DOLLARISATION OF A COUNTRY’S ECONOMY A Path to Monetary Stability or Surrender of Sovereignty

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Concept Dollarisation:

Dollarisation is the phenomenon where the US Dollar replaces a nation's own currency. It is ?a complex economic exercise. Imagine a country where shopkeepers price goods in Dollars, wages are negotiated in Dollars and even savings are tucked away in greenbacks. This is dollarisation, where a foreign currency takes over often replacing or supplementing the local currency. Driven by factors like high inflation, volatile exchange rates or a desire for economic stability, dollarisation can bring both boons and burdens impacting everything from everyday transactions to a nation's economic sovereignty. Whether viewed as a necessary evil or a surrender of control, dollarisation remains a fascinating economic conundrum with far-reaching consequences.

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Importance of A Country’s Sovereign Currency:

A country's sovereign currency holds immense significance like no other, both real and perceived, playing a crucial role in its economy, international standing, and above all in its national identity. A country’s national flag and its currency are perhaps the most important symbols of identity for a citizen of any country. Keeping this in mind, let us look at the significance that its currency commands – both real and perceived.

1. Medium of Exchange:?Most importantly,?a currency facilitates transactions within an economy.?Goods and services are priced and exchanged using this currency,?enabling a functioning commercial landscape.

2. Unit of Account:?It provides a common yardstick for measuring value and tracking economic activities.?Prices,?contracts,?and financial instruments are all denominated in this currency?offering clarity and comparability.

3. Store of Value:?Ideally,?a stable currency retains its purchasing power over time?allowing individuals and businesses to save and invest with confidence.?It protects against inflation while?encouraging long-term economic planning.

4. Monetary Policy Tool:?By controlling the money supply and setting interest rates,?governments can influence economic growth,?inflation,?and employment.?This policy tool,?however,?loses its effectiveness with dollarisation.

5. National Symbol:?A nation's currency embodies its sovereignty and economic independence.?It represents a tangible expression of its economic strength and historical development.

6. International Prestige:?A strong and stable currency often signifies a country's economic health and global clout.?Investors may be more confident in such economies?leading to increased foreign investments and trade.

7. National Pride:?Currency can serve as a symbol of national unity and identity.?Its design and imagery can reflect a country's history,?culture,?and values?evoking a sense of shared belonging among the citizens.

8. Intrinsic Trust:?Stable currencies generate trust in financial institutions and economic systems.?When people confidently use their currency for daily transactions,?it fosters stability imbued with a sense of security.

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In short, a country's sovereign currency holds complex and significant real and perceived value as mentioned above. It underpins the country’s economic activities, influences national pride, and shapes international perceptions about the country itself. Balancing the real and perceived significances involves maintaining stability, fostering trust and navigating the interconnectedness of global financial systems.? Under these circumstances it is an extremely difficult decision for any government to let go of (or deliberately undermine) its own national currency – a heart wrenching decision in itself. ?Depreciation or hyperinflation can erode trust in the currency and hamper economic activity.?People become hesitant to spend or invest?leading to a downward economic spiral. ?Emerging economies with weak currencies can be vulnerable to fluctuations in global markets and also policies of dominant economies like the US.? The adoption of the Euro by several European countries was aimed to strengthen economic integration and enhance its international standing.?While it brought benefits like reduced transaction costs,?concerns arose eventually about individual countries losing control over their monetary policies. Hyperinflation in Venezuela rendered its currency ?the Bolivar?nearly worthless?causing severe economic hardship and social unrest.?This starkly illustrates the importance of maintaining currency stability.

Consequences of Dollarisation:

Dollarisation is the process of a country adopting a foreign currency, usually the U.S. Dollar (hence the word dollarisation) as its official legal tender, either alongside or in place of its own currency. The usage of the word ‘dollarisation’ stems from the fact that Dollar is arguably the most stable and thereby the most sought-after currency in the whole world. This follows a formal sovereign decision by a government to make the US dollar the primary or sole legal currency across country.? The process involves retiring the existing domestic currency, converting all domestic prices and contracts to Dollars and deciding to hold the country’s foreign reserves in US Dollars.? It can also happen when people and businesses within a country start using the US Dollar extensively in transactions, even though it is not officially recognised as legal tender – a de facto dollarisation.? It is import here to state upfront that dollarisation is far from a pure academic discussion. ?Let us now see why this subject today is such a hotly debated issue. For this let us take a short trip to Argentina. Javier Milei is the recently elected the President of the south American country of Argentia, known so far only for football and its patron saints Diego Maradona and Lionel Messi. Milei has romped home in the recently concluded elections in Argentina, a country that was under a military dictatorship and more importantly a country with an inflation upwards of 150%! Milei, the self-confessed “anarcho-capitalist” has sworn to replace Argentina’s currency, the Pesos with US Dollars.? In the process, he has promised to shut down the country’s Central Bank and slash drastically its government spending. The country’s electorate has thrown their weight behind Milei ?more out of desperation than their love for unconventional economics. The economists around the globe are keenly watching these developments in the American continent to see how his unconventional economic adventure plays out in real time.? The economists across the world are watching eagerly to see whether dollarisation can be a solution to an economy under the burden of such a runaway inflation as in Argentina. Dollarisation, by the way, can be a solution to runaway inflation primarily for two reasons, viz., the reality of cash losing its pre-eminence in the system and the economy becoming more transparent.? Before we proceed further, let us see the widely propounded advantages and challenges to Dollarisation to understand this process.? Argentina has a history of economic challenges, including high inflation and continual currency depreciation. In the past, there have been instances of de facto dollarisation where people used the US Dollar for transactions to protect themselves from the local currency's instability. The country had faced economic crises before, such as the one in 2001 leading to a default on its sovereign debt. During these turbulent times the US Dollar was widely used as a store of value. However, officially adopting Dollars as the country’s currency can have complex and unexpected consequences impacting the country's ability to control its monetary policy and respond to emerging economic challenges. Now let us look at the advantages and challenges associated with such a revolutionary monetary reform like dollarisation.

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A. Advantages of Dollarisation:

1. Economic Stability:?Dollarisation can help stabilise economies facing hyperinflation or currency volatility.?It can also lower interest rates and attract foreign investments.

2. Trade and Investment:?Using a widely accepted currency like the US Dollar can facilitate international trade and smoother financial transactions.

3. Protection against Currency Crises:?Dollarisation can help shield economies from sudden depreciations of their domestic currencies.

4. Reduced Transaction Costs:?Using a single currency can eliminate the costs associated with exchanging currencies.

5. Cost of Protection of Currency: The costs of having to protect and safeguard the value through constant and continuous interventions in the currency market gets considerably reduced.

6. No Need to play the Role of a Lender of Last Resort: There is no necessity for the country’s central bank maintain a system to print and monitor a local currency and be a lender of last resort.

B. Challenges Associated with Dollarisation:

1. ?Loss of Monetary Policy Control:?A dollarised country loses the ability to set its own interest rates or control its money supply.? The authorities of such country become mute spectators even when they are convinced that they can do something different to redress economic crises facing them.? Dollarised economies completely lose control over their domestic interest rates thereby limiting their own influence in stabilising the countries’ money markets. The US Federal Reserve determines interest rates based on that country’s domestic circumstances and compulsions limiting thereby the ability of the dallarised economy to address its own local conditions.? Without an independent monetary policy, countries cannot use tools like interest rate adjustments to respond to economic shocks. Dollarisation may limit a government's ability to use monetary policy to finance budget deficits. This can constrain fiscal policy options during economic downturns. During economic crises, dollarised economies have fewer tools to address their own economic challenges. The absence of an independent monetary policy for the country can also limit their ability to implement counter-cyclical measures as they deem necessary.

2. ?Unjustified Vulnerabilities to US Economic Policies:?A dollarised country becomes more vulnerable to the economic shocks or policy changes in the US. The dollarised economy has no wherewithal to rectify or fiddle with any economic process based on local conditions that may be unique to those countries. Dollarised economies become more vulnerable to economic conditions in the United States that may be ?unrelated to the dollarised countries. Changes in the US interest rates, and economic policies can have unpredictable impact in the dollarised economy.

3. ?Potential Costs of Transition:?The initial transition to dollarisation can involve costs associated with currency conversion and endless adjustments of their own financial systems.? In the event ?of failure of dollarisation, the dollarised country would find it very difficult and extremely costly ?to revert to the previous regime.

4. ?Possible Loss of Revenues: The country loses the ability to earn seigniorage which is the profit made from issuing its own currency. This can result in a reduction in government revenues. Similarly, dollarised countries cannot adjust exchange rates to enhance export competitiveness, a task that is extremely important for the nation’s economic future. This lack of flexibility can potentially affect the international competitiveness of their goods and services. Similarly, dollarisation can lead to a mismatch between dollar-denominated liabilities and local currency assets, exposing financial institutions to risks during currency fluctuations.

