Dollarisation art

As the Latin American region battles with inflation, the use of the greenback is set to increase. Does the dollar represent a concrete possibility or a legacy of the past? Barbara Pianese reports.

There is only one price which everyone knows in Latin America, from government officials to marchantes in the local markets: the current dollar exchange rate.

Dollarisation, the use of foreign currency in addition to or instead of the domestic fiat currency, has been a feature in the region due to exchange rate volatility and high inflation. The topic is increasingly present in the public debate today, whether proposed by Javier Milei, libertarian presidential candidate in next year’s Argentine general election, or Primero Justicia, the centre-right Venezuelan opposition party.

Rising inflation across the region is fuelling the debate. The International Monetary Fund forecasts inflation in the region to hit 12% this year, its highest in 25 years, and remain above 8% next year. When inflation soars and Latin American currencies depreciate against the dollar, dollar-denominated deposits become a safe-haven and the demand for them increases.

“Given the sorry state of Latin American currencies, I anticipate that de facto dollarisation will accelerate in the region,” says Steve H Hanke, professor of applied economics at Johns Hopkins University and a leading expert on dollarisation. “As for ‘dollarisation de jure’, about all one can say is that the probability of official dollarisation always increases in the face of a currency crisis — witness Ecuador in 2000, when the sucre became worthless.”

Adopting the dollar can be a quick way to achieve macroeconomic stability. In a fully dollarised economy, the central bank loses its ability to directly control its economy through independent monetary policy. Its inflation rates, and therefore interest rates, tend to shadow the US’s. On the plus side, by shadowing US monetary policies and conditions, dollarised countries benefit from relatively low interest and inflation rates.

Three countries in the region have officially adopted the dollar as a legal tender: Panama in 1904, Ecuador in 2000 and El Salvador in 2001. The monetary regime has worked well in all these countries, according to Mr Hanke.

when the economy is dollarised and faces a shock, or prices go up or down, you cannot do anything

Edmund Valpy Fitzgerald

“In general, dollarised economies have low levels of inflation, convergence with US inflation, reduction in country risk, improvement in credibility, reduction in interest rates and increases in the level of investment,” says León Padilla, professor of economics at the Universidad de las Américas, Ecuador. “However, dollarisation does not solve the structural problems of the economies and makes the countries that adopt it more susceptible to external shock.”

Edmund Valpy Fitzgerald, professor of international development finance at Oxford University, agrees. “When the economy is dollarised and faces a shock, or prices go up or down, you cannot do anything,” he explains. “Dollarisation tends to exaggerate economic cycles, which might especially be a challenge for Latin America, whose exports rely on cyclical commodities prices.”

The process towards dollarising the economy is not always easy, especially at the beginning. The central bank needs to have enough dollar reserves to pump into the economy in exchange for the local currency. “In Ecuador, the exchange rate was fixed at 25,000 sucres per dollar. This resulted in a reduction of people’s purchasing power,” says Daniel Godoy, financial and macroeconomic expert economist at Ecuadorian lender Produbanco. “On the positive side, it made it easier for families to plan, take loans and travel, as they could rely on a stable currency.”

The question is how much currency substitution can solve the issue that economies with high inflation face.

Currency stabilisation

The two main candidates for official dollarisation are Argentina and Venezuela, because of the issues both have in stabilising their currency.

Over the past year, Argentina’s consumer prices have soared by around 71% and are expected to hit 95% by year’s end. Likewise, this year Venezuela has exited the hyperinflation cycle in which it had been stuck been since 2017. It closed 2021 with an accumulated annual inflation of 686.4%. Despite the deceleration, inflation is still running at more than 100% this year.

Both the Argentine peso and Venezuelan bolivar are depreciating rapidly against the dollar, which is fuelling a lack of confidence in the local currency’s stability.

In Venezuela, the use of the dollar was forbidden until 2019, when restrictions were lifted in an attempt to stem inflation. This year, the government has been pushing Venezuelans to increase use of the bolivar by slapping a 3% tax on purchases made with dollars in shops and restaurants. However, the dollar is still used in almost 70% of commercial transactions, despite many people — especially in the public sector — still getting paid in bolivar.

