In the wake of Javier Milei’s landmark election in Argentina, focus has turned to his dollarization pledge.
It’ll be incumbent on market participants to cultivate at least a vague familiarity with Milei’s platform. He promises to be an outspoken political figure and Argentina is poised to be a testing ground for what, if Milei manages to implement even half of his agenda, will be a radical macroeconomic pivot.
As discussed here on Monday, Milei’s dollarization promise faces what might fairly be described as insurmountable hurdles. It’s a logistical impossibility but… well, stranger things have happened, I suppose.
Given the sheer amount of interest in Milei’s dollarization pretensions, it’s worth reviewing both the costs and disadvantages of dollarization, as well as the preconditions for successful implementation.
Back in September, Goldman’s Alberto Ramos and Sergio Armella reminded the world that “dollarization ain’t a free lunch.” “It has costs and limits the policy tool kit,” they wrote. “From a technical standpoint, dollarizing is also not an easy step [while] preserving it and benefiting from it over the long run are even more challenging.”
The costs and disadvantages are relatively straightforward. Ramos and Armella began by noting that a dollarizing nation loses seignorage revenue from domestic money issuance, but more importantly, you “lose of control over the money supply, i.e., the money stock become exogenous,” the central bank becomes constrained in its capacity to act as a lender of last resort “since the printing press is shut down” and the country is stripped of its ability to “use monetary and FX policy to respond to shocks both via the exchange rate and via interest rate policy.”
Maybe the benefits for Argentina outweigh those costs and disadvantages, but Goldman seems to doubt it. “There are several economic characteristics, or preconditions, which mitigate the costs of adopting the dollar as currency [and] in our assessment, none are really met in the current Argentine context,” the bank said.
Below, find heavily abridged excerpts from Goldman’s 31-page assessment of the prospects for dollarization in Argentina. Suffice to say the bank doesn’t appear to believe the odds of success are especially high. To wit:
Significant economic integration and/or similar economic structures are valuable whenever a country adopts the currency of another country. If the two economies are highly economically and financially integrated or have similar economic structures, there is a higher likelihood that their business cycles are somewhat synchronized. In that case, at any given moment in time, the appropriate monetary policy stance would likely be broadly similar for both countries, thereby reducing the costs of giving up on having independent monetary policy. But the level of economic and financial integration between Argentina and the United States is low.
Being a commodity-based economy presents additional challenges when contemplating adopting the USD. Not only do commodity price cycles tend to exhibit large swings (which in turn lead to sharp swings in the business cycle), but periods of dollar strength tend to weigh down on dollar commodity prices. As a result, for Argentina, a strong USD in global markets may exacerbate negative shocks to commodity prices, amplifying the impact on the economy of a potential decline in the terms of trade. A flexible exchange rate regime has the advantage of allowing the domestic currency to act as an automatic stabilizer, cushioning part of the terms of trade shocks (e.g., swings in commodity prices) and smoothing the business cycles.
Factor markets flexibility (labor and capital) is also key. Price and wage flexibility is valuable if a country decides to adopt another’s currency. In the absence of exchange rate flexibility, flexible prices and wages can help a country adjust to shocks and preserve external competitiveness. In Argentina, however, labor market rigidities are pervasive [and] backward looking indexation and nominal wage stickiness are high. All in, the hurdles to adjust prices (or wages) down would imply higher unemployment and more prolonged recessions when the economy is hit by negative idiosyncratic or external shocks.
In addition, without the capacity to run independent monetary policy Argentina would be more exposed to economic and financial shocks. Fiscal discipline overall and flexibility would help to mitigate these vulnerabilities and provide the government with some tools to respond to idiosyncratic shocks. Argentina, however, has a long history of fiscal profligacy and debt crises. Given the idiosyncratic political economy dynamics of Argentina for over 30 years, it is questionable whether policymakers would be able and/or willing to deliver the strong credible fiscal anchor that would be needed to preserve dollarization and minimize its costs.
Lastly, to execute the formal dollarization transaction, authorities must either have at hand, or secure, enough Dollars to do it at a reasonable exchange rate. As a starting point, the government needs to purchase the stock of domestic currency in circulation, exchanging all Pesos for Dollars. At the official overvalued exchange rate, ARS in circulation currently amounts to close to US$15.2bn, but at the parallel unofficial exchange rate it is around US$6.6bn. Additionally, the central bank should have enough Dollars to cover banks’ reserve requirements on ARS and USD deposits: these reserve requirements are bank deposits at the central bank; i.e., a liability of the central bank and at 800 ARS/USD they would amount to US$11bn (US$1.5bn from ARS deposits and US$9.6bn from foreign currency deposits).
Dollarization also requires dealing with the local currency remunerated liabilities of the central bank (which are short-term assets of the financial system). Given extensive funding of the budget and declining money demand, sterilization operations grew rapidly and with them the short-term liabilities of the central bank. The stock of central bank remunerated securities in Pesos stands at close to 12% of GDP (around US$60.4bn at the official exchange rate; US$26.4bn at the parallel unofficial rate). Upon dollarization, these short-term instruments would also be converted into dollar liabilities. Hence, the central bank should have as assets, a combination of US dollars and dollar tradable securities at market value, to cover these remunerated liabilities (Leliqs, Reverse Repos, etc.), preferably with a cushion to act in case of need as a lender of last resort to the financial system. If not, the domestic financial system may be prone to confidence shocks and runs due to limitations on the capacity of the central bank to act given the inability to ease liquidity conditions by printing USDs.
With the central bank’s net international reserve position currently in negative territory and low levels of non-encumbered gross reserves, implementing dollarization would require either dollarizing at a very weak exchange rate, or securing fresh dollar liquidity by borrowing abroad, increasing the already high level of sovereign debt, another source of future macro vulnerability. Financing sources, however, are scarce, including access to additional funding from multilateral organizations, such as the IMF.
As such, dollarizing the economy would most likely have to be done at a weak, very depreciated exchange rate. The weaker the exchange rate, the fewer dollars the authorities would need to have at hand to dollarize. At 1,000 ARS per USD, with roughly US$15bn authorities would be able to buy the monetary base and cover the reserve requirements on ARS and USD deposits. Covering the stock of central bank remunerated liabilities as well, would push the overall price tag to around US$35bn.
Perhaps the most important takeaway from the analysis was captured by Ramos and Armella in just a few sentences. Fiscal consolidation, they emphasized, “is not an automatic byproduct of dollarization.”
“Without fiscal discipline, dollarization is very painful [and] would entail very significant costs in terms of growth and employment, or would eventually collapse,” they went on, adding that although “dollarization can be part of a broader solution to your most intractable problems,” in isolation, it could be “no solution at all.”
