By Yang Shiqi, Ph.D. candidate at the School of International Politics and Economics, University of Chinese Academy of Social Sciences, and Xia Guangtao, associate researcher at the Institute of World Economics and Politics, Chinese Academy of Social Sciences, and assistant dean of the School of International Politics and Economics, University of Chinese Academy of Social Sciences
As an important economy in Latin America, why does Argentina completely abandon its sovereign currency, the peso, and fully embrace the US dollar? What are the consequences of Argentina's move to fully dollarize? This paper attempts to systematically explore the motivation and potential impact of Argentina's proposal of currency dollarization on the basis of theoretical analysis, in order to enrich the international community's academic discussion on the issue of dollarization under the new situation.
Javier Milei was officially inaugurated as the new president of Argentina on December 10, 2023. Milley, an economist by training, proposed radical "shock therapy" during the election campaign, such as cutting public spending, shutting down the Banco Central de la República de Argentina (BCRA), and replacing the Argentine peso with a dollar.
Theoretical analysis of the dollarization of money
Definition of the concept of currency dollarization
Former Argentine President Carlos Saul Menem proposed the idea of dollarization in 1999, planning to abandon the exchange rate system pegged to the dollar at the time and adopt a policy of allowing the dollar to completely replace the Argentine peso. Since then, dollarization has also been much discussed in the literature. Dollarization is divided into de jure dollarization and de facto dollarization, the former refers to the fact that in the economic life of a country or region, foreign currency is given legal tender status, which completely or partially replaces the national currency and legally performs the main monetary functions such as the unit of denomination, means of payment and store of value.
In fact, dollarization refers to the fact that although the US dollar does not have legal status, it is used in the same jurisdiction as the local currency, in which the lower level of dollarization means that a country widely uses the US dollar in its economic life, and a higher level of dollarization means that the local currency adopts a fixed ratio with the US dollar, such as the currency board system. According to President Milley's vision, Argentina would completely abandon its national currency, the peso, and use the US dollar as the only legal tender, which is the highest level of complete dollarization.
In addition, dollarization can also be divided into currency substitution or asset substitution. Currency substitution refers to the use of foreign currencies as a means of payment, usually in the case of high inflation or hyperinflation, where the high cost of transacting in the national currency prompts a country to look for alternative currencies. Asset substitution refers to the use of dollar-denominated assets by domestic financial intermediaries as a store of value, which can take the form of foreign borrowing (domestic banks or enterprises borrowing directly from abroad) and deposit dollarization (domestic asset holders deposit in foreign currencies locally). Asset substitution is often the result of the optimal allocation of domestic and foreign assets by residents of a country.
The research on dollarization has rich theoretical origins. Generally speaking, sovereign countries will choose to issue their own modern credit currency with their own characteristics as legal tender, and two important considerations are seigniorage revenue and monetary policy independence. According to the trilemma theory, a country should abandon at least one of the three policy objectives of monetary policy independence, exchange rate stability, and free movement of capital in exchange for the achievement of the other two goals. Financial crises in developing countries are frequent due to financial vulnerabilities such as "Origin Sin".
On the one hand, after the outbreak of the Asian financial crisis, scholars generally believed that even if there was a certain degree of capital control, the peg exchange rate system would not be feasible under the condition of large capital flows. On the other hand, financial markets in most emerging economies are weak, and when capital flows freely, large capital inflows can cause exchange rates to rise sharply, which can seriously affect their economies and financial stability. Therefore, it is suggested that developing countries should abandon their national currencies and adopt a policy of full dollarization, that is, at the expense of monetary policy independence, in exchange for currency stability and free capital flows.
