Dollarization without the rose tinted glasses

Some see "dollarization" as a magic wand: a one stop solution to all our economic stability problems. If you dive into the nitty-gritty, it's not so simple.

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Back in September last year, Ecuadorean President Rafael Correa made a strange request to citizens living near the Colombian border: please stop crossing the border to buy stuff in Colombia. He appealed to his compatriots’ conscience and national pride, pleading with them to buy locally and support domestic production. A week later, to show his faith in the patriotism of Ecuadorians, he slapped a tax of up to 45% on goods brought through the border.

Ecuadorians were flocking to Colombia thanks to dollarization, a policy that keeps being proposed in Venezuela, especially in conferences held by organizations close to the opposition. A MUD deputy even promised to “dollarize wages”. Ecuador, which dollarized its economy in 2000, is one of the examples frequently cited a success stories. But the fairy tale is over, with the constraints imposed by dollarization now apparent to all.

Ecuadorians were going to Colombia to buy anything from school supplies to food and TV sets at prices much, much lower than back home. In the Ecuadorean border province of Carchi, 40% of stores have closed.

 

For Ecuador, dollarization has turned into a straightjacket.

Why? Was this some kind of conspiracy to destabilize the Ecuadorean government? Hardly.

In the twelve months before Correa’s plea, the Colombian Peso had lost around 40% of its value against the dollar. For dollar-holding Ecuadorians, that was as though every store in Colombia was running a 40% Off Sale. Of course, Ecuadorians poured over the border to shop.  

Among oil producers, Colombia was far from alone in letting the value of its currency slide after prices collapsed. Most oil-producing countries did the same.

Alas, Ecuador has no currency of its own to devalue.

As a result, the automatic adjustment Quico described in his post about the Canadian dollar after the oil bust is impossible for them. For Ecuador, dollarization has turned into a straightjacket.

But to understand what’s going on, we first need to understand what dollarization is.

 
A basic issue about dollarization should be apparent: to dollarize the first thing you need is dollars.

Some proponents see it as a simple matter of saying “Let’s use the dollar from now on”. Every so often, you find someone in the opinion pages saying the Venezuelan economy is de facto dollarized, because real estate prices are being set in dollars, and the prices of some imported goods move along with the black market exchange rate.

That’s not dollarization.

To formally dollarize the Venezuelan economy, the government would have to commit by law to exchange every bolívar in circulation for US dollars, at a fixed rate, without limits on quantity.

The process can be carried out either by physically exchanging every bolívar note for dollars and eliminating the bolívar completely, or by keeping the bolivar in circulation but under a legal duty to trade them at that fixed rate forever and ever. The first option – the one we’ll focus on – is what Ecuador did, as well as such economic powerhouses as Zimbabwe, El Salvador and the Federated States of Micronesia, as well as Panama. The second option, a sort of dollarization lite, is similar to the Argentinian “convertibilidad” policy that died a fiery death in 2002, or to Hong Kong’s less catastrophic currency board.

From that last paragraph a basic issue about dollarization should be apparent: to dollarize the first thing you need is dollars.

Most proponents in Venezuela fail to mention that all-important detail, probably because they don’t realize it. To dollarize an economy you need actual dollars. The Central Bank would then have to exchange the bolivars in circulation for those dollars.

To withdraw those bolivars from circulation, the BCV would use up its foreign reserves, which amount to around USD 13 billion. Most of these are in gold, which would have to be sold for cash first.

The bare minimum amount of bolivars that need to be exchanged is what’s known as the Monetary Base: all the bolivar notes and coins, plus the reserves of commercial banks deposited in the BCV. The last available official figure was published back in January, but we can safely assume it’s currently around Bs 1.8 trillion.

The bolivars we hold today could then be exchanged, using the foreign reserves, for dollars at a rate of no less than 138 VEF/USD (although, for reasons that it’s not worth explaining here, it might be best to exchange a broader measure of money, M2, resulting in an exchange rate of 340 VEF/USD).

That rate doesn’t sound too bad, considering the black market rate is eight times that. However, a dollarization at this rate would leave the minimum-wage earners at a paltry USD 83 monthly, or USD 180 including food stamps (ahem, cestatickets). You can’t survive on those wages in a dollar-denominated economy without some huge subsidies. If you want to dollarize at a stronger rate, the country would need to raise a few more billion dollars.

 
By adopting a foreign currency, a country gives up authority over monetary and exchange rate policy.

These kind of grubby details are rarely, if ever, frankly discussed when dollarization comes up in Venezuela: how many billion we would need, where we’ll get them, at what rate we should (or could) dollarize, and what adjustments and subsidies will be necessary to make it socially feasible. At a recent conference, a “specialist” on the subject said that Venezuela has enough dollars to dollarize 50 times. Well, sure, we could… if we exchange bolivars for dollars at a rate of 7000 VEF/USD.

Dollarization certainly has some benefits. Rule out external devaluations and inflation should start aligning close to that of the USA. The government could no longer finance deficits by printing money, since it can’t print dollars. The cost of borrowing abroad will drop for both the public and private sector; and the country would look more enticing to international investors.

