Can dollarisation save an economy? (GS Paper 3, Economy)
Why in news?
- Javier Milei, the recent winner of Argentina’s presidential election, has claimed dollarisation as a “medium-term” goal.
- He pledged in his campaign to replace Argentina’s currency, the peso, with the dollar, to eliminate the Central Bank and to slash government spending.
- Whether dollarisation can be achieved immediately and painlessly is an important question, given the scarcity of dollar reserves with the Argentinian Central Bank
Why dollarisation?
- Dollarisation can act as a solution to hyperinflation by breaking the feedback link between rising prices and rising money supply.
- If the domestic currency is replaced by dollars, so the theory goes, money supply can no longer be controlled by vested political interests who can increase spending for political ends.
- The incessant rise of prices would be forced to moderate since consumers would no longer be able to access currency easily, thus slowing down consumption demand.
Advantages of Dollarisation:
- Since a small economy can only access dollars through foreign trade and/or capital inflows, it would incentivise the economy to focus on export successes and easing conditions for foreign capital, who would be more willing to invest in an economy with a stable currency.
- The stable value of the dollar would ensure that economic agents both foreign and domestic would be able to make long-term plans regarding economic activity, plans that would otherwise not be possible under a currency that rapidly lost value.
Challenges:
- The adoption of dollars as a currency implies that economies lose an important source of policy leverage, with monetary policy now unable to control money supply.
- On the foreign trade front, countries would no longer be able to take recourse to depreciation to boost exports, focusing only on export promotion to stave off downturns.
- Some proponents of dollarisation see this as a positive outcome, since it would ensure the government resorts to productivity boosting methods to combat recessions, instead of changing exchange rates.
The experience of Ecuador:
- The experiences of some countries hold out promise for the project of dollarisation. Three fully dollarised economies; Ecuador, Panama and El Salvador have had successful economic outcomes following dollarisation, with Ecuador a useful case study.
- The Ecuadorian economy suffered a series of debilitating crises in the late 1990s, with economic output contracting by almost 7%, inflation at roughly 67%, and the domestic currency, the Sucre, depreciating by almost 200% in 1999.
- President Jamil Mahuad announced the adoption of the dollar in January 2000; widespread protests following the move forced him to resign. Despite this political upheaval, Ecuador persisted with dollarisation.
Outcome:
- The economy has shown considerable progress since then, on parameters measuring both economic growth and social welfare. The World Bank estimates a growth of 4.5% in real GDP between 2001 to 2014.
- The poverty rate fell from 36.7% in 2007 to 22.5% in 2014, with inequality, as measured by the Gini index, falling by 9 percentage points over this period.
- During the 2008 recession, the economy lost only 1.3% of GDP, reaching its 20-year growth trend only two years after the onset of the recession. The inflation rate in Ecuador hit a high of 108% in September 2000.
- Following dollarisation, the inflation rate averaged around 4% between 2003 to 2006, a remarkable achievement for an economy experiencing double-digit inflation rates since the 1970s. The ratio of foreign debt to GDP also reduced from 55% in 2000 to 21.5% in 2006.
Factors responsible for success in Ecuador:
- Ecuador is helped by significant reserves of oil and gas. The commodity price boom of the 2000s greatly aided the growth of the economy and allowed for a greater inflow of dollars. Subsequently, the reduction in oil prices after 2014 saw a reduction in economic growth and rising debt and deficit levels, bringing new challenges to the economy.
- New contracts with oil exploration companies operating within Ecuador were negotiated, giving the Ecuadorian government greater revenue, using nationalisation of oil fields as leverage against foreign oil companies.
- They also restructured some of Ecuador’s foreign debt, defaulting on certain bonds it deemed “illegitimate” that provided unfair gains to private parties. This freed up fiscal space which was used for social spending, which increased from roughly 5% of GDP in 2006 to 10.3% in 2011.
- Moreover, the Central Bank was not independent of the executive throughout this time.
- Dollarisation may have broken the back of inflation, but active fiscal policy played an important role in ensuring sustainable growth. Several economists have decried a return to austerity economics in Ecuador, with the International Monetary Fund (IMF) insisting on the independence of the Central Bank as a pre-condition for receiving financial assistance.
Case of Greece:
- The dangers of adopting an external currency without the ability to chart independent policy can be seen in the case of Greece. The adoption of the euro fuelled growth in Greece, with capital inflows rising and tourism booming on the back of a stable currency.
- However, in the wake of the Eurozone crisis, Greece was bereft of both fiscal and monetary policy space, with monetary policy being determined by the European Central Bank (ECB) and fiscal policy restrained as a pre-condition for adopting the Euro.
- The Greek economy saw no alternative but to adopt crushing austerity in exchange for financial assistance from the IMF and the ECB.
Conclusion:
- Dollarisation, therefore, is not a silver bullet, but if used well in conjunction with nimble domestic policy, can offer a route to success.
- But with a president-elect that brandishes a chainsaw to indicate his desire to slash government spending, and who has asserted that he will abolish the Central Bank, policy in Argentina might find its sphere reduced under the Milei administration.
- The world awaits the results of yet another macroeconomic gamble played out on the backs of a suffering populace.