In recent years, the new literature is no longer limited to the choice of legal tender at the national level, but more discusses the spontaneous dollarization choice of micro entities such as enterprises and financial institutions. First, the dollarization tendency of central banks' choice of money has received extensive attention in the literature. The U.S. dollar is the world's main anchor currency. Central banks also hold large US dollar reserves, accounting for 58.36% of the world's official foreign exchange reserves. Some of the literature also focuses on currency choices at the level of non-financial firms. The literature found that global trade is denominated in a single dominant currency (the US dollar), i.e., the dominant currency pricing paradigm (DCP).
Although the United States is often not a trade participant, foreign trade is still mostly denominated and settled in US dollars. In addition to trade valuation, companies also raise funds through the issuance of US dollar debt, i.e., dual dollarization of trade denominated and trade finance. In addition, in terms of currency selection at the bank level, non-US banks raised a large number of US dollar deposits. According to the Bank for International Settlements' (BIS) Local Banking Statistics (LBS), about 60% of banks' foreign currency liabilities are denominated in US dollars.
The above-mentioned dollarization choices of different actors in the trade and financial sectors are highly correlated and mutually reinforcing. The choice of dollarization in the valuation and settlement of a country's trading enterprises will increase the degree of dollarization of the assets and liabilities of the country's financial intermediaries, which in turn will form an important incentive for the country's central bank to hold dollar reserves. Under the global risk aversion, the demand for safe assets is also a major determinant of the dollarization choice of central banks, financial institutions and other investment entities.
Analysis of the pros and cons of currency dollarization
To this day, there is still no consensus in the academic community on the trade-offs of dollarization.
On the one hand, dollarization can indeed bring certain benefits to a country's economy. First, for small countries (or regions) that are highly dependent on the external economy, dollarization can help alleviate exchange rate risks and interest rate risks, avoid the adverse effects of frequent and large fluctuations in exchange rates, and improve the credibility and effectiveness of policies in developing countries. Second, for countries where hyperinflation often occurs, domestic economic agents lose confidence in their own currencies, and dollarization can play a role in stabilizing currency values and restoring confidence.
Under the sovereign credit monetary system, monetary authorities often over-issue fiat currency to earn seigniorage revenues, thereby triggering inflation, which is essentially a decrease in the intrinsic value of the currency, i.e., the real purchasing power, which in turn will damage the credit of the sovereign currency, resulting in a large number of inflationary currencies being sold off in the foreign exchange market, which in turn will expose the country to continuous currency depreciation and capital flight. Dollarization can bring a country's domestic inflation level into line with that of the United States, which can effectively reduce inflation and inflation expectations, facilitate economic recovery, and reverse capital flight. Third, for countries with close economic and trade ties with the United States, dollarization can save a lot of currency exchange costs and reduce foreign exchange transaction risks, which is conducive to promoting foreign trade and attracting foreign investment. Fourth, dollarization can promote the deep integration of a country's economic entities into the international market and participate in free competition, which will help improve the efficiency of domestic economic operation and promote economic development.
On the other hand, dollarization also comes at a high cost and cost. Empirical studies of countries that have implemented dollarization show that dollarized countries have lower growth rates but higher volatility than non-dollarized countries, and that their investment and growth are more affected by external shocks. While dollarization can help a country deal with high inflation in the short term, it does not guarantee that the country will be able to effectively address deeper structural and institutional problems in the long term. Moreover, dollarization means that central banks will automatically abandon their position as currency issuers, the central banking system will completely disintegrate, monetary sovereignty will be lost, seigniorage revenues will shrink, and monetary policy will become ineffective. For emerging economies, it is difficult for central banks to fulfill their role as lenders of last resort simply by issuing public bonds, for example. In addition, dollarized economies lack the policy space to manage exchange rate and interest rate levels, and their financial vulnerabilities and macroeconomic volatility rise significantly in the face of external shocks.
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Article source丨Tsinghua Financial Review, Issue 125, April 2024
This article is edited by Zhou Mingyi
Editor-in-charge丨Ding Kaiyan, Lan Yinfan
Preliminary trial丨Xu Lanying
Final Review丨Zhang Wei
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