty truly exists.
A Mexican perspective
As if to bolster Frankel’s argument that the choice of exchange rate regimes is fundamentally driven by individual circumstances, both Guillermo Ortiz and Miguel Kiguel debated the pros and cons of dollarization from their countries’ recent experiences with two very different regimes. Argentina, Mexico, and now Brazil, Ortiz noted, have adopted their current exchange rate regimes amid crises. When Mexico adopted a floating regime in 1994, it had run out of reserves and options.
Ortiz admitted that he was no fan of floating rates at the time. He feared a floating rate regime would be volatile in a country such as Mexico, that lacked futures and forward markets. At best, he hoped, Mexico might use the floating rates as an interim solution while it built up its reserves again. But four and a half years later, Ortiz was a convert. Floating rates had not impeded efforts to significantly lower inflation rates (down to an anticipated 13 percent in 1999 from 52 percent in 1995), and volatility has not been the problem he feared. Foreign investment flows have also held reasonably steady, and the floating regime has allowed Mexico to weather the Asian, Russian, and Brazilian shocks “in a very satisfactory fashion.”
Ortiz contrasted Mexico’s experience with those of Canada, Australia, and New Zealand, which also have floating regimes and have been hit by terms of trade shocks. In all four countries, the real exchange rate depreciated by 8-12 percent, but growth was preserved in all but New Zealand. This track record compares favorably with two economies with currency boards in place—Hong Kong SAR and Argentina, which both suffered recessions. “But of course,” Ortiz added, “the fact that we are next to the United States, and Argentina is next to Brazil may have something to do with it, no?” On the flip side, Ortiz acknowledged, inflation has been higher in Mexico—and much higher for Mexico than for Canada, Australia, or New Zealand. Ortiz pointed to the credibility of monetary policies as one of Mexico’s biggest remaining challenges.
On dollarization, Ortiz toted up the possible costs and benefits and found little to tempt Mexico. Latin America was not yet sufficiently integrated with the U.S. economy to accrue the types of benefits that a common currency (under the optimal currency area literature) might afford. And he was skeptical of credibility achieved essentially by burning one’s bridges. Dollarization would reduce inflation and provide a great incentive to fiscal and financial discipline, but a dollarized economy would need a very strong financial system with ample liquidity and credit lines from abroad to function without a lender of last resort. He also underscored that, with monetary policy independence and floating rates, Mexico has been able to cope with external shocks and preserve growth.
At this juncture, Ortiz argued, greater integration with North America makes more sense for Mexico than dollarization. If Mexico were able to move toward the fiscal surpluses, very low inflation, and strong financial systems of its North American Free Trade Agreement (NAFTA) partners, any exchange rate regime would function better.
Why Argentina may be different
Acknowledging that Canada, Mexico, and now perhaps Brazil are satisfied with floating rate regimes, Miguel Kiguel nonetheless insisted that Argentina is “somewhat special.” A currency board arrangement has allowed the country to record possibly the best performance it has had in the century, despite recessions in 1995 and 1999. Running down a list of achievements, he cited the lack of interest that currently greets the release of inflation figures as perhaps the best indication of the profound change that has taken place in Argentina. Foreign investment has reached record levels, and foreign direct investment has been at its highest levels since the 1920s.
It is also important to understand, he said, that Argentina is already a highly dollarized economy. “People think in dollars,” he observed; whenever a big figure is mentioned, it is a dollar figure. The capital market functions fully in dollars. While the peso is used for current transactions, Argentines by and large save in dollars: 92 percent of public debt is in dollars or other foreign currencies, and 58 percent of bank deposits—and 74 percent of savings—is in dollars. Argentines borrow in dollars also, with 66 percent of current bank loans denominated in dollars.
The obvious question then is, if the currency board has been a success, why raise the issue of full dollarization? Because, in times of crises, Kiguel said, the peso-dollar spread still rises sharply when there is an external crisis. The hope is that full dollarization will provide added stability.
This step, given Argentina’s currency board and degree of dollarization, would not be as drastic a change for Argentina as it would be for other countries. Loss of monetary policy is cited as a distinct disadvantage of dollarization, but Argentina already has an essentially passive monetary policy, Kiguel pointed out. The quantity of money is determined entirely endogenously in the system, and the interest rate is fully market determined. The central bank still controls liquidity requirements, which affect credit; this, he suggested, is perhaps the key issue today.
