Reassessing the feasibility of adopting dollarization in Latin America.
| Autor | Padilla, Leon |
Introduction
It is well known that currency substitution--or partial dollarization--is a recurring problem in Latin America (LA) nations and that the greater the degree of a shift away from domestic to foreign currencies, the more sensitive a country's monetary aggregates are to sudden movements in exchange rates, productivity and interest rates (Prock et al., 2003). In fact, currency substitution is a form of dollarization and can even be the door to giving up the national currency (Calvo and Vegh, 1992). In this sense, official dollarization is an extreme--fixed-exchange rate--monetary regime, in which the dollarized country formally renounces the issuance of national banknotes and coins and adopts the currency of another country (usually the dollar) as a means of payment and unit of account. Furthermore, official or partial dollarization is a consequence of political, economic considerations (such as hyperinflation), currency instability and strong trade links with a specific country (Mengesha and Holmes, 2013).
Likewise, this system represents an even stronger commitment because of the difficulty of regaining control of monetary policy and establishing a new exchange rate. Basically, in a dollarized country there is no exchange rate and there cannot, therefore, be an exchange rate crisis (Bird, 2004). For this reason, dollarization provides a much more credible mechanism, compared to other alternatives to fixed exchange rate regimes, especially in developing economies that lack internal discipline and have institutional weaknesses (Alesina et al., 2002). In addition to gaining credibility, positive features of a dollarized system include lowering information costs, providing a cushion for sharp relative price changes (Calvo, 2001a); mitigating the exchange rate risk, country risk and interest rates, and promoting the convergence between domestic inflation and that of the US (Dornbusch, 2001; Edwards, 2011; Larrain and Tavares, 2003); fostering bilateral trade between the dollarized countries and the US; and improving credit rating and access to international markets by reducing debt restrictions (Levy-Yeyati and Sturzenegger, 2002). Besides, the costs involved in this arrangement are the loss of seigniorage; vulnerability to external shocks by loss of the ability to manage exchange rate policy and monetary policy; the inability to establish cyclical policies; nominal price and wage rigidities that limit the reduction of production costs; and the absence of a lender of last resort (Calvo, 2001b; Schmitt-Grohe and Uribe, 2001).
On the other hand, although dollarization can lead to macroeconomic stability, several studies have also shown harmful effects at an economic level. Edwards and Magendzo (2003, 2006) found that (1) dollarized countries have experienced a slightly lower growth rate compared to countries that maintain their own currency--this difference is statistically significant (albeit small)--and (2) the output volatility has been significantly higher in dollarized economies. Therefore, even though dollarization--as well as other fixed-rate systems--provides an anchor for inflation, it does not guarantee the resolution of deeper structural and institutional problems (Hochreiter and Siklos, 2002).
Moreover, although several economists (Alesina et al., 2002; Calvo and Mishkin, 2003) raised the possibility at the beginning of the 21st century that LA countries might adopt dollarization as a measure to reduce macroeconomic imbalances and exchange rate volatility, after the dollarization in Ecuador and El Salvador, no other LA country has adopted this regime. Nonetheless, because of hyperinflation and macroeconomic imbalances in certain LA nations, the dollarization debate has resurfaced in recent years. Venezuela has faced an economic debacle for around 15 years: inflation exceeded 1.000.000% in 2018, along with higher projections, persistent fiscal deficits, scarcity of goods, unemployment close to 50%, economic dependence on the oil sector, the dramatic migration of the Venezuelan population, continuous currency devaluations and proliferation of a black money market. Urdaneta et al. (2019) show that after the implementation of exchange controls in 2003, the demand for money in foreign currency has grown well above the demand for money in national currency, which is indicative of dollarization.