On the other hand, the peso is still used for routine purchases in Argentina, but prices for many large-ticket items, such as houses and cars, are set in dollars. People got used to cashing in their payroll cheque in pesos to purchase dollars. Subsequently, they would sell the US dollar almost daily to do shopping in local currency.

“Dollarisation in Argentina always becomes a hot topic when inflation gets out of control, as happened since the second half of last year,” says Diego Chameides, chief economist at Banco Galicia.

The country has been toying with the idea of official dollarisation since the Mexican ‘Tequila crisis’ of 1995. “At that time, president Carlos Menem requested that I draft a dollarisation law, which I did,” Mr Hanke says. “Although [he] had the law in his desk drawer and threatened to use it, he did not because the Tequila crisis abated thanks to what was, at the time, Argentina’s convertibility plan.”

Despite being a long-term feature of the Argentinian economy, an increasing shift towards the dollar is visible these days. More sectors are using the US currency for setting prices. “If you wanted to rent a house or hire a photographer a couple of years ago, we would find that almost every price was set in pesos. Now, a lot of them are in dollars,” according to Mr Chameides.

“Spontaneous dollarisation is another factor that puts even more pressure on the nominal exchange rate and is a gateway to full dollarisation,” adds Mr Padilla.

Fiat versus dollar

But why is it so difficult for countries like Venezuela and Argentina to adopt the dollar as a legal tender?

“When a country dollarises, it gives up a type of funding for the government,” explains Daniel Tenengauzer, head of markets strategy at BNY Mellon. “It can only issue debt if it manages to persuade investors that it will be able to generate dollars to repay such debt. As a result, the fiscal restraint that comes with the dollar regime is very significant and is not easy to implement politically.”

Adopting dollarisation requires a certain degree of prudential discipline to make sure the country attracts sufficient capital flows in dollars, or else it risks a strong monetary contraction.

“A country also needs to have a very dynamic private sector that could be the main attractor of hard currency,” adds Jaime Reusche, sovereign analyst at rating agency Moody’s. “If you rely on the state to be the primary source of hard currency into the economy, you are going to incur a debt problem.”

Panama managed to adopt the dollar thanks to its constant flow of dollar revenues from the canal, which supports its credibility and the ability to bring dollars into the country. Also, the smaller and more integrated with the US the country is, the easier it is to substitute its currency with the dollar.

“I do not think that dollarisation would be a great solution for Argentina, as it will make it difficult to balance current account shocks given that Brazil is our main trade rather than the US,” explains Mr Chameides. “There are other ways of stabilising without losing your monetary independence. What Argentina needs is prudent fiscal policy.”

Venezuela has the largest untapped oil reserves in the world, which could theoretically support the kind of collateralisation process that happens in Panama.

“But the country does not have the infrastructure needed to take the oil out of the ground and any investor in the oil sector runs the risk of nationalisation,” says Mr Tenengauzer. “As a result, issuing in dollars becomes much more challenging and they end up sticking to the local currency, even though inflation is going through the roof.”

Mr Reusche adds: “Clearly, the government of Venezuela is in two minds. They seem to want to allow, or at least turn a blind eye to, transactions in dollars in the country. But at the same time, they are kind of hostile to it.”

International relations also play a role. “Argentina and Venezuela have very difficult diplomatic relations with the US. It might be difficult for [the latter] to justify a potential dollarisation before the electorate,” Mr Tenengauzer notes.

Obviously, with the renewal of discussions between Venezuela and the US, a full dollarisation might be easier to implement. A better relationship with the US might support the government’s credibility in issuing dollars, according to Mr Tenengauzer.

Soft dollarisation

Unofficial or de facto dollarisation occurs when a country issues a domestic currency, but foreign currencies, or assets denominated in foreign currencies, are also used as a means of payment and/or a store of value.

Dollarisation is a legacy of the inflation the region experienced from the 1970s onwards, after the collapse of the gold standard, which assured a relative monetary stability. The commodities price rises and oil shocks in those years gave life to economic distortions and inflation across the region.

There was no trust in the currency because there was no price stability or exchange rates. Countries in the region took different routes to deal with dollarisation and lack of trust in the currency.

By the end of 2020, Uruguay had the highest level of dollarisation, with 74% of deposits in dollars, followed by Paraguay, Costa Rica and Peru, with 44%, 42% and 39%, respectively, according to a Moody’s report.

