As Argentina is in the middle of a major financial turmoil and the currency board regime is on the verge of collapse, the country is considering whether it should formally dollarize, i.e. give up the peso altogether and formally adopt the dollar as its currency for all contracts and transactions.
In this paper I compare and discuss the foreign exchange currency regime options available to Argentina (section 1) and then discuss the formal criteria to assess a country’s readiness for dollarization (section 2). Alternative exchange rate regimes have different implications for the amount of domestic and foreign debt restructuring and/or debt reduction that the country will have to undertake in the near future to restore medium term debt sustainability. Thus, while discussing these alternative currency regimes, I will also consider the implications of these alternatives for the amount of debt reduction that will be required to restore the medium term sustainability of the debt of the country (section 1).
The main conclusions of the paper are as follows:
The currency board regime and “convertibility” are effectively dead as severe capital controls and restrictions on bank deposits (a partial freeze) have been imposed. The country will have to move soon to a new foreign currency regime.
The only feasible currency regimes are either a move to a float (flexible exchange rate) or dollarization.
Dollarization could occur at the current parity or after a final devaluation.
In the short run the balance sheet effects of a depreciation/devaluation under a move to a float or a “dollarization cum devaluation” would be significant. Thus, a greater debt writedown of government and private sector foreign currency liabilities would become necessary if the change in currency regime is associated with a nominal and real depreciation. Such debt writedown will be particularly messy and complex to achieve for the private sector agents’ dollar liabilities with the risk of severe real costs deriving from disorderly bankruptcies. Thus, some creative ex-ante solutions to reduce such real costs are discussed and explored in the paper.
On the other hand, a real depreciation is necessary to restore competitiveness as the overall evidence suggests that currency is overvalued and the fundamental real exchange rate is significantly depreciated relative to its current value. Thus, dollarizing at the current parity would be undesirable.
Balance sheet effects deriving from the real depreciation necessary to change relative prices (real depreciation) would occur, in amounts similar to the regimes of float or dollarization after final devaluation, even if Argentina dollarizes without first devaluing; such effects would occur via the price deflation necessary to change relative prices. Thus, dollarizing without devaluing will not prevent such balance sheet effects from occurring and causing financial distress for agents whose relative terms of trade have worsened for good. Thus, the argument that dollarizing at the current parity avoids balance sheet effects is flawed.
Extensive capital and exchange controls and a freeze of bank liabilities will be necessary for quite a protracted period of time regardless of which new currency regime is chosen. The loss of credibility in the financial system and the severe real and financial distress of a wide range of financial and non-financial institutions will require extensive controls to prevent a disorderly run on assets. But the restructuring of various claims will be messy and prolonged in any case and scenario.
The country does not satisfy most of the criteria for optimal long run dollarization. Thus, from a long run perspective, dollarization risks to have more costs than benefits even if, in the short run, dollarization may appear to be less risky than an outright move to a float. As dollarization at the current parity does not prevent the balance effects from occurring over time and it does not even solve the short run competitiveness problem while it has also undesirable long run consequences, it is the least desirable option.
The risks of a float are a possible return to high inflation and disorderly balance sheet effects if the nominal and real exchange rates overshoot. But dollarization would not be an optimal long-run strategy, even with a final devaluation before dollarization. Thus, to float is the better strategy that the country should choose. While monetary policy would be constrained in a float regime, in this regime the ability to change the real exchange rate via a nominal depreciation would not be undermined even with widespread liability dollarization. At the same time, the risks of a flexible exchange rate regime could be minimized and monetary stability and low inflation ensured via inflation targeting and the choice of a credible, independent and conservative central banker.
Regardless of the new currency regime and the amount of debt restructuring/reduction, radical economic reforms will have to be undertaken to ensure long run fiscal discipline, openness to trade and structural changes in the functioning of the state and greater structural flexibility of the economy.
Section 1. Should Argentina dollarize or move to a float? Pros and cons of alternative exchange rate regimes in Argentina and implications for debt restructuring/reduction of these currency regime options