How would dollarisation affect Argentina’s competitiveness?

Replacing Argentina’s currency with the US dollar was a central policy promise of the country’s new president, Javier Milei. The primary intention was to tame rampant inflation, but the impact on the country’s competitiveness could be significant.

Argentina is in the middle of substantial economic reforms, both on the fiscal and monetary side. The country’s monetary policy programme aims to introduce a free competition of currencies, which would mean allowing multiple currencies to be used and to compete freely. Although official dollarisation (replacing the local currency with the US dollar) is unlikely to happen, according to recent government announcements, it might emerge as a potential outcome considering that it was a central part of the president’s economic agenda during the election campaign.

Research on optimum currency areas (which explores the extent to which geographical regions should share a common currency) does not show conclusively that dollarisation decreases exports or undermines external competitiveness. Yet insights from both economic theory and Argentina’s history indicate that dollarisation is likely to have a negative impact on the country’s ability to achieve export-led economic growth.

What is President Milei’s plan for monetary policy?

Less than a year ago, before the start of his administration, Milei said that ‘it is super easy to dollarise Argentina‘. At the time, the then presidential candidate was known for, among other things, proposing dollarisation as a solution for Argentina’s chronic inflation problem. In Milei’s view, replacing the peso with the dollar was, above all, a moral mandate: in essence, he argued, printing money is as wrong as stealing money because it inevitably leads to increasing inflation and, consequently, a generalised loss of purchasing power.

So, dollarisation removes the ‘money printing machine’ from the hands of politicians, who have historically been exceptionally irresponsible when using it. In Milei’s view, Argentina’s history of high inflation shows that the politicians’ lack of discipline when operating this machine is exceptionally bad compared with other Latin American countries. For him, Argentina can’t have a central bank like the others.

This perspective is crucial to understanding the urgency and relevance of the Milei administration’s proposed economic stabilisation plan. On the campaign trail, he showed signs of having a plan for official dollarisation that followed a model similar to that of Ecuador – a country that, in his view, was undoubtedly a ‘successful case‘. Yet the plan has hit several roadblocks and appears not as easy to deliver as the new president first thought.

According to different estimates, to take pesos out of circulation, Argentina would need an amount of dollars that is far-fetched for a national government that faces such a high level of liabilities. Although the new government has achieved a positive fiscal balance in its first few months in office, and the central bank is sharply reversing the previously declining trend in net international reserves, the goal of official dollarisation has proved to be economically unfeasible in the short term. Turning words into actions is hard.

On top of that, there are both political and legal challenges to dollarisation. Milei would have to discuss such structural changes in monetary policy in Congress, and even a call for a referendum on the issue would still need to pass through the legislative branch. The president of the Supreme Court has also declared that implementing official dollarisation would be unconstitutional in Argentina. These challenges highlight the complexity of implementing such a policy and the need for a more nuanced approach.

But Milei’s economic stabilisation plan seems to have evolved from the initial proposal voiced during the election campaign. Instead of official dollarisation (in the style of Ecuador), the stabilisation plan now seems to aim to allow multiple currencies to be used and to compete freely, while also terminating existing exchange controls. This would mean that both the peso and the dollar could be used in the country at the same time. Since the long-term plan includes lifting foreign exchange controls and not intervening with the exchange rate, all currencies could be traded at market prices.

This shift in the model, which seems to have gravitated towards being more like Peru, could bring several benefits to Argentina’s economy. The goals of this model, if aligned with Peru’s stabilisation plan, would be much more reasonable than before (given that the case of Peru’s stabilisation plan is much less controversial than that of Ecuador).

Macroeconomic reforms during the 1990s helped Peru to solve a hyperinflation crisis while achieving long-term stability and trust in the central bank and the country’s domestic currency. Consequently, Peru went from having around 85% of bank deposits and 80% of bank loans denominated in dollars in the late 1990s (Catao and Terrones, 2016) to 35% and 24%, respectively, by 2022 (IMF, 2023 Article IV).

But full dollarisation in Argentina might still be on the cards if free currency competition leads to a situation like in El Salvador. In 2001, El Salvador introduced free currency competition via the ‘Monetary Integration Law’, only to dollarise the economy officially shortly afterwards. In that context, and according to Milei, official dollarisation reflected market choices as people moved away from El Salvador’s domestic currency and towards the dollar.