When high levels of financial deposits in a country are dollarised, or when a lot of transactions are conducted in a foreign currency, the central bank loses monetary policy effectiveness. To address some of these issues, the policy framework shifted in some countries, such as Colombia and Brazil, where they simply prohibited dollarisation.

Different paths

Other countries embraced dollarisation, such as Uruguay, where less than 50% of the price setting is in local currency. As in Argentina, large-ticket purchases, such real estate and auto loans, are typically set in foreign currency in Uruguay, whereas smaller purchases and everyday transactions are in pesos.

“Uruguay has always struggled with high single-digit inflation,” adds Mr Reusche. “And because you have this peculiar situation, they do not really have all of the monetary policy tools in order to fight inflation.”

Uruguay would be a perfect candidate to either completely dollarise or de-dollarise. Thanks to its relatively strong political institutions, it also attracts foreign currency deposits from neighbouring countries, such as Argentina. “So, you would think that they would choose formal dollarisation, but it does not seem to be the case,” says Mr Reusche. “They want to have their cake and eat it, too. They are keen to gain competitiveness and having a local currency in which wages are set makes it easier.”

High inflation and the continuous depreciation of the peso will continue to lead Uruguayan savers to the safety of dollars, according to Moody’s.

In other countries, the progress on dealing with dollarisation was slow, but steady. And perhaps two of the best cases are Chile and Peru, which both had bouts of very high inflation in the late 1970s or 1980s. The countries avoided punitive measures to dissuade people from holding dollar deposits, but rather tried to win the credibility of their population to switch to the local currency.

“The ratio of foreign currency deposits to total deposits throughout the 1990s was very close to 90% in Peru. As the 2000s came along, and as the central bank started getting more credibility for being successful in controlling inflation, people gradually trusted more in the currency and the dollarisation ratio started to ease,” says Mr Reusche.

In Chile, we confronted inflation many decades ago by developing an index linked to inflation

Sergio Lehmann

With the commodity boom of the early 2000s, there were appreciating pressures on the exchange rate and that actually put the switch towards local currency deposits. “In the end, the central bank started taking more macroprudential measures to dissuade citizens from transacting in dollars,” he says.

“In Chile, we confronted inflation many decades ago by developing an index linked to inflation, which protected the purchasing power of savings,” explains Sergio Lehmann, chief economist at Chilean lender Banco de Crédito e Inversiones. “This has allowed us to develop a deep fixed-income market, similar to the US Treasury’s inflation-protected securities. At the same time, Chile has a credible and autonomous central bank, which has maintained the inflation rate around 3% on average in the past three decades. Following this, dollarisation has not been significant.”

The rate of inflation is once again an issue in the country. “We expect inflation to converge to 3% in 2024, which is the target of the central bank. So even if it has produced some volatility and capital outflows, we are not expecting an increase in dollarisation,” adds Mr Lehmann.

In general, it is unlikely that in the short term, another Latin American country will adopt the dollar as legal currency, mainly due to the rigidities that this option implies.

“Nevertheless, a very remote possibility is that South America or Latin America adopt a common currency,” Mr Padilla says. “The main problem is that there has been very little progress on economic and political integration because countries prioritise their own agendas instead of a regional one.”

Safety valve

While official dollarisation is a decision difficult to make and reverse, a bit of soft dollarisation allows for a sort of escape valve whenever an economy faces a crisis.

Typically, in an emerging market economy, whenever there is a shock, foreigners rush to take their money out of the country. “But when there is a layer of dollarisation, there is the possibility to switch from local currency to dollars as a defence,” explains Mr Reusche. “And if the shock persists, or it doesn’t become more diluted, then that is when foreigners take the next step of actually moving their capital outside of the country, which is a lot more traumatic for many of these countries. This is the hidden benefit of dollarisation.”

Currency substitution is often discussed in stark terms. “But there is a happy medium in which you have a soft dollarisation that allows for an escape valve anytime you have shock. [This is] something that not everyone is aware of when talking about the topic,” says Mr Reusche.

Clearly, dollarisation is much more widespread in Latin America and the Caribbean than people realise. “Dollarisation is often talked about within the framework of an economic crisis or high-level policy decisions. However, it is a built-in characteristic of the nature of the Latin American economy,” says Mr Fitzgerald.


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