Argentina is another country that is dealing with a serious economic crisis. Since 2015, the Argentinian economy has contracted by approximately 4%. Since 2010, it has faced recurrent government budget deficits, and its external debt is now over 60% of gross domestic product (GDP). Moreover, the Argentine peso has lost two-thirds of its value since 2018, and the inflation rate is close to 50%. In this sense, even though dollarization is not the most appropriate monetary system because it implies important rigidities, this arrangement may work well in countries with a long history of imbalances and instability (Edwards, 2011). Therefore, a key question is whether these economies should adopt an official dollarization system, considering that partial dollarization can lead to an acceleration of inflation in both the short run and long run and put more pressure on the exchange rate (Mengesha and Holmes, 2015).
Consequently, this paper reassesses the feasibility of adopting an extreme fixed exchange regime in LA countries using the framework of the optimal currency areas (OCA) theory, considering that, in fact, dollarization is an incomplete monetary union. We use a structural vector autoregressive (SVAR) model to identify what type of structural shock--country-specific, regional or global--prevails in LA economies. For this purpose, the US output is used to represent the global output and determine how the shocks of the US influence the output trajectory of each LA nation. The higher the influence of the US product, the lower the costs of adopting the US dollar. This strategy allows us to determine whether an economy could adopt the dollar as a currency. The structure of the paper is as follows. In the second section, the literature studies related to dollarization and the OCA theory are revised. The third section details the methodology, model and data used. The fourth section describes the most important results. In the fifth section, different estimates are made to ensure the robustness of the results. The sixth section is a discussion section on the main results. Finally, the main conclusions of the study are presented.
Dollarization, the incomplete monetary union: a literature review
Fixed exchange-rate regimes--such as currency boards or dollarization--also involve a de facto monetary union. Robert Mundell, who developed the OCA theory, defined a monetary area either as a region in which a single currency prevails or as one in which different regions with their own currency relate their currencies to each other through a fixed exchange rate. The benefits and costs of dollarization are like those assumed by the creation of a monetary area. However, both currency boards and dollarization are considered to be incomplete currency unions because both monetary systems are unilateral decisions (Hochreiter and Siklos, 2002; Vernengo, 2006). While dollarization only involves the replacement of the local currency with the US dollar, a complete monetary union is a much more complex process, in which political and economic coordination is required in addition to institution-building by countries interested in introducing a single currency (De Grauwe, 2012; Hochreiter et al., 2002).
Traditionally one of the factors determining the suitability of the creation of a monetary area is the business cycle synchronization between economies. If the business cycles of the members of a monetary area are synchronized, the cost of losing the monetary policy is lower, as country members can use a common monetary policy to deal with external shocks (Alesina et al., 2002; Frankel and Rose, 1997). Therefore, even though dollarization corresponds to an incomplete monetary union, the business cycle synchronization criterion can also be used to assess the feasibility of adopting this monetary agreement--in the case of LA countries, the degree of business cycle synchronization between a candidate economy to adopt the dollar and the US. In an empirical examination of dollarization versus regional currency union as options for the economies of East Asia, South America and Central America, Larrain and Tavares (2003) concluded that dollarization may be an option for Central American countries but neither dollarization nor a regional currency would be a good decision for South American (SA) economies. Canova (2005) found that US monetary shocks generate large and negative responses to LA macroeconomic variables regardless of the exchange rate regime. Kandil (2009) demonstrated that trade openness and financial linkages are important transmission channels of US business cycles in various heterogeneous LA countries. Gong and Kim (2018) determined that global financial linkages play the most important role in explaining regional business cycle synchronization in both East Asia and LA nations. In addition, although the integration--through business cycle synchronization analysis--between the US and other LA nations would seem to have increased in the last two decades, Miles (2017) found evidence that Ecuador and El Salvador appear to be the countries that are least integrated with the US.
Methodology
According to Bayoumi and Eichengreen (1993), highly correlated or symmetrical supply shocks within a region indicate that a group of countries are good candidates for a monetary union--regardless of whether they are formal or incomplete monetary unions. Nonetheless, one criticism of this methodology is that it is not possible to distinguish between different types of disturbances; that is, between domestic (or country-specific), regional...
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