5. ?Adverse Distributional Effects: Dollarisation may have distorted or unjustified distributional effects potentially benefiting certain segments of the population at the cost of adversely affecting others where the income distribution is unequal.? In a progressive state this would be unacceptable.

6. ?Unemployment and Economic Adjustment: Dollarisation may hinder the ability to implement policies to address unemployment and economic adjustment during downturns. Dollarisation may also hinder the ability to implement policies to address unemployment and economic adjustment during such downturns.? The government of the dollarised nation cannot but be a silent bystander.?

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Overall, dollarisation is a complex issue with both potential benefits and serious drawbacks. Countries considering dollarisation must carefully weigh the economic and political implications before deciding to opt for such drastic currency policy. “Dollarisation has evolved as one of the noteworthy features of globalisation during the last two decades.”?said Mr. Yilmaz, the then Governor of the Central Bank of the Republic of Turkey at a conference on dollarisation in December 2006.? He should know.? This remains more relevant now than ever before for his country. Turkey has seen unpredictable turmoil on the economic front during the last few years under its current President, Tayyab Erdogan.? On account of the increasing integration of the international financial system, the lifting of restrictions on capital mobility and the growing volume of trade, the debate on dollarisation found growing interest in the 1990s.

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Having seen what dollarisation entails, let us look back into history to see if any lessons are there to be learnt from those nations who had attempted similar measures in the past.? There are indeed some countries who had attempted dollarisation and there are indeed some lessons too to be learnt therefrom.? The important ones are:

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a. Ecuador:?In 2000 Ecuador officially adopted the US?Dollar after a severe economic crisis that led to hyperinflation and currency instability. According to economists this move helped stabilise the country’s economy, attract foreign investment and reduce financial transaction costs.

b. El Salvador:?In 2021 El Salvador became the first country to make Bitcoin a legal tender alongside the US?dollar which was being used widely in the country.?The goal was to promote financial inclusion and reduce reliance on traditional banking systems.? Economic experts seem to suggest that this could be achieved.

c. Zimbabwe:?While not officially dollarised, Zimbabwe has experienced significant unofficial dollarisation due to hyperinflation and lack of confidence in its domestic currency since 2009. US Dollars are widely used in the country for everyday transactions and also savings.

d. Panama:?Panama has a dual currency system using both the US?Dollar and its own Panamanian balboa since 1903.?The US Dollar is widely used in the country especially in the banking and tourism sectors.

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Going by Milei’s track record, ever since he has become the President of Argentina on the 10th of December 2023, watch closely the developments in that country.? Milei by all account is a quintessential maverick. Note that Milei has not even completed one month of his Presidency as of writing this piece. He is all of 53. He has taught university courses in?Macroeconomics, Economic Growth,?Microeconomics, and Mathematics for economists. He has written numerous books and has hosted radio programmes. Milei's views distinguish him in the?Argentinian political landscape?and have garnered significant public attention and polarising reactions all across the globe.? Milei is known for his flamboyant personality, distinctive personal style, and strong media presence. He has been described politically as a?right-wing libertarian?and?right-wing populist and he supports?laissez-faire?economics aligning specifically with?minarchist?and?anarcho-capitalist?principles. Milei has proposed a comprehensive overhaul of the country's fiscal and structural policies. He supports?freedom of choice?on drug policy, guns, prostitution, same-sex marriage, sexual preference, and gender identity, while opposing abortion and euthanasia. In foreign policy he advocates closer relations with the United States, supporting Ukraine in response to Russia's invasion and distancing Argentina from geopolitical ties with China.? One thing is for sure when it comes to Milei and his country, Argentina. Things will never be the same for both. As of writing this Milei has already scrapped 366 economic rules of his country.? Some of the measures taken by him ever since assuming office are as instructive as they are radical.? He has promised to reform the labour laws that are in existence since 1975.? He has scrapped the limit on exports from the country. He has moved to limit the rights to strike. He has abolished subsidies to the public transportation company that would increase the ticket prices by as much as ten times!? These are a few for starters.? To his critics he has this to say: "There may be people suffering from Stockholm Syndrome. They are infatuated with a model that impoverishes them”. This self-confessed anarcho-capitalist is destined to be thrown in the dustbin of history for what he has done so far, or he is ordained to walk the aisle proudly displaying the Nobel Prize in Economics in the not-too-distant future.

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Thank you.

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Venkat R Venkitachalam