But, do the benefits outstrip the costs? Among the many costs, there are two main issues we should focus on: the way it leaves policy makers out of options in many circumstances, and the punishing effect of dollarization during an economic downturn. These two factors often combine, with dreadful results, especially in fiscally irresponsible countries.

By adopting a foreign currency, a country gives up authority over monetary and exchange rate policy. Under dollarization, monetary policy will now come from the USA’s Federal Reserve, which makes policy decisions without worrying for a nanosecond about what happens in Ecuador, or Zimbabwe, or Micronesia. The problem, of course, is that what’s good at some point for the USA can be the opposite of what these other countries need. By dollarizing, we’d be joining a group of countries with no control over its exchange rate, for better or worse, and with no ability to tailor monetary policy to their own needs, both in times of calm and of crisis.

This isn’t just some academic concern. If a deep banking crisis hits, the Central Bank won’t be able to rescue banks or guarantee the deposits (similar to what happened in Iceland in 2008, when all major banks got in trouble in dollars, and the State had to let them fail).

 
Giving up your own currency doesn’t stop irresponsible politicians from spending irresponsibly, what it does is punish the people unfortunate enough to be governed by them much more severely.

Another claim made by proponents of dollarization is that it promotes fiscal responsibility. That’s just not true. Dollarization does remove one of the tools some irresponsible governments use when they want to spend more than they can afford: printing money. But a dollarized country can still spend like it’s going out of style, without printing money. It can still borrow a lot more than it can repay, or it can deplete its savings until there’s nothing left, with simply horrendous social consequences. If you don’t believe me, hop a plane to Athens and ask the first pensioner you meet on the street.

What Greece found out is that giving up your own currency doesn’t stop irresponsible politicians from spending irresponsibly, what it does is punish the people unfortunate enough to be governed by them much more severely.

During the Greek crisis you might have heard that many experts thought the country should abandon the euro. That was another way of saying: “Greece should regain its currency, so it can devalue it”. And it should have, but it couldn’t. Turning back a dollarization (or, in this case, euroization) is a logistical nightmare that can cause much more chaos and disruption than the problems it seeks to solve. Just imagine if the government’s plan to leave the Euro leaked in advance, it would trigger the mother of all banking crisis.

 
An external devaluation takes days; an internal one can take years.

Unable to undergo an external devaluation to regain competitiveness and deal with its deficit, Greece has since been undergoing a much more painful thing: internal devaluation. That is deflation of prices and wages. Since it can’t alter the exchange rate to make its wages, prices and exports more appealing to foreigners, then nominal wages and prices must go down. The average Greek pensioner received €1,350 a month before the crisis, now he gets €833.

Other countries that were not as irresponsible as Greece, such as Spain, have still had to suffer through internal devaluations, thanks to euroization.

An external devaluation takes days; an internal one can take years. Years of pain. Greece has lost around a quarter of its GDP. Spain and Portugal have gone through similar, if less extreme, processes. Or check back on Ecuador in a few years.

Oh and about Ecuador – that newest poster child for the “Dollarization does not guarantee fiscal responsibility” campaign – consider this: since Correa took over in 2007, government spending increased almost every year, going from 21% of GDP, to 39% in 2015, after reaching 44% in both 2013 and 2014 during the height of the oil boom. The Latin-American average for the same period is 28%. It has run a fiscal deficit every year for the last seven years – and again, most of those were oil boom years. And its performance inflation-wise wasn’t that impressive. Since 2003, it has an accumulated inflation of 93%. That of its non-dollarized neighbors, Colombia and Peru, stands at 87% and 57%, respectively.

Now that the oil party is over, Ecuadorians are asking the same questions as Venezuelans: Where’s the money? Why don’t we have any savings?

The Ecuadorean government has been forced to cut spending aggressively, to seek big loans from China with undisclosed terms, and it now says it wants to freeze or tax public sector pensions. It will soon impose a 5% tax on Ecuadorean travelers taking more than $1098 in cash or spending more that $5000 with their credit cards abroad. Correa shamelessly exploited the recent earthquake as an excuse to enact some of the measures he was considering: VAT will rise by two points, and workers will be forcibly deducted one or more days of wages to “fund the reconstruction”.

Look, the oil shock was going to hit Ecuador hard no matter what currency it was using. Even if Correa hadn’t thrown a party, dollarization would still be forcing the country to absorb the income shock through lower nominal wages and prices, instead of through the exchange rate like the Canadians did. Correa’s fiscal profligacy just made it worse.

The takeaway here is that dollarization is not a magic wand. Its supposed usefulness in promoting fiscal responsibility rests on the assumption that politicians will behave better under dollarization because the consequences of bad fiscal policies are so dire.

Everything hinges on that belief. Trouble is, there’s no evidence to back it.

The question for Venezuela then, is what type of bad years do we want? When there’s an economic downturn, whether caused by bad government or simply bad luck, having your own currency is no small thing. Should we prefer the bad years Colombia had – which have been painful, but manageable – or the economic catastrophe Greece endured and Ecuador is now facing?

There is no shortcut to fiscal responsibility. There’s no magic to it. The recipe is common knowledge: you need good economic policies, strong institutions to keep the government in check, and relatively sane, more-or-less competent policy-makers. That’s it. If a stable economy is the dish you want to cook, dollarization is an ingredient that adds nothing, except risk.

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