One of the chief benefits of dollarization, the central bank analysis indicated, would be reduced country risk. If the fear of devaluation could be removed, country risk would be diminished. The Argentine report estimated that removing the devaluation risk could produce a significant (150-200 basis point) reduction in country risk.
Argentina also holds substantial reserves. Argentina could dollarize tomorrow if it wants, Kiguel said, but unilateral dollarization is not nearly as attractive a proposition as negotiated dollarization. If it dollarized unilaterally, Argentina stood to lose $700-750 million a year (about 2 percent of government revenues) when it exchanged its present holdings of U.S. treasury bills for dollars. Argentina was searching for ways to continue to earn the same interest. Dollarization would also effectively halve reserves, so that Argentina is seeking, he said, some combination of private sector and multilateral or U.S. government arrangements to enable the central bank to act as lender of last resort.
Dollarization, Kiguel stressed, is no panacea, but it does offer a means of strengthening convertibility and could thus afford Argentina less volatile interest rates and less uncertainty. Of course, he added, with either convertibility or dollarization, Argentina must continue to pursue strict fiscal policy, sound debt management, and an even stronger banking sector.
Issues to be considered
The present currency board arrangement and the substantial amount of dollars already in the economy do make dollarization a much less drastic step for Argentina than it would be for Mexico or other floating regimes, Eduardo Borensztein observed. But the decision, once made, would be very hard to reverse, and the potential costs and benefits could be difficult to measure, he advised.
Traditional optimal currency area literature has little relevance, he said, for countries considering dollarization, since they are in search of more immediate gains—namely, market credibility and shelter in the event of crises. The more pertinent issues, Borensztein argued, are seigniorage, country risk, and lender of last resort. The first two are relatively easy to quantify. The dollarized economy will lose seigniorage, and the country risk premium should be lower with dollarization. He cautioned, however, that the extent to which country risk could be reduced could be difficult to predict with accuracy. While there is a close correlation between currency risk and sovereign risk, it is less clear that currency risk causes sovereign risk. Panamanian bond spreads, for example, have not been fully protected from contagion or international market sentiment and tend to follow emerging market trends.
Argentina’s experience with a currency board arrangement would facilitate its adaptation, under a dollarization scheme, to the absence of a formal lender of last resort. Floating regimes do provide the authorities with greater flexibility, but Borensztein noted that if there is a large problem in the banking sector, the ability to solve it by printing money has its limits. As a rule, he said, the more open an economy becomes and the higher the level of its capital mobility, the less margin there is for monetary policy.
Argentina’s participation in the MERCOSUR regional trade arrangement and Mexico’s in NAFTA also raise the issue of whether dissimilar exchange rate regimes complicate regional trade arrangements. At present, Argentina has a currency board, while Brazil, the largest member of MERCOSUR, has adopted a floating rate. Dollarization would not worsen the situation that already exists, Borensztein argued. There has not been significant exchange rate volatility other than the wide fluctuations that have been correlated with periods of high inflation and stabilization and the recent currency crisis in Brazil. With regard to Mexico and NAFTA, he believed exchange rate fluctuations would become problematic only if the regional arrangement were to deepen. The creation of a single market would, however, provide the impetus for a common currency. (A deepening of the MERCOSUR relationship would likely also raise the question of whether Argentina’s trading partners would be willing to adopt the dollar.)
Ultimately, Borensztein noted, the biggest potential benefits from dollarization are likely to be the hardest to assess. Will adoption of the U.S. dollar increase trade and foreign direct investment and enhance credibility? And if it does, will this significantly accelerate convergence with the U.S. economy? With few country experiences to draw from, the gains that large economies might expect from dollarization remain difficult to measure with any certainty, he concluded.
The full transcript of “Dollarization: Fad or Future for Latin America” is available on the IMF’s website (http://www.imf.org).
Economic Forum participants
New Century Chair, The Brookings Institution, and Harpal Chair, Kennedy School of Government, Harvard University
Governor, Bank of Mexico
Chief, Cabinet of Advisors, and Under Secretary of Finance, Argentina,
Chief, Developing Country Studies Division, Research Department, IMF
Deputy Director, Western Hemisphere Department, IMF
Ian S. McDonald
Senior Editorial Assistant
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