In addition to these challenges, a major downside of the plan is that it is not a warranty against significant fiscal imbalances, as the case of Ecuador shows. Although dollarisation helped to solve Ecuador’s inflation problem, it did not prevent subsequent administrations from drastically increasing fiscal deficits by acquiring foreign debt at high costs. This is a concern because one of the main arguments in favour of dollarisation is to remove the money printing machine and force a fiscal balance.

Ecuador’s example shows how even in a dollarised economy, a government can finance its spending through the central bank. Later on, this required major fiscal adjustments without any real contributions to Ecuador’s economic growth path during the whole process. As a result, official de-dollarisation is a constant topic in Ecuador’s public debate (Levi Yeyati, 2021). Currency realignment is not a silver bullet for economic woes.

What would dollarisation mean for Argentina’s export competitiveness?

Dollarisation would pose risks to Argentina’s competitiveness since its business cycle is not aligned with that of the United States. Under dollarisation, US monetary policy would directly affect Argentina’s economy and its competitiveness. So, from Argentina’s perspective, it would be beneficial if both economies were aligned. Otherwise, US monetary policy could be sub-optimal for Argentina, as the country might become expensive when it needs to be cheap.

In 2002, researchers (Alesina et al, 2002) asked themselves what are the pros and cons for different countries of adopting foreign currencies as an anchor. In that study, they explored how the correlation of output and prices between the countries adopting the dollar as an anchor currency and the United States can illustrate if those countries are poised to benefit from dollarisation because their business cycles are aligned with that of the United States.

We have updated that analysis using the 1960-2022 period and focusing only on the co-movement of output (GDP per capita). The updated analysis for Argentina shows that its co-movement with the United States is limited and below that of the Eurozone and South American currencies (see Figure 1). This result is similar to the one in the original study, where the authors show that the euro is more attractive as an anchor currency for Argentina, considering that the co-movement of output and prices is more aligned with the Eurozone than with the United States.

An example of high co-movement would be a country that exports similar commodities to those of Argentina – an increase in global demand for these commodities would be likely to increase growth in both economies. In the case of the co-movement between Argentina and the United States, both the timing and sizing of shocks vary significantly. So, an appreciation or depreciation of the dollar may occur at times that are not beneficial for Argentina (as the two economies are not very similar). Even if the timing was right, the size of the response may also not be suited to the needs of the Argentine economy. It is not only the correlation of economic shocks between countries in a common currency area that matters for the alignment of business cycles, but also the magnitude of these shocks relative to the size of the economy (Alesina et al, 2002). If, for example, Argentina and the United States face similar shocks but of very different magnitudes, then the monetary policy response of the US Federal Reserve (America’s central bank) is likely to be inadequate for that of Argentina.

Figure 1: Co-movements of GDP per capita. Argentina and reference countries (including the United States)

Note: We thank Fernando García for his help in producing this analysis

Source: World Development Indicators

More recent research suggests that movements in the exchange rates of open economies do not affect export competitiveness via traditional channels, except in the case of the United States. As shown by Gita Gopinath, First Deputy Managing Director of the International Monetary Fund’s (IMF), because most international trade involves dollar invoicing, exchange rate depreciations (appreciations) do not decrease (increase) export volumes for most countries that invoice their exports in foreign currency (Gopinath, 2015). The relative stability of the price of exports invoiced in dollars implies that a depreciation of the exchange rate does not affect their prices, as conventional economic wisdom would explain, especially if they are commodities. For example, if a major oil producer such as Saudi Arabia devaluates its currency, its oil exports will not become more competitive since oil is commonly traded in dollars.

Yet, depreciations lead to higher profits for exporting firms. This, in turn, can ‘feed into increased exports via new product entry’ (Gopinath, 2015). Since exporting firms may have higher profits, their larger financial leeway may allow them to invest and expand operations into new products. This finding is consistent with the overall idea that exchange rate fluctuations are relevant for the tradable sector. It is natural to assume that increased profits are followed by higher investments from existing and new firms, which can lead to higher productivity within industries, the opening of new export markets, and diversification into related products.

If Argentina adopts the dollar as an anchor currency, it will not be able to use exchange rate mechanisms to compensate for lower productivity. The problem is that the country has already been losing ground. This is most clear in comparison with the United States and Brazil, especially when it comes to agriculture exports. Although agriculture in Argentina is a high-productivity sector, it went from being almost 50% as productive as the United States in the 1970s to being just 15% as productive in 2020.

Conversely, Brazil has experienced a massive boom in agriculture production in the past few decades, going from being 35% less productive than Argentina in the early 2000s to over 15% more productive in 2020. The agriculture sector has accounted for over 80% of Argentina’s net exports in the past two decades (see Atlas of Economic Complexity), so there are reasons to believe that recent concerns voiced by agricultural business leaders about dollarisation should be taken seriously. It is not a sector in which the country can afford to fall behind.

What lessons can we draw from Argentina’s economic history?

Argentina pegged the peso to the dollar in 1991 – and its experience with convertibility should serve as a cautionary tale for today’s discussions. The policy was initially a success: it managed to control inflation, and Argentina’s economy performed well, with an average GDP growth rate of nearly 6% a year between 1991 and 1998.

Much of this growth came amid growing global investment flows in emerging markets and increased commodity prices (USDA, 2009). But while the country was growing, the government incurred significant external debt that was used to maintain the peg. The rigid exchange rate regime and a failure to address fiscal imbalances also made it vulnerable to external shocks.

The inability to respond to external shocks via monetary policy negatively affected Argentina. In the late 1990s, external factors such as the East Asian and Russian crises in 1997-98, a fall in commodity prices, and the connected decreased capital flows to emerging markets led to an unfavourable environment for Argentina’s economy (IMF, 2004).

Amid this turmoil, the Brazilian government decided to devalue its currency in 1999. This was a shock to the Argentine economy given that Brazil was by far its largest export destination (31.5% of all exports went to Brazil in 1998) and its main competitor in some of Argentina’s biggest exports, especially the agricultural sector. In turn, Argentina’s goods became relatively more expensive for Brazilians and less competitive compared with Brazilian exports. The resulting loss of competitiveness led to a fall in Argentina’s exports to Brazil, which went from $12.86 billion in 1998 to $9.96 billion in 1999.

The costs of dollarisation can be especially high in times of large external shocks, given the strength of the dollar. In response to the external shocks during the 1990s, Brazil devalued its currency – all the while the dollar became stronger. This pattern persists across important periods in time. For example, Brazil, exemplary for other developing countries, reacted to global shocks such as the global financial crisis of 2007-09, declining commodity prices and the Covid-19 pandemic through a decreased value of its currency. At the same time, the dollar remains strong, as investors seek relatively safer assets (see Figure 2).

This dynamic would pose a risk if Argentina were to dollarise since its competitiveness would suffer from a dollar that is strengthening relative to other currencies (in turn making Argentina’s exports more expensive). This was the exact experience of Argentina in the late 1990s. A stronger dollar led to lower exports and higher imports, which inevitably resulted in current account deficits of nearly 5% of GDP, leading to large foreign debt (Feldstein, 2002). The increase in foreign debt ultimately reached unsustainable levels in the face of the peg and contributed to Argentina’s default in 2001.

Figure 2: External shocks and key currency movements

Source: INDEC (Price of Exports Index in Argentina), FRED (Real Broad Dollar Index & Real Broad Effective Exchange Rate for Brazil)

In conclusion, the latent possibility of official dollarisation in Argentina poses a risk to the country’s economic prospects. Economic theory suggests that because Argentina’s business cycles are not aligned with those in the United States, adopting the dollar as an anchor currency would make the country more sensitive to external shocks.

On the other hand, while exchange rate fluctuations do not affect the price of exports invoiced in dollars, they can affect profits and, consequently, productive diversification, investment and overall productivity. For dollarisation not to harm Argentina’s exports, the country’s productivity needs to be on par with that of the United States and Brazil, especially in agriculture. Argentina’s past experiences suggest that dollarisation could adversely affect the nation’s prospects for export-led economic growth.